IFRS 9 Best long-read SPPI Test

The SPPI Test

If an asset is in a hold-to-collect or hold-to-collect or sell business model, an entity assesses whether the cash flows from the financial asset meet the ‘solely payments of principal and interest’ (SPPI Test) benchmark – i.e. whether the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest.

  • Principal’ is the fair value of the financial asset on initial recognition. The principal may change over time – e.g. if there are repayments of principal.
  • Interest’ is consideration for the time value of money and credit risk. Interest can also include consideration for other basic lending risks and costs, and a profit margin.

A financial asset that does not meet the SPPI Test is always measured at FVPL, unless it is a non-trading equity instrument and the entity makes an irrevocable election to measure it at FVOCI. Here is the decision tree to put the narrative in context:

SPPI Test

Contractual cash flows that meet the SPPI Test are consistent with a basic lending arrangement in the banking industry.

The SPPI assessment is made with reference to the currency in which the financial asset is denominated, and therefore multi-currency features may cause failure of the SPPI Test. Fixed and floating rates are generally consistent with SPPI as long as they meet the definition of interest.

Leverage increases the variability of the contractual cash flows such that they do not have the economic characteristics of interest – e.g. stand- alone options, forward contracts and swap contracts.

Food for thought – Legal form versus substance of the lending arrangement

The objective of the SPPI test is to determine whether an arrangement pays only interest and principal, asSPPI Test defined, not to quantify their respective amounts. Ordinarily, it should be possible to establish this by considering the nature of the lender’s rights to cash flows, and the cash flows risks and volatility to which the lender is exposed.

IFRS 9 provides general guidance to assist in this evaluation. As a general rule, loans and receivables that require only fixed payments on fixed dates, or only fixed and variable payments where the amount of the variable payment for a period is determined by applying a floating market rate of interest for that period (e.g., the BA rate, the prime rate, or LIBOR) plus a fixed spread to a specified reference amount (such as a stated maturity amount) will have payments that meet the SPPI test.

IFRS 9 states that in concept, instruments which are not loans and receivables in legal form still might pass the SPPI test.

Under IFRS 9, embedded derivatives in a hybrid contract with a host that is a financial asset are not separated from the host contract, but are included in the classification assessment – i.e. assessing whether the cash flows of the hybrid contract meet the SPPI Test.

Food for thought – Tenor mismatch
Some instruments have a so-called ‘tenor mismatch’, where the time period or ‘tenor’ in the variable interest rate paid (for example, 3 months in the case of 3-month Libor) does not match the frequency at which the variable interest rate is reset on the instrument (for example, monthly in the case where the rate resets each month). This is an example of what IFRS 9 calls a ‘modified time value of money’. Such features have been seen in parts of the Eurozone and elsewhere.

One reason for this type of feature is that longer-term interest rates are generally more stable, and so they can protect retail customers from the volatility that a shorter-term interest rate might create.

If the time value of money element is modified, the bank will need to compare the contractual cash flows of the instrument to the cash flows of a ‘perfect’ (‘benchmark’) instrument that does not have the tenor mismatch. If the cash flows could be significantly different, the contractual cash flows of the instrument are not considered to be SPPI. In some circumstances, the bank might be able to make this determination by performing a qualitative assessment; in other cases, a quantitative assessment is needed.

Interpreting ‘significantly different’ when performing the modified time value of money test

An entity issues a bond with a structured coupon that varies with an underlying interest rate – for example, a constant maturity swap (‘CMS’) bond.

Under IFRS 9, such bonds will fall within the modified time value of money guidance. IFRS 9.B4.1.9C states that, if the modified time value of money element could result in contractual cash flows that are ‘significantly different’ from the un-discounted benchmark cash flows, the financial asset does not give rise to cash flows that are solely payments of principal and interest, and so the whole asset should be classified as FVPL.

Can the ‘double-double test’ for embedded derivatives in IFRS 9.B4.3.8 be used to determine ‘significantly different’?

No. ‘Significantly different’ is a matter of judgement for management to determine, and it should be assessed on an individual instrument-by-instrument basis. Whether this test is met for instruments such as CMS bonds will depend on a range of factors, including the life of the bond, yield curves and reasonably possible changes in yield curves over the bond’s life. There are no bright-line tests that should be applied, such as the ‘double-double test’ for embedded derivatives in IFRS 9.B4.3.8.

Determining when a qualitative assessment of the SPPI Test is required if the time value of money element is modified under a range of different scenarios

If the time value of money element is modified, an entity should perform a benchmark test to assess the modification, to determine whether the SPPI Test is still met. In some circumstances, the entity might be able to make that determination by performing a qualitative assessment; in other cases, a quantitative assessment is needed.

When would a qualitative assessment be sufficient to determine whether the SPPI Test is met?

IFRS 9 does not define the terms ‘modified’ and ‘imperfect’. However, the underlying principle of IFRS 9 is that, if the financial asset contains contractual terms that introduce exposure to risks or volatility unrelated to a basic lending arrangement (for example, equity prices or commodity prices), the SPPI Test is failed without performing a benchmark test.

