IFRS 9 The SPPI test explained by example

IFRS 9 The SPPI test explained by example

 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. 

In this case, interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.

In order to meet this condition, there can be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Leverage is generally viewed as any multiple above one.

Classification and measurement of financial assets

Classification model
If the financial asset is a debt instrument (or does not meet the definition of an equity instrument in its entirety from an IAS 32 perspective), management should consider whether both the following tests are met: The objective of the entity’s business model is to hold the asset to collect the contractual cash flows; and The asset’s contractual cash flows represent only payments of principal and interest. Interest is consideration for the time value of money and the credit risk associated with the principal amount outstanding during a particular period of time.

If both these tests are met, the financial asset falls into the amortised cost measurement category. If the financial asset does not pass both tests, it is measured at fair value through profit or loss.

Even if both tests are met, management also has the ability to designate a financial asset as at fair value through profit or loss if doing so reduces or eliminates a measurement or recognition inconsistency (‘accounting mismatch’). IFRS 9-The SPPI test explained by example

Business model test IFRS 9-The SPPI test explained by example
Financial assets are subsequently measured at amortised cost or fair value based on the entity’s business model for managing the financial assets. An entity assesses whether its financial assets meet this condition based on its business model as determined by the entity’s key management personnel (as defined in IAS 24, ‘Related party disclosures’).

Management will need to apply judgement to determine at what level the business model condition is applied. That determination is made on the basis of how an entity manages its business; it is not made at the level of an individual asset. The entity’s business model is not therefore a choice and does not depend on management’s intentions for an individual instrument; it is a matter of fact that can be observed by the way an entity is managed and information is provided to its management. IFRS 9-The SPPI test explained by example

Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, some sales or transfers of financial instruments before maturity may not be inconsistent with such a business model. IFRS 9-The SPPI test explained by example

The following are examples of sales before maturity that would not be inconsistent with a business model of holding financial assets to collect contractual cash flows: an entity may sell a financial asset if it no longer meets the entity’s investment policy, because its credit rating has declined below that required by that policy; when an insurer adjusts its investment portfolio to reflect a change in the expected duration (that is, the timing of payout) for its insurance policies; or when an entity needs to fund unexpected capital expenditure.

However, if more than an infrequent number of sales are made out of a portfolio, management should assess whether and how such sales are consistent with an objective of collecting contractual cash flows. There is no rule for how many sales constitutes ‘infrequent’; management will need to use judgement based on the facts and circumstances to make its assessment.

An entity’s business model is not to hold instruments to collect the contractual cash flows − for example, where an entity manages the portfolio of financial assets with the objective of realising cash flows through sale of the assets. Another example is when an entity actively manages a portfolio of assets in order to realise fair value changes arising from changes in credit spreads and yield curves, which results in active buying and selling of the portfolio. IFRS 9-The SPPI test explained by example

Contractual cash flows that are solely payments of principal and interest IFRS 9-The SPPI test explained by example
The other condition that must be met in order for a financial asset to be eligible for amortised cost accounting is that the contractual terms of the financial asset give rise on specified dates to cash flows that are ‘solely payments of principal and interest on the principal amount outstanding’. In this case, interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. IFRS 9-The SPPI test explained by example

In order to meet this condition, there can be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows, with the result that they do not have the economic characteristics of interest. IFRS 9-The SPPI test explained by example

However, unlike leverage, certain contractual provisions will not cause the ‘solely payments of principal and interest’ test to be failed. For example, contractual provisions that permit the issuer to pre-pay a debt instrument or permit the holder to put a debt instrument back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest as long as the following certain conditions are met: The pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding (which may include reasonable additional compensation for the early termination of the contract). IFRS 9-The SPPI test explained by example

Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument are also regarded as being solely payments of principal and interest, provided during the term of the extension the contractual cash flows are solely payments of principal and interest as well (for example, the interest rate does not step up to some leveraged multiple of LIBOR) and the provision is not contingent on future events. IFRS 9-The SPPI test explained by example

Context

To put the SPPI test in context here is a illustration of the use of the SPPI test in IFRS 9:

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IFRS 9 The SPPI test explained by example

The classifications (and resulting specific IFRS requirements) of ‘Amortised costs’, ‘FVOCI (recycling)’, ‘FVP&L’ (or FVPL) and ‘FVOCI (no recycling)’ are summarised below after the examples…..

IFRS 9 The SPPI test explained by example

Here are some examples to obtain an understanding for the IFRS reasoning: IFRS 9 The SPPI test explained by example

Loan with zero interest and no fixed repayment terms 

Relevant IFRS paragraphs [IFRS 9.B4.1.7] – [IFRS 9.B4.1.9] IFRS 9 The SPPI test explained by example

Parent A provides a loan to Subsidiary B. The loan is classified as a current liability in Subsidiary B’s financial statements and has the following terms:

  • No interest; IFRS 9-The SPPI test explained by example
  • Repayable on demand of Parent A. IFRS 9-The SPPI test explained by example

Question: Does the loan meet the SPPI contractual cash flows characteristic test?

