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. IFRS 9-The SPPI test explained by example!!!

Classification and measurement of financial assets

Classification model IFRS 9-The SPPI test explained by example!!!
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.

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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’).

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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!!!

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.

IFRS 9-The SPPI test explained by example

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