Do financial assets with ESG-linked features meet the SPPI test?

As pressure builds for countries and entities to meet their ‘net zero’ commitments, there is a focus on Environmental, Social and Governance (ESG) reporting to drive accountability. This is particularly so for financial institutions and lenders, who are uniquely positioned to drive enhanced ESG behaviour through incentives or disincentives in the terms of lending arrangements.

IFRS 9 Financial Instruments only permits financial assets (or loans) to be classified and measured at amortised cost if both of the following conditions are met:

  1. The financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows
  2. The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.

If one of these conditions is not met, the instrument is measured at fair value through profit or loss.

We continue to see new types of lending arrangements that provide for principal and interest payments where the amount of the interest payment is driven by ESG conditions or targets. An example of this is where the interest rate increases if a specified reduction in greenhouse gas emissions is not achieved by the borrower.

What is the problem?

Financiers prefer to classify and measure financial assets at amortised cost because this reduces the need for fair value measurements and eliminates profit or loss volatility. However, the emergence of ESG-linked features poses challenges for preparers in determining whether these features meet the conditions in IFRS 9 to be considered SPPI. Concerns were raised with the International Accounting Standards Board (IASB) as part of its post-implementation review of IFRS 9.

IASB response

In response to stakeholder concerns, the IASB provided additional guidance in IFRS 9 on how to interpret ESG adjustments when assessing whether the SPPI test has been met. They did not introduce specific requirements or exceptions for financial assets with ESG-linked features. Rather, they amended IFRS 9 to clarify the general SPPI principles, including:

  • Elements of a basic lending arrangement
  • Contractual terms that change the timing or amount of cash flows.

We are here to help

With the IASB choosing the general guidance path rather than specifically clarifying how ESG-linked features affect the SPPI test, we anticipate that navigating these amendments will be difficult, time-consuming and require extensive judgement. Our team of IFRS & Corporate Reporting experts is here to help. Contact us today.

More information

Please read our publication for more on these amendments. The amendments can be viewed in the Australian amending standard, AASB 2024-2 Amendments to Australian Accounting Standards – Classification and Measurement of Financial Instruments.