The following table contains examples of contractual features that are considered modified (that is, imperfect) under the IFRS 9 guidance. The guidance suggests situations in which a qualitative assessment is sufficient. The list is not exhaustive, and the assessment is only provided as guidance. As such, the terms of the instrument must be examined on a case-by-case basis, to determine the kind of assessment required.

Description/Example Only qualitative assessment
Inverse floater where the coupon rate has an inverse relationship to a benchmark rate

(6% – 2 × 3m EURIBOR)

Due to guidance in IFRS 9.B4.1.14, Instrument G, the SPPI Test is not passed. This can be demonstrated based on a qualitative assessment.
The currency of the reference interest rate differs from the currency of the instrument

($–Bond with $ interest payments but EURIBOR reference rate)

If the currencies are not clearly linked, a qualitative assessment is sufficient, and the SPPI Test is likely to fail. If the currencies are clearly linked (as, for example, where one currency is pegged to the other), a quantitative assessment would be required, to demonstrate whether the SPPI Test is met.
Instrument’s interest rate is only adjusted if the reference rate exceeds a pre-defined threshold

(reference rate = 1-month EURIBOR; interest rate of the instrument is only adjusted if the 1-month EURIBOR exceeds a cap of 6%)

The benchmark test is not relevant here. This is because the instrument is seen as a variable-rate instrument with a cap and, as such, there is no modified time value of money. The instrument in question should meet the SPPI Test.
Interest rates are calculated as an average of different reference (benchmark) rates

(coupon is fixed by using the average of 3/6 and 12-month EURIBOR)

A quantitative assessment is likely to be required, to determine if the SPPI Test would be met.

 

Interest rates are calculated as the average of a reference (benchmark) rate

(interest rate is calculated as the average of 3-month EURIBOR from the last month)

A qualitative assessment would be sufficient, provided that the benchmark used is the average over a short time frame (for example, three months), and a period of low volatility in that benchmark interest rate, because it is unlikely to fluctuate significantly.

If so, the SPPI Test would be met. If the average of the benchmark rate is over a longer or highly volatile period, a quantitative assessment is likely to be needed.

Interest rates are calculated on the basis of a reference (benchmark) rate multiplied by a factor other than 1

(interest rate is calculated by 1-month EURIBOR * 1.5)

A factor of more than 1 would normally indicate that the cash flows do not have the economic characteristics of interest and hence fail the SPPI Test. Any factor less than 1 should not fail the modification test and the SPPI Test.
Interest is linked to the inflation of a different currency

(interest rate of a EUR bond is linked to the US consumer price index (‘CPI’))

If the currencies are not clearly linked, based on a qualitative test, the SPPI Test would be failed. If the currencies are clearly linked, a quantitative assessment is likely to be required, to demonstrate whether the SPPI Test is met.
Interest rates are reset, based on a lagged reference (benchmark) rate

(interest rates are reset every 3 months using the 3-month EURIBOR reference rate from the last day of the previous month)

Based on a qualitative assessment, if the lag reference is not too long and the rate is not that of a highly volatile economic environment, the SPPI Test should be met.

Applying the modified time value test to a 10-year bond whose interest rate resets annually to a 10-year rate

Consider a bond that is issued in June 2015, matures in 10 years (in June 2025), and contains a constant maturity reset feature where the interest rate resets annually to a 10-year rate of interest. The interest is linked to the bond’s original maturity, which means that, if the interest rate is reset in June 2016, it will be reset to the 10-year interest rate until June 2026.

How should the modified time value of money test be applied to the bond, in order to assess whether it meets the SPPI Test, and how many scenarios should be taken into consideration?

The test should compare the contractual un-discounted cash flows on this bond to those on a bond that resets annually to a one-year rate, in order to assess whether the cash flows of the two bonds could be significantly different. A number of different interest rate scenarios should be considered, in order to determine how the relationship between the one-year rate and a 10-year rate could change over the life of the instrument.

However, it is only necessary to consider reasonably possible scenarios rather than every possible scenario. If, in any reasonably possible scenario, the cash flows are significantly different from the benchmark cash flows (that is, based on a one-year rate), the bond will not meet the SPPI condition (and must be measured at FVPL).

In jurisdictions where interest rates on loans are extensively regulated by the government, the quantitative test might not be applicable, and a qualitative assessment would be sufficient to assess that the financial asset meets the SPPI Test.

Apply the ‘benchmark test’ when performing the SPPI Test

For debt instruments with a modified time value of money element, a quantitative assessment might be required to determine whether or not the instrument’s contractual cash flows represent solely payments of principal and interest (‘SPPI’) on the principal amount outstanding. The time value of money element is that which provides consideration for only the passage of time.

To perform this quantitative assessment, IFRS 9.B4.1.9C requires an entity to compare the contractual cash flows of the financial asset under assessment to the cash flows of a ‘benchmark’ instrument whose time value of money element is not modified (known as the ‘benchmark test’).

As an example, if a loan contains a variable interest rate that is reset every month to a one-year interest rate, the assessment would compare the cash flows of the loan to those on a ‘benchmark’ loan with identical contractual terms and the identical credit risk, except that the variable interest rate resets monthly to a one-month interest rate.

