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The valuation of loans and debt instruments is a central element of financial reporting, risk management, and transaction and valuation practice. Although observable market prices are available for liquid financial instruments, valuing illiquid financings, particularly in private debt markets and for intra-group loans, demands more robust methodologies, well-justified assumptions, and comprehensive documentation. In such cases, valuation is regularly model-based and requires a consistent representation of cashflows, credit risks and market yields.
The valuation of loans is largely determined by the applicable accounting standard. While the German Commercial Code (HGB) is shaped by the prudence principle and generally aligns the valuation of loans with historical acquisition costs, IFRS, with the fair value concept and forward-looking impairment models, place greater emphasis on current market conditions and the perspective of typical market participants. This results in significant valuation differences, particularly in the case of illiquid loans or loans bearing non-market interest rates.
A fundamental introduction to valuation principles and the private debt market can be found in the first part of this article series on loan valuation, “Introduction to Loan Valuation and the Private Debt Market”.
The fair value valuation of loans is governed by IFRS 13, which sets out a uniform framework for the measurement of assets and liabilities. The objective is to determine the price at which a loan would be transferred between independent market participants at the measurement date, from the market participant perspective. For this purpose, IFRS 13 distinguishes three fundamental valuation approaches: the market approach, the income approach and the cost approach.
For credit instruments, particularly illiquid and individually structured financings, valuation practice predominantly applies market and income approaches, for example discounted cashflow models (DCF). IFRS 13 also refers to the cost approach, but does not make an explicit statement about its relevance for the valuation of loans. Market participants therefore primarily rely on the market approach or, particularly for illiquid instruments, on the income approach.
The market approach is based on observable prices from comparable transactions and is particularly applicable to liquid instruments such as listed corporate bonds. Prices of identical or similar instruments are used and appropriately adjusted for differences in maturity, credit quality, seniority, security, covenants or other contractual features.
IFRS 13 also assigns fair value measurements to a three-level hierarchy. Level 1 comprises quoted prices in active markets, Level 2 comprises indirectly observable inputs such as yield curves or credit spreads, while Level 3 is based on unobservable, model-driven assumptions. Illiquid loans without observable market prices, for example direct lending in the private debt space or intra-group loans, are in practice regularly classified as Level 3 measurements under IFRS 13 because of significant unobservable drivers. At the same time, IFRS 13 requires observable inputs to be used as far as possible and unobservable assumptions to be limited to the minimum necessary.
For illiquid loans, the DCF approach represents the central income approach within the meaning of IFRS 13. Fair value is determined as the present value of the expected future cashflows. These cashflows comprise not only contractually agreed interest and principal payments, but also fees, floating-rate components or performance-related remuneration, provided these are part of the loan structure.
The discount rate reflects the return requirement of a typical market participant and is typically made up of several components. In addition to a risk-free base rate, which is often derived from the relevant yield curve, it includes a credit-risk-specific spread that reflects the borrower’s credit quality. In addition, premia for illiquidity, structural complexity or specific contractual features may be required.
A core principle of fair value measurement is consistency between cashflows and the discount rate. Credit risks can either be incorporated explicitly in the cashflows through probabilities of default and recovery assumptions, or implicitly through a higher discount rate. Double counting the same risk must be avoided. Assumptions regarding collateral, covenants and the ranking of the loan must also be reflected coherently in the modelling.
In valuation practice, scenario models are often used for complex loan structures or portfolios. Different economic developments, for example a base case, a stress case and an upside case, are explicitly modelled and weighted probabilistically. This approach reflects the uncertainty of future cashflows and corresponds to market practice, particularly in private debt.
The effective interest rate (EIR) under IFRS 9 represents the internal rate of return of a loan at the time of initial recognition. It discounts the expected contractual cashflows over the instrument’s term to the gross carrying amount and forms the basis for measurement at amortised cost. Economically, the effective interest rate therefore corresponds to the internal rate of return (IRR) of the loan at origination.
