Instruments with certain par prepayment features

Instruments with certain par prepayment features debt instruments with prepayment features that give rise to compensation being paid to the party triggering the possibility to be measured at amortised cost or fair value through other Instruments with certain par prepayment features comprehensive income (FVOCI) in certain circumstances. Instruments with certain par prepayment features

If a financial asset would otherwise meet the SPPI test, but fails to do so only as a result of a contractual term that permits or requires prepayment before maturity, or permits or requires the holder to put the instrument back to the issuer, then the asset can be measured at amortised cost or FVOCI if:

  • the relevant business model test is satisfied; Instruments with certain par prepayment features
  • the entity acquired or originated the financial asset at a premium or discount to the contractual par amount;
  • the prepayment amount substantially represents the contractual par amount and accrued (but unpaid) contractual interest, which may include reasonable compensation for early termination; and
  • on initial recognition of the financial asset, the fair value of the prepayment feature is insignificant. [IFRS 9 B4.1.12]

 

Reasoning behind the par prepayment exception Instruments with certain par prepayment features

The IASB decided to provide this narrow-scope exception because it was persuaded by the feedback that amortised cost would provide useful and relevant information for certain financial assets that would otherwise fail the SPPI test. The Board gives the following examples:

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

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 a prepayment will occur. In the first example, the prepayment is very unlikely because the financial asset is impaired and so the borrower is unlikely to have funds from which it could prepay the asset.

In the second example, 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. [IFRS 9 BC4 193–194]

These examples discuss circumstances in which a financial asset is originated or purchased at a discount to the par amount. However, the IASB noted that its rationale for the exception is equally relevant for assets that are originated or purchased at a premium. Possible examples might include: Instruments with certain par prepayment features

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

After IFRS 9 was issued, the IFRS Interpretations Committee (the Interpretations Committee) received a submission asking how to classify particular prepayable financial assets applying IFRS 9. Specifically, the submission asked whether a debt instrument could have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding if its contractual terms permit the borrower to prepay the instrument at a variable amount that could be more or less than unpaid amounts of principal and interest, such as at the instrument’s current fair value or at an amount that reflects the remaining contractual cash flows discounted at the current market interest rate.

As a result of such a contractual prepayment feature, the lender could be forced to accept a prepayment amount that is substantially less than unpaid amounts of principal and interest. Such a prepayment amount would, in effect, include an amount that reflects a payment to the borrower by the lender (instead of compensation from the borrower to the lender) even though the borrower chose to terminate the contract early. Applying IFRS 9, those contractual cash flows are not solely payments of principal and interest, and therefore the financial assets would be measured at fair value through profit or loss. Instruments with certain par prepayment features

However, Interpretations Committee members suggested that the Board consider whether using amortised cost measurement could provide useful information about particular financial assets with such prepayment features, and if so, whether the requirements in IFRS 9 should be changed in this respect.

In the light of the Interpretations Committee’s recommendation and similar concerns raised by banks and their representative bodies in response to the Interpretations Committee’s discussion, the Board decided to propose a narrow exception to IFRS 9 for particular financial assets that would otherwise have contractual cash flows that are solely payments of principal and interest but do not meet that condition only as a result of a prepayment feature. Applying the proposals, some such financial assets would be eligible to be measured at amortised cost or at fair value through other comprehensive income, subject to the assessment of the business model in which they are held, if particular conditions are met.

Instruments with certain par prepayment features

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