Where the modified time value of money element could result in contractual cash flows that are significantly different from the benchmark cash flows, the financial asset fails SPPI.

How should the ‘benchmark test’ be applied?

IFRS 9 does not prescribe a single way of performing the ‘benchmark test’, so different methods might beSPPI Test appropriate. Judgement will therefore be required and the approach adopted should be applied consistently.

However, factors to consider in developing an approach to applying the ‘benchmark test’ include:

  • Instrument-by-instrument test: The objective of the ‘benchmark test’ is to determine how different the contractual (undiscounted) cash flows of a financial asset are from those that would arise if the time value of money element of that asset were not modified. The test is therefore an instrument-by-instrument test applied to the undiscounted cash flows of the financial asset.
  • Two tests: IFRS 9 requires differences between the cash flows on the actual and benchmark instruments to be considered, both in each reporting period and cumulatively over the life of the financial instrument. It would not be appropriate to perform only a single cumulative test over the total life of the instrument. Nor would it be appropriate to include the impact of other periods within a test of a single reporting period, since this could hide the impact of significant positive and negative differences arising in individual reporting periods by offsetting them. Similarly, performing only a regression-type analysis that focuses on the overall relationship between the actual and benchmark instrument risks overlooking the impact of significant differences in a single reporting period as well as potentially over the total life, and so would not be appropriate in isolation.
  • Reporting period: The ‘benchmark test’ must be performed at the initial recognition of a debt investment, considering the effect of the modified time value of money element in each ‘reporting period’ and cumulatively over the whole life. Given that IFRS 9.B4.1.9C does not refer to the ‘annual reporting period’, the ‘reporting period’ required to be considered will be three months if an entity issues quarterly interim financial reporting and six months if an entity issues semi-annual interim financial reporting. However, given that it would be anomalous for two entities to reach different conclusions on SPPI solely because of their different reporting periods, when determining what is a ‘significant’ difference for the purposes of a reporting period of less than 12 months (see also Definition of ‘significant’ below), it would be acceptable to use a threshold that is greater than a simple pro rata split of the threshold that would be used for a 12-month reporting period.
  • Number of scenarios to be considered: IFRS 9.B4.1.9D requires an entity to consider ‘only reasonably possible scenarios instead of every possible scenario’. If no significant differences arise when applying historically observed scenarios that include a financial crisis or other period with significant volatility, then an instrument might appear to pass the ‘benchmark test’. However, entities should also ensure that the scenarios used appropriately incorporate previously unobserved outcomes that are nevertheless reasonably possible in the future (for example, due to changes in the geo-political environment). Nevertheless, an entity could use only the most extreme of the scenarios considered reasonably possible (that is, those reasonably possible scenarios that give rise to the greatest positive and negative differences between the actual and benchmark cash flows) since, if these pass the benchmark test, then all other less extreme scenarios will similarly pass, so that these other less extreme scenarios do not need to be considered separately.
  • Exclusion of principal amounts: The objective of the ‘benchmark test’ is to consider adjustments made only to the time value of money element, which is generally a component of the interest receipts. Hence, inclusion of the principal payments in the ‘benchmark test’ risks diluting the impact of differences in the time value of money element, and therefore principal payments should be excluded. However, if cash flows are a combination of principal and interest (for example, an amortising mortgage loan where monthly payments include elements of both principal and interest) then, unless the cash flows are separated between principal and interest, thresholds should be appropriately lowered to mitigate the risk of obscuring the modified time value of money element due to the principal’s inclusion.
  • Absolute versus relative: In determining appropriate thresholds for what is considered ‘significant’, entities might use (i) a specified percentage of the benchmark cash flows, or (ii) a combination of a specified percentage of the benchmark cash flows and an absolute numerical threshold, used to avoid absolute small differences causing an instrument to fail SPPI. For example, to take account of very low interest rate environments, it might be judged appropriate to use a relative test assessing whether differences between the instruments’ cash flows expressed as a percentage of the benchmark instrument’s cash flows exceed X% and then also apply an absolute test assessing whether the difference between these cash flows also exceed CU Y. The absolute threshold itself should take account of the size of the instrument being assessed, because it would not be appropriate to apply the same absolute numerical threshold to all instruments under the benchmark test.
  • Definition of ‘significant’: IFRS 9 does not define ‘significant’ in the context of the benchmark test. Entities will therefore need to exercise judgement in determining this. For example, it might be appropriate to establish a ‘lower’ boundary for differences below which an instrument will always be SPPI, and an ‘upper’ boundary for differences above which an instrument will always fail SPPI. Instruments with differences falling between these ranges would require further analysis, including consideration of how often and in what circumstances the lower boundary is exceeded, qualitative factors etc.
  • Disclosure: Where the approach taken to applying the benchmark test is a significant accounting judgement (for example, because an alternative approach could result in a material amount of financial instruments changing classification between FVPL and amortised cost), the disclosures in paragraph 122 of IAS 1 should be provided.
Something else -   Hold to collect and sell - How 2 best account it in IFRS 9 classification of financial assets

Overall assessment

IFRS 9’s approach to assessing SPPI focuses on an overall assessment of what the entity is being compensated for and whether there is a basic lending arrangement, rather than on how much the entity receives for a particular element. In addition, the concept of a de minimis contractual feature is introduced under IFRS 9.