In subsequent measurement, the effective interest rate generally remains unchanged. Changes in credit quality therefore do not lead to an adjustment of the rate, but are reflected through the expected credit loss (ECL) model under IFRS 9. This mechanism reflects the transaction-based logic of amortised cost measurement and serves the appropriate period allocation of interest income. By contrast, fair value measurement under IFRS 13 is based on current market yields. These reflect the return that market participants would require at the measurement date for a comparable credit instrument. Changes in the risk-free yield curve, market spreads or perceived credit quality therefore regularly lead to differences between market yield and the historical effective interest rate. This difference is a key driver of fair value volatility and highlights the conceptual distinction between transaction-based and market-oriented measurement. In certain cases, IFRS 7 requires explicit disclosure of the difference between the transaction price and fair value at initial recognition. This applies in particular where fair value is not based exclusively on observable Level 1 or Level 2 inputs. Typical cases are intra-group loans with non-market interest rates, where the agreed effective interest rate deliberately differs from the arm’s length market rate. The market approach under IFRS 13 is based on measurement using observable prices and terms from comparable transactions. For loans, this means that loans with similar maturity, credit quality, seniority, security and comparable covenants are used as references. In liquid markets, particularly for listed bonds, such comparable prices can be observed directly or derived using standardised methods such as matrix pricing. For illiquid loans, for example in private debt, such references often do not exist or exist only to a very limited extent. In valuation practice, market-based information, for example credit spreads of comparable issuers, is therefore frequently used within a discounted cashflow model to calibrate the discount rate. The aim is to anchor the model-based valuation to observable market information. Methodologically, however, this approach still constitutes an income approach rather than a market approach in the narrow sense. Even where market-based spreads are used, the resulting fair value is materially driven by unobservable assumptions. Accordingly, the valuation is regularly to be classified as a Level 3 measurement under IFRS 13. In such cases, the standard requires transparent disclosure of the methodology applied, as well as the key valuation assumptions and sensitivities.
The interest on intra-group loans is subject to the arm’s length principle of the OECD Transfer Pricing Guidelines. Accordingly, the terms of intra-group financing must correspond to those that independent parties would have agreed under comparable circumstances. The aim is to prevent inappropriate profit shifting through non-market interest rates.
The OECD guidance on financial transactions from 2020 emphasises the comparable uncontrolled price method as the preferred approach for determining arm’s length interest rates, provided there are sufficiently comparable market transactions. In practice, however, its application is often limited because intra-group loans are frequently tailored to the specific case and, particularly for unsecured or subordinated financings, only a few suitable comparables exist.
To determine an arm’s length interest rate, the OECD guidelines require a stand-alone creditworthiness analysis of the borrower, without taking group support into account. The loan must first be delineated economically, accurate delineation, to ensure that, in terms of its economic substance, it is in fact to be classified as debt. Implicit group support may be considered, but must not be overstated.
German case law makes clear that a lack of collateral within a group cannot automatically be offset by group backing. Accordingly, risk premia for unsecured or subordinated intra-group loans are in principle arm’s length. The credit margin reflects in particular the borrower’s credit quality, the term and the structural design of the loan (see BFH, judgment of 09.06.2021 – I R 32/17).
Under § 1 of the German Foreign Tax Act (AStG), cross-border financing relationships between associated enterprises must be tested against the arm’s length principle. If agreed interest rates fall outside the arm’s length range, this may lead to tax adjustments. The BMF Administrative Principles on Transfer Pricing (2024) specify these requirements in particular for intra-group financial transactions. Under the OECD Transfer Pricing Guidelines, remuneration must be linked to the actual allocation of functions and risks. If a financing company does not effectively control the risks associated with providing capital, it is generally entitled only to a risk-free return. Any excess returns are to be allocated to the entities that actually control the economically significant risks. In addition, intra-group loans are subject to extensive documentation requirements under the master file, local file and, where applicable, country-by-country reporting. Insufficient documentation significantly increases the risk of tax adjustments.
If the interest rate on an intra-group loan deviates from a market level, the loan must be measured at fair value on initial recognition under IFRS 9. Fair value is generally determined using a discounted cashflow model applying an arm’s length market rate of interest. The difference between the nominal amount and fair value is often recognised as an equity contribution or a distribution.
Subsequent measurement is at amortised cost, applying the effective interest rate derived from fair value and taking into account impairment under the ECL model. For tax purposes, however, it remains decisive whether the agreed interest rate satisfies the arm’s length principle, which makes close alignment between financial reporting and transfer pricing design necessary.
