How do you account for contractual provisions in a financial instruments contract that change the timing or amount of contractual cash flows?
Contractual cash flows of some financial assets may change over their lives. For example, an asset may have a floating interest rate. Also, in many cases an asset can be prepaid or its term extended. [IFRS 9 B4.1.10, IFRS 9 B4.1.12]
For such assets, an entity determines whether the contractual cash flows that could arise over the life of the instrument meet the SPPI criterion. It does so by assessing the contractual cash flows that could arise both before and after the change in contractual cash flows.
In some cases, contractual cash flows may change on the occurrence of a contingent event. In these cases, an entity assesses the nature of the contingent event. Although the nature of the contingent event in itself is not a determinative factor in assessing whether the contractual cash flows meet the SPPI criterion, it may be an indicator.
IFRS 9 provides the following examples of contractual terms that change the timing or amount of contractual cash flows and meet the SPPI criterion.
Contractual changes in timing or amount of cash flows that meet the SPPI test [IFRS 9 B4.1.11]
Variable interest rate
A variable interest rate that consists of consideration for:
A prepayment feature:
Term extension feature
A term extension feature that:
An instrument whose interest rate is reset to a higher rate if the debtor misses a particular payment may meet the SPPI criterion because of the relationship between missed payments and an increase in credit risk. [IFRS 9 B4.1.10]
This can be contrasted with contractual cash flows that are indexed to the debtor’s performance – e.g. net income. In such cases, the contractual feature would generally reflect a return that is inconsistent with a basic lending arrangement and would not meet the SPPI criterion – unless the indexing results in an adjustment that only compensates the holder for changes in the credit risk of the instrument. [IFRS 9 B4.1.10, IFRS 9 B4.1.13]
Variable compensation for credit risk
In many cases, the component of a variable interest rate that represents compensation for credit risk is fixed at initial recognition. However, in some cases this may not be the case and the compensation for credit risk may vary in response to perceived changes in the creditworthiness of the borrower – e.g. if covenants are breached. [IFRS 9 B4.1.11]
If there are variations in the contractual cash flows of an instrument related to credit risk, then an entity considers whether the variations can be regarded as compensation for credit risk, and therefore whether the instrument may meet the SPPI criterion.
Prepayment at fair value with ‘make-whole’ clauses
A bond may contain a ‘make-whole’ clause – e.g. on early termination, the exercise price is based on the higher of:
- the fair value of future payments of principal and interest; and
- the principal amount plus accrued interest.
In this case, it appears that it is possible that the SPPI criterion may be met. This is because the additional amount payable under the make-whole clause if the fair value is higher may represent reasonable additional compensation for early termination.
Mutual agreement to make changes to the contract
Sometimes, a contract may include a clause that provides for the parties to mutually agree to make specified changes to the terms of the contract at some point in the future. It appears that if a change of terms is subject to the future free and unconstrained mutual agreement of both parties, then it is not a cash flow characteristic that is included in the initial SPPI assessment. Such a clause would not preclude the contract from meeting the SPPI criterion.