1 best Test Contractual cash flows SPPI

Contractual cash flows SPPI

This Contractual cash flows SPPI test is part of the decision model for the classification and measurement of financial assets, that started in the IFRS 9 Framework for financial assets. But you can also read it without doing the test …. off course?

Ok so the financial instrument to classify and measure is a debt instrument and the business model is hold to collect and sell.

What is the SPPI test is about the classification of non-equity instruments (financial assets) under IFRS 9, that is dependent on two key criteria:USD

The solely payments of principal and interest (SPPI) test requires that the contractual terms of the financial asset (as a whole) give rise to cash flows that are solely payments of principal and interest on the principal amounts outstanding ie cash flows that are consistent with a basic lending arrangement. Unlike the business model test, this assessment must be carried out on an instrument by instrument basis.

Principal is defined as being the fair value of the financial asset at initial recognition. Interest is defined narrowly as being compensation for the time value of money and credit risk although it can also include compensation for other lending risks such as liquidity, administrative costs and a profit margin. Cash flows that provide compensation for other risks such as equity or commodity risk will fail the SPPI test because they are inconsistent with a basic lending arrangement.

Contractual cash flows SPPI

Which financial assets are likely to meet the SPPI test?

Common examples of financial assets that will meet the SPPI test are:

  • A bond repayable in 3 years and paying variable or fixed market rate of interest
  • A fixed rate loan repayable in 10 years but allows the borrower to prepay at an amount equal to unpaid amounts of principal and interest on the principal amount outstanding
  • An interest free loan by a parent to a subsidiary that is repayable in 5 years – this is because the principal amount (i.e. fair value at initial recognition) would be accreted back to par using the effective interest rate method.

Which financial assets are likely to fail the SPPI test?

Common examples of financial assets that will fail the SPPI test are:

  • All equity investments because their contractual terms give rise to equity risk
  • All derivatives because they are leveraged in nature
  • A bond with interest payments linked to the EBITDA or revenue of the issuer or contingent consideration linked to profits generated by a business that has been sold – this is because these features introduce exposures to equity like risks.

Both the business model test and the SPPI test have to be met in order to account for an instrument at Amortized Cost or FVOCI. On this page, when we talk of passing or meeting one of these tests, we mean the asset can be measured at Amortized Cost or FVOCI as appropriate, assuming that the other test is met.

When we talk of failing the test, we mean that the asset must be measured at FVPL. Applying the Business Model and SPPI tests is not necessarily straightforward and their outcomes sometimes can be surprising. Consider, for example, the following table, which illustrates how the tests can affect the classification and measurement of common types of financial assets.

Factors to consider in applying the SPPI test

IFRS 9 identifies the following factors as being relevant in applying the SPPI test:

  • Whether payment terms are “not genuine” or “de minimis”Contract terms that are not genuine or de minimis should not be considered in applying the SPPI test. A payment term is not genuine if it affects an instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. It is de minimis only if it is de minimis in every reporting period and cumulatively over the life of the financial instrument. The Basis for Conclusions for IFRS 9 indicates that in order to meet the “not genuine” test, the probability that a payment will occur has to be more than “remote”. How much more it needs to be is a matter of judgment.
  • Rights in bankruptcy or when non-payment happens – An instrument has contractual cash flows that are solely payments of interest and principal only if the debtor’s non-payment is a breach of contract and the holder has a contractual right to unpaid amounts of principal and interest in the event of the debtor’s bankruptcy. Consider an investment in preferred shares that is mandatorily redeemable at par plus accrued dividends. Typically on bankruptcy such shares are entitled to a priority claim in any remaining net assets up to their preference amount, but not a fixed legal claim on the preference amount itself. Accordingly, investments in mandatorily redeemable preference shares may fail the SPPI test. Investments in mandatorily redeemable preferred shares ordinarily must be measured at FVPL.
  • Arrangements denominated in a foreign currency – Principal and interest determinations should be assessed in the currency in which loan payments are denominated. This guidance applies only to lending arrangements where all payments are denominated in the same foreign currency. It is not relevant to arrangements with what would have been considered embedded foreign currency derivatives under IAS 39.
  • Prepayment and term extending options – IFRS 9 states that a contract term that permits the issuer to prepay a debt instrument, or the holder to put a debt instrument back to the issuer before maturity, does not violate the SPPI test in the following situations:
    • The prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding; or
    • The prepayment amount substantially represents the contractual par amount and accrued but unpaid contractual interest, the instrument was acquired or originated at a premium or discount to the contractual par amount, and when the instrument is initially recognized, the fair value of the prepayment feature is insignificant.In both cases, the prepayment amount can include reasonable additional compensation for the early termination of the contract.Similarly, the SPPI test is not violated if an arrangement includes an option that allows the issuer or borrower to extend the contractual term of a debt instrument and the terms of the option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding. Payments may include a reasonable amount of additional compensation for the extension of the contract.Often under IAS 39 entities did not compute the fair value of prepayment options where loans were pre-payable at par because generally such prepayment options were considered closely related to the host contract and thus not an embedded derivative that has to be measured
      at FVPL. By contrast, IFRS 9 requires that the entity assess whether the fair value of the prepayment feature is significant for loans acquired or issued at a premium or discount and therefore adds to the complexity of the analysis for the classification of such instruments. Entities will need to develop a policy to assess “significance” in this context.IFRS 9 adds complexity to the classification of instruments that can be prepaid.
  • Other contingent payment features – Lending agreements often include contingent payment terms, which could change the timing or amount of contractual cash flows for reasons other than changes in market rates of interest, prepayments or term extensions. IFRS 9 gives two such examples:
    • A contractual term where the interest rate specified in the arrangement resets to a higher rate if the debtor misses a particular number of payments.
    • A contractual term where the specified interest rate resets to a higher rate if a specified equity index reaches a particular level.For such features, IFRS 9 states that an entity must assess whether the contractual cash flows that could arise both before, and after, such a change to determine whether the contract terms give rise to cash flows that are solely payments of principal and interest. It also states that while the nature of the contingent event (i.e., the trigger) is not a determinative factor, it may be an indicator. For example, it is more likely that the interest rate reset in the first case results in payments that are solely payments of principal and interest because of the relationship between the missed payments and an increase in credit risk.In the Basis for Conclusions, the IASB emphasizes that all contingent payment features should be assessed the same way; that is, there should be no difference in the way prepayment and other contingent payment features are evaluated. As a result, it is always appropriate to
      consider whether a contingent payment feature has a significant impact on cash flows. We expect that it rarely will be the case that an entity will be able to form a judgment whether the SPPI test is met in contingent payments arrangements without considering the nature of the contingent event. In the second case in the IASB example, for instance, the increase in the interest rate as the result of the change in the equity index would most likely be viewed as a return for accepting equity price exposure rather than interest income, notwithstanding that it only changes the interest rate. In effect, the lender is taking a position on the future direction of equity prices, which is not consistent with a basic lending arrangement.
  • Non-recourse arrangements – IFRS 9 emphasizes that the fact that a financial asset may have contractual cash flows that in form qualify as principal and interest does not necessarily mean that the asset will pass the SPPI test. Lending arrangements where a creditor’s claim is limited to specified assets of the debtor or the cash flows from specified assets (so-called “non-recourse” financial assets) may not, for example. For such arrangements, the lender must “look through” to the underlying assets or cash flows in making this determination. If the terms of the financial asset give rise to any other cash flows or otherwise limit the cash flows, the asset does not meet the SPPI test.For non-recourse arrangements, the lender must “look through” to the underlying assets or cash flows.Consider a non-recourse loan whose principal amount finances 100% of the cost of a portfolio of equity instruments that will be sold when the loan is due. In this situation, a decline in the value of the portfolio below its cost will reduce the cash flows available to repay the lender; i.e., under the terms of the arrangement the lender is exposed to changes in the value of the equity portfolio (in effect, the lender has written a put option on the portfolio). The SPPI test thus is not met.
  • The time value of money element of interest – IFRS 9 states that in determining whether a particular interest rate provides consideration only for the passage of time, an entity applies judgment and considers relevant factors such as the currency in which the financial asset is denominated and the period for which the interest rate is set.IFRS 9 addresses the example where the tenor of a floating rate loan is modified so that it does not correspond exactly to the interest rate reset period. For example, the interest rate resets every month to a one year rate or to an average of particular short- and long-term rates rather than the one month rate. It states that this feature introduces a variability in cash flows that is not consistent with a basic lending arrangement. In such circumstances, the entity must consider whether the modification is significant by performing a qualitative or quantitative assessment. The objective is to establish on an undiscounted basis how different the asset’s contractual cash flows could be from the cash flows that would arise if there was a perfect link between the interest rate and the period for which the rate is set. A difference may be significant if it could be significant in a single reporting period or cumulatively over the life of the instrument. If a difference is significant, the SPPI test is not met.
  • Contractually linked instruments (tranches) and negative interest rates – IFRS 9 contains 1) complex requirements for debt instruments issued in tranches whose terms create concentrations of credit risk (i.e., lower ranking tranches absorb the first dollars of credit risk before higher ranking tranches often occurring in interests held in securitizations; and 2) a special exception for loans that pay a negative interest rate.

See also IFRS Community: IFRS 9 SPPI

The question is: Are the contractual cash flows solely payments of principal and interest on the principal amounts outstanding?

Yes / No

Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI

Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI

Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI

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Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI

Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI Contractual cash flows SPPI