The important Solely Payments of Principal and Interest Test
IFRS 9 The Solely Payments of Principal and Interest Test is the second necessary condition (see IFRS 9 Classification and Measurement of Financial Instruments) for classifying loans and receivables at Amortized Cost, Fair Value through Other Comprehensive Income (FVOCI), or the Fair value through Profit or Loss (FVPL) as the residual class. This means that the contractual payments give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding.
The classification and measurement of non-equity instruments (financial assets) under IFRS 9 is dependent on two key criteria:
- The business model within which the asset is held (the business model test), and
- The contractual cash flows of the asset (the SPPI test, yes that’s the one discussed here).
Here is the decision tree to obtain an easy overview: Solely Payments of Principal and Interest Test
Meaning of principal and interest in Solely Payments of Principal and Interest
Because it is a test it is important to get right what the meaning of principal and interest is.
Contractual cash flows are considered to be SPPI if the contractual terms of the financial asset only give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding on specified dates (i.e. the contractual cash flows are consistent with a basic lending arrangement).
IFRS 9 defines principal as the fair value of a financial asset at initial recognition, which may change over the life of a financial instrument (for example, if there are repayments of principal). Solely Payments of Principal and Interest
Whilst the consideration for the time value of money and credit risk are typically the most significant elements of ‘interest’, IFRS 9 acknowledges that it can also contain other elements such as consideration for liquidity risk, profit margin and service or administrative costs.
If the lending arrangement includes a clause that compensates the lender for these other elements and they do not result in a change in the nature of the lending arrangement (i.e. profit margin is maintained) then the inclusion of these elements are consistent with a basic lending arrangement. Solely Payments of Principal and Interest
Food for thought – Objective of the Solely Payments of Principal and Interest Test
The objective of the SPPI test is to determine whether an arrangement pays only interest and principal, as 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, discussed below, 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.
Food for thought – Linked interest contractual cash flows
It is common for lending arrangements to contain clauses which permit the lending bank to adjust the interest rate charged. Where the bank has published interest rate that apply across a range of products that it offers to its customers, those rates will often be driven by general market interest rates and may be linked to specified benchmark interest rates.
In those circumstances, it may be possible to conclude without significant analysis that the cash flows meet the SPPI Test. However, in other cases the interest rate may change as a result of a future contingent event, or the lender may have full discretion to vary the interest rate charged during the term of a loan (with the borrower having an option to prepay the loan without penalty if it does not wish to accept the new rate).
In those cases, judgement will be required in assessing whether the contractual cash flows are consistent with a basic lending arrangement.
However, if the contractual cash flows are linked to features such as changes in equity or commodity prices, they would not pass the SPPI test because they introduce exposure to risks or volatility that are unrelated to a basic lending arrangement.
Food for thought – Linked interest to issuer’s equity instruments
A typical example of an instrument where the contractual cash flows would not meet the SPPI Test would be a debt instrument with an interest rate that is linked to the issuer’s share price. Similarly, a debt instrument with an equity conversion feature. under which the holder has an option to convert the debt instrument into a fixed number of the issuer’s equity shares on maturity, would not meet the SPPI Test.
However, if an issuer uses its own shares as a ‘currency’ to settle a convertible debt instrument, then this might meet the SPPI test. This could be in circumstances in which the equity conversion feature is for a variable number of the issuer’s equity shares that have a fair value equal to the unpaid principal and interest. and the equity shares are quoted on a public market. However, if the issuer was a private company then it is likely that the SPPI Test would fail because of liquidity risk.
Food for thought – The SPPI contractual cash flow test – Logical outcome
The SPPI contractual cash flow test means that only debt instruments can qualify to be measured at amortised cost. The terms of an equity instrument are never capable of giving rise to Solely Payments of Principal and Interest. Derivatives will also fail the SPPI Test, due to leverage.
