Introduction

IFRS 9 is mandatory for periods beginning on or after 1 January 2018, with early adoption permitted, except for entities that issue insurance contracts and that qualify for the temporary exemption.

This chapter only covers the classification and measurement requirements of IFRS 9 for financial assets and financial liabilities. The other requirements of IFRS 9 are addressed in separate chapters.

Scope

IFRS 9 must be applied by all entities preparing their financial statements according to IFRS and to all types of financial assets and financial liabilities within its scope (see chapter 40 para 43 for a detailed overview of the scope of IFRS 9).

Financial assets and financial liabilities that are designated as hedged items are subject to measurement under IFRS 9’s hedge accounting requirements (or IAS 39, if applicable). These special accounting rules generally override the normal accounting rules for financial assets.

Classification of financial assets

An entity recognises a financial asset when it first becomes a party to the contractual rights and obligations in the contract. It is, therefore, necessary to measure those contractual rights and obligations on initial recognition.

Classification and measurement of investments in money market funds under IFRS 9 Money market funds (MMFs), also known as money market liquidity funds, are open-ended mutual funds that invest in short-term debt instruments (for example, one day to one year) such as treasury bills, certificates of deposit, bonds, government gilts and commercial paper. Question: How should investments in MMFs be classified and measured under IFRS 9? Solution: IFRS 9 classification and measurement In the context of MMFs, IFRS 9’s classification and measurement requirements can be worked through as follows. Step 1: Is the investment in MMFs a debt or equity investment? Under IFRS 9, the holder will classify an investment as debt or equity by assessing whether the instrument meets the definition of debt or equity for the issuer under IAS 32. Most investments in MMFs are puttable – that is, the holder can sell its holding back to the MMF in return for cash. Whilst such puttable instruments might be classified as equity by the issuer in accordance with paragraph 16A of IAS 32, they do not meet the definition of equity (see chapter 43 para 35). Consequently, most MMFs will be considered debt instruments from the holder’s perspective. Step 2a: If the investments in MMFs are debt, how should they be classified and measured under IFRS 9? IFRS 9 requires entities to consider whether the cash flows on debt investments are solely payments of principal and interest (SPPI) and whether the business model for holding those assets is for the collection of cash flows, sale of the assets, or a combination of the two. In most cases, cash flows of investments in MMFs will not be SPPI. Whilst the underlying investments held by the MMF might have cash flows which do represent SPPI, those investments are periodically sold by the MMF. The MMF’s net asset value will not represent SPPI, because it includes gains/losses from the sale of the underlying investments. Consequently, investments in MMFs which are puttable back to the MMF are puttable at an amount which is not SPPI. Further, any interest/dividends which are receivable on the investment in MMFs do not represent SPPI, since they are also based on the net asset value of the MMF, which includes gains/losses from the sale of the underlying investments. Investments in MMFs which are not SPPI should be held at fair value through profit or loss. If the net asset value of the MMF does not include gains/losses, further analysis will be required to determine whether the cash flows of investments in that MMF are SPPI. Many investments in MMFs are presented as cash equivalents in the statement of financial position and cash flow statement. FAQ 7.6.1 sets out when investments in MMFs can be presented as cash equivalents. Therefore, in many cases, investments in MMFs will be measured at fair value through profit or loss but presented as cash equivalents in the statement of financial position and cash flow statement. From a disclosure perspective, the entity holding the investments in MMFs will need to ensure that these investments are disclosed as held at fair value through profit or loss in the notes to the financial statements, and it will determine the level at which they are included in the IFRS 13 fair value hierarchy disclosures. If fair value movements on the investments in MMFs are material, the entity holding those investments will need to consider how to present any fair value movements in the income statement. Step 2b: If the investments in MMFs are equity, how should they be presented and accounted for under IFRS 9? As noted above, there are limited circumstances in which investments in MMFs might meet the definition of investments in equity instruments. If the investment in MMFs does meet the definition of an equity investment, it will be held at fair value through profit or loss unless the holder of the investment makes an irrevocable election to designate that investment at fair value through other comprehensive income.

All financial assets under IFRS 9 are to be initially recognised at fair value, plus or minus (in the case of a financial asset not at FVTPL) transaction costs that are directly attributable to the acquisition of the financial instrument.

IFRS 9 has two measurement categories: amortised cost and fair value. Movements in fair value are presented in either profit or loss or other comprehensive income (OCI), subject to certain criteria being met, as described below.

To determine which measurement category a financial asset falls into, management should first consider whether the financial asset is an investment in an equity instrument, as defined in IAS 32, by considering the perspective of the issuer or a debt instrument. If the financial asset is an investment in an equity instrument, management should consider the guidance for ‘equity instruments’. If the financial asset is not an investment in an equity instrument, management should consider the guidance for ‘debt investments’.

Classification of debt investments

If the financial asset is a debt instrument (or does not meet the definition of an equity instrument in its entirety), management should consider the following assessments in determining its classification: The entity’s business model for managing the financial asset. The contractual cash flows characteristics of the financial asset.

These considerations are represented in the following flow chart:

A financial asset should be subsequently measured at amortised cost if both of the following conditions are met:

• the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows; and
• the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.

A financial asset should be subsequently measured at FVOCI if both of the following conditions are met:

• the financial asset is held within a business model whose objective is achieved by both holding financial assets in order to collect contractual cash flows and selling financial assets; and the contractual terms of the financial asset give rise on specified dates to cash flows that are SPPI.

If the financial asset is measured at FVOCI, all movements in the fair value should be taken through OCI, except for the recognition of impairment gains or losses, interest revenue in line with the effective interest method and foreign exchange gains and losses, which are recognised in profit or loss.

If the financial asset does not pass the business model assessment and SPPI criteria, or the fair value option is applied, it is measured at FVTPL. This is the residual measurement category.

Business model

An entity’s business model refers to how an entity manages its financial assets in order to generate cash flows. IFRS 9 prescribes two business models: holding financial assets to collect contractual cash flows; and holding financial assets to collect contractual cash flows and selling. FVTPL is the residual category which is used for financial assets that are held for trading or if a financial asset does not fall into one of the two prescribed business models.

Business model assessment: stress case scenarios Question: Should an entity take stress case scenarios into account in its business model assessment? Solution: No. If an entity expects that it will sell a particular portfolio of financial assets only in a stress case scenario, that scenario would not affect the entity’s assessment of the business model for those assets if the entity reasonably expects that such a scenario will not occur.

Impact on the business model assessment of a bond issuer’s offer to repurchase or replace a bond Question: Prior to the contractual maturity of a bond, an issuer might offer to the bondholder either to repurchase the bond for cash or to replace it with a newly issued bond with substantially different terms. A bondholder might accept such an offer for various reasons (for example, if it is concerned that the bond will become illiquid if other bondholders accept the offer). Assume that the offer is not caused by an increase in the issuer’s credit risk, it does not take place close to the contractual maturity of the bond, and acceptance of the offer by the bondholder results in derecognition of the original bond. What is the impact of such a transaction on the bondholder’s business model assessment? Solution: Scenario 1: the written terms of the bond state the issuer’s right to offer to repurchase or replace the bond before the contractual maturity. IFRS 9 explains that derecognition might result from either (i) expiry of the contractual rights to the cash flows from the financial asset, or (ii) a transfer of the financial asset that qualifies for derecognition. In this case, repurchase or replacement of the bond by the issuer results in expiry of the rights to contractual cash flows – such an expiry of the rights to cash flows is not a sale for the purposes of the business model assessment. Since the repurchase or replacement of the bond is also in accordance with the written terms of the bond, acceptance of such an offer and the resulting derecognition represents collection of the contractual cash flows. It is therefore consistent with a ‘hold to collect’ business model in accordance with IFRS 9. This conclusion on the business model assessment would also apply where the bondholders have the right to request redemption if the issuer would otherwise exercise a unilateral right to adjust the interest rate of the bond before contractual maturity. The redemption would represent expiry of the bonds, and not a sale for the purposes of the business model assessment. Pre-payment clauses (of which a repurchase / replacement right would be one) also need to be considered as part of the SPPI assessment, in particular, consideration of those clauses at fair value, and the frequency of exercise. Scenario 2: the written terms of the bond do not state the issuer’s right to offer to repurchase or replace the bond before the contractual maturity Repurchase transactions in this scenario typically take place at fair value. IFRS 9 does not provide clear guidance on repurchase transactions with the original issuer of securities, and it is appropriate to consider two possible views. One possible view is that such a repurchase at fair value is not a sale, for the reasons set out in scenario 1. However, judgement is required in concluding whether amortised cost is the most appropriate measurement basis where such offers could be made and accepted. In substance, it does not matter whether or not the right to make such an offer is included in the written terms of the bond, because an issuer can always make a unilateral offer to repurchase or replace a bond. If an issuer has a past practice of offering to repurchase or replace bonds at fair value, it could also be seen as an implied term to pre-pay at fair value. Therefore, as in scenario 1, the resulting expiry can be considered consistent with a ‘hold to collect’ business model. However, if there is a high likelihood that an issuer might offer to repurchase or replace a bond and that the bondholder will accept the offer, it could be questioned whether amortised cost is the most appropriate measurement basis. A second possible view is that the repurchase or replacement in scenario 2 is neither a sale nor a collection of the bond’s contractual cash flows, since the bond’s written terms do not provide for such a repurchase or replacement. Such a transaction is therefore not consistent with a business model whose objective is achieved either (i) by collecting contractual cash flows, or (ii) by collecting contractual cash flows and selling financial assets. Accordingly, the bond should be classified within an ‘other’ business model and measured at FVPL in accordance with IFRS 9. Therefore, an entity should choose an accounting policy and apply this consistently. The policy should be disclosed appropriately. If an entity concludes that a ‘hold to collect’ business model is appropriate, and bonds are measured at amortised cost, any gains and losses on derecognition, including any arising from a repurchase or replacement, should be disclosed in the statement of profit or loss in accordance with IAS 1.

Determining the business model

An entity’s business model is determined by the entity’s key management personnel (as defined in IAS 24).

The business model is typically observable through the activities that the entity undertakes to achieve the objective of the business model. The business model for managing financial assets is not determined by a single factor or activity. Instead, management has to consider all relevant evidence that is available at the date of the assessment. Such relevant evidence includes, but is not limited to:

• how the performance of the business model (and the financial assets held within) is evaluated and reported to the entity’s key management personnel;
• the risks that affect the performance of the business model (and the financial assets held within) and, in particular, the way that those risks are managed; and
• how managers of the business are compensated (for example, whether the compensation is based on the fair value of the assets managed or the contractual cash flows collected).

Determining the level at which the business model condition should be applied

Management will need to apply judgement to determine the level at which the business model condition is applied. That determination is made on the basis of how an entity manages its business; it is not made at the level of an individual asset, rather it is performed at a higher level of aggregation. So, the entity’s business model is not a choice and does not depend on management’s intentions for an individual instrument; it is a matter of fact that can be observed by the way in which an entity is managed and information is provided to its management.

An entity can have multiple business models. For example, it might hold one portfolio of investments that it manages in order to collect contractual cash flows, and another portfolio of investments that it manages in order to sell to realise fair value changes. In some circumstances, it might be appropriate to separate a portfolio of financial assets into sub-portfolios, to reflect how an entity manages those financial assets. This might be the case if an entity originates or purchases a portfolio of mortgage loans, and manages some of the loans with an objective of collecting contractual cash flows and manages the other loans with an objective of selling them. This will be a highly judgemental area, because it might be difficult to distinguish, within a portfolio, which financial assets are held to collect, to collect and sell, or to trade.

Business model assessment: useful indicators Question: What are some of the indicators that management might find helpful to consider in assessing the business model for each portfolio that it has identified? Solution: Some useful indicators would include: ·        the purpose of the portfolio, as assessed by management (for example, whether the portfolio is held to collect cash flows, to maximise investment return or to meet liquidity requirements); ·        the composition of the portfolio, and its alignment with the declared objectives of the portfolio; ·        the mandates granted to the manager of the portfolio (for example, the breadth of the investments that can be made, and the limitations on disposals); ·        the metrics used to measure and report on portfolio performance (for example, whether fair values are an important KPI); ·        the methodology for the portfolio manager’s remuneration (for example, whether the manager is remunerated based on realised profits or unrealised gains and losses); and ·        levels of, and reasons for, any sales of assets in the portfolio.

 ‘Hold to collect’ business model

If the entity’s objective is to hold the asset (or portfolio of assets) to collect the contractual cash flows, the asset (or the portfolio) should be classified under the ‘hold to collect’ business model. If the entity’s objective is to hold to collect and sell the asset, see the guidance at paragraph 42.28 onwards below.

Although the objective of an entity’s business model might be to hold financial assets in order to collect contractual cash flows, the entity does not need to hold all of those instruments until maturity. Thus, an entity’s business model can be to hold financial assets to collect contractual cash flows, even where sales of financial assets occur or are expected to occur in the future.

IFRS 9 provides guidance on the particular considerations that should be taken into account when assessing sales within the ‘hold to collect’ business model:

• The historical frequency, timing and value of sales.
• The reason for the sales (such as credit deterioration).
• Expectations about future sales activity.

Sales themselves do not determine the business model, and so they cannot be considered in isolation. Rather, information about past sales, and expectations about future sales, provide evidence related to the entity’s objective for managing the financial assets and, specifically, how cash flows are realised and value is created.

Credit risk management activities aimed at minimising potential losses due to credit deterioration are not inconsistent with the ‘hold to collect’ business model. Selling a financial asset because it no longer meets the credit criteria specified in the entity’s documented investment policy is an example of a sale that has occurred due to an increase in credit risk. However, in the absence of such a policy, the entity could demonstrate in other ways that the sale occurred due to an increase in credit risk.

Is alignment required between ‘increase in credit risk’ for business model purposes and ‘significant increase in credit risk’ for ECL purposes? Question : When assessing the business model requirements of IFRS 9, the standard states that sales due to ‘an increase in the assets’ credit risk’ are not inconsistent with a ‘hold to collect’ business model. This is because the credit quality of financial assets is relevant to the entity’s ability to collect contractual cash flows. This might appear similar to the concept of a ‘significant increase in credit risk’ (SICR) in the IFRS 9 expected credit loss (ECL) impairment model, after which lifetime expected credit losses are recognised on financial instruments (sometimes referred to as ‘stage 2’). Is alignment required between an SICR for ECL purposes and an ‘increase in credit risk’ for business model purposes, so that a sale from a ‘hold to collect’ business model is only justified on the basis of increased credit risk if the asset has also moved to ‘stage 2’ for impairment purposes? Solution : No. IFRS 9 states that a ‘hold to collect’ business model does not require an entity to wait to sell the financial asset until it has incurred a credit loss or until there has been a significant increase in credit risk (and lifetime expected credit losses are recognised on the asset). However, a substantive increase in credit risk nevertheless needs to have occurred based on reasonable and supportable information – a sale cannot be justified just because some future adverse event might happen. Furthermore, the information used to demonstrate that a sale is due to an increase in credit risk for business model purposes would be expected to be consistent with the information used to assess SICR. If it is not, there should be appropriate justification for this. In order for a sale to be justified due to an asset’s increase in credit risk, the sale would generally be expected to take place shortly after the entity becomes aware of the increase in credit risk and not left until a later date. The longer the period between the increase in credit risk and the sale, the more evidence that is required to justify the delay and that the sale was due to the increase in credit risk, rather than due to some other reason. The delay, for example, could be due to a lack of buyers in the market. In contrast to the requirements of SICR, the IFRS 9 business model requirements also include no explicit statement that an ‘increase in credit risk’ should be assessed by reference to the credit risk of the asset at initial recognition. However, the requirement for the sale to be in response to an increase in credit risk will generally mean that this is required. Consider an example where an entity acquires a financial asset when the asset has a BB credit rating, following which the credit rating improves to AA but then declines to A, at which point the entity sells the asset. It would be rare that such a sale would be justified for business model purposes on the basis of an increase in credit risk: if, when acquired, the credit risk at BB was considered acceptable in the context of the entity holding the asset to collect its contractual cash flows, the same would be expected to be true when the credit rating had improved to A. In rare circumstances, an entity might change its credit criteria for holding financial assets, but such changes are expected to be infrequent and would need to be supported by sufficient evidence.

Are sales of loans due to credit deterioration permissible in a ‘hold to collect’ business model where the deterioration occurred prior to the date of initial application of IFRS 9? Question: When a bank originates loans, the loans might subsequently become non-performing loans (‘NPLs’) or otherwise experience a deterioration in credit quality. These loans might be held within portfolios of performing loans or managed in separate ‘workout’ units. A bank might maximise its recovery of principal and interest payments via a range of possible strategies, which could include loan sales. IFRS 9 states that sales due to an increase in an asset’s credit risk are not inconsistent with a ‘hold to collect’ business model, because the credit quality of financial assets is relevant to the entity’s ability to collect contractual cash flows. Where a bank expects to make frequent and more than insignificant sales of loans that have experienced credit deterioration prior to the date of initial application of IFRS 9, do such sales preclude a ‘hold to collect’ business model? Solution: No. When performing the business model assessment, IFRS 9 requires that “at the date of initial application, an entity shall assess whether a financial asset meets the condition mentioned on the basis of the facts and circumstances that exist at that date”. IFRS 9 provides no additional guidance on how this requirement should be interpreted or applied, so judgement is required. In our view, there are two possible interpretations. One view is that the past decline in credit quality is a ‘fact and circumstance’ that exists at the date of initial application, and so it can be considered when performing the business model assessment at initial application. This would mean that a sale of a loan after the date of initial application, as a result of a decline in credit quality prior to the date of initial application, would not preclude a ‘hold to collect’ business model. The second view is that the facts and circumstances existing at the date of initial application comprise only the credit quality at the date of initial application, and not changes since the entity originated the loan. This would mean that a further decline in the credit quality since the date of initial application would be required for the sale to not preclude a ‘hold to collect’ business model due to credit deterioration. An entity should make a policy choice, and it should apply the selected policy consistently.

Some sales or transfers of financial instruments before maturity that are not related to credit risk management activities might be consistent with such a business model if they are infrequent (even if significant in value) or insignificant in value, either individually or in aggregate (even if frequent).

How should sales be considered in determining if the business model is ‘hold to collect’? Question: How should sales be considered in determining if the business model is ‘hold to collect’? Solution: An entity’s business model can be to hold financial assets to collect contractual cash flows (‘hold to collect’ business model), even where sales of financial assets occur or are expected to occur in the future. Firstly, irrespective of their frequency and value, sales due to an increase in credit risk are not inconsistent with a ‘hold to collect’ business model. In addition, sales might also be consistent with the objective of holding financial assets in order to collect contractual cash flows if the sales are made close to the maturity of the financial assets and the proceeds from the sales approximate the collection of the remaining contractual cash flows. Secondly, sales other than those due to an increase in credit risk or close to maturity might be consistent with a ‘hold to collect’ business model, regardless of the reason for the sale, if those sales are either: ·        insignificant in value, both individually and in aggregate (even if frequent); or ·        infrequent (even if significant in value). Lastly, if sales other than those noted above are expected to be made out of a portfolio, the entity needs to assess whether and how such sales are consistent with a ‘hold to collect’ business model. Similarly, an increase in the frequency or value of sales in a particular period is not necessarily inconsistent with an objective to hold financial assets in order to collect contractual cash flows if an entity can explain the reasons for those sales and demonstrate why those sales do not reflect a change in the entity’s business model. These reasons and explanations might require disclosure as critical accounting judgements under IAS 1. However, whether a third party imposes the requirement to sell the financial assets, or that activity is at the entity’s discretion, is not relevant to this assessment.

Sales that are insignificant in value Question 1: IFRS 9 states that sales of financial assets could be consistent with a business model whose objective is to hold financial assets in order to collect contractual cash flows if those sales are infrequent (even if significant in value) or insignificant in value, both individually and in aggregate (even if frequent). What is the reference point for ‘insignificant in value’? Solution: Whether or not sales are ‘insignificant in value’ requires assessment of the value of those sales (that is, the sale price). The appropriate reference point for comparison of this amount should be the value of the portfolio subject to the business model. An inappropriate reference point is the entity’s total assets, because this does not relate to the portfolio that is subject to the business model assessment. An entity might also choose to internally monitor gains/losses arising from sales, given that this is required to be presented as a separate line item in the statement of profit or loss. [IAS 1 para 82(aa)]. However, using gains/losses as the only reference point for assessing whether or not sales are insignificant in value would not be appropriate. Such an approach could result in a business model still being considered ‘hold to collect’, even where a substantial percentage of the loans are sold at book value so that no gains or losses result. Question 2: How should the term ‘in aggregate’ be interpreted? Does this relate to the reporting period or to the average life of the portfolio? Solution: Sales should be considered over the average life of the portfolio when assessing whether they are insignificant in value. The average life of the portfolio takes into consideration those portfolios with long-dated average maturities which might be completely turned over during a particular period. As such, consideration of sales only during a particular reporting period is not considered sufficient.