Worked example – Investment in a convertible bond

Company B has an investment in a convertible bond. Under the terms of the bond, the holder has the option to convert it into a fixed number of equity shares of the issuer. The convertible bond is analysed for classification in its entirety.

The conversion option causes the instrument to fail the SPPI Test. This is because the embedded feature cannot be separated and the contractual terms of the convertible bond as a whole do not give rise solely to payments of principal and interest on the principal amount outstanding on the bond.

The return on the bond is not just consideration for the time value of money and credit risk, but also reflects the value of the issuer’s equity.

Therefore, the convertible bond in its entirety is classified as at FVPL.

There are various other contractual provisions that could change the contractual cash flows. An SPPI assessment considers all contractual features of the financial asset.

In some cases, a financial asset may have contractual cash flows that are described as principal and interest, but are not payments of principal and interest.

The fact that a financial asset is non-recourse does not in itself mean that the SPPI Test is not met. In this case, the holder of the asset has to assess (‘look through to’) the underlying assets or cash flows to determine whether the terms of the asset give rise to other cash flows or limit the cash flows so that they are not consistent with the SPPI Test.

The new standard introduces the concept of the ‘modified time value of money’. It gives the following examples:

  • if the asset’s interest rate is periodically reset but the frequency of that reset does not match the term of the interest rate – e.g. the interest rate resets every month to a one-year rate; or
  • if the asset’s interest rate is periodically reset to an average of particular short-term and long-term rates.

When assessing whether a modified time value of money feature meets the SPPI Test, an entity determines how the undiscounted contractual cash flows could differ from the undiscounted cash flows that would arise if the time value of money element was not modified (the benchmark cash flows). If the difference could be significant, then the SPPI Test is not met.

An entity considers the effect of the modified time value of money element in each reporting period and cumulatively over the life of the financial asset. However, an entity considers only reasonably possible scenarios, instead of every possible scenario.

For assets with extension options – i.e. an option that permits the issuer or the holder to extend the contractual term of a debt instrument – an entity determines whether the contractual cash flows that could arise over the life of the asset meet the SPPI Test.

A term extension feature meets the SPPI Test if the contractual cash flows during the extension period are solely payments of principal and interest on the principal amount outstanding. The contractual cash flows may include reasonable compensation for the extension of the contract (see below).

Money market funds

Amongst their mix of investments, treasury functions might hold investments in money market funds. Whilst it SPPI Testmight make little difference to the carrying amount, given that fair value typically approximates to amortised cost, the classification will matter from a disclosure point of view, and it is not always straightforward.

For example, if the fund investment meets the definition of equity under IAS 32 in the issuing fund (which is not the same as being classified as equity under IAS 32, because some puttable investments in a fund might be eligible to be classified as equity, even though they do not meet the IAS 32 definition of equity), the only options for the holder are FVPL or to take the instrument-by-instrument election to measure at FVOCI without P&L recycling. In this case, amortised cost is not an option.

If, instead, the fund investment is a debt instrument rather than equity, the next key consideration is whether the return paid by the fund meets SPPI. This can be complicated if there is no stated return, but rather the investor gets their share of the return generated by the underlying investments.

However, depending on the nature of the underlying investments, there might be grounds to say that, qualitatively, the returns meet SPPI, without the need to do the detailed analysis required by the ‘benchmark’ test – for example, if all of the underlying instruments held by the fund are themselves SPPI and the fund does not sell instruments (see IFRS 9.B4.1.9B to B4.1.9D).

A similar analysis can also be applicable to some central counterparty (or ‘CCP’) default funds, where the cash placed by a clearing member with the CCP is invested in a fund-type arrangement.


Factors to consider in 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”
  • Rights in bankruptcy or when non-payment happens
  • Arrangements denominated in a foreign currency
  • Prepayment and term extending options
  • Other contingent payment features
  • Non-recourse arrangements
  • The time value of money element of interest
  • Contractually linked instruments (tranches) and negative interest rates
  • Statutory or regulatory terms that are not part of the financial asset’s contractual terms

Whether payment terms are “not genuine” or “de minimis”

Requirement – 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. In other words, payment terms are not genuine when they are not part of a normal or real business transaction.

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.

It is de minimis only if it is de minimis in every reporting period and cumulatively over the life of the financial instrument. In other words, payment terms are de minimis when they are limited in size/importance compared to terms in the loan contract (for example loans between related parties).

Rights in bankruptcy or when non-payment happens

Requirement – 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.

Arrangements denominated in a foreign currency

Requirement – Principal and interest determinations should be assessed in the currency in which loan payments are denominated.

Prepayment and term extending options

The contractual cash flows of some financial assets may change over the life of the asset – e.g. in many cases an asset can be prepaid.

Requirement – A prepayment feature meets the SPPI Test if:

  • the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding – which may include reasonable compensation for the early termination of the contract; and
  • it permits the issuer (i.e. the debtor) to prepay a debt instrument or permits the holder (i.e. the creditor) to put the debt instrument back to the issuer before maturity.

