The IASB recently discussed some potential amendments to the contractual cash flow characteristics requirements in IFRS 9 Financial Instruments.
The purpose of these would be to clarify some of the underlying principles of the “solely payments of principal and interest” (‘SPPI’) assessment. Feedback from the post-implementation review of IFRS 9 had indicated “that the IASB could help entities with consistent application by clarifying particular aspects of the SPPI requirements. This was indicated in particular by the many questions raised by respondents about how to apply the SPPI requirements to financial assets with ESG-linked features, and about the scope of the requirements for contractually-linked instruments” (so while this is my first blog post in a while that hasn’t focused on the two big sustainability standard-setting projects, it’s still hard to get away from the general topic).
You’ll recall that IFRS 9 is based on the premise that amortized cost provides useful information to users of financial statements about the amount, timing and uncertainty of future cash flows of financial assets only if such cash flows meet that SPPI criterion; in such cases, the cash flows are viewed as being consistent with a “basic lending arrangement.” The assessment of interest focusses on what the entity is being compensated for (consideration for basic lending risks, costs and a profit margin) rather than on the amount it receives. The IASB, noting that the global market for financial instruments with ESG-linked features is expected to grow rapidly, considered whether to create an exception for ESG-linked features from the general requirements, but decided instead that the issue could be addressed by providing more explanation and guidance. Consequently, it tentatively decided at its September meeting “to amend IFRS 9 to clarify that for contractual cash flows of a financial asset to be ‘solely payments of principal and interest on the principal amount outstanding’, a basic lending arrangement does not cause variability in cash flows arising from risks or factors that are unrelated to the borrower, even if such terms and conditions are common in the specific market in which the entity operates.” Against that backdrop, a financial asset including contractual terms that change the timing and amount of the contractual cash flows would be consistent with ‘a basic lending arrangement’ when all the following apply.
- The contractual cash flows that could arise from any contingent events are solely payments of principal and interest in all circumstances. In developing IFRS 9, the IASB rejected the view raised by some stakeholders that a contingent feature shouldn’t affect the classification of a financial asset if the likelihood that the future event will occur is remote; it concluded instead that even if the probability of a contingent event is remote or low, the entity has to consider all contractual cash flows that could arise over the life of the instrument. Put another way, for the purpose of the SPPI assessment, an entity must assume that the contingent event will occur.
- The contingent event must be specific to the borrower. For example, consider contractual terms including ESG-linked features. A contingent future reduction in the interest rate based on a reduction in the industry average of greenhouse gas emissions doesn’t result in cash flows that are SPPI – in that case the target depends on collective action and isn’t specific to the borrower. But if the entity itself has to meet pre-defined ESG targets, then the occurrence of the event is specific to the borrower (even if the targets are the same as those individually imposed by the lender on other borrowers).
- The timing and amount of any variability in contractual cash flows must be determinable and specified in the contract. A financial asset is classified at initial recognition on the basis of the contractual cash flows over the life of the instrument. If an entity isn’t able to determine that all contractual cash flows that could arise over the life of the instrument (including from contingent events) are SPPI, the financial asset is measured at fair value through profit and loss.
- The contractual cash flows arising from the contingent event must not represent an investment in the borrower or exposure to the performance of any underlying assets. For example, consider a contractual term that increases the interest rate on a loan if the borrower’s profitability exceeds a certain threshold. Although this contingent event is specific to the borrower, it’s akin to an investment in the borrower (that is, sharing in the borrower’s profitability) and not consistent with a basic lending arrangement.
The IASB also tentatively decided to add examples in order to illustrate the application of the contractual cash flow characteristics assessment to specific fact patterns. But before any of that moves forward, the IASB “will continue to discuss further potential clarifications of the requirements….”
The opinions expressed are solely those of the author