Sales that are infrequent Question How should the term ‘infrequent’ be interpreted? Solution The standard contains no guidance on how the term ‘infrequent’ is to be interpreted. In our view, the following principles should be applied: ·        ‘Infrequent’ refers to frequency alone, and so it should not be assessed on a relative basis (that is, what is ‘infrequent’ for a business model holding many assets should not differ from what is infrequent for a business model holding fewer assets) or on a qualitative basis (that is, the reason for any sales is not relevant to whether they are infrequent or not). ·        The observation period for determining whether sales are infrequent should not comprise only a single reporting period. This is because the assessment of whether the business model is hold to collect considers whether the objective is to collect assets’ contractual cash flows over their entire life, rather than only in a single period. ·        In determining whether sales are infrequent, an entity should take into account all sales, including those that are considered insignificant in value; this is because, taken together, they might be both more than insignificant and more than infrequent.

The impact of sales to a fellow group entity due to regulatory capital constraints. Question : Some groups have business models which operate across multiple legal entities. Sales might occur between legal entities (for example, due to regulatory capital constraints in an individual legal entity). Consider the following example: ·        Bank XYZ has multiple legal entities and business models within the consolidated Group. Two 100% owned entities, Subsidiary A and Subsidiary B, each originate loans that meet SPPI and are part of the same ‘hold to collect’ business model at the consolidated group level. ·        Due to regulatory capital constraints at the legal entity level, Subsidiary A sometimes sells loans to Subsidiary B to avoid breaching its regulatory capital requirements, resulting in derecognition of these loans in Subsidiary A’s separate financial statements. It is not known, at the time when a loan is originated, whether the loan will subsequently be sold. ·        Such sales are more than infrequent, more than insignificant in value, and there are no other circumstances that indicate that they are consistent with a ‘hold to collect’ business model (such as an increase in the assets’ credit risk). ·        No accounting gain or loss is recognised by Subsidiary A from the intragroup sales to Subsidiary B, because the loans are sold at book carrying amount. ·        On a stand-alone legal entity reporting basis, no fair value information is reviewed by Subsidiary A in assessing performance, remuneration or risk management; only amortised cost information is used. In assessing the business model of Subsidiary A at an individual legal entity level, are such sales inconsistent with an objective of holding assets to collect the contractual cash flows? Solution : Yes. As illustrated by IFRS 9, a group can have a ‘hold to collect’ business model at the consolidated group level, but have a business model other than ‘hold to collect’ at the legal entity level where sales occur between different legal entities. Further, IFRS 9 states that “Whether a third party imposes the requirement to sell the financial assets, or that activity is at the entity’s discretion, is not relevant to this assessment”. Therefore, the fact that the sales by an entity might arise from regulatory capital requirements imposed by a third party does not alter the business model analysis (that is, these sales cannot be disregarded). The need to sell existing loans can also be viewed as resulting from the entity’s own free choice; this is because, if it did not originate new loans in Subsidiary A, then these sales would not be necessary. Therefore, in assessing the business model of Subsidiary A at the individual legal entity level, such sales cannot be disregarded. Since such sales are more than infrequent, more than insignificant in value and there are no other circumstances that indicate that they are consistent with a ‘hold to collect’ business model, they are not consistent with a business model whose objective is to hold assets to collect contractual cash flows. This is consistent with the fact that sales are an integral part of the business model of Subsidiary A at the individual legal entity in order for it to manage its regulatory capital risk. As a result, the business model of Subsidiary A at the individual legal entity level cannot be ‘hold to collect’.

There is no bright line for how many sales constitute ‘infrequent’ or ‘significant’; an entity will need to use judgement, based on the facts and circumstances. An increase in the frequency or value of sales in a particular period is not necessarily inconsistent with an objective to hold financial assets in order to collect contractual cash flows, if an entity can explain the reasons for those sales and demonstrate why those sales do not reflect a change in the business model. In addition, sales might be consistent with the objective of holding financial assets in order to collect contractual cash flows if the sales are made close to the maturity of the financial assets, and the proceeds from the sales approximate to the collection of the remaining contractual cash flows. IFRS 9 includes a number of examples of how to perform the business model assessment.

If more than an infrequent number of sales are made out of a portfolio, management should assess whether (and how) such sales are consistent with an objective of collecting contractual cash flows. However, management should be clear about the reason for determining if sales would prevent a group of financial assets from being classified within the ‘hold to collect’ business model. Entities might consider setting up a process to track this information.

What examples of sales before maturity would not be inconsistent with a business model of holding financial assets to collect contractual cash flows? Question: What examples of sales before maturity would not be inconsistent, according to IFRS 9, with a business model of holding financial assets to collect contractual cash flows? Solution: Some examples would include: ·        the sale of a financial asset if it no longer meets the entity’s investment policy, because its credit rating has declined below that required by that policy; ·        sales so close to maturity or the financial asset’s call date that changes in the market rate of interest would not have a significant effect on the financial asset’s fair value; ·        sales to execute a liquidity crisis plan when the crisis event is not reasonably expected; and ·        other than the above, sales due to an isolated event that is beyond the entity’s control, is non-recurring and could not have been reasonably anticipated by the entity, such as: o   sales in response to a change in tax law that significantly affects the tax status of the financial asset, or a significant change in regulations (such as a requirement to maintain regulatory capital) that directly affects the asset; or o   sales in response to a significant internal restructuring or business combination.

What is the impact of changes in cash flows that are no longer in line with the initial business model assessment? Question : What is the impact on the business model if cash flows are realised in a way that is different from the entity’s expectations when performing the initial business model assessment? Solution : If cash flows are realised in a way that is different from the entity’s expectations at the date when the entity assessed the business model (for example, if the entity sells more or fewer financial assets than it expected when it classified the assets), that does not give rise to a prior period error in the entity’s financial statements, nor does it change the classification of the remaining financial assets held in that business model (that is, those assets that the entity recognised in prior periods and still holds), provided that the entity considered all relevant information that was reasonably available at the time when it made the business model assessment. However, when an entity assesses the business model for newly originated or newly purchased financial assets, it must consider information about how cash flows were realised in the past, along with all other reasonably available relevant information. Therefore, new investments can be considered to have a different business model as a result of evaluating the facts and circumstances surrounding historical sales activity for the intended portfolio.

Business model assessment: portfolio of sub-prime loans Question : An entity buys a portfolio of non-pre-payable sub-prime loans at a substantial discount from their face value, as most of the loans are not performing (that is, no payments are being received, in many cases because the borrower has failed to make payments when due). The entity has a good record of collecting sub-prime loan arrears, and it plans to hold the loan balances bought to recover the outstanding cash amounts. What is the business model for these loans? Solution : The business model is ‘held to collect’, because the entity intends to hold the loans to collect the contractual cash flows, and not to sell them.

Business model assessment: securitised loans Question: An entity originates loans with a view to later selling them to a securitisation vehicle. On the sale to the vehicle, the loans continue to be recognised in the consolidated financial statements, but they are derecognised in the separate financial statements of the originating entity. Assuming that the loans are held by the securitisation vehicle to collect their contractual cash flows, will the business model for the loans be ‘held to collect’ in both the consolidated and the separate financial statements? Solution: In the consolidated financial statements, the loans are part of a portfolio managed to collect the contractual cash flows, since the rights to the contractual cash flows have not been transferred and derecognition has not been achieved (that is, they are not considered ‘sold’ for accounting purposes). Therefore, they are a part of a ‘held to collect’ business model in the consolidated entity. Similarly, in the separate financial statements of the securitisation vehicle, they are considered part of a ‘held to collect’ business model. However, in the separate financial statements of the originating entity, where they are derecognised, they cannot be considered part of a portfolio that is ‘held to collect’.

Business model assessment for inter-company loans Question: Entity X owns subsidiaries that hold investment properties. The investment properties are largely funded by inter-company debt from the parent. The inter-company debt is repayable at par if there is a sale of property or if the subsidiary as a whole is sold. If there are insufficient funds to pay off the debt on sale of the property, the subsidiary would be in default. The loan is assessed as meeting SPPI. What is the business model for the inter-company debt? Solution: The business model for the inter-company debt is hold to collect. This is because, whether there is a sale of property or not, the contractual cash flows will be collected from the subsidiary, and there is no plan to sell the debt to a third party. A sale of property merely accelerates the repayment on the loan which is repayable at par, and it therefore comprises only principal and interest outstanding. As such, the inter-company debt should be viewed separately from the investment strategy of the properties.

‘Hold to collect and sell’ business model

If the entity’s objective is to hold a group of financial assets to collect the contractual cash flows and then to sell those financial assets, the portfolio of assets should be classified under the ‘hold to collect and sell’ business model. The objective of this business model is unlike the ‘hold to collect’ business model, in which the objective was only to collect contractual cash flows.

Examples of business model objectives that could be consistent with the ‘hold to collect and sell’ business model are:

• managing everyday liquidity needs;
• maintaining a particular interest yield profile; and
• matching the duration of the financial assets to the duration of the liabilities that are funding those assets.

Compared to a business model whose objective is to hold financial assets to collect contractual cash flows, this business model will typically involve greater frequency and value of sales. This is because selling financial assets is integral to achieving the business model’s objective, instead of being only incidental to it. However, there is no threshold for the frequency or value of sales that must occur in this business model, because both collecting contractual cash flows and selling financial assets are integral to achieving its objective.

The following are examples of when the objective of the entity’s business model can be achieved by both collecting contractual cash flows and selling financial assets.

Business model assessment: financial assets used to fund future capital expenditure Question: An entity anticipates capital expenditure in a few years. The entity invests its excess cash in financial assets, so that it can fund the expenditure when the need arises. The entity will hold the financial assets to collect the contractual cash flows and, when an opportunity arises, it will sell financial assets to re-invest the cash in financial assets with a higher return. The managers responsible for the portfolio are remunerated based on the overall return generated by the portfolio. What is the business model for the financial assets? Solution: In this scenario, the objective of the business model is achieved by both collecting contractual cash flows and selling financial assets. The entity will make decisions on an ongoing basis about whether collecting contractual cash flows or selling financial assets will maximise the return on the portfolio until the need arises for the invested cash. Therefore, the business model is held to collect and sell.

Business model assessment: financial assets held to manage liquidity needs Question: A financial institution holds financial assets to meet its everyday liquidity needs. The entity holds financial assets to collect contractual cash flows, and it sells financial assets to re-invest in higher-yielding financial assets or to better match the duration of its liabilities. In the past, this strategy has resulted in frequent sales activity, and such sales have been significant in value. This activity is expected to continue in the future. What is the business model for the financial assets? Solution: In this scenario, the objective of the business model is to maximise the return on the portfolio to meet everyday liquidity needs, and the entity achieves that objective by both collecting contractual cash flows and selling financial assets. Therefore, the business model is held to collect and sell.

Business model assessment: financial assets held by an insurer to fund financial liabilities Question: An insurer uses the proceeds from the contractual cash flows on the financial assets to settle insurance contract liabilities as they become due. To ensure that the contractual cash flows from the financial assets are sufficient to settle those liabilities, the insurer undertakes significant buying and selling activity on a regular basis, to rebalance its portfolio of assets and to meet cash flow needs as they arise. What is the business model for the financial assets? Solution: The objective of the business model is to fund the insurance contract liabilities. To achieve this objective, the entity collects contractual cash flows as they become due, and it sells financial assets to maintain the desired profile of the asset portfolio. Thus, both collecting contractual cash flows and selling financial assets are integral to achieving the business model’s objective. Therefore, the business model is held to collect and sell. Nevertheless, if the insurance contract liabilities were re-measured in accordance with IFRS 4, with changes in value recognised in profit or loss, the assets could be designated at FVTPL to reduce an accounting mismatch.

Business model assessment: banks that sell down loans to manage single counterparty credit risk limits Question: Bank credit risk management frameworks and regulatory regimes often require banks to consider their credit risk exposure to a single counterparty (that is, concentrations of credit risk). Due to such credit concentration risk, banks might regularly and actively sell down loans when they would be close to breaching or exceeding the credit risk limits. Do such sales, in response to credit concentration risk, result in the relevant portfolios having a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets? Solution: It depends. Banks that regularly and actively sell down portions of their loan portfolio in response to credit concentration risk have a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. This is on the assumption that banks collect the contractual cash flows until they reach or exceed the credit risk limits. However, the facts and circumstances of each particular situation should be analysed.

Impact of internal transfers on the business model Question: Bank A has previously concluded, having considered all relevant information available at the time, that it comprises four separate business models: Unit A (hold to collect); Unit B (other – that is, FVTPL); Unit C (hold to collect and sell); and Unit D (hold to collect). Unit A has originated specific assets, but it now plans to transfer these assets internally. No internal transfers have occurred previously. The transfer will be in exchange for cash, and no arrangements will be put in place that will cause Unit A to retain any of the risks and rewards of the transferred assets, so the transfer is considered to be a sale. The assets to be sold are significant in size, and the transfers will be frequent. How should the following internal transfers by Unit A be analysed for the purposes of the IFRS 9 business model at the group level: a. transfer from Unit A to Unit B (other – that is, FVTPL); b. transfer from Unit A to Unit C (hold to collect and sell); and c. transfer from Unit A to Unit D (hold to collect)? Solution: a. Transfer from Unit A to Unit B The assets are no longer held within a business model whose objective is solely hold to collect, so the stated intention at origination (that is, to hold the assets only to collect their contractual cash flows) is no longer true. Therefore, the business model for Unit A, for newly originated or newly purchased assets, is no longer ‘hold to collect’. b. Transfer from Unit A to Unit C The assets are no longer held within a business model whose objective is solely hold to collect, so the stated intention at origination (that is, to hold the assets only to collect their contractual cash flows) is no longer true. Therefore, the business model for Unit A, for newly originated or newly purchased assets, is no longer ‘hold to collect’. c. Transfer from Unit A to Unit D The assets are still held within a business model that is hold to collect, so the initially stated intention (that is, to hold the assets to collect their contractual cash flows) remains true. Since both Unit A and Unit D operate a ‘hold to collect’ business model, they could potentially have been initially defined as one single ‘hold to collect’ business model, assuming that the assets were managed collectively, in which case there would be no sale outside the business model to even consider. It must be noted that, in all of the above circumstances where the business model is considered to have changed, the assets themselves are not reclassified, as the requirements of IFRS 9 regarding reclassification are unlikely to be triggered. Changes in the business model for managing financial assets that trigger reclassifications of financial assets must be significant to the entity’s operations and demonstrable to third parties. However, while there is no reclassification, the entity should consider whether, for newly originated or newly purchased financial assets, they will be realised in a similar way to those that the business model previously held, and, if not, a new business model would apply. This change in model only impacts future asset acquisitions after the change in model. This analysis is also from the perspective of the consolidated accounts and not from the separate financial statements of Unit A. However, similar principles would apply if the business models above existed within the same legal entity.

Impact of factoring on business model assessment Question 1 : Corporate A sets up a master trade receivables factoring agreement with a bank. At the inception of a trade receivable, it is often unknown whether it will be subject to factoring. The decision rests typically with the company’s management and is made later in the process, depending on a number of factors. The terms of the factoring agreement are such that all receivables that are factored meet the financial asset derecognition criteria, resulting in the original receivables being derecognised from the statement of financial position. What would be the applicable IFRS 9 business model for the trade receivables, potentially subject to factoring? Solution: The business model is a matter of fact, and it should be observable. When evaluating the business model, the relevant activities should be considered. In this scenario, one of two business models might be appropriate, depending on the facts and circumstances: 1. ‘Hold to collect and sell’ business model – This would apply where relevant activities are represented through both the collection of contractual cash flows (for those receivables that are not factored) and regularly selling receivables (via selling receivables into the master factoring agreement on a regular basis, even if the exact extent and the specific receivables impacted cannot be identified at inception). Therefore, the whole portfolio of trade receivables should be classified as ‘hold to collect and sell’. This is supported by example in IFRS 9. 2. Selling business model – Where entity A’s objective is to realise the cash flows primarily through selling, the business model is not held to collect and sell, and so the receivables should be measured at fair value through profit or loss. Alternatively, if an entity can sub-divide a portfolio such that it can identify which receivables it will factor and which it will not, there should be both a ‘hold to collect’ business model and a selling business model. The business model assessment should be supported by an analysis of past sales and expectations of future sales (both their frequency and value). Judgement must be applied, since IFRS 9 does not provide any bright line thresholds for sales. Given that, in the above case, entity A cannot specify which receivables it plans to factor, and provided that it both factors and holds significant amounts of receivables, the ‘hold to collect and sell’ business model might be more appropriate. Judgement must be applied based on an analysis of all of the facts and circumstances. Furthermore, the business model should be reviewed if those facts and circumstances change. Question 2 : Depending on the terms and conditions of a factoring agreement, it might or might not result in derecognising the subject trade receivable. Does a ‘derecognition’ under IFRS 9 arising from the transfer of the contractual rights to receive a financial asset’s cash flows meet the notion of a ‘sale’, as referred to in the business model assessment under IFRS 9, so that such a factoring that results in full derecognition of the receivables would also result in those receivables being ‘sold’ for the purposes of IFRS 9’s business model assessment? Solution: Yes. ‘Derecognition’ achieved through a transfer of the contractual rights to receive a financial asset’s cash flows under IFRS 9 is considered to be a ‘sale’ for the purpose of the business model assessment. Therefore, sales are considered to have taken place where the disposals/transfers of trade receivables under the factoring agreements qualify for derecognition as a result of a transfer of the contractual rights to receive a financial asset’s cash flows in their entirety under IFRS 9. Question 3 : Corporate A enters into a factoring arrangement for its trade receivables which involves the transfer of the contractual rights to receive the cash flows from its receivables (in accordance with IFRS 9) in return for an upfront cash payment from the factor. However, Corporate A retains substantially all risks and rewards of ownership via a guarantee of the credit risk of the receivables such that the transfer does not result in full or partial derecognition under IFRS 9. Do the receivables continue to qualify as held to collect in Corporate A’s IFRS 9 business model assessment? Solution: Corporate A has an accounting policy choice depending on how it interprets the ‘held to collect’ notion in IFRS 9. Corporate A might look to the accounting treatment of the receivables and their continued recognition on the balance sheet and conclude that the ‘held to collect’ business model is appropriate. Additionally, since the entity retains substantially all of the risks and rewards, it is economically in a similar position as if it had not transferred the contractual rights to the cash flows of the receivables. Alternatively, Corporate A might look to the transfer of the contractual rights to the cash flows of the receivables in return for the upfront cash payment and conclude that the ‘held to collect’ business model is not appropriate. Under this view, Corporate A has already collected cash up front and will thus not collect the contractual cash flows from the underlying receivables in the future, such that its objective is not to collect the contractual cash flows over the receivables’ life. This accounting policy choice might not apply in other circumstances – for example, where the entity enters into a pass-through arrangement and thus retains (and will collect) the contractual rights to receive the cash flows from the financial asset, or in a repo transaction.

Fair value through profit or loss category

If a financial asset or group of financial assets is not held within the ‘hold to collect’ or the ‘hold to collect and sell’ business model, it should be measured at FVTPL. FVTPL is the residual category under IFRS 9. Additionally, a business model in which an entity manages financial assets, with the objective of realising cash flows through solely the sale of the assets, would result in an FVTPL business model. Even though the entity might collect contractual cash flows while it holds the financial assets, the objective of such a business model is not achieved by both collecting contractual cash flows and selling financial assets. This is because the collection of contractual cash flows is not integral to achieving the business model’s objective; instead, it is incidental to it.

Business model assessment: different components of syndicated loans Question: A bank acts as the lead arranger of a syndicated loan facility. The client’s demand for credit exceeds the lead arranger bank’s risk appetite. The bank’s credit risk committee approves such a deal on the basis that the excess credit risk will be ‘sold down’ within a defined time frame, which would typically be less than a year. In classifying syndicated loans, can a bank have different business models for the portion of the loan within the credit limit and the portion exceeding the risk appetite credit limit? Solution: Yes. The unit of account can be determined to be at a level lower than the facility/loan. Therefore, IFRS 9’s classification model could be applied separately to the different components of the facility identified by the bank, resulting in more than one business model for a single facility/loan. In this situation, the bank needs to assess the business model for its loan within the credit limits separately from the business model for the excess funded loan which is to be sold down. Assuming that the bank’s objective is to hold the portion of the loan that is within the specified risk limits in order to collect contractual cash flows, these would be measured at amortised cost (provide that they meet the SPPI criterion). The excess would be viewed as part of a business model whose objective is to realise cash flows through the sale of the assets, and it should be measured at FVTPL. It should be clearly demonstrated internally that two different business models exist for the loan. However, the bank’s objective might not always be to hold all of the portion of the loan within the specified risk limits to collect contractual cash flows. For example, the bank might originate a facility/loan with a clear intention to hold 50%, and to sell 30%, but for which the purpose of the remaining 20% is unclear (that is, this portion might be held or sold). While judgement is needed in determining the business model for the remaining 20%, a lack of clear intention to hold this portion of the facility/loan means that it cannot be classified as ‘hold to collect’.