Accounting under HGB and IFRS follows different underlying principles, and these directly affect the valuation of loans. Under HGB, the prudence principle (§ 252 HGB) is paramount. Potential losses must already be taken into account, whereas gains may only be recognised once they have been realised at the reporting date. This so-called imparity principle leads to a more conservative measurement, with historical acquisition cost or production cost forming the basis. By contrast, IFRS is guided by the principles of decision usefulness. Measurement decisions are intended to be both relevant and a faithful representation, with fair value playing a central role and, in addition, measurement at amortised cost as well as cost-based models being applied.
In addition, IFRS 9 provides an expected credit loss model for loans, which tends to recognise credit risks earlier than an approach based on incurred losses. On the basis of these principles, loans under IFRS are first allocated to measurement categories, because this classification determines subsequent measurement. The starting point is the business model (hold, hold and sell, trading) and the so-called SPPI test, solely payments of principal and interest, which assesses whether the contractual cashflows represent only payments of principal and interest. If loans are held within a hold-to-collect business model and their cashflows pass the SPPI test, they are measured at amortised cost. If a hold-and-sell business model applies and the SPPI test is met, measurement is at fair value through other comprehensive income, FVOCI. All other loans, in particular those that fail the SPPI test or are held as trading positions, are to be allocated to the category fair value through profit or loss, FVTPL.
Closely linked to this is the ECL model, which distinguishes three risk stages. In Level 1, impairments are recognised on the basis of a 12-month probability of default, while in Levels 2 and 3 they are recognised on the basis of the probability of default over the remaining lifetime. In addition, loans that are already considered credit-impaired on acquisition are treated separately as purchased or originated credit-impaired, POCI. This model enables early and risk-based recognition of expected losses. In parallel, for certain financial instruments, in particular FVTPL assets or derivatives, fair value is determined in accordance with IFRS 13, taking into account the hierarchy levels, Levels 1 to 3, requiring disclosure of valuation techniques and presenting sensitivities to Level 3 inputs. By contrast, HGB accounting for loans is consistently anchored in acquisition cost. Loans originated by the entity are recognised at acquisition cost, while receivables acquired for consideration are recognised at purchase price. Measurement distinguishes between non-current and current assets. For non-current assets, the mitigated lower of cost or market principle applies, under which non-routine write-downs are required only in the case of an impairment that is expected to be permanent, whereas for current assets the strict lower of cost or market principle requires immediate write-downs when a loss in value occurs. Provisions with a remaining term of more than one year must be discounted using the average market rate of interest published by the Deutsche Bundesbank, and liabilities are recognised at the settlement amount, see § 253 HGB.
In addition to statutory rules, professional guidance and supervisory requirements also play an important role in valuation practice. IDW ERS HFA 48 addresses specific issues relating to the accounting for financial instruments under IFRS 9, in particular classification including the SPPI test, embedded derivatives, impairment topics, as well as derecognition and modifications of financial instruments, and thus serves to specify and support consistent application of the IFRS requirements.
For HGB-relevant issues, IDW RH HFA 1.014 specifies the measurement of receivables and securities, in particular the distinction between non-current and current assets and lower of cost or market testing. In addition, there are supervisory requirements such as MaRisk (BaFin Circular 05/2023), which set qualitative requirements for credit risk management, risk measurement and stress testing. These requirements indirectly affect valuation assumptions such as probability of default (PD), loss given default (LGD) or scenario assumptions, and influence both IFRS and HGB valuations.
In accounting for loans with embedded options or hybrid features, the key question is how these features are to be valued in order to ensure an IFRS-compliant presentation of the financial instruments. Embedded options may, for example, include termination rights, early repayment options or conversion rights, which alter the loan’s cashflow and therefore affect its economic value.