Relevant factors 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
Here is a more detailed discussion on these factors in the SPPI Test:
1. 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. Solely Payments of Principal and Interest
2. 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. Solely Payments of Principal and Interest
Food for thought – Mandatory redeemable preference shares
Consider an investment in preferred shares that is mandatory 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 mandatory redeemable preference shares may fail the SPPI test.
3. Arrangements denominated in a foreign currency IFRS 9 The Solely Payments of Principal and Interest Test
Principal and interest determinations should be assessed in the currency in which loan payments are denominated.
Food for thought – Foreign currency
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 (old) IAS 39.
4. Prepayment and term extending options IFRS 9 The Solely Payments of Principal and Interest Test
Debt instruments often contain prepayment options for the issuer, put options for the holder and extension option terms. These do not necessarily violate the SPPI contractual cash flow characteristics test.
The entity must determine whether the contractual cash flows that could arise over the life of the instrument due to that contractual term are SPPI on the principal amount outstanding. An example provided in IFRS 9 is a contractual term that permits the issuer (i.e. the debtor) to prepay a debt instrument or permits the holder (i.e. the creditor) to put a debt instrument back to the issuer before maturity and the prepayment 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.
A debt instrument that would otherwise give rise to cash flows that are SPPI on the principal amount outstanding, but does not do so only as a result of a contractual term that permits (or requires) the issuer to prepay the debt instrument or permits (or requires) the holder to put a debt instrument back to the issuer before maturity is eligible to be measured at amortised cost or fair value through other comprehensive income (depending on the entity’s business model) if:
- The financial asset is acquired or originated at a premium or discount to the contractual par amount;
- The prepayment or put amount represents substantially all the contractual par amount and accrued (but unpaid) contractual interest (the prepayment or put amount may include reasonable additional compensation for early repayment); and
- When initially recognised, the fair value of the prepayment feature is insignificant.
To make this determination, contractual cash flows both before and after the change in cash flows should be assessed. The nature of contingent event(s) (i.e. the trigger) may also need to be assessed.
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. Solely Payments of Principal and Interest
Food for thought – Definition of significant fair value prepayment feature
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 definition to assess “significance” in this context (i.e. a significant fair value prepayment feature).
By contrast, under IAS 39 entities often 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.
5. Other contingent payment features IFRS 9 The Solely Payments of Principal and Interest Test
Other contractual provisions that change the timing or amount of cash flows can still meet the SPPI test if their effect is consistent with the return of a basic lending arrangement. 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. It can still meet the SPPI test as the resulting change in the contractual terms is likely to represent consideration for the increase in credit risk of the instrument.
- A contractual term where the specified interest rate resets to a higher rate if the debtor misses a particular number of payments Other instruments where the interest payment is linked to net debt/earnings before interest tax, depreciation and amortisation (EBITDA) ratio (where the ratio is intended to be a proxy reflecting the borrower’s credit risk) are unlikely to meet the SPPI test, except in rare cases when a genuine link can be made between the linkage feature and the required SPPI features. However, a financial instrument with an interest rate that resets to a higher rate if a specified equity index reaches a particular level (e.g. FTSE 100 reaching 8,000 points) will not meet the SPPI test, because there is no relationship between the change in equity index and credit risk.
A non-recourse provision does not in itself preclude a financial asset from meeting the SPPI contractual cash flow characteristics test. A non-recourse provision has the effect that, if the borrower defaults, the lender would only be able to recover its claim through the asset that has been pledged as security over the loan. The borrower has no further obligation beyond the asset that has been pledged.
When there is a non-recourse provision, a lender needs to ‘look through’ to the underlying assets or cash flows to determine whether the contractual cash flows of the financial assets are solely payments of principal and interest on the principal amount outstanding.
If the terms of the financial asset (including the effect of the non-recourse provision) give rise to any other cash flows or limit the cash flows in a manner that is inconsistent with SPPI, then the loan does not meet the contractual cash flow characteristics test. Whether, the underlying assets are financial or non-financial assets does not in itself affect this assessment.
