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The valuation of loans anddebt instruments is a central element of financial reporting, risk management,and transaction and valuation practice. Although observable market prices areavailable for liquid financial instruments, valuing illiquid financings, particularlyin private debt markets and for intra-group loans, demands more robustmethodologies, well-justified assumptions, and comprehensive documentation. Insuch cases, valuation is regularly model-based and requires a consistentrepresentation of cashflows, credit risks and market yields.
The valuation of loans islargely determined by the applicable accounting standard. While the GermanCommercial Code (HGB) is shaped by the prudence principle and generally alignsthe valuation of loans with historical acquisition costs, IFRS, with the fairvalue concept and forward-looking impairment models, place greater emphasis oncurrent market conditions and the perspective of typical market participants.This results in significant valuation differences, particularly in the case ofilliquid loans or loans bearing non-market interest rates.
A fundamental introduction tovaluation principles and the private debt market can be found in the first partof this article series on loan valuation, “Introduction to Loan Valuationand the Private Debt Market”.
The fair value valuation ofloans is governed by IFRS 13, which sets out a uniform framework for themeasurement of assets and liabilities. The objective is to determine the priceat which a loan would be transferred between independent market participants atthe measurement date, from the market participant perspective. For thispurpose, IFRS 13 distinguishes three fundamental valuation approaches: themarket approach, the income approach and the cost approach.
For credit instruments,particularly illiquid and individually structured financings, valuationpractice predominantly applies market and income approaches, for examplediscounted cashflow models (DCF). IFRS 13 also refers to the cost approach, butdoes not make an explicit statement about its relevance for the valuation ofloans. Market participants therefore primarily rely on the market approach or,particularly for illiquid instruments, on the income approach.
The market approach is basedon observable prices from comparable transactions and is particularlyapplicable to liquid instruments such as listed corporate bonds. Prices ofidentical or similar instruments are used and appropriately adjusted fordifferences in maturity, credit quality, seniority, security, covenants orother contractual features.
IFRS 13 also assigns fairvalue measurements to a three-level hierarchy. Level 1 comprises quoted pricesin active markets, Level 2 comprises indirectly observable inputs such as yieldcurves or credit spreads, while Level 3 is based on unobservable, model-drivenassumptions. Illiquid loans without observable market prices, for exampledirect lending in the private debt space or intra-group loans, are in practiceregularly classified as Level 3 measurements under IFRS 13 because ofsignificant unobservable drivers. At the same time, IFRS 13 requires observableinputs to be used as far as possible and unobservable assumptions to be limitedto the minimum necessary.
For illiquid loans, the DCFapproach 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 principalpayments, but also fees, floating-rate components or performance-relatedremuneration, provided these are part of the loan structure.
The discount rate reflects thereturn requirement of a typical market participant and is typically made up ofseveral components. In addition to a risk-free base rate, which is oftenderived from the relevant yield curve, it includes a credit-risk-specificspread that reflects the borrower’s credit quality. In addition, premia forilliquidity, structural complexity or specific contractual features may berequired.
A core principle of fair valuemeasurement is consistency between cashflows and the discount rate. Creditrisks can either be incorporated explicitly in the cashflows throughprobabilities of default and recovery assumptions, or implicitly through a higherdiscount rate. Double counting the same risk must be avoided. Assumptionsregarding collateral, covenants and the ranking of the loan must also bereflected 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 anupside case, are explicitly modelled and weighted probabilistically. This approachreflects the uncertainty of future cashflows and corresponds to marketpractice, particularly in private debt.
The effective interest rate(EIR) under IFRS 9 represents the internal rate of return of a loan at the timeof initial recognition. It discounts the expected contractual cashflows overthe instrument’s term to the gross carrying amount and forms the basis formeasurement at amortised cost. Economically, the effective interest ratetherefore corresponds to the internal rate of return (IRR) of the loan atorigination.
