Concessional loans and first-loss tranches: the day-one difference

DFIs deliberately lend below the rate a commercial lender would charge for the same risk, or invest in the junior, first-loss tranche of a blended-finance fund at a return far below its risk, to crowd in private capital. IFRS 9 requires every financial asset to be recognised initially at fair value, so a concessional loan of USD 10 million that a market participant would value at USD 8.5 million cannot be booked at USD 10 million. The difference is a real cost of the development mandate and must be recognised somewhere: usually as an expense at day one, unless someone else (a donor, the government, or a co-investor) is paying for it, in which case the counterpart may be a grant, a capital contribution or a receivable. Booking at face value and earning a low yield hides the cost of the concession in reduced future margins and overstates assets.

Is the interest rate, fee or expected return below what a market participant would require for this borrower's credit, country and currency risk and the instrument's tenor and subordination? Is the concession the DFI's own policy choice under its mandate, or is it funded by a donor, the government or a blended-finance facility that compensates the DFI? If the government shareholder funds it, is it acting in its capacity as owner (capital contribution) or as a government providing assistance (grant)? Is the fair value at initial recognition evidenced by a quoted price or a technique using only observable inputs, or does it depend on unobservable inputs? For first-loss tranches, does the junior instrument pass SPPI under the contractually linked instrument rules, or is it at FVTPL? Is the DFI itself a borrower of concessional funds from its shareholder?

1. Determine the fair value of the loan or tranche at initial recognition using market-participant inputs: a discount rate reflecting the borrower's credit spread, country risk, currency and tenor, or for a junior tranche the return a market investor would require for first-loss risk.
2. Compare fair value with the amount advanced.
3. Identify what the difference represents. If part of the consideration given is for something other than the financial instrument (a deliberate concession under the development mandate), the asset is still recognised at fair value and the excess advanced is an expense unless it qualifies as another asset.
4. If the concession is funded by a third party, recognise the funding separately: a grant from a government in its capacity as government (recognised in profit or loss as the related concession cost is recognised), a capital contribution in equity if the shareholder acts as owner, or a receivable or liability under the facility agreement.
5. Apply the day-one rule for other differences: recognise them in profit or loss only if fair value is evidenced by a Level 1 price or a technique using only observable inputs; otherwise defer and recognise them as market-participant factors change.
6. Subsequently measure an amortised cost loan using the effective interest rate based on its fair value at initial recognition, so the discount unwinds into interest revenue over the life; measure an FVTPL tranche at fair value.

Fair value at initial recognition is the present value of contractual cash flows at the market rate for an instrument with similar terms and credit risk, or, for a first-loss tranche, an income or option-based valuation using a market investor's required return. The day-one concession cost equals the amount advanced less that fair value. Interest revenue on an amortised cost concessional loan is then recognised at the market-based effective interest rate, which exceeds the contractual coupon, so the concession cost recognised upfront is recovered gradually through higher interest revenue. If a donor or government grant compensates the concession, it is measured at the amount receivable and recognised against the concession expense in the same period.

Disclose: (1) the accounting policy for concessional loans and first-loss investments, including how fair value at initial recognition is determined; (2) the amount of concession cost recognised in the period and how it is presented; (3) for differences deferred under the day-one rule, the policy for recognising them, the aggregate difference yet to be recognised and a reconciliation of its movement; (4) the nature and amount of donor, government or blended-finance support that compensates concessions, and any unfulfilled conditions; (5) the valuation techniques and significant unobservable inputs for FVTPL first-loss tranches; (6) related party disclosures where the subsidy comes from the government shareholder.

• Recognising concessional loans at the amount advanced and the low contractual rate as interest revenue
• arguing that the transaction price is fair value simply because the DFI always lends on those terms, without evidence of a market of independent participants at those prices
• deferring a deliberate concession under the day-one rule instead of expensing it
• recognising a donor's first-loss contribution as income when the DFI only administers it
• recognising a government shareholder's compensation as income when it is in substance a capital contribution
• measuring a first-loss fund tranche at amortised cost without testing the contractually linked instrument criteria
• forgetting the borrower-side mirror where the DFI itself receives below-market funding from the government