IFRS 13 permits the use of option pricing models here, such as the Black–Scholes model or binomial models, provided these models reflect customary market practice and are based on consistent assumptions. The selection of model parameters, such as volatility, interest rates or exercise probabilities, should be transparent and grounded in plausible market data in order to ensure valuation quality. In practice, the value of these optional or structured loan features is often determined by calculating the incremental value. This results from the difference between the present value of cashflows that incorporate the feature, assuming optimal or rule-based exercise and a consistently defined benchmark without the feature. In practical terms, valuation is often performed within tree or Monte Carlo simulations or by applying option-adjusted spread (OAS) methods, which allow a flexible and risk-adjusted representation of cashflows. These approaches ensure that the value of embedded options is captured realistically and presented transparently in the financial statements, without affecting the fundamental classification of the loan under IFRS 9.
The valuation of distressed debt and non-performing loans (NPLs) requires particular attention to default risks and the associated uncertainties in cashflow expectations. Under the requirements of the European Banking Authority (EBA) and the European Central Bank (ECB), loans are considered non-performing if they are either materially more than 90 days past due or the borrower is classified as unlikely to pay, meaning that full repayment without realisation of collateral is assessed as unlikely. BaFin applies a consistent definition in line with the Capital Requirements Regulation (CRR) and EU Directive 2021/2167. It also includes terminated exposures and receivables that have already been impaired or written off. These definitions make clear that NPLs are not only about payment arrears, but about a qualitative assessment of the borrower’s ability to pay.
Under IFRS 9, such exposures are classified in Stage 3 as soon as there is objective evidence of impairment, for example significant payment arrears, restructurings or indicators of insolvency. POCI assets represent a special category. They are to be classified as credit-impaired at initial recognition. In this case, no loss allowance is recognised initially, because the expected losses are already reflected in the credit-adjusted effective interest rate (EIR). In subsequent measurement, only the cumulative change in lifetime ECL since initial recognition is recognised as a loss allowance, while interest recognition continues to be based on the credit-adjusted EIR applied to amortised cost. This approach enables timely and expectation-based recognition of credit risk without creating unrealistic loss anticipation.
HGB accounting for problem loans follows a different approach. There is no ECL model, and impairments are recognised, when there are specific default indicators such as insolvency or persistent payment disruptions, through non-routine write-downs to the lower fair value. At the same time, there are also standardised forms, so-called general loan loss provisions, to cover latent risks. For non-performing loans recognised as non-current assets, the mitigated lower of cost or market principle applies, requiring a non-routine write-down only where the impairment is expected to be permanent, whereas for current assets the strict lower of cost or market principle applies. For financial fixed assets there is also an option to write down even if the impairment is not expected to be permanent (§ 253 HGB). This shows that HGB accounting is more strongly focused on historical values and conservative risk recognition, whereas IFRS 9 is expectation-based.
For practical market and valuation analysis of distressed debt, investors typically use discounted cashflow models with recovery assumptions. These models incorporate different scenarios, such as reorganisation, sale or liquidation, and weight them with implicit probabilities. High, risk-adjusted discount rates are used in order to reflect the uncertainties adequately. For NPLs, valuation often shifts away from the classic income-based approach that is based on the borrower’s ability to pay, towards an asset-based approach consistent with a gone concern scenario. The decisive factor then is the fair value of the underlying collateral, for example real estate or machinery, less liquidation costs and discounts for the time required to realise the collateral. In addition, ECB guidance for NPLs requires robust valuation processes including regular revaluations of collateral in accordance with EBA standards, and the EBA data templates for NPL transactions are intended to improve comparability and transparency for buyers, thereby effectively standardising valuation inputs.
Overall, the valuation of distressed debt and NPLs under both IFRS and HGB requires complex judgements that go well beyond a pure assessment of contractual cashflows. IFRS places the emphasis on expected losses and consistent recognition of risk premia, whereas HGB focuses on historical acquisition costs and conservative impairments. For market practitioners, this means that both scenario analysis and collateral valuation are central elements of a realistic valuation.
The valuation of loan portfolios presents a particular challenge because it must take into account both the individual instruments and their interaction within the portfolio. For this purpose, IFRS 13 permits the so-called portfolio exception, which may be applied where market and credit risks are managed jointly on a net exposure basis. This is particularly relevant for trading books, in which risks are actively managed and assessed at portfolio level. While IFRS primarily cites derivative trading portfolios as a typical use case, the exception is not limited to trading books, but is linked to the criteria for group measurement as defined in IFRS 13.