In subsequent measurement, theeffective interest rate generally remains unchanged. Changes in credit qualitytherefore do not lead to an adjustment of the rate, but are reflected throughthe expected credit loss (ECL) model under IFRS 9. This mechanism reflects thetransaction-based logic of amortised cost measurement and serves theappropriate period allocation of interest income. By contrast, fair valuemeasurement under IFRS 13 is based on current market yields. These reflect thereturn that market participants would require at the measurement date for acomparable credit instrument. Changes in the risk-free yield curve, marketspreads or perceived credit quality therefore regularly lead to differencesbetween market yield and the historical effective interest rate. Thisdifference is a key driver of fair value volatility and highlights theconceptual distinction between transaction-based and market-orientedmeasurement. In certain cases, IFRS 7 requires explicit disclosure of thedifference between the transaction price and fair value at initial recognition.This applies in particular where fair value is not based exclusively onobservable Level 1 or Level 2 inputs. Typical cases are intra-group loans withnon-market interest rates, where the agreed effective interest ratedeliberately differs from the arm’s length market rate. The market approachunder IFRS 13 is based on measurement using observable prices and terms fromcomparable transactions. For loans, this means that loans with similarmaturity, credit quality, seniority, security and comparable covenants are usedas references. In liquid markets, particularly for listed bonds, suchcomparable prices can be observed directly or derived using standardisedmethods such as matrix pricing. For illiquid loans, for example in privatedebt, such references often do not exist or exist only to a very limitedextent. In valuation practice, market-based information, for example creditspreads of comparable issuers, is therefore frequently used within a discountedcashflow model to calibrate the discount rate. The aim is to anchor themodel-based valuation to observable market information. Methodologically,however, this approach still constitutes an income approach rather than amarket 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 3measurement under IFRS 13. In such cases, the standard requires transparentdisclosure of the methodology applied, as well as the key valuation assumptionsand sensitivities.
The interest on intra-grouploans is subject to the arm’s length principle of the OECD Transfer PricingGuidelines. Accordingly, the terms of intra-group financing must correspond tothose that independent parties would have agreed under comparable circumstances.The aim is to prevent inappropriate profit shifting through non-market interestrates.
The OECD guidance on financialtransactions from 2020 emphasises the comparable uncontrolled price method asthe preferred approach for determining arm’s length interest rates, providedthere are sufficiently comparable market transactions. In practice, however,its application is often limited because intra-group loans are frequentlytailored to the specific case and, particularly for unsecured or subordinatedfinancings, only a few suitable comparables exist.
To determine an arm’s lengthinterest rate, the OECD guidelines require a stand-alone creditworthinessanalysis of the borrower, without taking group support into account. The loanmust first be delineated economically, accurate delineation, to ensure that, interms 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 clearthat a lack of collateral within a group cannot automatically be offset bygroup backing. Accordingly, risk premia for unsecured or subordinatedintra-group loans are in principle arm’s length. The credit margin reflects inparticular the borrower’s credit quality, the term and the structural design ofthe loan (see BFH, judgment of 09.06.2021 – I R 32/17).
Under § 1 of the GermanForeign Tax Act (AStG), cross-border financing relationships between associatedenterprises must be tested against the arm’s length principle. If agreedinterest rates fall outside the arm’s length range, this may lead to taxadjustments. The BMF Administrative Principles on Transfer Pricing (2024)specify these requirements in particular for intra-group financialtransactions. Under the OECD Transfer Pricing Guidelines, remuneration must belinked to the actual allocation of functions and risks. If a financing companydoes not effectively control the risks associated with providing capital, it isgenerally entitled only to a risk-free return. Any excess returns are to beallocated to the entities that actually control the economically significantrisks. In addition, intra-group loans are subject to extensive documentationrequirements under the master file, local file and, where applicable,country-by-country reporting. Insufficient documentation significantlyincreases the risk of tax adjustments.
If the interest rate on anintra-group loan deviates from a market level, the loan must be measured atfair value on initial recognition under IFRS 9. Fair value is generallydetermined using a discounted cashflow model applying an arm’s length market rateof interest. The difference between the nominal amount and fair value is oftenrecognised as an equity contribution or a distribution.
Subsequent measurement is atamortised cost, applying the effective interest rate derived from fair valueand taking into account impairment under the ECL model. For tax purposes,however, it remains decisive whether the agreed interest rate satisfies thearm’s length principle, which makes close alignment between financial reportingand transfer pricing design necessary.
