Accounting for green bonds – organically grown!

Here’s the background to another issue recently discussed by CPA Canada’s IFRS Discussion Group:

  • Green bonds are debt instruments where the interest rate is linked to certain environmental, social and governance (ESG) metrics. Green bonds include contractual terms that cause cash flows to vary depending on whether certain ESG metrics are met (ESG features).
  • Some examples of ESG features include:
    • A global crude oil trading company issues a loan where its base interest rate is the Canadian dollar offered rate (CDOR) plus 1 per cent, but the margin is adjusted every year based on the status of its total sustainability score. The total score is calculated based on a predetermined formula using sustainability key performance indicators (KPIs), including air emissions, oil spills and employee safety measures…
    • A telecommunications company issues a loan for general corporate purposes. The interest rate on the loan is 4 per cent but will increase by up to 0.05 per cent if certain social and governance metrics are not maintained. These metrics are based on: (a) the percentage of women on the board of directors and in the company’s total workforce; (b) the number of training hours for employees; and (c) the number and severity of data breaches.

The group discussed a few issues relating to whether ESG features affect the issuer’s accounting for such green bonds measured at amortized cost, including whether those features should be separated and accounted for as derivatives. Recall that the definition of a derivative includes (among other things) that “its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.” The group noted that this will be an issuer-specific matter of judgment, based on considering the nature of each ESG feature: “ESG features are specific to the issuer if they relate to the issuer’s operations and are intended to drive the issuer to meet predetermined sustainability performance objectives. In addition, ESG features related to “physical” variables or measures and do not have financial elements to them would be considered to have non-financial variable underlying (e.g., the amount of greenhouse gas the issuer emits). ESG features that do not meet the definition of a derivative would not be separately accounted for as a derivative.”

IFRS 9 states: “For floating-rate financial assets and floating-rate financial liabilities, periodic re-estimation of cash flows to reflect the movements in the market rates of interest alters the effective interest rate.” The group considered whether, if no embedded derivative is separated for ESG features, this aspect of IFRS 9 applies to changes in cash flows resulting from those features. One view would be that it doesn’t apply because the changes in the interest payments due to ESG features don’t reflect changes in market rates of interest – in this case changes in estimated interest payments would result in the issuer recording adjustments to the amortized cost of the loan, recognizing the corresponding income or expense in profit or loss. Alternatively, given that IFRS 9 doesn’t define “floating rate” or expand in detail on the concept of market rates of interest, the guidance might still be viewed as applicable. The group thought either view might be appropriate depending on the specific circumstances, with the latter view more likely to apply when the interest rate movement from the ESG feature is expected to reflect changes in the issuer’s credit risk (a determination that might itself require some judgment).

The group then considered a scenario where an industrial company issues convertible bonds which can be converted by bondholders at any time into common shares with a fixed conversion ratio; the contractual terms of the bond include a provision whereby if the company doesn’t meet certain ESG criteria by a stated date, the company must pay bondholders an amount equal to 10 per cent of the bond’s nominal value. The group considered whether the conversion feature meets the equity classification criteria in this situation, and mostly thought that it does, noting that the penalty amount is always paid in cash and doesn’t affect the conversion ratio, and that in this particular scenario the ESG feature was (in line with the above) assessed as a component of credit risk.

Overall this entire discussion was for the purpose of raising awareness, with no action recommended to the IASB. It’s another example of how, even if the standards are broad and flexible enough to encompass ESG disclosure and accounting issues, there’s often some work required in determining this to be the case. Maybe some of these matters will be addressed more fully at some point…

The opinions expressed are solely those of the author.

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