If a financial asset would otherwise meet the SPPI Test, but fails to do so only as a result of the prepayment feature, then it may still be eligible for measurement at amortised cost or FVOCI (depending on its business model) if the exception applies.

The exception applies if all of the following conditions are met:

  • Discount or premium – Asset is originated or acquired at a discount or premium to contractual par amount,
  • Prepayment at par1 + interest – Prepayment amount consist of the contractual par plus accrued interest, which may include reasonable compensation for early termination, and
  • Fair value prepayment feature insignificant – When the financial asset is initially recognised, the fair value of the prepayment feature is insignificant.

Food for thought – Prepayment features requires judgement

An entity needs to evaluate the nature of the prepayment feature. It also needs to consider what the prepayment amount would be at each date on which the prepayment feature is exercisable, to determine for all cases whether the prepayment amount substantially represents ‘unpaid amounts of principal and interest’. This requires an entity to consider the economic characteristics of the contract and may require judgement.

Further, IFRS 9 does not define ‘reasonable compensation’ and an entity will need to apply judgement when determining whether any penalty for early termination is reasonable compensation (see below for more guidance).

As shown above, an exception for prepayment features at par is available, allowing measurement at amortised cost or FVOCI. This might apply to:

  1. purchased, credit-impaired assets acquired at a deep discount to par; and
  2. financial assets issued at below-market rates – e.g. a loan provided to a customer as a marketing incentive such that the loan’s fair value on initial recognition is significantly below its contractual par amount.

In these cases, the borrower may have the contractual ability to prepay at par, but the contractual prepayment feature would have an insignificant fair value as it is very unlikely that prepayment will occur.

In the example under 1 above, prepayment is very unlikely because the financial asset is impaired and so the borrower is unlikely to have funds to prepay the asset.

In the example under 2, it is very unlikely that the customer will choose to prepay, because the interest rate is below-market and the financing is advantageous. Consequently, the amount at which the loan can be prepaid does not introduce variability that is inconsistent with a basic lending arrangement.

The above examples deal with circumstances in which a financial asset is originated or purchased at a discount to the par amount. However, the exception is equally relevant for assets that are issued or purchased at a premium. Possible examples might include:

  • a fixed-rate bond that is acquired at a substantial premium to par, but is redeemable at par only at the option of the holder; or
  • a bond that is acquired at a substantial premium to par but is prepayable at par at the option of the issuer only in the event of a specified change in tax law, which is considered very unlikely to occur.

Worked example – Investment in a corporate bond prepayable at par

Company B invests in a corporate bond with a par value of 100. It acquires the bond at a premium – for 115 – due to a decline in market interest rates since its original issue. The corporate bond is prepayable at the option of the issuer only in the event of a specified change in tax law. It can be prepaid at the contractual par amount plus accrued but unpaid interest.

B considers the fair value of the prepayment feature to be insignificant because it is unlikely that the specified change in tax law will occur. To support this, B determines the fair value of the prepayment option by comparing the fair value of an otherwise identical bond without the prepayment option with the fair value of the corporate bond.

Reasonable compensation in a prepayment clause

In IFRS 9.B4.1.11(b), one of the examples provided of instruments whose cash flows are ‘solely payments of principal and interest’ or ‘SPPI’, is an instrument with a contractual term that permits the issuer (that is, the debtor) to prepay or permits the holder (that is, the creditor) to put the instrument back to the issuer before maturity. The prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable compensation for the early termination of the contract.

What is reasonable compensation?

The IASB issued an amendment to IFRS 9 in October 2017 addressing prepayment features with negative compensation. The amendment is mandatory for annual periods beginning on or after 1 January 2019, though earlier application is permitted where applicable. However, the amendment added paragraphs to the Basis for Conclusions on what is reasonable compensation and these are also considered relevant in interpreting ‘reasonable additional compensation’ in the pre-amendment version of IFRS 9 issued in July 2014.

The guidance set out below, which incorporates the additional guidance contained in the amendment, is therefore considered relevant to both annual periods beginning on or after 1 January 2019 and earlier periods to which IFRS 9 is applied.

IFRS 9 does not provide detailed guidance on what is considered ‘reasonable compensation’. An entity therefore needs to apply judgement in developing its own accounting policy and in determining whether specific compensation clauses provide for only reasonable compensation. That policy should be consistently applied. In making this judgement, the following factors are relevant.

Overall considerations
In order to assess whether or not a compensation clause provides for only reasonable compensation, the first step is to understand the economic rationale of the clause, what it is designed to achieve and in what circumstances it may in practice be exercised. The assessment of whether a clause contains ‘reasonable compensation’ is complicated by the fact that a wide variety of clauses exist in practice, and their meaning and application can be unclear.

For this reason an entity may consider it appropriate in some circumstances to seek legal advice in order to assess the enforceability of a clause and its contractual effect. A clause should not automatically be considered to result in ‘reasonable compensation’ just because it occurs more commonly or is a ‘market standard’ clause, so analysis of the specific details will still be needed where this is the case.

