The IASB recently discussed some potential amendments to the contractual cash flow characteristics requirements in IFRS 9 Financial Instruments.
We’ve already addressed some potential amendments to clarify some of the underlying principles of the solely payments of principal and interest (‘SPPI’) assessment. 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.
When it developed IFRS 9, the IASB considered instruments with contractual cash flows that are described as ‘principal and interest’ but that aren’t economically consistent with how IFRS 9 uses those terms. One such category arises in cases where the lender’s claim is limited to specified assets of the borrower or the cash flows from specified assets – the standard labels these as ‘non-recourse’ financial assets, Feedback from the post-implementation review of IFRS 9 indicated (not too surprisingly) some difficulty in applying this concept. The IASB therefore tentatively described at its September meeting to to clarify that a financial asset with non-recourse features:
- exposes the lender to the performance risk of underlying assets throughout the life of the instrument, both in making contractual payments as well as in default; and
- restricts the lender’s contractual right to receive contractual payments over the life of the instrument to the cash flows generated by the underlying assets.
That is to say, the contractual terms of a financial asset would be inconsistent with a basic lending arrangement if the lender is, in addition to (or instead of) the credit risk of the borrower, exposed to the performance risk of an underlying asset (or pool of assets); in such a scenario, the lender isn’t only exposed to basic lending type risks. This is distinguished from a lender in a full recourse loan collateralized by another asset; in that case the exposure to the collateralized asset is only to the extent that the borrower is unable to make the contractual payments through other means.
The assessment of the contractual cash flows requires judgement based on the specific facts and circumstances. In some cases, the non-recourse feature may result from the substance of the contractual cash flows, rather than being an explicit contractual term. For example, a loan to a special purpose entity (SPE) may have contractual cash flows described as payments of principal or interest, but the lender’s contractual right to the cash flows may be limited to a specified portfolio of the SPE’s assets. The IASB tentatively decided to include examples (not exhaustive, and none of them determinative in isolation) of relevant factors that an entity could consider when assessing the contractual cash flow characteristics of a financial asset with non-recourse features. These include:
- the legal or capital structure of the borrower. The staff paper notes: “SPEs are typically established with only nominal equity and therefore with very little loss absorbency capacity. If the loan provided by the lender is acting as quasi-equity such that any or all losses from the underlying assets are absorbed by the lender, the contractual cash flows are not SPPI.”
- the extent to which the expected cash flows from the underlying assets exceed the contractual cash flows of the financial asset; or whether there are other sources of finance (that is, loans) that are subordinated to the loan from the lender. The paper notes: “If the underlying assets are funded entirely by the loan from the lender (ie a 100% loan-to-value ratio), the lender would be exposed to any and all losses from the underlying assets and the loan would represent an investment in the underlying assets rather than cash flows that are SPPI. On the other hand, if the loan from the lender only funds a portion of the underlying assets and other loans to the SPE are subordinated to the loan from the lender, the contractual cash flows could be SPPI despite the non-recourse feature.”
No doubt the impact of these changes, if implemented as currently envisaged, might be significant in some cases where a financial interest currently characterized as that of a lender would instead be reflected as that of an investor, giving a truer representation of the associated risk and potential volatility. And of course, the harder a preparer has to work to demonstrate that a particular stream of cash flows meets that “SPPI” criterion, the more likely it probably is that another form of presentation and disclosure is more appropriate…
Anyway, for now the IASB will “continue to discuss further potential clarifications of the requirements….”
The opinions expressed are solely those of the author