Answer: Yes.IFRS 9 The SPPI test explained by example

The terms provide for the repayment of the principal amount of the loan on demand. The solely payments of principal and interest (SPPI) test

Loan with zero interest repayable in 5 years

Parent A provides a loan of CU10 million to Subsidiary B. The loan has the following terms: The solely payments of principal and interest (SPPI) test

  • No interest;
  • Repayable in five years.

Question: Does the loan meet the SPPI contractual cash flows characteristic test?

Answer: Yes.

The principal (fair value) is CU10 million discounted to its present value using the market interest rate at initial recognition. The final repayment of CU10 million represents a payment of principal and accrued interest.

Loan with interest rate capIFRS 9 The SPPI test explained by example

Entity B lends Entity C CU5 million for five years, subject to the following terms:

  • Interest is based on the prevailing variable market interest rate;
  • Variable interest rate is capped at 8%;
  • Repayable in five years.

Question: Does the loan meet the SPPI contractual cash flows characteristic test?

Answer: Yes.

Contractual cash flows of both a fixed rate instrument and a floating rate instrument are payments of principal and interest as long as the interest reflects consideration for the time value of money and credit risk. Therefore, a loan that contains a combination of a fixed and variable interest rate meets the contractual cash flow characteristics test.

Loan with profit linked element

Entity D lends Entity E CU500 million for five years at an interest rate of 5%.

Entity E is a property developer that will use the funds to buy a piece of land and construct residential apartments for sale. In addition to the 5% interest, Entity D will be entitled to an additional 10% of the final net profits from the project.

Question: Does the loan meet the SPPI contractual cash flows characteristic test?

Answer: No.

The profit linked element means that the contractual cash flows do not reflect only payments of principal and interest that consist of only the time value of money and credit risk. Therefore, the loan will fail the requirements for amortised cost classification. Entity D will account for the loan at fair value through profit or loss.

The IFRS 9 classifications

Amortised costs

In short – Financial assets at amortised cost are measured at initial recognition minus the principal repayments, minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount and adjusted for any loss allowance (expected credit losses or more specific impairments).

More explanations and help:

Measurement at initial recognition (also for the other IFRS 9 classifications): This is at fair value, plus for financial assets not classified at fair value through profit or loss, directly attributable transaction costs:

  • Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and
  • Directly attributable transaction costs are incremental costs that are attributable to the acquisition of the financial asset.
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Amortisation using the effective interest method: This is a method of calculating the amortised cost of a financial asset and allocating the interest income over the relevant period to profit or loss. It is not a straight-line method, the amortisation under the effective interest method reflects a constant periodic return on the carrying amount of the financial asset. Here is a comprehensive example.

Loss allowance: With limited exceptions, a 12-month expected credit losses must be recognised initially for all financial assets subject to impairment (to profit or loss). For example, an entity recognises a loss allowance at the initial recognition of a purchased debt instrument rather than when an event of default by the issuer occurs. Because every loan and receivable carries with it some risk of default, every such asset has an expected loss attached to it—from the moment of its origination or acquisition. Here is a detailed explanation.

FVOCI (recycling)

Financial fixed assets (not being equity instruments) at fair value through other comprehensive income are initially and subsequently measured at fair value (see above ‘measurement at initial recognition‘ on amortised costs).

Interest revenue, credit impairment (and reversals thereof) and foreign exchange gains or losses are recognised in profit or loss. Interest income (effective interest rate method) and expected credit losses are computed and recognised in the same manner as financial assets measured at amortised cost.

Other gains and losses (mainly changes in fair value) are recognised in other comprehensive income (as unrealised gains and losses).

Upon derecognition of the financial asset (mainly sale) cumulative gains and losses, recorded in other comprehensive income over the time of holding the financial asset, are reclassified (recycled) from other comprehensive income to profit or loss (as realised gains and losses).

FVOCI (no recycling)

Equity instruments (using the fair value option) at fair value through other comprehensive income are initially and subsequently measured at fair value (see above ‘measurement at initial recognition‘ on amortised costs).

Dividends are recognised in profit or loss (being realised).

Changes in fair value and foreign exchange differences are recognised in other comprehensive income. No impairment losses are recorded.

Cumulative gains and losses, recorded in other comprehensive income over the time of holding the financial asset, are NOT reclassified (recycled) from other comprehensive income to profit or loss. Here are more details.

FVP&L (or FVPL)

Financial assets (failing the business model or SPPI tests, or using the fair value option), derivatives (by default) and equity instruments (when not applying the fair value option) at fair value through profit or loss are initially and subsequently measured at fair value (see above ‘measurement at initial recognition‘ on amortised costs).

Financial assets, derivatives and equity instruments – Changes in fair value are recognised in profit or loss.

IFRS 9-The SPPI test explained by example

IFRS 9 The SPPI test explained by example

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