Impact of fair value information on business model classification for reverse repo transactions Question: Bank X undertakes repo and reverse repo transactions. All reverse repo assets are held to maturity, to collect the contractual cash flows. However, the bank’s traders manage their cash flow exposures by layering on new trades or ceasing to roll overnight repos, based on fair value information. This is done with the objective of creating or eliminating exposures to different parts of the interest rate yield curve, and achieving the same economic outcome as if they were buying and selling financial instruments. Fair value information is used for management reporting and compensation purposes. Is this business model ‘hold to collect’? Solution: No. Reverse repo assets which are held to maturity would normally meet the requirement in IFRS 9, which states that a ‘hold to collect’ business model is one ‘whose objective is to hold financial assets in order to collect contractual cash flows’. However, IFRS 9 states that “a portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis is neither held to collect contractual cash flows nor held both to collect contractual cash flows and to sell financial assets” . In this case, the use of fair value-based management information is associated with a business model involving trading out of positions by layering on offsetting positions to realise fair value gains and losses. Furthermore, classifying these assets as FVTPL will present users of the accounts with the fair value information that management itself deems the most relevant in understanding and managing the business. Therefore, in such a situation, even though assets are held to maturity to collect contractual cash flows, the layering of transactions and the management of the exposure on a fair value basis should result in FVTPL classification. This is supported by IFRS 9.

Business model for syndications of loan commitments and drawn loans Question: As a lead arranger of a syndicated loan facility, a bank is fully committed to finance a wholesale client. Based on an initial credit committee, the bank estimates how much of the loan will be syndicated, and by how much this amount could reasonably vary, depending on market appetite. Only when the committed loan is subsequently drawn down, with final buyers and amounts known, will the lead arranger be sure of the final amount that it will retain. How should the bank assess the business model for this syndicated loan? In particular, should the business model be assessed only at the date when the loan commitment is entered into, or can the bank make a second assessment when the loan is drawn? Solution: Only commitments that are in a class where there is no past practice of selling the loans that result from drawdown shortly after origination are excluded from the scope of IFRS 9. If there is such a past practice, the commitments are derivatives measured at fair value through profit or loss. IFRS 9 requires that once a financial asset is initially recognised, the bank needs to assess the business model within which the financial asset falls. For the portion of the loan that the bank is confident that it will hold to collect the contractual cash flows and it does not have a past practice of selling those portions, the accounting treatment is straightforward: provided that the commitment is not to provide a loan at a below market rate of interest, cannot be settled net and is not designated at fair value through profit or loss, there is no derivative to account for at the commitment date, because the loan commitment is not within the scope of IFRS 9. Once drawn, the loan will be classified within a ‘hold to collect’ business model. For the portion of the loan that the bank is confident that it will sell and it has a past practice of selling those portions, the accounting treatment is also straightforward: the bank needs to account for a derivative at the commitment date that will be measured at fair value through profit or loss. Once the loan is drawn, to the extent that it has not already been sold, it will be in an ‘other’ business model and hence measured at fair value through profit or loss, provided that the intention to sell this portion has not changed. For the remaining portion (that is, where the bank does not know whether it will hold or sell when it commits to the loan), the bank needs to account for a derivative at the commitment date, on the basis that there will have been a past practice of selling loans in the same class shortly after origination. The derivative will be measured at fair value through profit or loss. The question then arises as to whether there needs to be consistency between the classification of the loan commitment and the classification of the drawn loan – in other words, if the commitment is measured at fair value through profit or loss, should the drawn loan also be measured at fair value through profit or loss? As IFRS 9 is silent on this issue, in our view, there is an accounting policy choice that should be disclosed and applied consistently. The business model could be determined at the commitment date on the basis that the loan commitment and the drawn loan are considered to be the same unit of account; in this case, this portion of the loan cannot be classified in a ‘hold to collect’ business model. Alternatively, the business model could be determined once the loan is drawn, in which case this portion could possibly be classified in a ‘hold to collect’ business model, depending on the facts and circumstances at that date. If the latter policy is chosen, a ‘hold to collect’ business model would not be appropriate if the bank still has the intention to sell the loan once the commitment has been drawn.

Solely payments of principal and interest criteria

Once the business model assessment has been performed, management should assess whether the contractual cash flows of the financial asset represent solely payments of principal and interest (SPPI). Instruments that do not meet the ‘hold to collect’ or ‘hold to collect and sell’ business models are measured at FVTPL. For these instruments, the SPPI criterion is not relevant for the purposes of determining the appropriate classification and measurement.

IFRS 9 provides definitions of ‘principal’ and ‘interest’ that will help management to make a preliminary assessment of whether contractual cash flows represent SPPI:

• ‘Principal’ is defined as the fair value of the financial asset at initial recognition.
• ‘Interest’ consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding, and for other basic lending risks (for example, liquidity risk) and costs (for example, servicing or administrative costs) associated with holding a financial asset for a period of time, as well as a profit margin. These are consistent with features of a basic lending arrangement. In extreme economic circumstances, interest can be negative if, for example, the holder of a financial asset, either explicitly or implicitly, pays for the deposit of its money, and that fee exceeds the consideration that the holder receives for the time value of money, credit risk and other basic lending risks and costs.

Assessing SPPI for floating-rate instruments acquired at a discount Question: Entity A acquires a floating-rate bond for C85. The par amount of the bond is C100 and pays interest based on one-month LIBOR, reset every month. The discount of C15 represents a charge for credit risk and liquidity risk. Does the bond meet the SPPI criterion under IFRS 9? Solution: Yes. The discount on the bond represents consideration for the credit risk and liquidity risk, which is consistent with a basic lending arrangement in accordance with IFRS 9. In a basic lending arrangement, consideration for the time value of money and credit risk is typically the most significant element of interest. However, in such an arrangement, interest can also include consideration for other basic lending risks (for example, liquidity risk) and costs (for example, administrative costs) associated with holding the financial asset for a particular period of time.

Do ‘off-market’ assets automatically fail the SPPI test? Question : At initial recognition, the interest cash flows of a financial asset are ‘offmarket’ (that is, they are not equal to the current market interest rate for such an instrument). This situation might arise, for example, when a financial instrument is acquired in the secondary market, or when an intercompany loan is advanced between two related parties. Does this cause the asset to automatically fail the SPPI test, since the interest cash flows do not adequately compensate for the time value of money, credit risk, as well as the other risks and costs of holding the financial asset? Solution : No. The SPPI test performed upon initial recognition requires an entity to determine whether the asset’s contractual cash flows are solely payments of principal and interest on the principal amount outstanding. IFRS 9 defines the principal amount as the fair value of the financial asset at initial recognition. Therefore, to the extent that interest cash flows are ‘off-market’, this will be reflected in determining the initial fair value of the financial instrument, which will be either a premium or a discount to the contractual par value of the asset. As a result, when considered relative to this principal amount, the IFRS 9 interest comprising both the interest cash flows and the amortisation of the initial premium or discount (that is, the effective interest rate, assuming there are no transaction costs) will equal the current market interest rate used in determining the initial fair value. The interest will therefore represent appropriate compensation for the time value of money, credit risk, as well as the other risks and costs of holding the financial asset. To illustrate this, consider an entity that acquires a bond with contractual par amount of CU100, a residual maturity of one year and fixed interest payments of 3% per annum. If the market rate of interest for the bond at the date of acquisition is 4%, the fair value at initial recognition will be approximately CU99 (that is, the terminal cash flow totalling CU103 discounted at a rate of 4%). The IFRS 9 interest that will be recognised totalling 4% is equal to the current market rate, and so represents appropriate compensation for the time value of money, credit risk, as well as the other risks and costs of holding the financial asset. Furthermore, the fact that a financial asset’s interest cash flows are ‘offmarket’ at initial recognition does not, of itself, introduce exposure to risks or volatility in the contractual cash flows unrelated to a basic lending arrangement that would cause the asset to fail SPPI under IFRS 9. Nonetheless, the other relevant requirements of IFRS 9 will also need to be considered before concluding that an ‘off-market’ financial asset meets SPPI. For assets with pre-payment features, this would potentially include the guidance set out in IFRS 9 specifically relating to financial assets acquired or originated at a premium or discount to the contractual par amount. Where the fair value on initial recognition differs from the transaction price, consideration should be given as to what this difference represents in accordance with IFRS 9.

Contractual features that introduce exposure to risks or volatility in the contractual cash flows unrelated to a basic lending arrangement, such as exposure to changes in equity or commodity prices, do not give rise to contractual cash flows that are SPPI. For example, convertible bonds and profit participating loans will not meet the SPPI criterion.

Interplay between SPPI test and derecognition Question: A bank originates a loan that is held within a portfolio, with the objective of collecting contractual cash flows. The loan’s cash flows are solely payments of principal and interest (SPPI) on the principal amount outstanding. The loan is therefore measured at amortised cost. One year later, the borrower experiences financial difficulties and, as a result, the loan becomes non-performing. The bank renegotiates the terms of the loan with the borrower. The new terms introduce a feature that does not represent SPPI on the principal amount outstanding. When assessing whether or not the loan needs to be derecognised as a result of the change in terms, does the fact that the new terms are no longer SPPI, of itself, mean that the loan has to be derecognised? Solution: No. The fact that the new terms are no longer SPPI does not, of itself, mean that the loan has to be derecognised. However, the changes that led to the terms no longer being SPPI should be considered when assessing whether the loan should be derecognised. The SPPI test can act as a useful indicator for the derecognition assessment. but it does not, on its own, provide conclusive evidence that an asset should be derecognised. Because there is no guidance in IFRS 9 as to when a financial asset whose terms have been modified should be derecognised, an entity should apply judgement, taking into consideration qualitative and/or quantitative factors to make its assessment.

Assessing SPPI for convertible bonds that deliver shares to the value of the outstanding principle and interest Question: An entity (the holder) invests in a mandatorily convertible bond that, at maturity, delivers to the holder a variable number of shares in the issuer to the value of the outstanding principal and interest, instead of cash. Would such a feature cause the bond to fail the SPPI criterion? Solution: It depends. IFRS 9 states that contractual terms that introduce exposure to risks or volatility in the contractual cash flows, such as exposure to changes in equity or commodity prices, are unrelated to a basic lending arrangement and do not meet the SPPI criterion. It is therefore necessary to assess, based on the specific facts and circumstances, if the mandatory conversion of the bond exposes the holder to any equity price risk or other variability that is inconsistent with SPPI. This will mean assessing the conversion mechanism and the characteristics of the issuer’s shares, to ensure that neither could introduce variability that is inconsistent with SPPI. When assessing the conversion mechanism, features might exist that could result in the holder receiving a number of shares whose fair value at the conversion date might not always equal the outstanding principal and interest of the bond, introducing equity price risk. These features could include caps or floors on the number of shares which can be issued, or conversion prices calculated using an average share price over a set time period. Such features would be inconsistent with meeting the SPPI criterion. When assessing the characteristics of the issuer’s shares, inherent in the SPPI criterion is the requirement for the holder to receive principal and interest in cash. Therefore, to meet the SPPI criterion the holder would need to demonstrate that it is indifferent as to the settlement mechanism (that is, cash or shares). This requires the holder to demonstrate an ability to immediately sell the shares received on conversion without experiencing variability in the cash flows received greater than a de minimis effect compared to the outstanding principal and interest of the bond. It should therefore be clear that the shares will be quoted in an active market (as defined by IFRS 13) at the time of conversion so that the holder can readily sell them. Whilst not exhaustive, factors indicating that the holder might be exposed to equity price risk, which would be inconsistent with the SPPI criterion, include: ·        absence of quoted prices for the issuer’s shares in an active market when the convertible bond is issued; ·        doubt over the existence of quoted prices for the issuer’s shares in an active market when the bond will convert; or ·        restrictions on the sale of the shares post conversion that might delay sale. Similar considerations would also apply when performing the SPPI assessment for an instrument that, rather than delivering shares, delivers other assets to the value of the outstanding principal and interest.

Modified solely payments of principal and interest

When assessing the SPPI condition, interest is, amongst others, consideration for the time value of money or, put simply, the passage of time. The time value of money element does not provide consideration for other risks or costs associated with holding the financial asset. In order to assess whether the time value of money element provides consideration for only the passage of time, an entity applies judgement and considers relevant factors, such as the currency in which the financial asset is denominated and the period for which the interest rate is set.

In some cases, however, the time value of money element can be modified. This might be the case, for example, if a financial asset’s interest rate is periodically reset to an average of particular short- and long-term interest rates, or if a financial asset’s interest rate is periodically reset but the frequency of that reset does not match the tenor of the interest rate (for example, the interest rate resets every month to a one-year rate). IFRS 9 provides guidance on how to assess whether contractual cash flows represent SPPI where the time value of money element of interest has been modified (the ‘modified time value of money’ element). Both qualitative and quantitative approaches can be used to determine whether the time value of money element of the interest rate provides consideration for just the passage of time.

When assessing a financial asset with a modified time value of money element, the IFRS 9 proposes that an entity should compare the contractual cash flows of the financial asset under assessment to the cash flows of a ‘perfect’ (‘benchmark’) instrument (that is, the cash flows that would arise if the time value of money element was not modified). For example, if the financial asset under assessment contains a variable interest rate that is reset every month to a one-year interest rate, the entity would compare that financial asset to a financial instrument with identical contractual terms and the identical credit risk, except that the variable interest rate is reset monthly to a one-month interest rate. If the difference between the cash flows of the benchmark instrument and the cash flows of the instrument under assessment are significantly different, its contractual cash flows are not considered SPPI, and the instrument must be measured at FVTPL.

It is not necessary to perform a detailed quantitative assessment if it is clear, with little or no analysis, that the cash flows of the instrument with a modified time value of money element are, or are not, significantly different from the benchmark cash flows (that is, ‘qualitative assessment’ only). In performing a quantitative assessment for the instruments within the scope of this test, several factors need to be considered:

• An entity compares contractual un-discounted cash flows of the instrument with the contractual un-discounted cash flows that would arise if the time value of money element was not modified (that is, the ‘benchmark’ cash flows).

• The appropriate comparable ‘benchmark’ instrument is one with the same credit quality and the same contractual terms (for example, the same reset terms), except for the modification being evaluated.
• An entity must consider the effect of the modified time value of money element in each reporting period and cumulatively over the life of the instrument.

• An entity considers only reasonably possible scenarios rather than every possible scenario. However, identification of a range of scenarios is required, which means that more than one scenario needs to be evaluated.

Interpreting ‘significantly different’ when performing the modified time value of money test Question: An entity issues a bond with a structured coupon that varies with an underlying interest rate – for example, a constant maturity swap (‘CMS’) bond. Under IFRS 9, such bonds will fall within the modified time value of money guidance. IFRS 9 states that, if the modified time value of money element could result in contractual cash flows that are ‘significantly different’ from the un-discounted benchmark cash flows, the financial asset does not give rise to cash flows that are solely payments of principal and interest, and so the whole asset should be classified as FVTPL. Can the ‘double-double test’ for embedded derivatives in IFRS 9 be used to determine ‘significantly different’? Solution: No. ‘Significantly different’ is a matter of judgement for management to determine, and it should be assessed on an individual instrument-byinstrument basis. Whether this test is met for instruments such as CMS bonds will depend on a range of factors, including the life of the bond, yield curves and reasonably possible changes in yield curves over the bond’s life. There are no bright-line tests that should be applied, such as the ‘double-double test’ for embedded derivatives in IFRS 9.

Determining when a qualitative assessment of the SPPI criterion is required if the time value of money element is modified under a range of different scenarios Question: If the time value of money element is modified, an entity should perform a benchmark test to assess the modification, to determine whether the SPPI criterion is still met. In some circumstances, the entity might be able to make that determination by performing a qualitative assessment; in other cases, a quantitative assessment is needed. When would a qualitative assessment be sufficient to determine whether the SPPI criterion is met? Solution: IFRS 9 does not define the terms ‘modified’ and ‘imperfect’. However, the underlying principle of IFRS 9 is that, if the financial asset contains contractual terms that introduce exposure to risks or volatility unrelated to a basic lending arrangement (for example, equity prices or commodity prices), the SPPI criterion is failed without performing a benchmark test. The following table contains examples of contractual features that are considered modified (that is, imperfect) under the IFRS 9 guidance. The guidance suggests situations in which a qualitative assessment is sufficient. The list is not exhaustive, and the assessment is only provided as guidance. As such, the terms of the instrument must be examined on a case-by-case basis, to determine the kind of assessment required. Description/Example Qualitative assessment sufficient?

Applying the modified time value test to a 10-year bond whose interest rate resets annually to a 10-year rate Question: Consider a bond that is issued in June 2015, matures in 10 years (in June 2025), and contains a constant maturity reset feature where the interest rate resets annually to a 10-year rate of interest. The interest is linked to the bond’s original maturity, which means that, if the interest rate is reset in June 2016, it will be reset to the 10-year interest rate until June 2026. How should the modified time value of money test be applied to the bond, in order to assess whether it meets the SPPI criterion, and how many scenarios should be taken into consideration? Solution: The test should compare the contractual un-discounted cash flows on this bond to those on a bond that resets annually to a one-year rate, in order to assess whether the cash flows of the two bonds could be significantly different. A number of different interest rate scenarios should be considered, in order to determine how the relationship between the one-year rate and a 10-year rate could change over the life of the instrument. However, it is only necessary to consider reasonably possible scenarios rather than every possible scenario. If, in any reasonably possible scenario, the cash flows are significantly different from the benchmark cash flows (that is, based on a one-year rate), the bond will not meet the SPPI condition (and must be measured at FVTPL). In jurisdictions where interest rates on loans are extensively regulated by the government, the quantitative test might not be applicable, and a qualitative assessment would be sufficient to assess that the financial asset meets the SPPI criterion.

How should the ‘benchmark test’ be applied when assessing SPPI? Question : For debt instruments with a modified time value of money element, a quantitative assessment might be required to determine whether or not the instrument’s contractual cash flows represent solely payments of principal and interest (‘SPPI’) on the principal amount outstanding. The time value of money element is that which provides consideration for only the passage of time. To perform this quantitative assessment, IFRS 9 requires an entity to compare the contractual cash flows of the financial asset under assessment to the cash flows of a ‘benchmark’ instrument whose time value of money element is not modified (known as the ‘benchmark test’). As an example, if a loan contains a variable interest rate that is reset every month to a one-year interest rate, the assessment would compare the cash flows of the loan to those on a ‘benchmark’ loan with identical contractual terms and the identical credit risk, except that the variable interest rate resets monthly to a one-month interest rate. Where the modified time value of money element could result in contractual cash flows that are significantly different from the benchmark cash flows, the financial asset fails SPPI. How should the ‘benchmark test’ be applied? Solution: IFRS 9 does not prescribe a single way of performing the ‘benchmark test’, so different methods might be appropriate. Judgement will therefore be required and the approach adopted should be applied consistently. However, factors to consider in developing an approach to applying the ‘benchmark test’ include: ·        Instrument-by-instrument test: The objective of the ‘benchmark test’ is to determine how different the contractual (un-discounted) cash flows of a financial asset are from those that would arise if the time value of money element of that asset were not modified. The test is therefore an instrument-by-instrument test applied to the un- discounted cash flows of the financial asset. ·        Two tests : IFRS 9 requires differences between the cash flows on the actual and benchmark instruments to be considered, both in each reporting period and cumulatively over the life of the financial instrument. It would not be appropriate to perform only a single cumulative test over the total life of the instrument. Nor would it be appropriate to include the impact of other periods within a test of a single reporting period, since this could hide the impact of significant positive and negative differences arising in individual reporting periods by offsetting them. Similarly, performing only a regression-type analysis that focuses on the overall relationship between the actual and benchmark instrument risks overlooking the impact of significant differences in a single reporting period as well as potentially over the total life, and so would not be appropriate in isolation. ·        Reporting period : The ‘benchmark test’ must be performed at the initial recognition of a debt investment, considering the effect of the modified time value of money element in each ‘reporting period’ and cumulatively over the whole life. Given that IFRS 9 does not refer to the ‘ annual reporting period’, the ‘reporting period’ required to be considered will be three months if an entity issues quarterly interim financial reporting and six months if an entity issues semi-annual interim financial reporting. However, given that it would be anomalous for two entities to reach different conclusions on SPPI solely because of their different reporting periods, when determining what is a ‘significant’ difference for the purposes of a reporting period of less than 12 months (see also Definition of ‘significant’ below), it would be acceptable to use a threshold that is greater than a simple pro rata split of the threshold that would be used for a 12-month reporting period. ·        Number of scenarios to be considered: IFRS 9 requires an entity to consider “only reasonably possible scenarios instead of every possible scenario” . If no significant differences arise when applying historically observed scenarios that include a financial crisis or other period with significant volatility, then an instrument might appear to pass the ‘benchmark test’. However, entities should also ensure that the scenarios used appropriately incorporate previously unobserved outcomes that are nevertheless reasonably possible in the future (for example, due to changes in the geo-political environment). Nevertheless, an entity could use only the most extreme of the scenarios considered reasonably possible (that is, those reasonably possible scenarios that give rise to the greatest positive and negative differences between the actual and benchmark cash flows) since, if these pass the benchmark test, then all other less extreme scenarios will similarly pass, so that these other less extreme scenarios do not need to be considered separately. ·        Exclusion of principal amounts : The objective of the ‘benchmark test’ is to consider adjustments made only to the time value of money element, which is generally a component of the interest receipts. Hence, inclusion of the principal payments in the ‘benchmark test’ risks diluting the impact of differences in the time value of money element, and therefore principal payments should be excluded. However, if cash flows are a combination of principal and interest (for example, an amortising mortgage loan where monthly payments include elements of both principal and interest) then, unless the cash flows are separated between principal and interest, thresholds should be appropriately lowered to mitigate the risk of obscuring the modified time value of money element due to the principal’s inclusion. ·        Absolute versus relative : In determining appropriate thresholds for what is considered ‘significant’, entities might use (i) a specified percentage of the benchmark cash flows, or (ii) a combination of a specified percentage of the benchmark cash flows and an absolute numerical threshold, used to avoid absolute small differences causing an instrument to fail SPPI. For example, to take account of very low interest rate environments, it might be judged appropriate to use a relative test assessing whether differences between the instruments’ cash flows expressed as a percentage of the benchmark instrument’s cash flows exceed X% and then also apply an absolute test assessing whether the difference between these cash flows also exceed CU Y. The absolute threshold itself should take account of the size of the instrument being assessed, because it would not be appropriate to apply the same absolute numerical threshold to all instruments under the benchmark test. ·        Definition of ‘significant’: IFRS 9 does not define ‘significant’ in the context of the benchmark test. Entities will therefore need to exercise judgement in determining this. For example, it might be appropriate to establish a ‘lower’ boundary for differences below which an instrument will always be SPPI, and an ‘upper’ boundary for differences above which an instrument will always fail SPPI. Instruments with differences falling between these ranges would require further analysis, including consideration of how often and in what circumstances the lower boundary is exceeded, qualitative factors etc. Disclosure: Where the approach taken to applying the benchmark test is a significant accounting judgement (for example, because an alternative approach could result in a material amount of financial instruments changing classification between FVTPL and amortised cost), the disclosures in IAS 1 should be provided.

