In the May 2018 edition of Accounting News we examined the classification of financial assets under IFRS 9 Financial Instruments (‘IFRS 9’).
In that article, we noted that, under IFRS 9, where a financial asset is a non-equity instrument such as a debt instrument, the default measurement approach is fair value through profit or loss, but measurement at amortised cost or at fair value through other comprehensive income will occur if specified criteria are met:
| If the instrument is: | It may be measured at: | If: |
| A non-equity instrument, e.g. a debt instrument | Amortised cost | It meets both:
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| Fair value through other comprehensive income | It meets both:
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As shown in the table and decision tree above, the classification of a financial asset that is a debt instrument is based on whether that financial asset will pass the contractual cash flow characteristics test and a business model test.
The remainder of this article examines the contractual cash flow characteristics test and the business model tests in greater depth.
The aim of this test is to identify financial assets with contractual cash flows that are consistent with a basic lending arrangement, i.e. payments of principal and interest on the principal outstanding, with the key components of interest being the time value of money and credit risk. Any debt instruments that do not meet the SPPI test must be classified at FVTPL irrespective of the business model in which they are held. Note this test is to be carried out on an individual asset basis.
The examples below illustrate when contractual cash flows are considered to be SPPI:
| Financial asset | Is the contractual cash flow characteristics test met, i.e. SPPI? |
| A bond that matures in three years and pays a variable market interest rate | Yes. Contractual cash flows of an instrument that has a variable interest rate are consistent with a basic lending arrangement if the interest reflects consideration for the time value of money and credit risk. |
| A bond that matures in three years and pays a fixed market interest rate of 5% | Yes. Contractual cash flows of an instrument that has a fixed interest rate are considered to be consistent with a basic lending arrangement if the interest rate is based on the market fixed rate at initial recognition. |
| A bond that matures in three years and pays a variable market interest rate that is capped at 8% | Yes. Contractual cash flows of both:
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| A bond with contractual interest payments linked to the EBITDA of the issuer | No. The interest rate reflects the performance of the issuer. |
| Company A provides a loan to its subsidiary, Company B. The loan has no interest and no fixed repayment terms, is repayable on demand, and is classified as a current liability in Company B’s books | It is possible for loans with such terms to be considered consistent with a basic lending arrangement and hence meet the SPPI test. However, in some situations (e.g. where the loan is a non-recourse loan or where the subsidiary only has one asset) further analysis may be required to determine whether the subsidiary is able to generate sufficient cash flows, such that the parent would be able to recover the principal amount lent. |
| Company C provides a loan to Company D. The loan is for $5 million at a fixed market interest rate and is repayable in five years’ time, but Company D has the option to repay the loan at any time at $5 million plus any accrued interest plus a prepayment penalty of 3% | Yes, if the prepayment penalty of 3% is deemed reasonable additional compensation for early contract termination. Contractual provisions that permit the issuer to prepay a debt instrument before maturity can be considered SPPI if the prepayment amount substantially represents unpaid amounts of principal and interest, which may include reasonable additional compensation for the early termination of the contract. |
| Company E provides a loan to Company F. The loan is for $5 million at a fixed interest rate of 8% and is repayable in five years. If Company F misses two interest payments, the interest rate is reset to 15% | Yes. There is a relationship between the missed payment and an increase in credit risk, which means that the key components of the penalty interest are the time value of money and credit risk. |
| Company G provides a loan to Company H. The loan is for $10 million at a fixed market interest rate and is repayable in five years’ time. Company H has the right to extend the term for another three years and, if it does so, a variable market interest rate will be charged from years 6 to 8 | Yes. Extension options meet the contractual cash flow characteristics test if the terms result in contractual cash flows during the extension period that are considered to be SPPI on the principal amount outstanding, which may include reasonable additional compensation for the extension of the contract. |
The business model test looks at how the financial asset is managed.
Hold to collect
A financial asset is managed on a ‘hold to collect’ basis where the entity’s business objective is to hold the financial asset in order to collect its contractual cash flows. The ‘hold to collect’ business model test does not require that financial assets are always held until their maturity - the test will likely still be met if there are only infrequent sales, and those sales occur for reasons such as to realise cash to deal with an unforeseen need for liquidity, or concerns about the collectability of the contractual cash flows.
Hold to collect and sell
A financial asset is managed on a ‘hold to collect and sell’ basis where the entity’s business objective is to both hold the financial asset in order to collect its contractual cash flows, and sell the financial asset. The ‘hold to collect and sell’ business model results in a greater frequency and volume of sales than the ‘hold to collect’ business model because selling financial assets is an integral part of achieving the entity’s business objective for the financial asset.
Example:
| If an entity has invested in a debt instrument (e.g. a government or a corporate bond) that matures in … | And the entity is likely to need the funds in… | The business model for the financial asset is likely to be… |
| 6 months | 3 months | Hold to collect and sell (because the funds will be required before the maturity date of the investment and selling the instrument would be an integral part of the investment) |
| 6 months | 6-12 months | Hold to collect (because the investment will mature before the funds are required) |
| 9 months | 2 years | Hold to collect |
| 10 years | 1 year | Hold to collect and sell |
Note: Unlike the contractual cash flows characteristics test, the business model can be carried out on a group basis.
Under IFRS 9, the characteristics of a financial asset that is a debt instrument are central to the manner in which it will be measured subsequent to initial recognition. As accounting teams prepare for their adoption of IFRS 9, they will need to understand both the characteristics of each of their classes of financial assets that are debt instruments, and identify the entity’s business strategy for its financial assets.