Accountingunder HGB and IFRS follows different underlying principles, and these directlyaffect the valuation of loans. Under HGB, the prudence principle (§ 252 HGB) isparamount. Potential losses must already be taken into account, whereas gainsmay only be recognised once they have been realised at the reporting date. Thisso-called imparity principle leads to a more conservative measurement, withhistorical acquisition cost or production cost forming the basis. By contrast,IFRS is guided by the principles of decision usefulness. Measurement decisionsare intended to be both relevant and a faithful representation, with fair valueplaying a central role and, in addition, measurement at amortised cost as wellas cost-based models being applied.
Inaddition, IFRS 9 provides an expected credit loss model for loans, which tendsto recognise credit risks earlier than an approach based on incurred losses. Onthe basis of these principles, loans under IFRS are first allocated tomeasurement categories, because this classification determines subsequentmeasurement. The starting point is the business model (hold, hold and sell,trading) and the so-called SPPI test, solely payments of principal andinterest, which assesses whether the contractual cashflows represent onlypayments of principal and interest. If loans are held within a hold-to-collectbusiness model and their cashflows pass the SPPI test, they are measured atamortised cost. If a hold-and-sell business model applies and the SPPI test ismet, measurement is at fair value through other comprehensive income, FVOCI.All other loans, in particular those that fail the SPPI test or are held astrading positions, are to be allocated to the category fair value throughprofit or loss, FVTPL.
Closelylinked to this is the ECL model, which distinguishes three risk stages. InLevel 1, impairments are recognised on the basis of a 12-month probability ofdefault, while in Levels 2 and 3 they are recognised on the basis of theprobability of default over the remaining lifetime. In addition, loans that arealready considered credit-impaired on acquisition are treated separately aspurchased or originated credit-impaired, POCI. This model enables early andrisk-based recognition of expected losses. In parallel, for certain financialinstruments, in particular FVTPL assets or derivatives, fair value isdetermined in accordance with IFRS 13, taking into account the hierarchylevels, Levels 1 to 3, requiring disclosure of valuation techniques and presentingsensitivities to Level 3 inputs. By contrast, HGB accounting for loans isconsistently anchored in acquisition cost. Loans originated by the entity arerecognised at acquisition cost, while receivables acquired for considerationare recognised at purchase price. Measurement distinguishes between non-currentand current assets. For non-current assets, the mitigated lower of cost ormarket principle applies, under which non-routine write-downs are required onlyin the case of an impairment that is expected to be permanent, whereas forcurrent assets the strict lower of cost or market principle requires immediatewrite-downs when a loss in value occurs. Provisions with a remaining term ofmore than one year must be discounted using the average market rate of interestpublished by the Deutsche Bundesbank, and liabilities are recognised at thesettlement amount, see § 253 HGB.
Inaddition to statutory rules, professional guidance and supervisory requirementsalso play an important role in valuation practice. IDW ERS HFA 48 addressesspecific issues relating to the accounting for financial instruments under IFRS9, in particular classification including the SPPI test, embedded derivatives,impairment topics, as well as derecognition and modifications of financialinstruments, and thus serves to specify and support consistent application ofthe IFRS requirements.
ForHGB-relevant issues, IDW RH HFA 1.014 specifies the measurement of receivablesand securities, in particular the distinction between non-current and currentassets and lower of cost or market testing. In addition, there are supervisoryrequirements such as MaRisk (BaFin Circular 05/2023), which set qualitativerequirements for credit risk management, risk measurement and stress testing.These requirements indirectly affect valuation assumptions such as probabilityof default (PD), loss given default (LGD) or scenario assumptions, andinfluence both IFRS and HGB valuations.
Inaccounting for loans with embedded options or hybrid features, the key questionis how these features are to be valued in order to ensure an IFRS-compliantpresentation of the financial instruments. Embedded options may, for example,include termination rights, early repayment options or conversion rights, whichalter the loan’s cashflow and therefore affect its economic value.