Regulated interest rates

In some jurisdictions, the government or a regulatory authority establishes interest rates. In some of these cases, the objective of the time value of money element in the interest rate is not to provide consideration for only the passage of time. However, a regulated interest rate is a proxy for the time value of money element, for the purpose of assessing the SPPI criterion, if that regulated interest rate provides consideration that is broadly consistent with the passage of time, and it does not provide exposure to risks or volatility in the contractual cash flows that are inconsistent with a basic lending arrangement. In this case, a qualitative assessment would be sufficient to assess that the financial asset meets the SPPI criterion.

Determining SPPI for loans in highly regulated countries Question: Certain loans in highly regulated countries are regulated by the government, and they are reset according to the original maturity of the loan rather than according to the remaining maturity or the period until the next reset date (for example, where the interest rate is reset to a three-year rate because the instrument has an original maturity of three years). Do such loans meet the SPPI criterion? Solution: Under the exception, this type of feature would not cause the instrument to fail the SPPI criterion, provided that the regulated interest rate provides consideration that is broadly consistent with the passage of time and does not provide exposure to risks or volatility in the contractual cash flows that are inconsistent with a basic lending arrangement.

Assessing SPPI for a five-year constant maturity interest rate loan Question : An entity has a loan whose interest rate is reset periodically to equal the prevailing rate applied to new loans with an initial term of five years, regardless of the remaining time to maturity of the existing loan. Would such a feature cause the loan to fail the SPPI criterion? Solution: If such a reset represents the only legal pricing basis available in a particular jurisdiction, it does not preclude the loan from having contractual cash flows that are SPPI. This might be the case in jurisdictions where interest rates on loans are extensively regulated by the government and are reset based on their original maturity, regardless of the remaining time to maturity. But, if, in the jurisdiction concerned, similar loans are available on other pricing bases (for example, a periodic reset to a rate that reflects the remaining time to maturity of the loan), the constant maturity interest rate will not represent SPPI.

Assessing SPPI for loans that have leverage-type features in relation to interest Question : Some loans and other debt instruments include leverage-type features in relation to interest. In some jurisdictions such features are introduced into financial assets by the government or a regulatory authority; in other cases they reflect local market practice. What factors should be considered in assessing whether or not such financial assets meet the SPPI criterion? Solution: IFRS 9 states that the existence of leverage will affect whether the SPPI criterion is met since “leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest” . It follows that in most cases, the inclusion of leverage-type features in a financial asset will cause the SPPI criterion to be failed. However in rare cases this might not be the case. This can be a complex area and in applying this guidance, judgement will be required to determine if a specific leverage-type feature causes the SPPI criterion to be failed. The following considerations are relevant: 1) Government or regulatory authority–set interest rates If interest rate leverage is due to a government or regulatory authority setting the interest rate (or framework within which interest rates must be determined) then the more specific guidance in IFRS 9 on government regulated rates should be applied. It refers to a “regulated interest rate [that] provides consideration that is broadly consistent with the passage of time and does not provide exposure to risks or volatility in the contractual cash flows that are inconsistent with a basic lending arrangement” . This therefore provides for some flexibility, so that a suitably low level of leverage is still considered compatible with SPPI. 2) Cash flows that have the economic characteristics of interest The principle in IFRS 9 is that the SPPI criterion is failed where leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest . Therefore, if it can be demonstrated that, despite the leveragetype feature, a financial instrument’s contractual cash flows nonetheless “have the economic characteristics of interest” (that is, the cash flows are still compensation for only time value of money, credit risk and other basic lending risks) the leverage-type feature does not cause the instrument to fail SPPI. For example, consider a loan whose interest rate is contractually specified as 115% × a benchmark floating rate. This might be judged to have the economic characteristics of interest and so meet SPPI in very specific circumstances, for example in an economic environment with high inflation and high and very volatile interest rates where, as a result, it is common market practice to have this feature at the time the loan is issued. In such a situation, the 15% × the benchmark floating rate component might represent a dynamic credit spread and profit margin that changes as the level of interest rates changes. However, such a feature would not have the economic characteristics of interest and hence would cause the loan to fail the SPPI criterion in other less volatile markets that do not exhibit these characteristics. Disclosures Where judgements as to whether or not leverage-type features meet SPPI have a significant effect, the disclosures on significant accounting judgements required by IAS 1 should be provided.

Contractual terms that change the timing or amount of contractual cash flows

If a financial asset contains a contractual term that could change the timing or amount of contractual cash flows, the entity must determine whether the contractual cash flows that could arise over the life of the instrument, due to that contractual term, are SPPI. To make this determination, the entity must assess the contractual cash flows that could arise both before and after the change in contractual cash flows.

Assessing SPPI for loans with ‘Green Variability’ Question Entities might issue loans where the interest rate is linked to certain environmental, social and governance (ESG) metrics. These loans are often referred to as ‘green’ loans – that is, loans whose contractual terms provide for the cash flows to vary depending on ESG metrics or other environmental measures (collectively, ‘green measures’). Examples of green measures referred to in such loans include measures relating to compliance with emissions and waste regulation standards, energy efficiency metrics, CO2 emissions standards, energy consumption standards relating to the asset being financed, or a sustainability index that measures the performance of an entity based on a basket of different green measures. The interest rate on a particular loan is adjusted periodically to reflect changes in the borrower’s performance relative to specified green measures (‘green variability’). Is the loan SPPI-compliant? Solution It depends. In order to determine whether such loans satisfy the SPPI test, the contractual terms that determine variability in cash flows as a result of the green measures should be carefully assessed. As part of this assessment, the following considerations should be borne in mind. Credit risk considerations A loan might pass the SPPI test where the variation in the interest rate reflects a change in credit risk, and the change in the interest rate is commensurate with the change in credit risk. In this context, similar considerations apply to green loans as apply to price-ratcheting clauses more generally. In particular: ·        The loan might be SPPI-compliant if the change in the interest rate reflects changes either in the probability of default of the loan or in the loss given default, since both are relevant factors in determining what is appropriate consideration for credit risk under IFRS 9 (for example, everything else being equal, the consideration for credit risk would be less for a collateralised loan than for an uncollateralised loan). ·        The magnitude of the change in the interest rate must be commensurate with the change in credit risk, and the formula should not introduce leverage. If the interest rate could vary in more than one way, each variation needs to be commensurate with the associated change in credit risk. When assessing whether a contractual variation of cash flows based on green measures reflects a change in credit risk, the following factors are likely to be relevant: ·        Nature of the asset: A loan that finances a particular asset whose value is affected by green measures, where the loan is also collateralised by way of a security interest in that asset, is more likely to be SPPI-compliant. This is because the value of the collateral might be favourably affected as a result of the entity meeting or outperforming certain green measures, leading to a lower loss given default and therefore a lower level of credit risk. In contrast, a loan that is unsecured is less likely to have a relationship between credit risk and green measures, and so it is less likely to be SPPI-compliant. ·        Nature of the borrower: For a business with relatively little direct exposure to green measures, such as an investment manager, green measures are less likely to reflect a change in credit risk. For a business with direct exposure to green measures, such as a power-generating business with statutory CO2 limits, a variation in the interest rate dependent on CO2 emissions is more likely to reflect changes in credit risk. ·        Specificity of the green measure: If cash flows vary as a function of a broad basket of green measures that incorporates elements such as tax transparency, water usage and labour standards, it is less likely that the resulting green variability reflects a change in credit risk. In contrast, if cash flow dependency is based on a narrow green measure, it is more likely that the resulting green variability reflects a change in credit risk. In making the assessment as to whether or not the variation in interest rate reflects a change in credit risk, it will be important to understand the commercial rationale for including Green Variability in the loan, and to obtain appropriate evidence to demonstrate that the magnitude of the change in the interest rate driven by Green Variability is commensurate with the change in credit risk. Other considerations ·        De minimis or non-genuine green variability clauses: If the impact of a cash flow characteristic can only ever be de minimis or is not genuine, the feature should be disregarded when assessing SPPI. However, it is important that the economic rationale for including the clause in the first place is carefully considered. ·        Green loans that do not include green variability: Some loans might be referred to as ‘green’ loans (for example, where the borrower operates in an environmentally friendly sector such as wind power), but they do not include any green variability in the determination of the interest rate after the loan has been issued. This guidance does not apply to the SPPI assessment of such loans. The following table provides examples of green measures that might or might not meet the SPPI test, and assumes that all green variability is genuine and more than de minimis. The list is not exhaustive, and the terms of any transaction must be examined on a case-by-case basis.

Contingent events affecting cash flows

The entity might also need to assess the nature of any contingent event (that is, the trigger) that would change the timing or amount of the contractual cash flows. While the nature of the contingent event in itself is not a determinative factor in assessing whether the contractual cash flows are SPPI, it might be an indicator.

Assessing SPPI where the issuer can pre-pay when the FTSE 100 index reaches a specific level Question: IFRS 9 states that “a contractual term that permits the issuer (i.e. the debtor) to pre-pay a debt instrument or permits the holder (i.e. the creditor) to put a debt instrument back to the issuer before maturity and the pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable compensation for the early termination of the contract results in contractual cash flows that are solely SPPI”. Assume that a contract issued at par permits the issuer to repay the debt instrument, or the holder to put the debt instrument back to the issuer before maturity at par, when the FTSE 100 index reaches a specific level. If the contingent event takes place, but only the timing of the cash flow changes (resulting in a pre-payment that represents unpaid amounts of principal and interest on the principal amount outstanding), does this always pass the SPPI test? Solution: Yes. IFRS 9 states that an entity might need to assess the nature of any contingent event that would change the timing or amount of the contractual cash flows. While the nature of the contingent event is not, in itself, a determinative factor in assessing whether the contractual cash flows are SPPI, it might be an indicator. The contingent event in this example (the FTSE 100 index reaching a specific level) changes the timing of the cash flows, but it still results in the redemption of the debt for an amount equal to par plus accrued interest. Therefore, it will always pass the SPPI test, because the cash flows still represent solely payments of principal and interest on the principal amount increase the risk of the borrower’s income from the plant reducing, and so increase the ‘probability of default’, given the likelihood that the borrower cannot repay the loan; and outstanding. If, on the other hand, the debt instrument was issued at a discount, but it is repayable at par, this might represent compensation to the issuer for the FTSE 100 achieving the target level, which is not congruent with SPPI.

Assessing SPPI for loans with embedded cross-selling clauses Some loan contracts include ‘cross-selling clauses’ that provide for a reduction in the interest rate either: on the occurrence of certain pre-defined events, such as the debtor becoming a client in another contract; or based on performance achieved/maintained by the debtor on other products. Economically, a bank can increase its overall exposure/business through these clauses, and it will look to charge a rate across all products that is sufficient to cover its costs and earn a reasonable profit margin across a client’s product portfolio. The reason for the reduction in the interest rate is that the total cost and the total profit margin are earned from a larger number of products (that is, a lower portion of overall cost / reduced profit margin is allocated to a single product). At the same time, there are not necessarily any changes in lending risks (for example, liquidity or credit risk). Illustration: Customer A is granted a floating-rate loan at EURIBOR 3m + 250 basis points. The interest rate reduces to EURIBOR 3m + 200 basis points, for the remaining period of the loan, as soon as customer A agrees to enter into an additional pre-determined amount of other floating-rate loans with the same bank. The risk profile does not change, but the bank profits from a larger volume of business and lower cost per product (for example, by not needing to repeat client acceptance procedures). Question 1 : Can a loan with an embedded cross-selling clause, such as the one in question, meet the SPPI criterion? Solution: It depends. A loan with an embedded cross-selling clause meets the SPPI criterion if interest will be reduced in the event that customer A enters into an additional pre-determined amount of loans with the bank, and the loans continue to have payments that are SPPI (but with a lower profit margin). On the other hand, if the trigger for the interest reduction was linked to, for example, customer A entering into management service agreements (performance obligations within the scope of IFRS 15), or the client entering into insurance contracts (within the scope of IFRS 4) issued by the bank, it might not be possible to demonstrate the relationship between the new products and the payments of principal and interest. Question 2 : Assuming that a loan with an embedded cross-selling clause meets the SPPI criterion, when the interest rate is reduced, how should the revised cash flows due to the cross-selling clause be accounted for? Given that IFRS 9 is not clear as to how the effective interest rate method applies for the change in contractual cash flows due to cross-selling clauses, an entity should make an accounting policy choice, either: to account for the change in estimated cash flows by adjusting the gross carrying amount of the loan, with a corresponding adjustment in profit or loss (IFRS 9); or to re-estimate the interest rate, with no immediate effect in profit or loss (IFRS 9). The chosen accounting policy should be applied consistently to all similar instruments.

Impact of change of control provisions and reasonable compensation on the SPPI criterion Question: Bank A (the issuer) has issued notes to entity B. The Notes contain the following change of control term: “Upon the occurrence of a Change of Control Triggering Event, unless the Issuer has exercised its right to redeem the Notes as described above, each holder of the Notes will have the right to require the Issuer to purchase all or a portion of such holder’s Notes at a purchase price equal to 101% of the principal amount outstanding thereof plus any accrued and unpaid interest”. For bank A, the 1% change of control premium amounts to approximately $100 million, and it is considered material to entity B. Does the inclusion of a change of control provision prevent the Notes from meeting the SPPI criterion, from entity B’s perspective? Solution: No. IFRS 9 states that “a contractual term that permits the issuer (ie the debtor) to pre-pay a debt instrument or permits the holder (ie the creditor) to put a debt instrument back to the issuer before maturity and the pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable compensation for the early termination of the contract” . In this case, the 1% change of control premium received from bank A, for early termination of the contract, is considered reasonable compensation. Therefore, the inclusion of the change of control provision does not prevent the Notes from meeting the SPPI criterion, from entity B’s perspective.

Assessing SPPI on a perpetual instrument that has discretionary coupon payments and contingent settlement provisions Question: An entity invests in a perpetual instrument that has the following key terms and conditions: ·        It has no fixed maturity date (that is, it is perpetual). ·        Its coupon rate is reset every five years to the then market rate for the next five years. Any coupon payments (including the interest on any deferred coupon, see below) are at the issuer’s full discretion to defer in perpetuity, but cumulative (‘discretionary coupon payments’). Interest accrues on any deferred coupon at the same rate applied to the scheduled coupon for the period. ·        The holder has the right to put the instrument back to the issuer, at principal amount plus cumulative but unpaid coupons, if one or more of the following events occur (‘contingent settlement provisions’): ·        issuer breaches covenants (such as leverage ratio, or default on other borrowings); ·        change of control of the issuer; or ·        deemed liquidation of the issuer (such as bankruptcy, insolvency, or sale of material assets). ·        The issuer has the right to redeem, at principal amount plus cumulative but unpaid coupons, at each reset date. The entire perpetual instrument is classified as a financial liability, from the issuer’s perspective, because of the contingent settlement provisions which are beyond the control of the issuer and holder. Do the discretionary coupon payments prevent the perpetual instrument from meeting the solely payments of principal and interest (SPPI) criterion? Solution: No. The perpetual instrument is classified as a financial liability of the issuer due to the contingent settlement provisions, since the issuer does not have an unconditional right to avoid delivering cash to settle the contractual obligation of paying principal and interest. The coupons are not therefore entirely discretionary, and it is the cash flows that would arise on occurrence of these contingent events that should be assessed for SPPI. In all instances, any deferred coupon payments will themselves accrue interest, so the amount payable on occurrence of the contingent events includes appropriate consideration for the time value of money on the principal outstanding, and so it is consistent with SPPI in that respect. Furthermore, as shown by Instrument H in IFRS 9, the fact that an instrument is perpetual does not, of itself, mean that the contractual cash flows fail the SPPI criterion

Pre-payment and extension options

If a financial asset contains a contractual term that could change the timing or amount of contractual cash flows, and the cash flows before and after the change in contractual cash flows are significantly different, the asset generally does not meet the SPPI criterion. Despite that, a financial asset meets the SPPI criterion if it contains a contractual term that permits (or requires) the issuer to pre-pay a debt instrument, or permits (or requires) the holder to put a debt instrument back to the issuer before maturity, if the entity acquires or originates the financial asset at a premium or discount to the contractual par amount, and: the pre-payment amount substantially represents the contractual par amount and accrued (but unpaid) contractual interest, which might include reasonable compensation for the early termination of the contract; and when the entity initially recognises the financial asset, the fair value of the pre-payment feature is insignificant.

