The IASB has issued Prepayment Features with Negative Compensation, an exposure draft of proposed amendments to IFRS 9, Financial Instruments, with comments to be received by May 24, 2017.
You’ll recall that under IFRS 9, an entity classifies financial assets for purposes of ongoing measurement on the basis of both its business model for managing the financial assets, and the contractual cash flow characteristics of those assets. It measures a financial asset at amortized cost if it holds the asset within a business model with the objective of collecting contractual cash flows, and if its contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
The application guidance to the standard goes through various contractual terms that are or aren’t consistent with this concept. In particular, an entity may be measured at amortized cost even though it contains a contractual term that permits the issuer to prepay a debt instrument or permits the holder to put a debt instrument back to the issuer before maturity, where 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.” In this case, the IASB reasoned that the prepayment terms don’t change the standard’s basic premise: the future cash flows associated with the instrument are essentially simple, and so amortized cost provides information that reflects their amount, timing and uncertainty.
The new exposure draft addresses whether a debt instrument might still be assessed as having 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 a current market interest rate). It reasserts that amortized cost won’t usually be an appropriate measurement basis for such instruments. However, the exposure draft proposes that an instrument remains eligible to be measured at amortized cost if, firstly, the prepayment substantially represents unpaid amounts of principal and interest and “the party that chooses to terminate the contract early (or otherwise causes the early termination to occur) may receive reasonable additional compensation for doing so.”
To illustrate how this changes the existing standard, the exposure draft discusses a case (“Asset B”) where the compensation payable on termination depends on the movement in the relevant market interest rate: “As a result, the borrower or the lender may receive an amount even if it is the party that chooses to exercise its option to terminate the contract early. That is, if Asset B is terminated early (by either party) and the relevant market interest rate has decreased since Asset B was initially recognized, then the lender will effectively receive an amount representing the present value of lost interest revenue over Asset B’s remaining term. Correspondingly, if the contract is terminated early (by either party) and the relevant market interest rate has increased, the borrower will effectively receive an amount that represents the effect of that change in that interest rate over Asset B’s remaining term.” Under IFRS 9 as it exists before the exposure draft, this goes a bit beyond just requiring “reasonable additional compensation for the early termination of the contract” and so precludes applying amortized cost. But the IASB thinks that overall, amortized cost still provides sufficiently useful information about such instruments.
The exposure draft proposes a second condition too though: that when the entity initially recognizes the financial asset, the fair value of the prepayment feature is insignificant. The IASB thinks this will “limit the scope of the proposed exception so that financial assets are eligible to be measured at amortized cost only if it is unlikely that prepayment (and thus, the ‘negative compensation’) will occur.”
One member of the IASB dissented from the exposure draft, worrying among other things that “IFRS 9 is a principle-based standard and if one request for a rule-based exception is granted, then (he) thinks it is likely that there will be more requests.” You might take the view though that if IFRS 9 is indeed a principle-based standard, it can already be hard sometimes to remember that fact, under the existing layers of definition and clarification – one more tweak doesn’t seem particularly likely to undermine anything fundamental. In contrast, a broad requirement, say, to measure all financial instruments at fair value through profit or loss might have provided a better basis for holding the line against special pleading. However, the existing basis for conclusions to IFRS 9 reminds us that “almost all respondents” to the 2009 exposure draft “supported the mixed attribute approach,” so the ship has decisively sailed, and likely won’t be back in the harbour any time soon…
The opinions expressed are solely those of the author