ESG-linked Loans – Debtor Accounting according to German GAAP and IFRS

published on 5 march 2025 I reading time approx. 5 minutes

The political objective of the EU to ensure the sustainability of companies’ economic activities, which has been made concrete through the “Green Deal”, also impacts corporate financing. At present, the use of so-called ESG-linked loans, which are based on fulfilling certain sustainability targets in the areas of “environmental, social & governance” (or short: ESG), is already often a subject of discussion. Beside the financial effects, companies must also face the quite complex accounting of these loans according to German GAAP as well as IFRS.

Terminological Classification: ESG-linked Loans vs. Green Bonds

ESG-linked loans must be distinguished from the so-called “green bonds”. The latter are used collectively for the financing of “green” projects, but they do not contain any specific conditions per se beside the appropriation. Thus, in general, there are no specific considerations in terms of the accounting of those bonds compared with conventional loans. ESG-linked loans, on the contrary, contain specific clauses that oblige companies to comply with certain ESG ratios or pay higher interest if specific thresholds are not met.

Measurement of the liability according to German GAAP and IFRS

The accounting of liabilities according to German GAAP and IFRS differs in certain details. Whereas liabilities are measured at their settlement amount – which means the undiscounted face value – according to German GAAP, IFRS regularly requires the application of the so-called effective interest method. If the interest on a loan depends on the company meeting certain ESG ratios, this does not impact the book value according to German GAAP, but would only be reflected as part of the interest expenses in the income statement. Only a variable repayment amount would need to be considered in the subsequent measurement of the liability, taking into account the highest value principle. This is different according to IFRS, because the effective interest method that needs to be applied considers all payments from a loan (interest and repayment) in the first step to discount them with the effective interest rate. In the case of a constant interest rate over the contract term without any special cases, this results in the same book values as under German GAAP.

If, however, the interest is variable, the expected cash flows can change over time, which might require an adjustment of the liability’s book value. Here, cases where the change reflects a change in market interest rates must be distinguished from cases where it does not. If this reflection of a market interest rate change applies, a new effective interest rate must be determined, such that the book value generally does not change as a result. If, however, the change in the expected cash flows does not reflect a change in market interest rates, the changed cash flows must be discounted with the original effective interest rate, and the resulting difference must be recognized through profit or loss.

The question of whether or not a change in variable interest that depends on an ESG ratio reflects a change in market interest rates must be evaluated based on whether or not the ESG ratio reflects the credit risk. This assessment must be made on a case-by-case basis and depends on the financed asset (that serves as collateral), the debtor and its business model, as well as the specificity of the ESG ratio itself. Further consideration must be given to the timeline. It is possible that the ESG ratio only has a long-term impact on the credit risk, whereas the lending period might only be short-term. Moreover, it must be considered that a change in variable interest does not reflect a change in market rates if the change only addresses the credit risk (or a part thereof), but there is no adequate adjustment for changes in the total interest.

ESG Clauses as a Potential Embedded Derivative

Before the accounting of a (single) liability with variable interest payments can be made according to the guidance mentioned above, it must be evaluated if an embedded derivative exists according to German GAAP as well as IFRS. The initial suspicion in case of ESG-linked loans is given, because a later payment depends on the performance of an ESG ratio. According to German GAAP, an embedded derivative is generally not to be separated unless it leads to significantly higher or additional (different) opportunities and risks. Since German GAAP does not provide any further specific guidance, referring to the IFRS regulations presented below might potentially constitute a practical solution.

There are detailed rules on how to identify embedded derivatives that need to be separated under IFRS. First, it must be analyzed if the resulting variability of the cash flows is attributable to a financial or a non-financial variable. The ESG ratio is a financial variable if it has a direct impact on the credit risk according to the regulations described above. If this is the case, then, however, there is also a close relation between the embedded derivative’s economic characteristics and risks and those of the host contract, and, as a consequence, the embedded derivative is not to be separated according to the rules of IFRS.

If the ESG ratio has no direct impact on the credit risk, it constitutes a non-financial variable. Here, IFRS only regulate the case of a non-financial variable that is not specific to one contractual party. In this case, the embedded derivative is not to be separated if the criteria of IFRS 9.4.3.3 are met. ESG ratios contained in loan contracts, however, are likely to be specific to the debtor in most cases. Here, there is a regulatory gap under IFRS, such that an accounting policy must be derived by each reporting entity individually. Subject to any con-tradicting circumstances in each individual case, as a result, many companies should be able to refrain from separating embedded derivatives from ESG-linked loans.

Conclusion

The accounting of ESG-linked loans can turn out to be very complex, depending on each individual case. Although it will often probably be appropriate to refrain from separating an embedded derivative, especially under IFRS, the question of how to subsequently measure ESG-linked loans requires a profound analysis of the specific circumstances. Due to the increasing relevance of ESG, it is expected that there will be more questions regarding traditional financial reporting in the future. For a broad overview of possible further questions see here.