What is reasonable compensation in a pre-payment clause? Question : IFRS 9, one of the examples provided of instruments whose cash flows are ‘solely payments of principal and interest’ or ‘SPPI’, is an instrument with a contractual term that permits the issuer (that is, the debtor) to pre-pay or permits the holder (that is, the creditor) to put the instrument back to the issuer before maturity. The pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which could include reasonable compensation for the early termination of the contract. What is reasonable compensation? The IASB issued an amendment to IFRS 9 in October 2017 addressing pre-payment features with negative compensation. The amendment is mandatory for annual periods beginning on or after 1 January 2019, though earlier application is permitted where applicable. However, the amendment added paragraphs to the Basis for Conclusions on what is reasonable compensation and these are also considered relevant in interpreting ‘reasonable additional compensation’ in the pre-amendment version of IFRS 9 issued in July 2014. The guidance set out below, which incorporates the additional guidance contained in the amendment, is therefore considered relevant to both annual periods beginning on or after 1 January 2019 and earlier periods to which IFRS 9 is applied. Solution: IFRS 9 does not provide detailed guidance on what is considered ‘reasonable compensation’. An entity therefore needs to apply judgement in developing its own accounting policy and in determining whether specific compensation clauses provide for only reasonable compensation. That policy should be consistently applied. In making this judgement, the following factors are relevant. Overall considerations In order to assess whether or not a compensation clause provides for only reasonable compensation, the first step is to understand the economic rationale of the clause, what it is designed to achieve and in what circumstances it might in practice be exercised. The assessment of whether a clause contains ‘reasonable compensation’ is complicated by the fact that a wide variety of clauses exist in practice, and their meaning and application can be unclear. For this reason, an entity might consider it appropriate in some circumstances to seek legal advice in order to assess the enforceability of a clause and its contractual effect. A clause should not automatically be considered to result in ‘reasonable compensation’ just because it occurs more commonly or is a ‘market standard’ clause, so analysis of the specific details will still be needed where this is the case. In some situations, the compensation for early termination might not affect whether the instrument meets the SPPI criterion. This will be the case where: ·        the reasonable compensation could only ever be de minimis (both in a single reporting period and cumulatively) or is non-genuine (that is, it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur) as stated in IFRS 9. However, such cases are expected to be rare, and it should be questioned why the compensation clause has been included in the contract if it appears that it might be either de minimis or non-genuine; or ·        the compensation feature arises solely as a matter of law rather than contract. Further analysis will be necessary where the above do not apply. Qualitative considerations IFRS 9 states that the following elements of interest are consistent with a basic lending arrangement that is SPPI: ·        time value of money; ·        credit risk associated with the principal amount outstanding; ·        other basic lending risks (for example, liquidity risk); ·        costs (for example, administrative costs) associated with holding the financial asset for a particular period of time; and ·        a profit margin. Therefore, where the additional compensation for early termination compensates only for some or all of these elements, the additional compensation might be considered reasonable on a qualitative basis, subject to the other considerations discussed below. Where additional compensation includes compensation for other factors, it would not be considered reasonable on a qualitative basis. For example, a loan whose pre-payment amount varies with the proceeds received on IPO by the borrower would introduce equity price risk into the loan, which is inconsistent with a basic lending arrangement and would fail SPPI. Particular judgement might be required when a financial instrument is prepayable at its current fair value or at an amount that includes the fair value cost to terminate an associated hedging instrument (which might or might not be designated in an accounting hedge of the pre-payable instrument). IFRS 9 states that, whilst there might be some circumstances in which such contractual pre-payment features meet SPPI, because the compensation is reasonable for the early termination of the contract, that will not always be the case. In the case of pre-payment that includes the fair value cost to terminate an associated hedging instrument, the standard includes an example where compensation might be considered reasonable. This is when the calculation of the pre-payment amount is intended to approximate unpaid amounts of principal and interest plus or minus an amount that reflects the effect of the change in the relevant benchmark interest rate. The cost to terminate a collateralised fixed / floating interest rate swap hedge whose critical terms (such as currency, maturity) match those of the instrument, would generally be expected to reflect the effect of the change in the relevant benchmark interest rate over the remaining term and so be consistent with SPPI. Conversely, a EUR denominated instrument prepayable at an amount that includes the lenders’ cost to terminate an associated EUR / USD cross-currency swap hedging instrument would introduce EUR / USD currency risk into the EUR denominated loan, which would not be consistent with a basic lending arrangement and would fail SPPI. In contrast to compensation that reflects the effect of changes in the benchmark interest rate, IFRS 9 contains no explicit guidance regarding circumstances in which the terms of a financial instrument provide for prepayment at the instrument’s current fair value. This will therefore be a particularly judgemental area. It can be argued that pre-payment at fair value compensates the holder for all of the components of SPPI and so can be considered reasonable compensation. Furthermore, if the instrument contained no pre-payment clause, fair value is the amount at which the two parties would often be expected to agree to terminate. However, if there is a high likelihood of pre-payment at fair value, it could be questioned whether amortised cost is the most appropriate measurement basis. The considerations in this paragraph would also apply where, rather than being pre-paid at current fair value, pre-payment is instead at a formulaic amount designed to approximate current fair value. Quantitative considerations IFRS 9 does not contain guidance on how to quantitatively assess what is reasonable, and so this aspect of the assessment might be particularly judgemental. However, relevant factors to consider in making this assessment include: 1. The mechanics of the compensation calculation : a formula used to determine compensation for lost interest that references a time period longer than the period remaining from pre-payment up to contractual maturity, for example double that period with the result that the compensation paid is twice the present value of lost interest, would not be reasonable. 2. Whether the clause is common in the relevant market : if the compensation to be paid is significantly more than the ‘market standard’ amount payable by other similar instruments, that would call into question whether the compensation was reasonable. It would then be necessary to understand the specific facts and circumstances of the instrument, the customer etc before concluding. Conversely, a compensation clause that is ‘market standard’ might indicate that the resulting compensation is reasonable; however, as noted above, a clause should not automatically be considered to result in ‘reasonable compensation’ just because it is a ‘market standard’ amount. Disclosure Where judgements as to whether compensation features provide only for reasonable compensation have a significant effect, the disclosures on significant accounting judgements required by IAS 1 should be provided.

Similarly, a financial asset meets the SPPI criterion if it contains a contractual term that permits the issuer or the holder to extend the contractual term of a debt instrument, and the terms of the extension option result in contractual cash flows during the extension period that are SPPI on the principal amount outstanding, which might include reasonable compensation for the extension of the contract. If these conditions are met, the financial asset could still be measured at amortised cost or FVOCI, subject to satisfying the business model assessment.

Assessing SPPI on a loan when the bank has an extension option Question: A bank has provided a loan with a five-year term and a fixed coupon rate of 8%. At the end of the five years, the bank has the option to extend the loan at the initial fixed coupon rate for an additional five years, regardless of the market rate at that time for a five-year instrument. The extension option embedded in the loan is not contingent on any future events other than the passage of time. Would this feature result in the loan failing the SPPI criterion? Solution: The commercial effect of the option is no different from a cap or a floor, or an early redemption option at year 5 of a 10-year loan at 8%. The interest rate in the extension period still gives rise to cash flows that represent consideration for the time value of money. As such, this feature would not result in the loan failing the SPPI criterion.

Examples of contractual terms

The standard provides the following examples of contractual cash flows that meet the SPPI criterion:

• An instrument such as a bond where the payments of principal and interest are linked to an un-leveraged inflation index of the currency in which the instrument is issued.

• An instrument that allows the borrower to choose the market interest rate on an ongoing basis, provided that the interest is reset with a frequency that matches the tenor of the interest rate, and the interest paid over the life of the instrument reflects consideration for the time value of money, for the credit risk associated with the instrument, and for other basic lending risks and costs, as well as a profit margin.
• An instrument such as a bond with a stated maturity date that pays a variable market interest rate that is subject to a cap, provided that the interest reflects consideration for the time value of money, for the credit risk associated with the instrument during the term of the instrument, and for other basic lending risks and costs, as well as a profit margin. The same principle applies to a bond that pays a variable market interest rate that is subject to a floor.
• An instrument such as a full recourse loan that is secured by collateral.

• An instrument that is issued by a regulated bank and has a stated maturity date. The instrument pays a fixed interest rate, and all contractual cash flows are non-discretionary. However, the issuer is subject to legislation that permits or requires a national resolving authority to impose losses on holders of the instrument in particular circumstances. For example, the national resolving authority has the power to write down the par amount of the instrument, or to convert it into a fixed number of shares (‘bail-in clause’).

Assessing SPPI for a euro bond linked to inflation in a Eurozone country Question: An entity has an investment in a euro bond that is linked to inflation in a Eurozone country and is not leveraged (that is, the bond has a coupon that goes up or falls, depending on inflation in that particular country). Would such a feature result in the bond failing the SPPI criterion? Solution: Not necessarily. The pricing of the bond inherently reflects the market price for the time value of money and credit risk. The adjustment factor applied would vary with the inflation index used, such that different eurodenominated bonds, each linked to inflation in a different Eurozone country, could all meet the SPPI criterion. But a euro-denominated bond linked to inflation in the UK (or other non-Eurozone country) would not meet the criterion.

Assessing SPPI for changing credit spreads in loans with price-ratcheting clauses Question: Some loans include price-ratcheting clauses. Under these clauses, the contractual interest rate is reset, in accordance with a scale of pre-defined rates, on the occurrence of one or more pre-defined events that are linked to the borrower. These clauses are included to avoid the need to renegotiate the loan when the credit risk of the borrower changes. Does a loan with a ratchet clause meet the SPPI criterion? Solution: The SPPI criterion will be met, provided that: the pre-defined trigger reflects an increase in the credit risk of the loan; and the new rate is established, at inception of the contract, so as to compensate the holder for the increased credit risk. IFRS 9 gives an example of a financial instrument whose interest rate is reset to a higher rate if the borrower misses a particular number of payments. This example indicates that such a reset feature could meet the SPPI criterion. The ratchet clause is similar in nature to this example.

Interaction of contractual and legal terms in loan contracts when assessing the SPPI criterion Question: IFRS 9 clarifies that, where payments arise only as a result of legislation that gives the regulatory authority power to impose changes to an instrument, they should be disregarded when assessing the SPPI criterion, because that power is not part of the contractual terms of a financial instrument. Instrument E in the guidance specifically refers to bail-in instruments as an example that might meet the SPPI criterion. Examples of instruments that often include bail-in features include TLAC (Total Loss Absorbing Capital) and MREL (Minimum Requirement for own funds and Eligible Liabilities) bonds. When should the contractual terms of an instrument which includes references to the legislation, such as a bail-in clause, be taken into account when assessing the SPPI criterion? Solution: The bail-in clause should not be taken into account, when assessing the SPPI criterion, where the clause merely acknowledges the existence of the bail-in legislation (that is, the clause does not create additional rights or obligations that would not have existed in the absence of such a clause). For this to be the case, it is necessary that: ·        the bail-in regulations themselves specify all of the key terms, including what the bail-in trigger is and the effects of the bail-in trigger being met; ·        the effects of the bail-in trigger are at the discretion of the regulator, and the contract does not add to this by allowing discretion of the entity or imposing an earlier trigger; and ·        the contract terms are drafted such that, if the regulations change, the bail-in terms of the instrument change in exactly the same way. However, some contract terms include non-viability trigger event clauses. These are clauses in debt agreements in certain jurisdictions that allow regulatory authorities to instruct an entity to modify the debt instrument on issue if it determines that, without the amendment, the entity would become non-viable. Such a contractual reference creates additional rights or obligations, with respect to the treatment of the instrument that would not have existed in the absence of such a clause, that extend beyond mere bail-in clauses. As such, the effects of such a clause should be taken into account when assessing the SPPI criterion, and they might cause it to fail. In certain situations it might be appropriate to obtain legal advice to determine whether or not the contractual terms included create additional rights or obligations that would not have existed in the absence of such a clause.

Assessing SPPI when banks can adjust interest rates Banks in many jurisdictions use ‘base rates’ as a reference rate for issuing variable-rate loans. Although banks are able to set their own base rate, they generally follow market convention. These base rates are typically based on a central bank rate, such as LIBOR or other market rate. Banks monitor the movements in their funding rates, and a correlation exists between changes in their funding rate and changes in their base rate. If a bank changes a base rate, the respective interest rates on its loans, whose interest rate is set as base rate plus a margin, are also adjusted. Question 1 : Are ‘base rates’ consistent with the basic lending arrangement of banks for the purpose of assessing the SPPI criterion under IFRS 9 for their loans, without performing a more detailed analysis? Solution : Yes, it is generally the case that banks’ base rates are consistent with the basic lending arrangement, providing compensation for credit risk and time value of money. Therefore, base rates would meet the SPPI criterion without a more detailed analysis. This is further supported by the standard, which acknowledges that a ‘lender’s various published interest rates’ might be consistent with the SPPI criterion. Question 2 : Does the instrument still meet the SPPI criterion if the bank has a contractual right to adjust the interest rates in cases of financial market, macro-economic or regulatory changes (that is, events outside the bank’s control)? Solution : It depends and requires the application of judgement. If the contractual agreement to change the rate is simply passing on, for example, costs related to a basic lending arrangement or costs associated with certain regulatory changes, this might still meet the SPPI criterion. However, if the adjustment is to pass on other costs or losses borne by the bank, which are not reflective of credit risk and consideration for time value of money specific to the instrument in question, this would not meet the SPPI criterion. Question 3 : Could the instrument meet the SPPI criterion if the bank has discretion to adjust the interest rate, irrespective of the market situation and the regulatory environment? Solution : It depends. Where banks have an unfettered ability to change rates, an assessment of the facts and circumstances is required on a case-by-case basis, to assess whether any change would reflect consideration for the time value of money and credit risk of the instrument in question. Take, for example, country X, where banks have historically issued variable-rate mortgage loans, with contractual clauses providing them with an unfettered ability to change the rates at their discretion. However, the natural competition in the banking sector in country X allows customers to easily refinance loans if their bank increases rates above standard market rates. As such, historically, the banks have not been able to exercise their unfettered ability to change rates to one above compensation of time value of money and credit risk, and this inability to exercise is expected to continue. In this case, the loans issued by the banks in country X are likely to satisfy the SPPI criterion. In contrast, a bank could potentially link changes in interest rates on issued loans to other variables completely outside credit risk and the time value of money, such as equity prices. These loans would not meet the SPPI criterion.

Assessing SPPI for a multi-currency bond Question: An entity holds a bond where it has the option to change the denomination of the bond at any time until maturity. For example, in year 1, the bond is denominated in HUF, with a floating interest rate of BUBOR plus a fixed margin. The borrower has the ability to change the denomination to EUR, in which case the loan is converted at the spot rate at the time of the exchange and, from that moment on, the interest rate is converted to EURIBOR plus a margin. The margin is fixed and is the same regardless of the currency. The borrower can switch back and forth between HUF and EUR as many times as it wishes. Would such a bond meet the SPPI criterion? Solution: Yes. Although the margin is fixed regardless of currency, this is no different from a plain vanilla floating-rate loan whereby, in each period, the reference rate is reset but the credit spread is fixed at inception. For such loans, there are no subsequent adjustments to the margin for changes in liquidity or credit risk after inception. Such loans would meet the SPPI criterion because, at any time, the interest rate is adjusted to the currency of the principal.

Assessing SPPI for step-up notes Question: An entity invests in a 10-year note, for which the floating interest rate on the note steps up by 100 basis points after five years, unless the issuer redeems the note. Would such a feature cause the note to fail the SPPI criterion? Solution: No. The instrument might be viewed as having an interest margin, during the first five years, that incorporates a credit spread that is at least equal to that of a similar instrument maturing at the end of five years, and the stepped-up rate represents at least the rate at inception for a similar instrument that starts in year 6 and matures at the end of year 10. Alternatively, if the step-up is higher, this might be intended to economically compel the issuer to exercise the call and to redeem the note. If the call is not exercised, it might indicate that market conditions have changed since the issuance of the note (for example, the issuer might have experienced a credit downgrade) and, hence, the step-up can be seen as compensating the holder for the time value of money and credit risk.

Assessing SPPI for shareholder loans that bear no interest Question: Entity A provides a shareholder loan, with no interest and no fixed terms of repayment, to its subsidiary, entity B. Would such a loan meet the SPPI criterion? Solution: If the loan is repayable on demand, it is classified as a current liability of entity B. In this case, the loan is deemed to have a contractual cash flow, being the repayment of the principal on demand, and, as such, it will meet the SPPI criterion. However, if there is no requirement for entity B to repay the loan, and it is classified as equity from entity B’s perspective, the loan is considered to be part of entity A’s investment in entity B. If the loan is within the scope of IFRS 9, it is treated as an equity investment in entity B and, therefore, the SPPI criterion is not relevant.

Assessing SPPI for dual currency bonds Question: An entity invests in a fixed-rate dual currency bond. The bond’s principal is denominated in JPY, and its interest payments are denominated in USD. Would such a bond meet the SPPI criterion? Solution: In this case, the bond might be separated into two components: a zero coupon JPY bond, and a USD interest-only strip that is equivalent to an amortising bond. Each component would need to meet the SPPI criterion, which will often not be the case. For example, if a dual currency bond contains an option to pre-pay (including on liquidation or in the event of bankruptcy) at the JPY principal amount, both components will fail the SPPI criterion. This is because, on early repayment, the investor in the JPY zero coupon bond is repaid the par amount, which is a payment that is considerably more than the unpaid amounts of principal and interest.

How is SPPI assessed on deemed loan assets arising in securitisation vehicles? Question: Where the transfer of a financial asset does not qualify for derecognition in the accounts of the transferor, the transferee is prevented from recognising the transferred asset as its own asset. Such situations are sometimes referred to as ‘failed sales’. In these cases, the transferee recognises a receivable, representing their right to receive cash from the transferor from the transferred asset (sometimes referred to as a ‘deemed loan asset’). The transferor recognises a ‘deemed loan liability’, representing their obligation to pay cash from the transferred asset. Failed sales often arise in securitisation transactions, with a common scenario being: ·        a bank originates fixed-rate loan assets and sells these (as transferor) to a special purpose entity (‘SPE’) (as transferee); ·        the SPE issues floating-rate notes referencing cash flows on the transferred assets; ·        the bank purchases the most junior tranche of notes on issue, with third parties purchasing the other notes; ·        the bank and the SPE enter into a fixed-for-floating swap referencing the underlying loan assets; and ·        the bank issues a ‘clean-up call’ option to the SPE to repurchase the loan assets when the outstanding value of the notes in issue falls below a predetermined threshold. Where, as a result of the above, the transaction does not meet the derecognition criteria, the SPE needs to classify and measure the deemed loan asset in its individual financial statements. Assuming that the deemed loan asset is in a ‘hold to collect’ or ‘hold to collect and sell’ business model, what factors are likely to be relevant when the SPE assesses solely payments of principal and interest (‘SPPI’) on the deemed loan asset in its individual financial statements? Note: This FAQ only addresses the SPPI assessment of a deemed loan asset. It does not indicate the components that should be included in, or excluded from, a deemed loan asset, nor the features of a transaction that will result in a transfer achieving or failing the derecognition criteria. Solution: IFRS 9 does not provide specific guidance on assessing the SPPI criterion for deemed loan assets; however, an entity should consider the factors below (depending on the specific features of the arrangement, and the reasons for the transfer not achieving derecognition, other considerations might also apply): ·        Identifying the ‘contractual’ terms: An entity assesses SPPI based on the contractual cash flow characteristics of a financial asset. A deemed loan does not have a single contract which sets out its contractual terms, but instead is formed from elements of the different contracts of transactions that give rise to the deemed loan. Therefore, in assessing a deemed loan asset, an entity must first determine what the contractual terms of the deemed loan are by considering the various contractual rights and obligations that the deemed loan asset represents. This requires an entity to consider the terms of the underlying assets and of the notes purchased, as well as any associated instruments and which of the cash flows of those underlying assets are included in the deemed loan (for example, this might be rights to the first of any cash collected from the underlying assets up to a specified amount), as well as any associated instruments entered into at the same time, such as interest rate swaps (that might swap cash flows from fixed to floating, or vice versa) and clean-up call options (that might give rise to rights equivalent to a pre-payment option). Since these transactions are entered into at the same time and in contemplation of the deemed loan, depending on the particular facts and circumstances an entity might consider some or all of these to be part of the deemed loan asset, and it might interpret the terms of such associated transactions accordingly. For example, a clean-up call option incorporated within a deemed loan asset would be considered an early pre-payment option within the deemed loan. ·        Assessment of ‘contractual’ terms: Having determined what the written contractual terms of the deemed loan asset are, the entity should assess them with reference to the guidance that would ordinarily apply to such cash flow characteristics – for example, cash flows resulting from interest rate swaps should be assessed under the time value of money, and clean-up calls should be assessed under the pre-payment guidance and reasonable compensation guidance. ·        Relevance of the contractually linked instrument (‘CLI’) guidance: Tranches of CLIs are often issued by SPEs whereby the cash flows that are generated by underlying assets held by the SPE are used to repay the CLIs issued by the SPE, using a ‘waterfall’ to prioritise payments between holders of different tranches. To achieve this, the SPE legally holds the underlying assets and hence has contractual rights to all of the cash flows of those transferred assets. Accordingly, when considering if the assets of the SPE, and hence the deemed loan, are CLIs, an acceptable view is that the tranching required to be within the scope of the CLI guidance is not present, so the deemed loan is not within the scope of CLI. This reflects that, whilst investors in the SPE hold tranches, the SPE does not – it is issuing, rather than holding, tranches. ·        Non-recourse guidance: All financial assets that are not within the scope of the CLI guidance must be assessed under the other SPPI guidance, which requires consideration of, among other things, any non-recourse provisions. Non-recourse provisions might result in an instrument not passing SPPI where, economically, the terms of the instrument result in the holder receiving cash flows that are not solely principal and interest, whether intentionally or not. For example, a non-recourse loan that will be repaid from proceeds on sale of a property (including upside and/or downside) will not meet SPPI, since the resulting cash flows include property risk. However, because deemed loans often arise as a result of substantially all of the risks and rewards of the underlying financial assets not being transferred, it might well not be the case that the holder of the deemed loan has significant exposure to the underlying assets (since such risk is retained by the transferor). This will often be the case where the transferor purchases the most junior notes in an SPE and remains exposed to substantially all of the underlying asset risk. To the extent that any credit enhancements are provided to the transferee within the structure, this further reduces exposure to the underlying assets.

The following are examples of contractual cash flows that do not meet the SPPI criterion:

• An instrument that is linked to an equity index or borrower’s net income.

• An instrument such as a bond that is convertible into a fixed number of equity instruments of the issuer.
• Bonds where the amount of interest varies inversely to a market rate of interest (inverse floaters).

• Deferrals of interest payments where additional interest does not accrue on those deferred amounts.