In practice, private debt exposures are usually valued on an instrument-by-instrument basis. Matrix or benchmarking approaches are often used to derive the relevant discount rates or credit spreads, grouping positions by sector, rating or spread buckets, seniority, maturity and liquidity. Material positions, or those with particularly pronounced idiosyncratic risk, are regularly valued and corroborated using dedicated, instrument-specific yield or DCF models. This makes it possible to capture both the individual risks of the loans and their consistent positioning within the portfolio.
ECL measurement under IFRS 9 can also be performed on a portfolio basis. This involves taking into account staging, risk parameters such as probability of default (PD), loss given default (LGD) and exposure at default (EAD), as well as macroeconomic, forward-looking information. IFRS 9 requires the information used to be reasonable, sufficiently supportable and forward-looking, so that forecasts of economic conditions feed into measurement. The EBA Guidelines (EBA/GL/2017/06) confirm this and additionally emphasise the importance of governance and control requirements, in particular a model validation framework covering roles and responsibilities, review of input data, model construction and design, analysis of results and, where necessary, remedial actions. In addition, the Guidelines on Loan Origination and Monitoring (EBA/GL/2020/06) highlight the importance of strong internal governance in credit granting and monitoring, as well as in creditworthiness assessment and credit decision models. The focus is on model understanding, data quality, avoidance of systematic bias, suitability assessments and model performance, in order to ensure that portfolio valuations rest on reliable and consistent foundations.
For the fair value measurement of entire portfolios, particularly Level 3 portfolios such as private credit funds, valuation is often performed starting from the individual instruments. Discounted cashflow, yield-based or spread-based techniques are used, applied consistently across reporting dates and, where possible, calibrated to observable market data. Anchoring the approach in the perspective of a typical market investor ensures that valuations are comprehensible and market-consistent. At portfolio level, additional plausibility checks and sensitivity analyses are performed. This includes aggregating key inputs and outcomes, conducting scenario and stress tests, and benchmarking against relevant market movements or reference metrics where these can meaningfully be used. Supervisory authorities emphasise, particularly for private market portfolios, the need for robust valuation processes and controls. This includes the independence, consistency and transparency of valuation processes, comprehensive documentation and reporting, and, where appropriate, the involvement of independent valuation advisers or committees to ensure that valuations are both defensible and fit for supervisory scrutiny.
Overall, the valuation of loan portfolios must consider both the instrument level and the portfolio level. While IFRS 13 provides theoretical exceptions for portfolio approaches, practical implementation often remains instrument-based and is supplemented by benchmarking and scenario analysis. The combination of consistent instrument-level valuation, corroborated assumptions and robust governance structures ensures that portfolio valuations are reliable both for internal steering purposes and for meeting regulatory requirements.
The valuation of loans and debt instruments differs depending on whether HGB or IFRS is applied. While HGB primarily focuses on historical acquisition costs, the prudence principle and impairment driven by lower-of-value considerations, IFRS 9 and IFRS 13 place fair value, the expected credit loss model (ECL) and the perspective of typical market participants at the centre. IFRS 9 links the classification of financial instruments to business models (hold, hold and sell, trading) and the SPPI criterion, and distinguishes between measurement at amortised cost, at fair value with recognition in other comprehensive income, or in profit or loss. Closely connected to this is the three-stage ECL framework, including the specific treatment of POCI exposures, whereas under HGB impairments are primarily based on specific and general loan loss allowances as well as discounting requirements.
For illiquid exposures such as private debt financings or intra-group loans, IFRS predominantly applies the discounted cashflow approach (DCF), often as a Level 3 measurement within the meaning of IFRS 13, with discount rates, credit risk and collateral playing a central role. For non-performing loans and distressed debt, the focus shifts from cashflow-based approaches towards recovery assumptions and the values of the underlying collateral, consistent with gone concern scenarios. At portfolio level, these principles are supplemented by portfolio-based ECL calculations, the use of the portfolio exception under IFRS 13, and plausibility checks and sensitivity analyses. Overall, these differing valuation logics can give rise to substantial divergences between HGB and IFRS values, particularly for illiquid, higher-risk or intra-group loans.
Loan Valuation series Part 1: Introduction to loan valuation and the private debt market
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