In some situations the compensation for early termination may not affect whether the instrument meets the SPPI Test. This will be the case where:

  • The reasonable compensation could only ever be de minimis (both in a single reporting period and cumulatively) or is non-genuine (that is, it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur) as stated in IFRS 9.B4.1.18. However, such cases are expected to be rare, and it should be questioned why the compensation clause has been included in the contract if it appears it may be either de minimis or non-genuine; or
  • The compensation feature arises solely as a matter of law rather than contract (refer to Interaction of contractual and legal terms, below).

Further analysis will be necessary where the above do not apply.

Qualitative considerations
IFRS 9.B4.1.7A states that the following elements of interest are consistent with a basic lending arrangement that is SPPI:

  • Time value of money;
  • Credit risk associated with the principal amount outstanding;
  • Other basic lending risks (for example, liquidity risk);
  • Costs (for example, administrative costs) associated with holding the financial asset for a particular period of time; and
  • A profit margin.

Therefore, where the additional compensation for early termination compensates only for some or all of these elements, the additional compensation may be considered reasonable on a qualitative basis, subject to the other considerations discussed below.

Where additional compensation includes compensation for other factors it would not be considered reasonable on a qualitative basis. For example, a loan whose prepayment amount varies with the proceeds received on IPO by the borrower would introduce equity price risk into the loan, which is inconsistent with a basic lending arrangement and would fail SPPI.

Particular judgement may be required when a financial instrument is prepayable at its current fair value or at an amount that includes the fair value cost to terminate an associated hedging instrument (which may or may not be designated in an accounting hedge of the prepayable instrument).

IFRS 9.BC4.232 states that whilst there may be some circumstances in which such contractual prepayment features meet SPPI as the compensation is reasonable for the early termination of the contract, that will not always be the case.

In the case of prepayment that includes the fair value cost to terminate an associated hedging instrument, IFRS 9.BC4.232 includes an example where compensation may be considered reasonable. This is when the calculation of the prepayment amount is intended to approximate unpaid amounts of principal and interest plus or minus an amount that reflects the effect of the change in the relevant benchmark interest rate.

The cost to terminate a collateralised fixed/floating interest rate swap hedge whose critical terms (such as currency, maturity) match those of the instrument, would generally be expected to reflect the effect of the change in the relevant benchmark interest rate over the remaining term and so be consistent with SPPI.

Conversely, a EUR denominated instrument prepayable at an amount that includes the lenders’ cost to terminate an associated EUR/USD cross-currency swap hedging instrument would introduce EUR/USD currency risk into the EUR denominated loan, which would not be consistent with a basic lending arrangement and would fail SPPI.

In contrast to compensation that reflects the effect of changes in the benchmark interest rate, IFRS 9 contains no explicit guidance regarding circumstances in which the terms of a financial instrument provide for prepayment at the instrument’s current fair value. This will therefore be a particularly judgemental area. It can be argued that prepayment at fair value compensates the holder for all of the components of SPPI and so can be considered reasonable compensation.

Furthermore if the instrument contained no prepayment clause, fair value is the amount at which the two parties would often be expected to agree to terminate. However, if there is a high likelihood of prepayment at fair value it could be questioned whether amortised cost is the most appropriate measurement basis. The considerations in this paragraph would also apply where, rather than being prepaid at current fair value, prepayment is instead at a formulaic amount designed to approximate current fair value.

Quantitative considerations
IFRS 9 does not contain guidance on how to quantitatively assess what is reasonable and therefore this aspect of the assessment may be particularly judgemental. However, relevant factors to consider in making this assessment include:

  • The mechanics of the compensation calculation – a formula used to determine compensation for lost interest that references a time period longer than the period remaining from prepayment up to contractual maturity, for example double that period with the result that the compensation paid is twice the present value of lost interest, would not be reasonable.
  • Whether the clause is common in the relevant market – if the compensation to be paid is significantly more than the ‘market standard’ amount payable by other similar instruments, that would call into question whether the compensation was reasonable. It would then be necessary to understand the specific facts and circumstances of the instrument, the customer etc. before concluding. Conversely, a compensation clause that is ‘market standard’ may indicate that the resulting compensation is reasonable, however as noted above, a clause should not automatically be considered to result in ‘reasonable compensation’ just because it is a ‘market standard’ amount.
Something else -   Low credit risk financial instruments

Disclosure
Where judgements as to whether compensation features provide only for reasonable compensation have a significant effect, the disclosures on significant accounting judgements required by IAS 1.122 should be provided.

Extending options

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.

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 need to develop a policy to assess “significance” in this context.

Other contingent payment features

Requirement – There are various other contractual provisions that could change the contractual cash flows. An SPPI assessment considers all contractual features of the financial asset.

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:

  1. 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.
  2. 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.

Consistent assessments of all features

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.

Expectations are 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 example under 2 above, 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

Requirement – 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.

If a non-recourse provision exists in a security, so a creditor’s claim is limited to specified assets, the bank is required to assess (that is, to ‘look through to’) the underlying assets or cash flows to determine whether the security’s contractual cash flows are SPPI.

If the security’s terms give rise to any other cash flows, or if they limit the cash flows in a manner inconsistent with the SPPI Test, the instrument will be measured in its entirety at FVPL. This applies if the security is not a ‘tranched’ instrument (if it is tranched, the CLI rules would apply instead).