Will a loan asset with an entity-specific non-financial underlying variable, such as a profit participating loan, fail SPPI? Question : Some loans have a feature that is not separated as an embedded derivative under IAS 39, because the feature has a non-financial underlying variable specific to a party to the contract. An example is a profit participating loan. Whilst the IAS 39 embedded derivative guidance remains applicable in IFRS 9 for financial liabilities, for financial assets an entity is instead required to assess whether the instrument’s contractual cash flows are solely payments of principal and interest on the principal amount outstanding (SPPI), in order for amortised cost or fair value through other comprehensive income to be a possibility. Consider a scenario where Entity A originates a profit participating loan to Entity B. Entity B only holds investment property on which it earns rental income. The loan principal is repayable in seven years. The loan has no fixed coupon or interest, but it entitles the holder to a mandatory percentage of earnings before interest, tax, depreciation and amortisation (EBITDA) of Entity B in each period. From the perspective of Entity A, will the inclusion of such a feature mean that the loan fails the SPPI test and is required to be measured at fair value through profit or loss (FVTPL)? Solution: Yes, this specific feature will cause the loan to fail the SPPI test under IFRS 9. In this case, the profit participating loan’s return will not represent only compensation for time value of money, credit and other basic lending risks (for example, liquidity risks), costs (for example, administrative costs), plus a profit margin; rather, it will also introduce an exposure to the underlying results of Entity B (such as rental income and fair value of the property) that is inconsistent with a basic lending arrangement. Therefore the loan will fail SPPI and will be measured at FVTPL by Entity A. Loans within the scope of IFRS 9 with other types of entity-specific nonfinancial underlying variables would need to be assessed based on their individual facts and circumstances, but they might well also fail the SPPI test.

Cash flows that are not genuinely SPPI, despite being described as such

In some cases, a financial asset might have contractual cash flows that are described as principal and interest, but those cash flows do not actually represent the payment of principal and interest on the principal amount outstanding, as defined in IFRS 9. For example, if the contractual terms of an instrument stipulate that the financial asset’s cash flows provide interest, but this interest is based on the volume of vehicles that use a particular toll road, those contractual cash flows are inconsistent with a basic lending arrangement. As a result, the instrument would not satisfy the SPPI criterion

Non-recourse

A non-recourse provision is an agreement that, if the debtor defaults on a secured obligation, the creditor can look only to the securing assets (whether financial or non-financial) to recover its claim. If the debtor fails to pay and the specific assets fail to satisfy the full claim, the creditor has no legal recourse against the debtor’s other assets. The fact that a financial asset is non-recourse does not necessarily preclude the financial asset from meeting the SPPI criterion.

If a non-recourse provision exists, the creditor is required to assess (that is, to ‘look through to’) the particular underlying assets or cash flows to determine whether the financial asset’s contractual cash flows are SPPI. If the instrument’s terms give rise to any other cash flows, or if they limit the cash flows in a manner inconsistent with the SPPI criterion, the instrument will be measured in its entirety at FVTPL.

Non-recourse loans which might be inconsistent with SPPI Question: What examples of non-recourse loans might be inconsistent with the SPPI criterion? Solution: Examples of non-recourse loans that might be inconsistent with the SPPI criterion are: a. a non-recourse loan made to fund the construction of a toll road, where the amount of the cash flows that are contractually due varies with the asset’s performance (such as where the number of cars that drive down the toll road determines the amounts to be paid); or b. a non-recourse loan that can be pre-paid at an amount that varies with the value of an underlying asset. There is limited guidance in IFRS 9 as to how the existence of a nonrecourse feature might impact the SPPI criterion. Judgement will be needed to assess these types of lending relationship.

Non-recourse real estate financing Question: A bank has a real estate financing business, where its business model is to provide non-recourse financing to customers so as to generate interest income on the resulting loans. The bank’s business model is not to participate in the economic performance of the underlying real estate (upside or downside). The bank limits its exposure to the real estate in several ways, including: a. by limiting the amount lent to between 60% and 75% of the value of the real estate at the inception of the loan (depending on the term of the loan and the nature of the real estate); b. by ensuring that the cash flows expected to be generated by the customer are more than sufficient to repay the loan (both principal and interest); and c. by ensuring that another party has contributed sufficient equity or subordinated financing to absorb all expected losses. Interest received is determined upfront as floating rate plus a fixed margin (determined primarily based on the credit quality of the borrower), with no reference to the performance of the underlying asset. Would the loans provided by the bank meet the SPPI criterion? Solution: Yes. Such a loan will meet the SPPI criterion, because the amount of cash flows due is not expected to vary with the asset’s performance, nor is the payment linked to asset risk.

Non-recourse to portfolio of equity instruments Question: A bank has provided a loan to a borrower with a fixed rate of interest and fixed maturity date. The loan is secured, on a non-recourse basis, on a portfolio of equity instruments (shares). The value of the shares approximates to the principal of the loan at inception. As such, at maturity of the loan, the borrower intends to sell the shares and to use the proceeds to repay the loan. The borrower would keep any upside in the share price, but the bank would suffer any loss. The pricing in this case is the same as a written put option on the shares. Would such a loan meet the SPPI criterion? Solution: No. This loan is likely to fail the SPPI criterion, because the amount of cash to be repaid varies with the performance of the equity instruments. Economically, the non-recourse feature in the loan behaves like a written put option on the equity instrument.

‘De minimis’ features

An entity does not need to take into consideration any contractual cash flow characteristics that do not represent SPPI if they could only have a ‘de minimis’ effect on the contractual cash flows of the financial asset.

How should the terms ‘not genuine’ and ‘de minimis’ be applied in assessing SPPI? Question : In assessing SPPI, IFRS 9 states that a contractual cash flow characteristic does not affect classification ‘if it could have only a de minimis effect on the contractual cash flows’ or if it could have an effect that is ‘more than de minimis (either in a single reporting period or cumulatively) but that cash flow characteristic is not genuine’. What is meant by ‘not genuine’ and ‘de minimis’? Solution: Clauses that are not genuine or de minimis are expected to be rare in practice. Therefore, it should be questioned why the clause has been included in the contract if it appears that it might be either de minimis or non-genuine. Not genuine IFRS 9 defines a clause as being ‘not genuine’ when it impacts contractual cash flows ‘only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur’. This definition of ‘not genuine’ is the same as that contained in IAS 32 for the purposes of assessing whether an instrument is debt or equity. It is generally interpreted to refer to contractual terms that do not have commercial substance. Whether a clause is ‘not genuine’ depends on the likelihood of an event occurring – that is, unlike ‘de minimis’, ‘not genuine’ considers probability. Consider, for example, a short term loan provided to an established company whose profits have been stable in recent years. The loan’s contractual terms require repayment of the outstanding principal and interest. An additional payment of 20% of the borrower’s profit is also required if profit increases by a factor of 20 from the previous reporting period. Such a clause might appear to cause the instrument to fail SPPI. However, if in the particular circumstances of the company, an increase in profit by a factor of 20 in one period is judged to be extremely rare, highly abnormal and very unlikely to occur, this clause is not genuine. However, a clause should not be considered ‘not genuine’ just because historically the relevant event has not occurred. If a clause is ‘not genuine’ the fair value and pricing of the instrument would also be expected to be the same regardless of whether or not the clause is included. De minimis The term ‘de minimis’ is not defined by IFRS. However, it is generally used to refer to things that are ‘clearly trivial’ or of ‘negligible’ impact. For example, if a CU1 million loan contains an early repayment clause which, if exercised, requires repayment of outstanding principal and interest plus CU1, the additional CU1 would have only a de minimis impact to cash flows in all circumstances. While IFRS 9 does not contain detailed guidance on making this assessment, the standard states that when assessing if a feature is de minimis an entity is not permitted to take into account the probability that the future event will occur, unless the contingent feature is not genuine (see above). The term ‘de minimis’ is within a sentence that deals with the classification of a financial asset. De minimis must therefore be assessed at the individual financial asset level and not at some higher level (for example, at a portfolio or entity level). In assessing whether a contractual feature is de minimis, IFRS 9 is unclear whether the impact on contractual cash flows should be assessed with reference to the principal, interest or both. However, given IFRS 9 states that a feature does not affect classification if it would have only ‘a de minimis effect on the contractual cash flows of the financial asset’, a reasonable interpretation is that the assessment might be made by reference to all the cash flows of an instrument. Further, the standard states that any assessment must consider the potential effect of a feature ‘in each reporting period and cumulatively over the life of the instrument’.

In considering whether the effect is ‘de minimis’, an entity must consider the possible effect of the contractual cash flow characteristic in each reporting period and cumulatively over the life of the financial instrument. Additionally, if a contractual cash flow characteristic could have an effect on the cash flows that is more than de minimis, but that characteristic is nongenuine, it does not affect the classification of a financial asset. A feature is non-genuine if it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. In practice, judgement will be required to assess whether a contractual feature could be considered non-genuine, and therefore be disregarded when assessing whether cash flows are SPPI.

How should the terms ‘not genuine’ and ‘de minimis’ be applied in assessing SPPI?

Contractually linked instruments (tranches)

In some types of transaction, known as contractually linked instruments, an issuer might prioritise payments to the holders of financial assets using multiple contractually linked instruments that create concentrations of credit risk (tranches). Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche. In such situations, the holders of a tranche have the right to payments of principal, and interest on the principal amount outstanding, only if the issuer generates sufficient cash flows to satisfy higher-ranking tranches. These financial instruments are often issued by special purpose entities (SPEs) in various tranches, with the more senior tranches being repaid in priority to the more junior ones. Contractually linked instruments are financial assets that create concentrations of credit risk. The holders of such instruments have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy any higher-ranking tranches.

What constitutes a tranche when assessing SPPI for a contractually linked instrument? Question : A special purpose vehicle (‘SPV’) holds a financial asset and issues only one type of note. Any cash flow collected on the transferred asset is then passed to the note holder, and to the party that transferred the financial asset to the SPV, using a waterfall. The waterfall structure contains a credit enhancement whereby the excess of the return on the financial asset over the rate paid on the issued note (also known as the ‘excess spread’) is retained by the SPV to absorb the first losses on the financial assets held by the SPV. This credit enhancement is paid back to the transferor using a predefined schedule defined in the waterfall, and is not equity in the SPV as defined by IAS 32. Does the ‘excess spread’ credit enhancement constitute a tranche when assessing whether the contractually linked instruments guidance should be applied to the structure? Solution: Yes. IFRS 9 defines a contractually linked instrument as “transactions in which an issuer may prioritise payments to the holders of financial assets using contractually linked instruments that create concentration of credit risk. Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche” . This definition does not restrict the form of a ‘tranche’ to only notes or securities. Since the structure contains the key feature of a contractually linked instrument (that is, it passes any cash flows that it collects using a waterfall in a manner that creates concentrations of credit risk), the ‘excess spread’ credit enhancement should be considered a tranche for the purposes of applying the contractually linked instruments guidance.

The classification criteria for the holder of such contractually linked instruments (tranches) should be assessed based on the conditions at the date when the entity initially recognised the investment using a ‘look through’ approach. This approach looks at the terms of the instrument itself, as well as through to the pool of underlying instruments. The assessment considers both the characteristics of these underlying instruments and the tranche’s exposure to credit risk relative to the pool of underlying instruments.

In such transactions, the tranche has cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if:

• The contractual terms of the tranche itself (without looking through to the pool of underlying instruments) give rise to cash flows that are SPPI.

• The underlying pool contains one or more instruments that have contractual cash flows that are SPPI on the principal outstanding. In addition, the underlying pool of instruments might also include instruments that:
• reduce the variability of the instruments in the underlying pool (for example, an interest rate cap or floor, or a contract that reduces the credit risk of the underlying pool of instruments); and
• align the cash flows of the tranches with the cash flows of the pool of underlying instruments to address differences in whether the interest rate is fixed or floating, the currency in which the cash flows are denominated (including inflation in that currency), or the timing of the cash flows.

• The credit rating of the tranche being assessed is equal to or higher than the credit rating that would apply to a single tranche funding the underlying pool of financial instruments. Tranches with a lower credit rating (that is, lower than a hypothetical single tranche funding the underlying pool of financial instruments) are viewed as having leveraged the credit risk, which violates SPPI.

Are liquidity facilities a tranche or an instrument in the pool when applying the CLI guidance? Question A special purpose entity (SPE) issues notes to investors to fund the acquisition of a pool of loans that meet the Solely Payment of Principal and Interest (SPPI) criteria. A waterfall agreement specifies how cash flows generated by the pool of loans are allocated to the different noteholders, and it is assumed that the structure falls within the scope of the contractually linked instrument (CLI) guidance set out in paragraphs B4.1.20–B4.1.26 of IFRS 9. The SPE also obtains a liquidity facility from bank A, which forms part of the waterfall agreement. In bank A’s individual financial statements, should the liquidity facility be considered: ·        a tranche of the structure so that, when drawn, bank A will need to apply the CLI guidance to assess whether the resulting receivable passes SPPI; or ·        an instrument in the underlying pool under IFRS 9, so that bank A will not need to apply the CLI guidance to assess whether the resulting receivable passes SPPI (since the liquidity facility cannot be both a tranche and an instrument in the underlying pool)? Answer It depends. The classification of liquidity facilities might require judgement based on the particular facts and circumstances. Where this represents a significant judgement, the disclosures required by IAS 1 should be provided. Consider the following two scenarios. Scenario 1 The liquidity facility: ·        has a maximum maturity of three months once the facility is drawn; ·        ranks most senior within the SPE’s payment waterfall; ·        has a maximum drawn amount that is a small portion of the total initial purchase price of the underlying pool of assets; ·        is designed to fund short-term mismatches between the timings of cash receipts from the underlying asset pool and cash payments to the noteholders; and ·        is not designed to provide credit protection to the noteholders. In this situation, the liquidity facility would be considered an instrument in the pool under IFRS 9 and not a tranche. This is because the liquidity facility aligns the cash flows of the tranches with the cash flows of the underlying pool, and its purpose is to address only differences in the timing of the cash flows. Scenario 2 The liquidity facility: ·        is part of a Commercial Paper (CP) issuance structure, whereby the notes issued by the SPE are in the form of a short-term CP; ·        the SPE’s assets are longer term and the facility is used primarily to fund the entirety of the underlying asset pool in the event that the CP cannot be rolled over; ·        this could occur if there is insufficient liquidity in the CP market or if the credit risk of the underlying assets in the pool deteriorates; ·        has a maximum maturity, once the facility is drawn, set equal to the contractual maturity of the longest-dated asset in the underlying pool of assets; ·        once drawn, the liquidity facility effectively ranks most junior within the SPE’s payment waterfall, since all noteholder redemptions will be funded by drawdowns on the liquidity facility if cash flows from the underlying pool of assets are insufficient; ·        has a maximum drawn amount equal to the total initial purchase price of the underlying pool of assets; and ·        is designed both to provide credit protection to the CP noteholders and to fund the structure when shorter-term notes mature and are not immediately reissued. In this situation, the liquidity facility would not be considered an instrument in the pool under IFRS 9, but should be treated as a tranche. Considering IFRS 9, the purpose of the liquidity facility is not solely to align the cash flows of the tranches and underlying pool to address differences in either interest rates, currencies or timing of the cash flows. Instead, the purpose of the liquidity facility is also to bear significant credit risk – that is, risk relating to the occurrence, rather than just the timing, of cash flows from the underlying pool. In determining the appropriate treatment, IFRS 9 is also relevant. This paragraph discusses instruments that reduce cash flow variability and so might also be included in the underlying pool, and gives as an example “a contract that reduces the credit risk on some or all of the instruments …”. It might therefore be argued that the liquidity facility in scenario 2 above can be considered an instrument in the pool, given that part of its purpose is to absorb credit risk on the underlying assets and to protect the CP noteholders. However, judgement is required in this area, since, taken to an extreme, a junior tranche in a structure that similarly reduces cash flow variability could be argued to be an instrument in the pool, which is clearly not the intention of the guidance. Neither does IFRS 9 contemplate an instrument that could fund the entire structure being an instrument in the pool. For that reason, the substance of the arrangement needs to be considered. Given the extent of the credit risk exposure of the liquidity facility in scenario 2, it would not be appropriate for the liquidity facility to be considered an instrument in the pool under IFRS 9.

Fair value measurement through profit or loss measurement is required if any instrument in the pool does not meet the conditions outlined above, or if the composition of the underlying pool might change after the initial recognition such that it would no longer meet the qualifying conditions, or if it is impracticable to look through. However, if the underlying pool includes instruments that are collateralised by assets that do not meet the conditions outlined above, the ability to take possession of such assets is disregarded, unless the entity acquired the tranche with the intention of controlling the collateral.

Derivatives in underlying pool of assets Question: A special purpose entity (SPE) holds floating-rate EUR assets, and it issues fixed-rate GBP notes contractually linked to the assets. The SPE has entered into one swap that is a pay EUR floating and receive GBP floating, and a second swap that is a pay GBP floating and receive GBP fixed. Both of these swaps would meet the requirements, in IFRS 9, of aligning the cash flows of the tranches with the cash flows of the pool of underlying instruments. Assuming that the other features of contractually linked instruments have been met (according to IFRS 9), would such a note in a tranche issued by an SPE meet the SPPI criteria? Solution: Yes. However, if the SPE had a derivative that introduced a third currency (say, USD), this would not align the cash flows, and the tranche would have to be measured at FVTPL.

Derivative with optionality in underlying pool of assets Question: An SPE holds a fixed-for-floating swap that also hedges pre-payment risk such that, if the underlying pool of fixed-rate assets pays down early, the derivative is cancelled, with no further amounts to pay. This is to ensure that there are no excess derivatives and no fair value gains or losses on settlement; this is because, when the assets pre-pay, the notes pre-pay. Assuming that the other features of contractually linked instruments have been met (according to IFRS 9), would such a note in a tranche issued by an SPE meet the SPPI criteria? Solution: Yes. This feature would not fail the SPPI criterion. This could also be achieved by other mechanisms (for example, the SPE could be required to enter into an offsetting derivative as soon as practicable), to make sure that there are no excess derivative positions after the pre-payment of the notes.

Investments in collateralised debt obligations (CDOs) Question: An entity has an investment in a cash CDO, where the issuing SPE holds the underlying referenced assets. Would such a note in a tranche issued by an SPE meet the SPPI criteria? Solution: The investment might meet the SPPI criteria, provided that the underlying assets also meet the SPPI criteria, and the other requirements of IFRS 9 are met for contractually linked instruments. But investments in synthetic CDOs (where the SPE has a credit derivative that references particular exposures) would not qualify, because the derivatives on the reference exposures do not have cash flows that are SPPI, nor do they align the cash flows permitted by IFRS 9.

Financial assets designated at FVTPL using fair value option

IFRS 9 permits only one condition to qualify for using the fair value option. Under IFRS 9, an entity can, at initial recognition, irrevocably designate a financial asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases.

Assessing SPPI on an instrument that has been designated as fair value through P&L Question : Where an instrument has been designated at fair value through P&L as a result of an accounting mismatch, are entities still required to perform the SPPI test? Answer : Yes. IFRS 7 states that “If the entity has designated as measured at fair value through profit or loss a financial instrument that would otherwise be measured at fair value through other comprehensive income or amortised cost” , the entity should provide additional disclosures relating to credit risk. In order to determine if the entity is required to make these additional disclosures, the entity would have to determine if the instrument would otherwise have been measured at FVOCI or amortised cost, which itself requires the entity to perform the SPPI test. In addition, IFRS 7 requires entities to separately disclose financial assets i) that have been designated at FVTPL, and ii) that are mandatorily measured at FVTPL, for which SPPI also needs to have been assessed.

Reclassification of financial assets

Once the initial classification has been determined, reclassification is only permitted where an entity changes its business model for managing financial assets. Changes to the business model are expected to be infrequent; the change is determined by the entity’s senior management as a result of external or internal changes, and it must be significant to the entity’s operations and should be evident to external parties. A change in an entity’s business model will occur when an entity either begins or ceases to perform an activity that is significant to its operations.

The following are examples of changes in business model:

1. An entity has a portfolio of commercial loans that it holds to sell in the short term. The entity acquires a company that manages commercial loans and has a business model that holds the loans in order to collect the contractual cash flows. The portfolio of commercial loans is no longer for sale; it is now managed together with the acquired commercial loans, and all are held to collect the contractual cash flows.
2. A financial services firm decides to shut down its retail mortgage business. That business no longer accepts new business, and the financial services firm is actively marketing its mortgage loan portfolio for sale.

The following are examples that are not changes in business model:

1. Change in intention related to particular financial assets (even in circumstances of significant changes in market conditions).

1. A transfer of financial assets between parts of the entity with different business models.
2. The temporary disappearance of a particular market for financial assets.

1. A convertible bond where the conversion feature lapses after a certain period of time. The lapse does not constitute a reclassification event.

Reclassification of the business model when loans are transferred to a run-off portfolio Question: An entity has a portfolio of loans that are classified as amortised cost. After a period of time, a small number of the loans become non-performing and are transferred into a run-off portfolio, where the entity’s intention is to maximise the recovery of the loans (which could be by selling the loans, if a good price can be obtained in the market). Does such an event require reclassification of the business model? Solution: Such a transfer does not constitute a reclassification event, because IFRS 9 is clear that a change of intention or a transfer of financial assets between different portfolios is not a reclassification event. IFRS 9 establishes that, if cash flows are realised in a way that is different from the entity’s expectations at the date when management assessed the business model, this fact does not give rise to a prior period error in the entity’s financial statements (in accordance with IAS 8) – for example, if the entity sells more or fewer financial assets than it expected when it classified the assets. It also does not change the classification of the remaining financial assets held in that business model (that is, those assets that the entity recognised in prior periods and still holds), provided that the entity considered all relevant and objective information that was reasonably available at the time when it made the business model assessment.