IFRS13 permits the use of option pricing models here, such as the Black–Scholesmodel or binomial models, provided these models reflect customary marketpractice and are based on consistent assumptions. The selection of modelparameters, such as volatility, interest rates or exercise probabilities,should be transparent and grounded in plausible market data in order to ensurevaluation quality. In practice, the value of these optional or structured loanfeatures is often determined by calculating the incremental value. This resultsfrom the difference between the present value of cashflows that incorporate thefeature, assuming optimal or rule-based exercise and a consistently definedbenchmark without the feature. In practical terms, valuation is often performedwithin tree or Monte Carlo simulations or by applying option-adjusted spread(OAS) methods, which allow a flexible and risk-adjusted representation ofcashflows. These approaches ensure that the value of embedded options iscaptured realistically and presented transparently in the financial statements,without affecting the fundamental classification of the loan under IFRS 9.
Thevaluation of distressed debt and non-performing loans (NPLs) requiresparticular attention to default risks and the associated uncertainties incashflow expectations. Under the requirements of the European Banking Authority(EBA) and the European Central Bank (ECB), loans are considered non-performingif they are either materially more than 90 days past due or the borrower isclassified as unlikely to pay, meaning that full repayment without realisationof collateral is assessed as unlikely. BaFin applies a consistent definition inline with the Capital Requirements Regulation (CRR) and EU Directive 2021/2167.It also includes terminated exposures and receivables that have already beenimpaired or written off. These definitions make clear that NPLs are not onlyabout payment arrears, but about a qualitative assessment of the borrower’sability to pay.
UnderIFRS 9, such exposures are classified in Stage 3 as soon as there is objectiveevidence of impairment, for example significant payment arrears, restructuringsor indicators of insolvency. POCI assets represent a special category. They areto be classified as credit-impaired at initial recognition. In this case, noloss allowance is recognised initially, because the expected losses are alreadyreflected in the credit-adjusted effective interest rate (EIR). In subsequentmeasurement, only the cumulative change in lifetime ECL since initialrecognition is recognised as a loss allowance, while interest recognitioncontinues to be based on the credit-adjusted EIR applied to amortised cost.This approach enables timely and expectation-based recognition of credit riskwithout creating unrealistic loss anticipation.
HGBaccounting for problem loans follows a different approach. There is no ECLmodel, and impairments are recognised, when there are specific defaultindicators such as insolvency or persistent payment disruptions, throughnon-routine write-downs to the lower fair value. At the same time, there arealso standardised forms, so-called general loan loss provisions, to coverlatent risks. For non-performing loans recognised as non-current assets, themitigated lower of cost or market principle applies, requiring a non-routinewrite-down only where the impairment is expected to be permanent, whereas forcurrent assets the strict lower of cost or market principle applies. Forfinancial fixed assets there is also an option to write down even if theimpairment is not expected to be permanent (§ 253 HGB). This shows that HGBaccounting is more strongly focused on historical values and conservative riskrecognition, whereas IFRS 9 is expectation-based.
Forpractical market and valuation analysis of distressed debt, investors typicallyuse discounted cashflow models with recovery assumptions. These modelsincorporate different scenarios, such as reorganisation, sale or liquidation,and weight them with implicit probabilities. High, risk-adjusted discount ratesare used in order to reflect the uncertainties adequately. For NPLs, valuationoften shifts away from the classic income-based approach that is based on theborrower’s ability to pay, towards an asset-based approach consistent with agone concern scenario. The decisive factor then is the fair value of theunderlying collateral, for example real estate or machinery, less liquidationcosts and discounts for the time required to realise the collateral. Inaddition, ECB guidance for NPLs requires robust valuation processes includingregular revaluations of collateral in accordance with EBA standards, and theEBA data templates for NPL transactions are intended to improve comparabilityand transparency for buyers, thereby effectively standardising valuationinputs.
Overall,the valuation of distressed debt and NPLs under both IFRS and HGB requirescomplex judgements that go well beyond a pure assessment of contractualcashflows. IFRS places the emphasis on expected losses and consistentrecognition of risk premia, whereas HGB focuses on historical acquisition costsand conservative impairments. For market practitioners, this means that bothscenario analysis and collateral valuation are central elements of a realisticvaluation.
Thevaluation of loan portfolios presents a particular challenge because it musttake into account both the individual instruments and their interaction withinthe portfolio. For this purpose, IFRS 13 permits the so-called portfolioexception, which may be applied where market and credit risks are managedjointly on a net exposure basis. This is particularly relevant for tradingbooks, 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 criteriafor group measurement as defined in IFRS 13.