For example, if an instrument’s cash flows came from toll road revenues and the cash flows paid would increase as more cars used the toll road, the instrument would not be a basic lending arrangement and so would fail SPPI.

Non-recourse loans which might be inconsistent with SPPI

What examples of non-recourse loans might be inconsistent with the SPPI criterion?

Examples of non-recourse loans that might be inconsistent with the SPPI criterion are:

  • A non-recourse loan made to fund the construction of a toll road, where the amount of the cash flows that are contractually due varies with the asset’s performance (such as where the number of cars that drive down the toll road determines the amounts to be paid); or
  • A non-recourse loan that can be pre-paid at an amount that varies with the value of an underlying asset. There is limited guidance in IFRS 9 as to how the existence of a non-recourse feature might impact the SPPI criterion. Judgement will be needed to assess these types of lending relationship.

Non-recourse real estate financing

A bank has a real estate financing business, where its business model is to provide non-recourse financing to customers so as to generate interest income on the resulting loans. The bank’s business model is not to participate in the economic performance of the underlying real estate (upside or downside). The bank limits its exposure to the real estate in several ways, including:

  • By limiting the amount lent to between 60% and 75% of the value of the real estate at the inception of the loan (depending on the term of the loan and the nature of the real estate);
  • By ensuring that the cash flows expected to be generated by the customer are more than sufficient to repay the loan (both principal and interest); and
  • By ensuring that another party has contributed sufficient equity or subordinated financing to absorb all expected losses.

Interest received is determined upfront as floating rate plus a fixed margin (determined primarily based on the credit quality of the borrower), with no reference to the performance of the underlying asset.

Would the loans provided by the bank meet the SPPI criterion?

Yes. Such a loan will meet the SPPI criterion, because the amount of cash flows due is not expected to vary with the asset’s performance, nor is the payment linked to asset risk.

Non-recourse to portfolio of equity instruments

A bank has provided a loan to a borrower with a fixed rate of interest and fixed maturity date. The loan is secured, on a non-recourse basis, on a portfolio of equity instruments (shares). The value of the shares approximates to the principal of the loan at inception.

As such, at maturity of the loan, the borrower intends to sell the shares and to use the proceeds to repay the loan. The borrower would keep any upside in the share price, but the bank would suffer any loss. The pricing in this case is the same as a written put option on the shares.

Would such a loan meet the SPPI criterion?

No. This loan is likely to fail the SPPI criterion, because the amount of cash to be repaid varies with the performance of the equity instruments. Economically, the non-recourse feature in the loan behaves like a written put option on the equity instrument.

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.

IFRS 9 contains a special set of SPPI rules for what it calls ‘contractually linked instruments’ (CLI). These apply, for example, in a ‘tranched’ structure such as a securitisation or an asset-backed security, where there are predefined rules specifying how payout of the cash flows from the underlying assets is prioritised between the different classes or ‘tranches’ of instruments, creating concentrations of credit risk.

The detailed requirements are in IFRS 9.B4.1.21-B4.1.26, but they are complex and set a high hurdle to demonstrate that an instrument meets SPPI. In particular, they require the entity to ‘look through’ the instrument to the underlying asset pool, which needs to comprise only instruments that meet SPPI or instruments that align specified cash flow mismatches or reduce cash flow variability (such as an interest rate cap).

It can be difficult enough to assess SPPI where an asset is on a entity’s own balance sheet and the entity has all of the contractual terms, so it is even more challenging where the assets are owned and structured by another party.

Derivatives in an underlying poll of assets

A special purpose entity (SPE) holds floating-rate EUR assets, and it issues fixed-rate GBP notes contractually linked to the assets. The SPE has entered into one swap that is a pay EUR floating and receive GBP floating, and a second swap that is a pay GBP floating and receive GBP fixed. Both of these swaps would meet the requirements, in IFRS 9.B4.1.24(b), of aligning the cash flows of the tranches with the cash flows of the pool of underlying instruments.

Assuming that the other features of contractually linked instruments have been met (according to para B4.1.21 of IFRS 9), would such a note in a tranche issued by an SPE meet the SPPI criteria?

Yes. However, if the SPE had a derivative that introduced a third currency (say, USD), this would not align the cash flows, and the tranche would have to be measured at FVPL. [IFRS 9.B4.1.24].

Tranches in the SPPI Test

A special purpose vehicle (‘SPV’) holds a financial asset and issues only one type of note. Any cash flow collected on the transferred asset is then passed to the note holder, and to the party that transferred the financial asset to the SPV, using a waterfall.

The waterfall structure contains a credit enhancement whereby the excess of the return on the financial asset over the rate paid on the issued note (also known as the ‘excess spread’) is retained by the SPV to absorb the first losses on the financial assets held by the SPV. This credit enhancement is paid back to the transferor using a predefined schedule defined in the waterfall.

Does the ‘excess spread’ credit enhancement constitute a tranche when assessing whether the contractually linked instruments guidance should be applied to the structure?

Yes. IFRS 9.B4.1.20 defines a contractually linked instrument as ‘transactions in which an issuer may prioritise payments to the holders of financial assets using contractually linked instruments that create concentration of credit risk. Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche’.