Assessing the criteria for reclassification of financial assets Question: IFRS 9 requires an entity to reclassify financial assets when, and only when, the entity changes its business model for managing those assets. Such changes are determined by the entity’s senior management as a result of external or internal changes, and they must be significant to the entity’s operations and demonstrable to external parties in accordance with the standard. What are relevant considerations when assessing whether there has been such a change? Solution: A change in business model is expected to be ‘very infrequent’ and will occur only when an entity either begins or ceases to perform an activity that is significant to its operations. It is therefore important to interpret the requirements in this context. IFRS 9 also states that the following are not changes in business model: a change in intention related to particular financial assets (even in circumstances of significant changes in market conditions); the temporary disappearance of a particular market for financial assets; or a transfer of financial assets between parts of the entity with different business models. Other relevant considerations in interpreting the standard, all of which should be met, are: ·        Significant to the entity’s operations : Significance should be considered at the overall entity level, because IFRS 9 does not state that any lower level should be considered. However, assessing whether a change is ‘significant’ is a matter of judgement, where both qualitative and quantitative factors should be considered. For example, in the case of a financial institution, managing regulatory capital might be considered a more critical area of the business than other aspects of the entity’s operations. Therefore, a change involving smaller numerical amounts that relates to regulatory capital might be considered to have a greater level of significance than a change involving similar numerical amounts in another, less critical, aspect of the entity’s operations. It is also possible that a change will be significant for the purposes of an entity’s individual financial statements, but it will not be significant in the group financial statements where the ‘entity’ is the larger consolidated group. This could result in different business models in individual and group financial statements because of the different significance thresholds. ·        Determined by the entity’s senior management : Given the requirement for a change to be both significant and determined by the entity’s senior management, it would be expected that the decision would be taken by the entity’s corporate governance process used for taking other significant decisions. In many cases, this will be through a collective group of senior management, such as the board of directors or an executive committee, since the significance will necessitate a collective decision rather than allowing one individual to make the decision alone. However, in some entities an individual might have responsibility for making significant decisions in the normal corporate governance process. In such a scenario, the entity’s ‘senior management’ could be concluded to be an individual for the purposes of the standard. ·        Demonstrable to external parties : Being demonstrable to external parties requires the change to be clearly visible to third parties. As illustrated by the examples provided, this visibility might result from a publicly disclosed acquisition of another entity or, for a financial institution, the closing down of its retail mortgage business, meaning that a customer can no longer obtain a new mortgage. This helps to ensure that the change is not easily reversed or only temporary, similar to the concept of a constructive obligation in IAS 37 where an entity takes actions visible to third parties that create the expectation in those other parties that it will discharge those responsibilities. In isolation, disclosure of the change in the financial statements, or material impacts on the entity’s reported results, would not be sufficient to meet the requirement to be ‘demonstrable to third parties’. Also, the absence of an activity, such as a lack of reported material sales, would not be sufficient to meet this requirement, because this is likely to be an internal decision that has little or no impact on external parties or customers. Evidence contained in documents such as board minutes, that are not available to third parties in the ordinary course of business, would also not be considered sufficient. Changes that are demonstrable to third parties will therefore be limited. In particular, it is less likely that this condition will be met for groups of assets that typically do not have direct external stakeholder involvement, such as a financial institution’s liquidity portfolio of high-quality investment securities. However, where a change such as making sales out of a ‘hold to collect’ business model was required by an external regulator, and a public announcement of this change was made, this would be considered demonstrable to third parties, because there is an externally visible requirement. Changes affecting only some assets : Where the changes affect the entirety of a pre-defined, clearly distinguishable portfolio within a business model, then dependent on the facts and circumstances, this might be treated as a change in business model for that portfolio and result in its reclassification. Otherwise, a change needs to affect the objective for all of the assets within that business model to be a change in business model that results in reclassification. It is not permitted to apply a change of business model and reclassification to only a subset of assets within a business model. This is because the standard is clear that intentions for individual (or groups of) assets within a single business model should not be considered in determining whether a change in business model has occurred. The standard also states that the transfer of financial assets between parts of the entity with different business models does not constitute a change in business model. Applying this in practice, consider a group of SPPI loans originated by a financial services group in a ‘hold to collect’ business model that is not the entirety of a pre-defined, clearly distinguishable portfolio and which is later transferred to the group’s insurance business as a natural hedge of long-term liabilities and subsequently managed on a fair value or ‘hold to collect and sell’ basis. Those assets would retain their original ‘hold to collect’ business model and continue to be measured at amortised cost in the group’s consolidated financial statements.

Impact on business model of changes relating to a predefined portfolio Question: A financial institution has two pre-defined and clearly distinguishable portfolios of retail mortgages: one portfolio comprises mortgages located in the north of the country; and the second portfolio comprises mortgages in the south of the country. The two portfolios are managed together as one group of assets by the same management team but their performance is evaluated and reported separately. Management compensation is related to the collection of the contractual cash flows of these assets as a whole group. Therefore, when defining its business model, the financial institution concludes that the two portfolios comprise a single business model. Assume that the business model is ‘hold to collect’. In a subsequent reporting period, the financial institution closes down its mortgage business in the south of the country. As a result, it ceases writing new mortgages and actively markets the mortgages located in the south for sale. A separate management team is put in place to manage the southern mortgages, the performance of the southern mortgages is evaluated based on their fair value, and they continue to be reported separately from the northern mortgages. The new management team is compensated by reference to the performance of the fair value and achieved sales of the southern mortgages only. The new management team has no involvement in the management of the northern mortgages. The original management team has no further involvement in the management of the southern mortgages and its compensation is now based on the collection of the contractual cash flows of the northern mortgages only. Otherwise, the management and reporting for the Northern mortgages remains unchanged. Ordinarily, a change needs to affect the objective for all of the assets within a business model to be a change in business model that results in reclassification. However, in this scenario, could it be acceptable to reclassify the southern mortgages portfolio alone, if all other aspects (for example, in relation to ‘significance’, ‘determined by senior management’ and ‘demonstrable to external parties’) are met? Solution: IFRS 9 requires that ‘When, and only when, an entity changes its business model for managing financial assets it shall reclassify all affected financial assets’. Further guidance on what constitutes a change in business model is provided. However, no additional guidance is provided on a change that affects the entirety of a pre-defined and clearly distinguishable portfolio of assets within a business model. In our view, in the specific scenario of the southern mortgages with the individual facts and circumstances as described above, an acceptable view would be to reclassify only the pre-defined portfolio of southern mortgages for the following reasons: ·        In describing an example of a change in business model, IFRS 9 refers to a ‘portfolio of commercial loans’ and does not state that this portfolio is the entire business model. This therefore implies that reclassification at a portfolio level within a business model could be permissible. ·        Whilst IFRS 9 states that a change in intention related to particular financial assets is not a change in business model, in this situation there has been more than a change in intention – there has also been a change in business objective and management practices. In fact, there could still be different management intentions for certain assets within the southern portfolio, but these would not be taken into account in assessing whether the business model for the southern portfolio has changed. ·        IFRS 9 states that ‘When, and only when, an entity changes its business model for managing financial assets it shall reclassify all affected financial assets in accordance with the standard. This does not require all assets in the business model to be affected by the change, so it can be inferred that a pre-defined and clearly distinguishable portfolio within an existing business model could be separated at a subsequent stage and all assets in that portfolio only could be reclassified, dependent on facts and circumstances. ·        Whilst the north and south portfolios were defined as a single business model, they could potentially have been defined instead as two separate business models. Reclassifying the southern portfolio alone achieves the same outcome as if two separate business models had been defined initially. (Note: the original decision to define the north and south portfolios as a single business model, rather than two separate business models, should be considered under the significant accounting judgement guidance in IAS 1, and applicable disclosures about this judgement should be made as relevant.)

Reclassifications should be accounted for prospectively from the reclassification date. The reclassification date is the first day of the first reporting period following the change in business model that results in an entity reclassifying financial assets. An entity should not restate any previously recognised gains or losses (including impairment gains or losses) or interest.

The following table shows the different reclassification scenarios and their accounting consequences:

Original category	New category	Accounting impact
Amortised cost	FVTPL	Fair value is measured at the reclassification date. Any difference between previous amortised cost and fair value on reclassification is recognised in profit or loss.
FVTPL	Amortised cost	Fair value at the reclassification date becomes its new gross carrying amount. The effective interest rate is determined on the basis of the fair value at reclassification date.
Amortised cost	FVOCI	Fair value is measured at the reclassification date. Any difference between previous amortised cost and fair value on reclassification is recognised in other comprehensive income (OCI). The effective interest rate is not adjusted as a result of the reclassification.
FVOCI	Amortised cost	Fair value at the reclassification date becomes its new amortised cost carrying amount. Cumulative gain or loss in OCI is removed from equity and adjusted against the fair value of the financial asset at the reclassification date. The effective interest rate is not adjusted as a result of the reclassification.
FVTPL	FVOCI	Fair value at the reclassification date becomes its new carrying amount. The effective interest rate is determined on the basis of the fair value at the reclassification date.
FVOCI	FVTPL	Fair value at the reclassification date becomes its new carrying amount. Cumulative gain or loss in OCI is reclassified to profit or loss at the reclassification date.

Classification of equity instruments

Investments in equity instruments (as defined in IAS 32, from the perspective of the issuer) are always measured at fair value. Equity instruments that are held for trading (including all equity derivative instruments, such as warrants and rights issues) are required to be classified at FVTPL, with dividend income recognised in profit or loss.

Classification of an investment in a puttable share Question : An entity (the holder) invests in a fund that has puttable shares on issue – that is, the holder has the right to put the shares back to the fund in exchange for its pro rata share of the net assets. Can the holder measure its investment in the fund at FVOCI? Solution: Puttable shares are not eligible for the irrevocable option to take fair value changes on equity instruments through OCI. IFRS 9 clarifies that the option is only available for equity instruments that comply with the definition of equity instruments in accordance with IAS 32. Whilst puttable instruments might be classified as equity for accounting purposes, they do not meet the definition of equity under IAS 32. Therefore, investments in puttable instruments are likely to be classified as FVTPL, because they cannot be regarded as equity instruments for IFRS 9; and, although they are considered to be investments in debt, it is unlikely that they will meet the SPPI criterion.

For all other equities within the scope of IFRS 9, management has the ability to make an irrevocable election on initial recognition, on an instrument-by-instrument basis, to present changes in fair value in OCI rather than profit or loss. However, where an entity that is a venture capital organisation or similar entity elects under IAS 28 to measure an investment in an associate or joint venture in accordance with IFRS 9 rather than applying equity accounting, that investment must be measured at FVTPL. Dividends are recognised in profit or loss unless they clearly represent a recovery of part of the cost of an investment, in which case they directly reduce the carrying amount of the investment. There is no recycling of amounts from OCI to profit or loss – for example, on sale of an equity investment – nor are there any impairment requirements. But the entity can transfer the cumulative gain or loss within equity. The FVOCI accounting for equity instruments differs from the FVOCI accounting for debt instruments, since the cumulative gain or loss previously recognised in OCI is reclassified when the asset is derecognised or reclassified. Another notable difference is that interest income using the effective interest method, foreign exchange gains and losses and impairment gains and losses are recognised in the income statement for debt instruments measured at FVOCI, and not for equity instruments measured at FVOCI.

Classification of an investment in a perpetual note Question: An entity (the holder) invests in a subordinated perpetual note, redeemable at the issuer’s option, with a fixed coupon that can be deferred indefinitely if the issuer does not pay a dividend on its ordinary shares. How should the issuer and holder account for the perpetual note? Solution: The issuer classifies this instrument as equity under IAS 32. The holder, unless the investment is held for trading, has the option to classify it at either FVOCI or FVTPL under IFRS 9, because it is an equity instrument (from the perspective of the issuer), as defined in IAS 32.

Accounting for a special dividend that is clearly recovery of the cost of investment Question: An entity invests in shares at a cost of C12 and designates these at FVOCI. The issuer immediately pays a special dividend of C10. How should this dividend be accounted for? Solution: This dividend is not recorded in profit or loss, because such a dividend clearly represents a recovery of part of the investment’s cost, which directly reduces the carrying amount of the investment.

Accounting for a special dividend that is not clearly recovery of the cost of investment Question: An entity invests in shares at a cost of C12, and it designates these at FVOCI. Over the next five years, it receives dividend income which is recognised in profit or loss. At the end of the five years, the fair value of the shares has gone up to C22, giving rise to an unrealised gain of C10 in OCI. The issuer then pays a special dividend of C10. How should this dividend be accounted for? Solution: IFRS 9 does not specify how to interpret the phrase ‘cost of investment’ in a more complex situation. One view is that cost could be interpreted as relating solely to the original cost of C12. Under this view, since the special dividend does not reduce the investment’s carrying value below its original cost, the special dividend of C10 is recognised in profit or loss. Alternatively, paragraph BC5.25 of IFRS 9 indicates that dividends that represent a return of investment, rather than a return on investment, should be recognised in OCI. If this is viewed as a broader interpretation of cost, then, since the special dividend is equal to approximately half of the fair value of the investment, it is a return of investment and should be recognised in OCI. Other interpretations of cost might also be appropriate, depending on the fact pattern. So an entity should make an accounting policy choice about how it interprets ‘cost of investment’ in the context of the FVOCI election. The policy should be applied consistently and disclosed where material.

Accounting for an investment in an associate Question: A venture capital organisation has an investment in an associate that it has previously designated at FVTPL according to IAS 39, as is permitted by the scope exclusion in IAS 28. Can the entity designate this investment at FVOCI under IFRS 9? Solution: This investment is not permitted to be accounted for at FVOCI under IFRS 9, because IAS 28 has not been amended to permit such accounting. But, on adopting IFRS 9, the venture capital organisation could revoke its previous designation and apply equity accounting. Also, the investment can still be accounted for at FVTPL.

Accounting for a convertible bond from the holder’s perspective Question: An entity has an investment in a convertible bond that, from the issuer’s perspective, has both a liability and an equity component. How should the holder account for the bond? Solution: Since the contract is a financial asset that is within the scope of IFRS 9 in its entirety, the contract should be accounted for as a whole. From the holder’s perspective, the cash flows on the convertible bond are not SPPI, so the bond cannot be classified as a financial asset measured at amortised cost, and it will always be classified at FVTPL by the holder. However, if a convertible bond were to be classified as equity in its entirety from the issuer’s perspective (for example, if the bond had no interest payments and mandatorily converted into a fixed number of the issuer’s equity instruments on a future date), the holder might choose to designate it at FVOCI.

Disclosure requirements of equity investments designated at FVOCI Question : An entity holds a non-traded equity investment in the scope of IFRS 9 in company ABC, for which it has made the irrevocable election to present subsequent changes in fair value in other comprehensive income (FVOCI). IFRS 7 states that disclosure is required of, among other things, “which investments in equity instruments have been designated to be measured at fair value through other comprehensive income”. To meet this disclosure requirement, does the entity need to name each individual investment for which the designation has been used? Solution: It depends on whether the name is material information. IAS 1 states that a specific disclosure requirement under IFRS does not need to be provided if the information is not material and that, in determining whether an item is material, the size or nature of the item (or a combination of both) could be the determining factor. The name of an investment might be considered material where an entity has a single large strategic investment designated at FVOCI. Conversely, the name might not be considered material where an entity holds a large number of similar individual investments designated at FVOCI or where the value of each investment is not material. In this case, the entity should still consider how the disclosure objective of IFRS 7 will be met (for example, disclosing by type of investment). Whether the name of an investment held by an entity is material to the financial statements, as required by IFRS 7, is a separate judgement from the remaining requirements of the standard.

Measurement of unquoted equity instrument

IFRS 9 removes the ability to measure unquoted equity investments at cost where fair value cannot be determined reliably. However, IFRS 9 indicates that, in limited circumstances, cost might be used as an estimate of fair value – for example, where more recent available information is insufficient to determine fair value; or where there is a wide range of possible fair value measurements, and cost represents the best estimate of fair value within that range. Although there are some circumstances in which cost might be representative of fair value, those circumstances would never apply to equity investments held by particular entities, such as financial institutions and investment funds.

Indicators of where cost might not be representative of fair value include:

• A significant change in the investee’s performance, compared with budgets, plans or milestones.
• Changes in expectation that the investee’s technical product milestones will be achieved.
• A significant change in the market for the investee’s equity or its products or potential products.
• A significant change in the global economy or the economic environment in which the investee operates.
• A significant change in the performance of comparable entities or in the valuations implied by the overall market. Internal matters of the investee, such as fraud, commercial disputes, litigation, or changes in management or strategy.
• Evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity) or by transfers of equity instruments between third parties.

The list above is not exhaustive. An entity should use all information about the performance and operations of the investee that becomes available after the date of initial recognition. To the extent that any such relevant factors exist, they might indicate that cost is not representative of fair value. In such cases, the entity must measure fair value.

Embedded derivatives in financial assets

An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way that is similar to a stand-alone derivative. An embedded derivative cause some or all of the cash flows, that otherwise would be required by the contract, to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided (in the case of a non-financial variable) that the variable is not specific to a party to the contract.

The accounting for embedded derivatives in host contracts that are financial assets is simplified by removing the requirement to consider whether or not they are closely related and should therefore be separated. The classification approach in IFRS 9 applies to all financial assets, including those with embedded derivatives. That is, if a hybrid contract contains a host that is a financial asset within the scope of IFRS 9, an entity should apply the business model assessment and SPPI criterion to the entire hybrid contract, in order to determine its measurement category. The accounting for embedded derivatives in non-financial host contracts remains unchanged from IAS 39.

Assessing SPPI for financial assets which contain embedded derivatives Question: Do embedded derivatives in financial assets prevent the SPPI criterion from being met? Solution: It depends. Many embedded derivatives introduce variability to cash flows, which is not consistent with the notion that the instrument’s contractual cash flows represent SPPI. If an embedded derivative was not considered to be ‘closely related’ under the IAS 39 requirements, this does not automatically mean that the instrument will not meet SPPI under IFRS 9. But the number of circumstances in which such instruments will meet SPPI is limited. There are some embedded derivatives (such as caps and floors) that might have required separation under IAS 39, but they might pass the SPPI condition in IFRS 9. Conversely, some hybrid contracts, in which the embedded derivative would be regarded as closely related under IAS 39, might fail the SPPI condition and be measured at FVTPL.

Negative fair values

The standard clarifies that, if a financial instrument that was previously recognised as a financial asset is measured at FVTPL and its fair value decreases below zero, it becomes a financial liability that should be measured. However, hybrid contracts with hosts that are financial assets within the scope of IFRS 9 are always measured in accordance with the classification approach in IFRS 9 for financial assets.

Classification of financial liabilities

An entity recognises a financial liability when it first becomes a party to the contractual rights and obligations in the contract. It is, therefore, necessary to measure those contractual rights and obligations on initial recognition.

All financial liabilities in IFRS 9 are initially recognised at fair value, minus (in the case of a financial liability that is not at FVTPL) transaction costs that are directly attributable to issuing the financial liability.

There continue to be two measurement categories for financial liabilities: fair value, and amortised cost. Financial liabilities are measured at amortised cost, unless they are required to be measured at FVTPL or an entity has opted to measure a liability at FVTPL.

Financial liabilities required to be measured at fair value through profit or loss

Certain liabilities are required to be measured at FVTPL. These include all derivatives (such as foreign currency forwards or interest rate swaps) and an entity’s own liabilities that it classifies as ‘held for trading’. Financial liabilities that are required to be measured at FVTPL (as distinct from those that the entity has chosen to measure at FVTPL, which is discussed below) continue to have all fair value movements, including those related to changes in the credit risk of the liability, recognised in profit or loss.

Financial liabilities designated at FVTPL using fair value option

Under IFRS 9, an entity can, at initial recognition, irrevocably designate a financial liability as measured at FVTPL where doing so results in more relevant information, because either:

1. it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or
2. a group of financial liabilities, financial assets, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel. Furthermore, financial liabilities can be measured at FVTPL if they are the host contract of an embedded derivative.

A common reason why entities might elect to use the fair value option is where they would otherwise have an accounting mismatch between a financial liability and an asset that is required to be held at FVTPL.

Entities can also choose to measure financial guarantees and loan commitments at FVTPL. Such instruments will continue to have all changes in fair value recorded in profit or loss where they have been designated at FVTPL.

The decision of an entity to designate a financial liability at FVTPL is similar to an accounting policy choice (although, unlike an accounting policy choice, it is not required to be applied consistently to all similar transactions).

Considerations in designating a financial liability at FVTPL Question: Assume that an entity has a number of similar financial liabilities that total C100, and a number of similar financial assets that total C50, but they are measured on a different basis. How can the entity use IFRS 9 to account for the financial assets and liabilities so as to reduce any measurement inconsistency? Solution: The entity could significantly reduce the measurement inconsistency by designating, at initial recognition, all of the assets but only some of the liabilities (for example, individual liabilities with a combined total of C45) at FVTPL. However, because designation at FVTPL can be applied only to the whole of a financial instrument, the entity must designate one or more liabilities in their entirety. It could not designate either a component of a liability (for example, changes in value attributable to only one risk, such as changes in a benchmark interest rate) or a proportion (that is, a percentage) of a liability.