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.
Food for thought – Importance of consistent assessment contingent payment 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.
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.
6. Non-recourse arrangements IFRS 9 The Solely Payments of Principal and Interest Test
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.
Food for thought – Exposure to changes in value of the equity portfolio
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). As a result, the SPPI test is not met.
7. The time value of money element of interest IFRS 9 The Solely Payments of Principal and Interest Test
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. Solely Payments of Principal and Interest
In some financial assets in certain jurisdictions, the time value of money element of interest may be modified in a way that is imperfect. Examples of modifications include:
- Instruments with variable interest rates where the frequency of interest rate reset does not match the tenor (or maturity) of the instrument, such as instruments where interest is reset monthly to a quarterly rate. Certain Japanese government bonds have a semi-annual interest rate reset but the rate is always reset to a 10-year rate regardless of maturity (known as Japanese 10-year constant maturity bonds);
- Instruments with a variable interest rate but the variable interest is reset before the start of the interest period (for example, two months before so that the rate at the date of reset is not the current floating rate, but is instead the floating rate two months before).
Where the time value component of the interest rate has been modified (such as for the instruments set out above), a further assessment is required to determine whether the time value component is significantly different from a benchmark instrument. The assessment can be qualitative or quantitative. It is necessary to determine how different the contractual undiscounted cash flows are in comparison with the undiscounted cash flows that could arise if the time value of money element was not modified (benchmark cash flows). Solely Payments of Principal and Interest
For example, if the financial asset under assessment contains a variable interest rate that is reset every month to a one-year interest rate, the entity would compare that financial asset to a financial instrument with identical contractual terms and the identical credit quality except the variable interest rate is reset monthly to a one-month interest rate. The comparison would take into account not only the existing difference in rates, but also the potential difference arising from possible future changes in interest rates.
If it is clear, with little or no analysis, that the contractual (undiscounted) cash flows on the financial asset under the assessment could (or could not) be significantly different from the (undiscounted) benchmark cash flows, it is not necessary to perform a detailed assessment. The term ‘significantly different’ is not defined and no quantitative threshold is provided, but in practice only a small variation would be permitted.
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. Solely Payments of Principal and Interest
Worked example – The SPPI Test – Modified time value of money
Entity B invests in a variable interest rate bond that matures in five years with interest payable every six months. The variable interest is reset every six months to a 5 year rate. At the time of the initial investment, the 6 month interest is not significantly different to the 5 year rate.
Can Entity B conclude that the modification is not significant without any additional analysis?
NO, Entity B cannot simply conclude based on the relationship between the 5 year rate and the 6 month rate at the date of initial recognition. Rather Entity B must simply conclude based on the relationship between the 5 year rate and the 6 month rate could change over the life of the bond such that the contractual (undiscounted) cash flows over the life of the bond could be significantly different from the (undiscounted) benchmark cash flows, the financial asset does not meet the SPPI criteria and therefore must be measured at fair value through profit and loss.
Regulated interest rates
In some jurisdictions, the government or a regulatory authority establishes interest rates. For example, such government regulation of interest rates may be part of a broad macroeconomic policy or it may be introduced to encourage entities to invest in a particular sector of the economy.
Under IFRS 9, a regulated interest rate may be used as a proxy for the time value of money element for the purpose of applying the SPPI test if that regulated interest rate provides consideration that is broadly consistent with the passage of time and does not provide exposure to risks or volatility in the contractual cash flows that are inconsistent with a basic lending arrangement.
IFRS 9 contains: Solely Payments of Principal and Interest
- 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 securitisations; and Solely Payments of Principal and Interest
- a special exception for loans that pay a negative interest rate. Solely Payments of Principal and Interest
Also read: IFRS 9 Classification Solely Payments of Principal and Interest
Solely Payments of Principal and Interest
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