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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Accounting for corporate finance: UK GAAP before 1 January 2005: lenders: mark to market: variable rate loans

Accounting for variable rate loans

A variable rate loan pays interest at an amount linked to the base rate, e.g. a 5 year loan paying interest at LIBOR plus 2%. The amount above LIBOR is negotiated between the lender and the borrower but is dependent primarily on the credit risk of the borrower and the nature of the security granted to the lender. Typically the lender will acquire (give money to the borrower) such a loan at face value. The return to the lender is the interest receivable on the loan.

Example

Wellbeach Bank plc lends £100m at LIBOR plus 2% for 5 years. In year 1 LIBOR is constant at 7%. At the start of year 2 LIBOR increases to 8% and remains at this level for the remainder of the 5 years.

At inception the bank advances £100m to the borrower. This is also called ‘purchasing’ the loan.

Debit debtor £100m

Credit cash £100m

How does Wellbeach Bank plc then account for this £100m variable rate loan?

Assuming that Wellbeach Bank plc has negotiated the correct terms for the loan the market value of the loan at inception will be £100m. This is because the market will discount the future cash flows at the same rate as the interest charged by the bank.

The increase in LIBOR at the end of year 1 will be reflected in the discount rate applied by the market when valuing the loan and will not directly change the market value of the loan. This is an important feature of variable rate loans as the fact that the rate of interest changes means that the value of the principal is constant.

Market valuation at start of loan (simplified discounting):

  Cash flow
£m Discount factor @ 7% Present value
£m        
         
  Interest at end of year 1 7 0.9346 6.54
  Interest at end of year 2 7 0.8734 6.11
  Interest at end of year 3 7 0.8163 5.71
  Interest at end of year 4 7 0.7629 5.34
  Interest at end of year 5 7 0.7130 4.99
  Repayment of loan 100 0.7130 71.30
        100

In fact the calculation is a bit more complicated because the market assumption about LIBOR will not be that it remains a constant 5% over the 5 years. If, for example, it is expected to rise in year 2 the cash flow in year 2 will be greater and the market value will remain at £100m.

Market valuation at start of year 2 (simplified discounting)

  Cash flow
£m Discount factor @ 8% Present value
£m        
         
  Interest at end of year 2 8 0.9259 7.41
  Interest at end of year 3 8 0.8573 6.86
  Interest at end of year 4 8 0.7938 6.35
  Interest at end of year 5 8 0.7350 5.88
  Repayment of loan 100 0.7350 73.50
        100

Despite the change in LIBOR the market valuation of the loan has remained unchanged at £100m.

The only change from a clean mark to market valuation of £100m will arise if the credit worthiness of the borrower changes. The rate of LIBOR plus 2% might have been agreed because the borrower had a credit rating of A+ but if this fell to A then the market would apply a larger discount rate and the market value of the loan would fall below £100m. This reflects the increased risk of default on the loan, i.e. a measure of bad debt built into the loan. Similarly if the credit rating improved to AA the market value of the loan would rise above £100m.

Changes in credit rating might happen if LIBOR changes significantly but is more likely to be caused by other factors unrelated to the loan itself.

On a dirty basis the market value of the loan will rise from £100m at inception to £107m immediately prior to the first payment of interest, falling to £100m immediately after receipt. It will then rise from £100m to £108m over the following year. These changes mirror what happens with a clean basis once one considers and takes account of the accrued interest receivable in the balance sheet.