As the mandatory effective date of 1 January 2018 approaches, we are going to consider a different element of IFRS 9 Financial Instruments on a regular basis. This month we take a look the solely payments of principal and interest (SPPI) test.
Why is the SPPI test important?
As explained in the June edition of Business Edge, the classification decision for non-equity financial assets under IFRS 9, is dependent on two key criteria:
- The business model within which the asset is held (the business model test), and
- The contractual cash flows of the asset (the SPPI test).
Consequently, determining whether a financial asset meets the SPPI test is necessary in order to determine the appropriate classification category under IFRS 9. The business model test was covered in the October edition of Business Edge
If a non-equity financial asset fails the SPPI test, it must be classified at Fair Value Through Profit or Loss (FVTPL) in its entirety. Unlike IAS 39, it is no longer possible to separate a financial asset into a ‘host’ contract (often measured at amortised cost) and an ‘embedded derivative’ component (measured at FVTPL). If a non-equity financial asset passes the SPPI test, then it will either be classified at amortised cost if the ‘hold to collect’ business model test is met, or at Fair Value Through Other Comprehensive Income (FVTOCI) if the ‘hold to collect and sell’ business model test is met.
What is the SPPI test?
The SPPI test requires that the contractual terms of the financial asset (as a whole) give rise to cash flows that are solely payments of principal and interest on the principal amounts outstanding ie cash flows that are consistent with a basic lending arrangement. Unlike the business model test, this assessment must be carried out on an instrument by instrument basis.
Principal is defined as being the fair value of the financial asset at initial recognition. Interest is defined narrowly as being compensation for the time value of money and credit risk although it can also include compensation for other lending risks such as liquidity, administrative costs and a profit margin. Cash flows that provide compensation for other risks such as equity or commodity risk will fail the SPPI test because they are inconsistent with a basic lending arrangement.
Which financial assets are likely to meet the SPPI test?
Common examples of financial assets that will meet the SPPI test are:
- A bond repayable in 3 years and paying variable or fixed market rate of interest
- A fixed rate loan repayable in 10 years but allows the borrower to prepay at an amount equal to unpaid amounts of principal and interest on the principal amount outstanding
- An interest free loan by a parent to a subsidiary that is repayable in 5 years - this is because the principal amount (i.e. fair value at initial recognition) would be accreted back to par using the effective interest rate method.
Which financial assets are likely to fail the SPPI test?
Common examples of financial assets that will fail the SPPI test are:
- All equity investments because their contractual terms give rise to equity risk
- All derivatives because they are leveraged in nature
- A bond with interest payments linked to the EBITDA or revenue of the issuer or contingent consideration linked to profits generated by a business that has been sold - this is because these features introduce exposures to equity like risks.
What action is needed?
In order to determine the appropriate classification category under IFRS 9, entities must assess whether their financial assets meet the SPPI test at the date of initial recognition. While financial assets that contained non-closely related embedded derivatives under IAS 39 are more likely to fail this test, it is important that the contractual terms of all financial assets are reviewed in accordance with the new requirements.
For help and advice on IFRS 9 please get in touch with your usual BDO contact or Dan Taylor.
Read more on IFRS 9:
IFRS 9 Explained - the new expected credit loss model
IFRS 9 explained - modifications of financial liabilities
IFRS 9 explained - the classification of financial assets
IFRS 9 explained - Hedge effectiveness thresholds
IFRS 9 explained - Impairment and the simplified approach
IFRS 9 Explained - Available For Sale Financial Assets
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