Inpractice, private debt exposures are usually valued on aninstrument-by-instrument basis. Matrix or benchmarking approaches are oftenused to derive the relevant discount rates or credit spreads, groupingpositions by sector, rating or spread buckets, seniority, maturity andliquidity. Material positions, or those with particularly pronouncedidiosyncratic risk, are regularly valued and corroborated using dedicated,instrument-specific yield or DCF models. This makes it possible to capture boththe individual risks of the loans and their consistent positioning within theportfolio.
ECLmeasurement under IFRS 9 can also be performed on a portfolio basis. Thisinvolves taking into account staging, risk parameters such as probability ofdefault (PD), loss given default (LGD) and exposure at default (EAD), as wellas macroeconomic, forward-looking information. IFRS 9 requires the informationused to be reasonable, sufficiently supportable and forward-looking, so thatforecasts of economic conditions feed into measurement. The EBA Guidelines(EBA/GL/2017/06) confirm this and additionally emphasise the importance ofgovernance and control requirements, in particular a model validation frameworkcovering roles and responsibilities, review of input data, model constructionand design, analysis of results and, where necessary, remedial actions. Inaddition, the Guidelines on Loan Origination and Monitoring (EBA/GL/2020/06)highlight the importance of strong internal governance in credit granting andmonitoring, as well as in creditworthiness assessment and credit decisionmodels. The focus is on model understanding, data quality, avoidance ofsystematic bias, suitability assessments and model performance, in order toensure that portfolio valuations rest on reliable and consistent foundations.
Forthe fair value measurement of entire portfolios, particularly Level 3portfolios such as private credit funds, valuation is often performed startingfrom the individual instruments. Discounted cashflow, yield-based orspread-based techniques are used, applied consistently across reporting datesand, where possible, calibrated to observable market data. Anchoring theapproach in the perspective of a typical market investor ensures thatvaluations are comprehensible and market-consistent. At portfolio level,additional plausibility checks and sensitivity analyses are performed. Thisincludes aggregating key inputs and outcomes, conducting scenario and stresstests, and benchmarking against relevant market movements or reference metricswhere these can meaningfully be used. Supervisory authorities emphasise,particularly for private market portfolios, the need for robust valuationprocesses and controls. This includes the independence, consistency andtransparency of valuation processes, comprehensive documentation and reporting,and, where appropriate, the involvement of independent valuation advisers orcommittees to ensure that valuations are both defensible and fit forsupervisory scrutiny.
Overall,the valuation of loan portfolios must consider both the instrument level andthe portfolio level. While IFRS 13 provides theoretical exceptions forportfolio approaches, practical implementation often remains instrument-basedand is supplemented by benchmarking and scenario analysis. The combination ofconsistent instrument-level valuation, corroborated assumptions and robustgovernance structures ensures that portfolio valuations are reliable both forinternal steering purposes and for meeting regulatory requirements.
Thevaluation of loans and debt instruments differs depending on whether HGB orIFRS 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) andthe perspective of typical market participants at the centre. IFRS 9 links theclassification of financial instruments to business models (hold, hold andsell, trading) and the SPPI criterion, and distinguishes between measurement atamortised cost, at fair value with recognition in other comprehensive income,or in profit or loss. Closely connected to this is the three-stage ECLframework, including the specific treatment of POCI exposures, whereas underHGB impairments are primarily based on specific and general loan lossallowances as well as discounting requirements.
Forilliquid exposures such as private debt financings or intra-group loans, IFRSpredominantly applies the discounted cashflow approach (DCF), often as a Level3 measurement within the meaning of IFRS 13, with discount rates, credit riskand collateral playing a central role. For non-performing loans and distresseddebt, the focus shifts from cashflow-based approaches towards recoveryassumptions and the values of the underlying collateral, consistent with goneconcern scenarios. At portfolio level, these principles are supplemented byportfolio-based ECL calculations, the use of the portfolio exception under IFRS13, and plausibility checks and sensitivity analyses. Overall, these differingvaluation logics can give rise to substantial divergences between HGB and IFRSvalues, particularly for illiquid, higher-risk or intra-group loans.
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