This definition does not restrict the form of a ‘tranche’ to only notes or securities. Since the structure contains the key feature of a contractually linked instrument (that is, it passes any cash flows that it collects using a waterfall in a manner that creates concentrations of credit risk), the ‘excess spread’ credit enhancement should be considered a tranche for the purposes of applying the contractually linked instruments guidance.

Investments in collateralised debt obligations (CDOs)

An entity has an investment in a cash CDO, where the issuing SPE holds the underlying referenced assets.

Would such a note in a tranche issued by an SPE meet the SPPI criteria?

Not sure. The investment might qualify for amortised cost accounting, provided that the underlying assets qualify for amortised cost accounting, and the other requirements of IFRS 9 are met for contractually linked instruments.

But investments in synthetic CDOs (where the SPE has a credit derivative that references particular exposures) would not qualify, because the derivatives on the reference exposures do not have cash flows that are SPPI, nor do they align the cash flows permitted by IFRS 9.

Derivative with option in underlying pool of asset

An SPE holds a fixed-for-floating swap that also hedges pre-payment risk such that, if the underlying pool of fixed-rate assets pays down early, the derivative is cancelled, with no further amounts to pay. This is to ensure that there are no excess derivatives and no fair value gains or losses on settlement; this is because, when the assets pre-pay, the notes pre-pay.

Assuming that the other features of contractually linked instruments have been met (according to IFRS 9.B4.1.21), would such a note in a tranche issued by an SPE meet the SPPI criteria?

Yes. This feature would not fail the SPPI Test, so the holder might be able to measure its investment at amortised cost. This could also be achieved by other mechanisms (for example, the SPE could be required to enter into an offsetting derivative as soon as practicable), to make sure that there are no excess derivative positions after the prepayment of the notes.

Statutory or regulatory terms

As a result of the regulatory response to the 2008 global financial crisis, bank-issued securities are often subject to ‘bail in’ features. These features are designed to pre-empt the bank breaching its regulatory capital requirement by allowing for the security to be written down to nil or converted into ordinary shares, boosting capital when it is needed most.

These ‘bail in’ features can be complex. When assessing SPPI for the holder of a security, the key principle is that the feature can be ignored for SPPI purposes if it only arises as a result of a regulator’s power to impose losses on the holder (see Instrument E in IFRS 9.B4.1.13). This is because IFRS 9 is a contract-based standard; so, if the resulting payments do not arise from a contractual term, but instead from regulation/legislation, they are not relevant to the IFRS 9 assessment.

However, if the feature is a contractual term (for example, because a security’s terms state a specific capital ratio threshold that will trigger ‘bail in’ when breached that is not prescribed by regulation/legislation), that would be considered a contractual term and be expected to cause the security to fail SPPI. This is even if the probability of loss is considered remote, which is normally the case. So, understanding the detail of any relevant clauses will be key.

The above assumes that the security is a liability under IAS 32 from the issuer’s perspective (that is, a debt instrument). An increasingly common instrument with a ‘bail in’ feature is an ‘AT1’ or ‘Additional Tier 1’ bond issued by a bank (sometimes also referred to as a ‘contingent convertible bond’). These are complex instruments and terms vary, but (in some territories, such as the UK) they can be wholly equity under IAS 32, which would mean that the holder has to classify the instrument as FVPL unless it takes the instrument-by-instrument election to measure it at FVOCI without P&L recycling.

Interaction of contractual and legal terms in loan contracts when assessing the SPPI Test

IFRS 9.B4.1.13 clarifies that, where payments arise only as a result of legislation that gives the regulatory authority power to impose changes to an instrument, they should be disregarded when assessing the SPPI Test, because that power is not part of the contractual terms of a financial instrument. Instrument E in the guidance specifically refers to bail-in instruments as an example that might meet the SPPI Test.

When should the contractual terms of an instrument which includes references to the legislation, such as a bail-in clause, be taken into account when assessing the SPPI Test?

The bail-in clause should not be taken into account, when assessing the SPPI Test, where the clause merely acknowledges the existence of the bail-in legislation (that is, the clause does not create additional rights or obligations that would not have existed in the absence of such a clause). For this to be the case, it is necessary that:

  • The bail-in regulations themselves specify all of the key terms, including what the bail-in trigger is and the effects of the bail-in trigger being met;
  • The effects of the bail-in trigger are at the discretion of the regulator, and the contract does not add to this by allowing discretion of the entity or imposing an earlier trigger; and
  • The contract terms are drafted such that, if the regulations change, the bail-in terms of the instrument change in exactly the same way.

However, some contract terms include non-viability trigger event clauses. These are clauses in debt agreements in certain jurisdictions that allow regulatory authorities to instruct an entity to modify the debt instrument on issue if it determines that, without the amendment, the entity would become non-viable.

Such a contractual reference creates additional rights or obligations, with respect to the treatment of the instrument that would not have existed in the absence of such a clause, that extend beyond mere bail-in clauses. As such, the effects of such a clause should be taken into account when assessing the SPPI Test, and they might cause it to fail.

 

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Something else -   IFRS 9 Continue to recognise the financial asset at best

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