Changes in own credit risk for financial liabilities designated at FVTPL using fair value option

IFRS 9 changes the accounting for financial liabilities which an entity chooses to designate at FVTPL. Except for loan commitments and financial guarantees (see para 42.76 ), changes in fair value of such liabilities related to changes in own credit risk are presented separately in OCI, whilst all other fair value changes are presented in the income statement. However, this does not apply if the recognition of fair value changes due to own credit risk in OCI would create an accounting mismatch.

Amounts in OCI relating to changes in own credit risk are not recycled to the income statement, even when the liability is derecognised and the amounts are realised. However, the standard allows transfers within equity, and so entities that wish to transfer realised balances to retained earnings, for example, could do so.

Presentation of a financial liability designated at FVTPL Question: Assume that a liability that has been designated at FVTPL has a fair value movement of C100 for the period. Of that C100, C10 relates to changes in own credit risk. How would this be presented? Solution: C Income statement Change in fair value other than from own credit risk 90 Other comprehensive income Change in fair value from own credit risk 10

If presenting the changes in own credit of a financial liability in OCI would create an accounting mismatch in profit or loss, all fair value movements are recognised in profit or loss. The accounting mismatch must arise due to an economic relationship between the financial liability and a financial asset that results in the liability’s credit risk being offset by a change in the asset’s fair value. The accounting mismatch:

• is required to be determined when the liability is first recognised;

• is not re-assessed subsequently; and

• must not be caused solely by the measurement method that an entity uses to determine the changes in a liability’s credit risk.

When recognising changes in own credit risk in OCI can create an accounting mismatch Question: When might an accounting mismatch arise on the recognition of changes in own credit risk on a liability designated at FVTPL? Solution: Take, for example, a mortgage bank that provides loans to customers and funds the loans by selling matching bonds in the market. The customer can repay the mortgage by buying the bond and delivering it to the mortgage bank. As a result of this contractual term, the mortgage loan would not meet SPPI, because its contractual cash flows will vary with reference to market factors including the lender’s credit risk, and would therefore be measured at FVTPL. If the fair value of the bond (the financial liability of the mortgage bank designated at FVTPL) changes as a result of own credit risk, it will be offset by changes in the fair value of the mortgage (financial asset). Therefore, recognising changes in credit risk of the bond in OCI, and changes in credit risk of the mortgage asset in profit or loss, would create an accounting mismatch in profit or loss. However, it must be noted that this exemption from the requirement to present movements in the own credit risk of a liability in OCI is expected to be rare.

Measuring changes in own credit risk of liabilities

For those financial liabilities where changes in fair value related to own credit risk are presented separately in OCI, own credit risk can be determined as either:

• the amount of fair value change not attributable to changes in market risk (for example, benchmark interest rates) – this is often referred to as the default method; or
• an alternative method that the entity believes more faithfully represents the changes in fair value due to ‘own credit’ (for example, a method that computes credit risk directly, based on credit default swap rates).

If the changes in fair value arising from factors other than changes in the liability’s credit risk or changes in observed interest rates (that is, benchmark rates such as LIBOR) are significant, an entity is required to use an alternative method and not the default method. For example, changes in the fair value of a liability might arise due to changes in value of a derivative embedded in that liability, rather than changes in benchmark interest rates. In that situation, changes in the value of the embedded derivative must be excluded in determining the amount of own credit risk that is presented in OCI.

The credit risk of a liability with collateral is likely to be different from the credit risk of an equivalent liability without collateral issued by the same entity.

Unit-linking features usually contain specific asset performance risk rather than credit risk – that is, the value of the liability changes due to changes in value of the linked asset(s) and not because of changes in the own credit risk of the liability. This means that changes in the fair value of a unit linked liability, due to changes in the fair value of the linked asset, will continue to be recognised in the income statement, because they are not regarded as being part of the own credit risk of the liability that is recognised in OCI.

Considerations for accounting for unit-linked liabilities at FVTPL Question: An entity issues unit-linked liabilities that it has designated at FVTPL, and it holds the related assets at fair value. At the beginning of the period, the assets and the liabilities both have a fair value of C100. During the period, the fair value of the assets falls by C20. The fair value of the liability also falls by C20 during the period, due to the change in the value of the linked assets. How should the change in fair value of the issued unit-linked liabilities be presented? Solution: This change in fair value is attributable to the change in the fair value of the related assets and not to credit risk, so the entire fair value change of C20 is recognised in profit or loss.

Embedded derivatives in financial liabilities and fair value option

Under IFRS 9, embedded derivatives that are not closely related to the financial liability host contract are separately accounted for at FVTPL, unless the entity elects to apply the fair value option to the liability in its entirety.

If a contract contains one or more embedded derivatives and the host is a financial liability, an entity could designate the entire hybrid contract at FVTPL, unless:

1. the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or
2. it is clear (with little or no analysis, when a similar hybrid instrument is first considered) that separation of the embedded derivative(s) is prohibited, such as a pre-payment option embedded in a loan that permits the holder to pre-pay the loan for approximately its amortised cost. A common reason for electing the fair value option is where liabilities have embedded derivatives that the issuer does not wish to separate from the host liability.

Financial liabilities arising on transfers of financial assets

Certain financial liabilities might arise when a transfer of a financial asset does not qualify for derecognition, or is accounted for using the continuing involvement approach. For example, a sale of an asset that is accompanied by the seller giving a guarantee of the asset’s future worth might, depending on the substance, give rise to the asset’s derecognition and recognition of a liability in respect of the guarantee, or it might result in the asset not being derecognised and the proceeds being shown as a liability. Special rules apply for the measurement of the transferred asset and the associated liability, so that these are measured on a basis that reflects the rights and obligations that the entity has retained.

Financial guarantee contracts

As discussed, a financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for a loss that it incurs because a specified debtor fails to make payment when due, in accordance with the original or modified terms of a debt instrument.

Financial guarantee contracts issued

Issued financial guarantee contracts, which the issuer has not previously asserted that it regards as insurance contracts under IFRS 4, are accounted for as financial liabilities under IFRS 9, and they are initially recognised at fair value. If the financial guarantee contract was issued to an unrelated party in a stand-alone arm’s length transaction, its fair value at inception is likely to be equal to the premium received, unless there was evidence to the contrary.

Recognition of future premiums by the issuer of a financial guarantee contract on initial recognition Question: In some circumstances, an issuer expects to receive recurring future premiums from an issued financial guarantee contract (for example, it issues a five-year guarantee with annual premiums due at the start of each year). On initial recognition, should the issuer recognise a receivable for the discounted value of the expected future premiums, or should it recognise only the initial cash received (if any)? Solution: IFRS 9 requires the issuer of a financial guarantee contract to initially record the guarantee at fair value, and this is likely to equal the premium received. By analogy with derivative contracts, the fair value will take into account any future cash flows on the instrument, including those relating to premiums receivable. IFRS 9 does not explicitly prohibit the recognition of a separate receivable for future premiums not yet due. This is evidenced by the basis for conclusions, which states that the IFRS 9 requirement for initial recognition at fair value is consistent with US GAAP, as represented by FIN 45 (FIN 45 requires recognition of a liability for the guarantee and a separate receivable for future premiums). Accordingly, entities are permitted to recognise a separate receivable. The entity should select a presentation policy and apply it consistently to all issued financial guarantee contracts.

Determining the fair value of an intra-group financial guarantee contract Financial guarantee contracts that are accounted for as financial liabilities under IFRS 9 by the issuer are initially recognised at fair value. Establishing such a fair value might be difficult if the financial guarantee contracts between related parties were not negotiated at arm’s length and there are no comparable observable transactions with third parties. Given that intra-group guarantees are unlikely to be negotiated in a ‘stand-alone arm’s length transaction’, fair value would have to be estimated. The valuation techniques that can be applied to determine the fair value of a financial guarantee contract that is not negotiated in an arm’s length transaction are considered below. I References to market prices of similar instruments An entity might be unable to identify a market price for financial guarantees identical to those that either it or a member of its group has issued. However, it might be possible to identify market prices for similar guarantees, credit default swaps or credit insurance products, the price of which could be adjusted. For example, parent P has guaranteed C100 million of five-year debt issued by subsidiary S. It might be possible to identify credit insurance products issued by a bank relating to debt of this amount, maturity and credit quality. However, an adjustment might still be necessary, for example, to reflect liquidity aspects and differences between entity P’s credit rating and that of the bank. II Interest rate differentials Under this method, the entity calculates the value of the difference between the interest charged on the guaranteed loan and what would have been charged if the loan had not been guaranteed. The premise is that the interest that the bank is willing to forgo represents a ‘price’ that it is willing to pay for the guarantee. For example, parent P has guaranteed C100 million of five-year debt issued by subsidiary S. Subsidiary S pays interest of X% on the debt. In the absence of the guarantee, the bank would impose an interest rate of Y%. Hence, the fair value of the guarantee represents the difference in the present value of the interest payments over the period of the guarantee. This model is simple in principle, but it presents practical problems when attempting to measure Y%. It is unlikely that the bank would provide a reliable estimate. In practice, many banks would not provide a loan if the guarantee had not been in place. Determining Y% requires an estimate of the credit spread (for example, above a base index such as LIBOR) appropriate to subsidiary S in isolation. This might prove difficult because, even without the guarantee, subsidiary S’s credit rating will benefit from the entity being a member of parent P’s group. Nevertheless, models based on determining a stand-alone credit rating for subsidiary S do exist, and these should enable a reliable estimate to be made. III Discounted cash flow analysis (expected value) Instead of considering the ‘price’ that a bank would pay for a guarantee, it might be possible to consider the ‘price’ that the issuer would demand for accepting the guarantee obligation. This can be estimated using a probability-adjusted discounted cash flow analysis. For example, parent P has guaranteed C100 million of five-year debt issued by subsidiary S. The probability of default by subsidiary S is estimated at 0.04% (based on historical default rates amongst companies with the same credit rating as subsidiary S), and the loss in the event of default is estimated at 50% (based on subsidiary S’s asset base and other collateral available to the bank). So the expected value of the liability (its fair value) would be C20,000. Similar to the interest rate differential approach described above, this model is simple in principle, but it presents practical problems when attempting to estimate the probability of default and the loss in the event of default. Although data on these points are available, they rely on determining subsidiary S’s credit rating, as in the interest rate differential approach.

Accounting for an intra-group financial guarantee issued by a parent Question : A parent issues a financial guarantee to a bank in respect of its subsidiary’s loan. The fair value of this intra-group guarantee does not equal the fee charged by the bank, if any. How should the parent account for the difference? Solution: The issuer needs to determine whether the difference between fair value and the fee charged for the guarantee should be treated as an expense, or as a capital contribution via an increase in investments in the subsidiary. This is an accounting policy choice. The method used should reflect the transaction’s economic substance, it should be applied consistently to all similar transactions, and it should be clearly disclosed in the financial statements. While each entity within a group can choose its own accounting policies, those policies must be aligned on consolidation

Subsequent to initial recognition, an issuer accounts for financial guarantee contracts at the higher of:

• the amount determined in accordance with the expected credit loss model in IFRS 9; and
• the amount initially recognised (fair value) less, where appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15.

However, the financial guarantee measurement requirements in IFRS 9 do not apply:

• if the financial guarantee contract was designated at FVTPL at inception – such a contract is measured at fair value subsequently; or
• if the financial guarantee contract was entered into or retained on transferring financial assets or financial liabilities to another party and prevented derecognition of the financial asset or resulted in continuing involvement.

Financial guarantee contracts purchased

From the perspective of the purchaser of a financial guarantee, who could be either the borrower or the lender, the contract is outside the scope of IFRS 9 and IFRS 4.

Accounting treatment for the cost of a financial guarantee contract by the purchaser Question : An entity, who could be either the borrower or the lender, purchases a financial guarantee contract in respect of a debt instrument and pays the cost of the guarantee on inception of the guarantee. How should the entity account for the cost of the financial guarantee? Solution: The purchaser’s accounting treatment of the cost of the guarantee depends on whether the financial guarantee is both, in substance, part of the contract terms (that is, integral to the debt instrument) and not recognised separately by the purchaser. If the financial guarantee is both integral to the guaranteed debt instrument and not recognised separately, it is treated as an adjustment to the effective interest rate of the guaranteed debt instrument as a transaction cost, unless the financial instrument is measured at FVTPL. However, if the financial guarantee is not integral to the debt instrument or it is recognised separately, the cost is recognised as a separate pre-payment asset and amortised over the shorter of the life of the guarantee and the expected life of the guaranteed debt instrument. The pre-payment asset is tested for impairment under IAS 36.

Subsidiary’s accounting for a loan guaranteed by its parent Question : Where a parent entity provides a guarantee to a bank that has advanced a loan to one of its subsidiaries, the subsidiary has obtained a benefit, in that it would pay a lower rate of interest on the loan than it would have otherwise paid for an un-guaranteed loan. How should the subsidiary account for the benefit of the intra-group guarantee? Solution: IFRS 9 does not address the accounting for financial guarantees by the borrower, and there is no requirement in IAS 24 to fair value non-arm’s length related party transactions. Therefore, there is an accounting policy choice. The subsidiary could either: ·        fair value the loan from the bank by reference to a normal market rate of interest that it would pay on a similar but un-guaranteed loan, and take the benefit of the interest differential to equity as a capital contribution from the parent; or ·        view the unit of account as being the guaranteed loan, in which case the fair value would be expected to be the face value of the proceeds that the subsidiary receives. In practice, there is diversity on which accounting policy is applied; however, the majority of subsidiaries do not take the capital contribution to equity approach, and they recognise instead the fair value of the guaranteed loan.

Reclassification of financial liabilities

An entity should not reclassify any financial liability. Consistent with its decision to retain most of the existing requirements for classifying and measuring financial liabilities in IFRS 9, the IASB decided to retain the requirements that prohibit reclassifying financial liabilities between amortised cost and fair value. The IASB noted that IFRS 9 requires reclassification of assets in particular circumstances. However, the classification and measurement approaches for financial assets and financial liabilities are different; so, the IASB decided that it is unnecessary and inappropriate to have symmetrical requirements for reclassification. Moreover, although the reclassification of financial assets has been a controversial topic in recent years, the IASB is not aware of any requests or views that support reclassifying financial liabilities.

Measurement on initial recognition

All financial instruments under IFRS 9 are to be initially recognised at fair value, plus or minus (in the case of a financial asset or financial liability not at FVTPL) transaction costs that are directly attributable to the acquisition or issue of the financial instrument.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The concept of fair value and the requirements for determining the fair value of financial instruments are discussed in detail in chapter 5.

A financial instrument’s initial fair value will normally be the transaction price (that is, the fair value of the consideration given or received).

In some circumstances, the consideration given or received might not equal the financial instrument’s fair value. An example is an interest-free long-term note receivable for which the full-face value is paid up-front, while the market rate for a similar instrument would not be zero. In such a case, some of the amount paid up-front is not included in the initial recognition amount of the note receivable. The additional amount lent should be accounted for following its economic substance, which might be an expense or a reduction of income, some other type of asset, or (in the case of intra-group transactions) a dividend payment or an equity contribution.

Initial recognition of an interest-free loan to a company Question: Entity A lends C1,000 to entity B for five years, and it measures the asset at amortised cost. The loan carries no interest. Instead, entity A expects other future economic benefits, such as an implicit right to receive goods or services at favourable prices. How should the loan be measured on initial recognition? Solution: On initial recognition, the market rate of interest, for a similar five-year loan with payment of interest at maturity, is 10% per year. The loan’s initial fair value is the present value of the future payment of C1,000, discounted using the market rate of interest for a similar loan of 10% for five years (that is, C621). In this example, the consideration given of C1,000 is for two things: the fair value of the loan of C621; and entity A’s right to obtain other future economic benefits that have a fair value of C379 (that is, the difference between the total consideration given of C1,000 and the consideration given for the loan of C621). Entity A recognises the loan at its initial fair value of C621, which will accrete to C1,000 over the term of the loan using the effective interest method. The difference of C379 is not a financial asset, since it is paid to obtain expected future economic benefits other than the right to receive payment on the loan asset. Entity A recognises that amount as an expense, unless it qualifies for recognition as an asset under, say, IAS 38, or as part of the cost of investment in a subsidiary, if entity B is a subsidiary of entity A.

Initial recognition of an interest-free loan to an employee Question: An entity grants an interest-free loan of C1,000 to an employee for a period of two years. The market rate of interest to this individual, for a two-year loan with payment of interest at maturity, is 10%. How should the loan be measured on initial recognition; and what, if any, is the impact of the loan being made to an employee? Solution: The consideration given to the employee consists of two assets: ·        The fair value of the loan – that is, C1,000 / (1.10)2 = C826. ·        The difference of C174, that is accounted for as employee compensation in accordance with IAS 19.

Initial recognition of an interest-free loan received from a government agency Question: An entity is located in an enterprise zone and receives an interest-free loan of C500,000 from a government agency. The loan carries no interest and is repayable at the end of year 3. How should the loan be measured on initial recognition? Solution: Loans received from a government that have a below-market rate of interest should be recognised and measured in accordance with IFRS 9. The benefit of the below-market rate of interest should be measured as the difference between the initial carrying value of the loan, determined in accordance with IFRS 9, and the proceeds received, in accordance with IAS 20. So, if the fair value is estimated at C450,000 under IFRS 9, the loan would be recorded initially at its fair value of C450,000. The difference between the consideration received and the fair value of the loan (that is, C50,000) would be accounted for as a government grant in accordance with IAS 20

Trade receivables that do not have a significant financing component are initially measured at their transaction price. A similar concept is commonly applied to short-term trade payables where the effect of discounting would be immaterial, consistent with the requirements of IAS 8.

In some circumstances, an entity might originate a loan that bears an off-market interest rate (for example, a loan that carries a higher or lower rate than the prevailing current market rate for a similar loan) and pays or receives an initial fee as compensation. In that situation, the entity still recognises the loan at its initial fair value (that is, net of the fee paid or received). The fee paid or received is amortised to profit or loss using the effective interest method (when the instrument is subsequently measured at amortised cost) or is part of the future revaluation (when measured at fair value). Fees that are an integral part of a financial instrument’s effective interest rate are generally treated as an adjustment to the effective interest rate.

Initial recognition of an off-market loan with an origination fee Question: An entity originates a loan for C1,000 that is repayable in five years’ time. The loan carries interest at 6%, which is less than the market rate of 8% for a similar loan. The entity receives C80 as compensation for originating a belowmarket loan. How should the loan be initially recognised, and what is the treatment of the C80 compensation? Solution: The entity should recognise the loan at its initial fair value of C920 (net present value of C60 of interest for five years and principal repayment of C1,000 discounted at 8%). This is equal to the net cash received by the borrower (loan of C1,000 less origination fee of C80). The net amount of the loan of C920 accretes to C1,000 over the five-year term using an effective interest rate of 8%. The upfront fee received of C80 exactly compensates the entity for interest shortfall of C20 for each of the next five years, discounted at the market rate of 8%. Hence, no gain or loss arises on initial recognition.

‘Day 1’ gain or loss

The transaction price is generally the best evidence of the financial instrument’s initial fair value. However, it is possible for an entity to determine that the instrument’s fair value is not the transaction price. This might occur, for example, when models are used to estimate the initial fair value of financial instruments. The difference between the transaction amount and the fair value is accounted for as follows: The difference is recognised as a gain or loss only if fair value is evidenced by a quoted price in an active market for an identical asset or liability (that is, a level 1 input) or based on a valuation technique that uses only data from observable markets. In all other cases, an entity recognises the instrument at fair value and defers the difference between the fair value at initial recognition and the transaction price. As a result of the requirement to use a level 1 input or observable inputs only, an immediate ‘day 1’ gain or loss is rarely recognised on initial recognition.

After initial recognition, the entity recognises any deferred difference as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.

Subsequent measurement of ‘day 1’ gain or loss Question: Question: Entity A acquires a financial asset for C110, which is not quoted in an active market. The asset’s fair value, based on the entity’s own valuation technique, amounted to C115. However, that valuation technique does not solely use observable market date, but it relies on some entity-specific factors that market participants would not normally consider in setting a price. Can a ‘day 1’ gain or loss be recognised? Solution: No, the entity cannot recognise a ‘day 1’ profit of C5 and record the asset at C115. The use of unobservable entity-specific inputs, to calculate a fair value that is different from the transaction price on ‘day 1’, is not a fair value evidenced by a quoted price in an active market for an identical asset or liability (ie a level 1 input) or based on a valuation technique that uses only data from observable markets. Hence, recognition of a ‘day 1’ gain or loss is not appropriate. Accordingly, the entity restricts its valuation to the transaction price, and the asset is recorded at C110.

Factors to consider where there is a large apparent ‘day 1’ gain or loss Question: How should any gain or loss not recognised on ‘day 1’ be recognised? Solution: An unrecognised ‘day 1’ gain or loss should be recognised after initial recognition only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price. It is not clear how the phrase “a change in a factor (including time) that market participants would consider in setting a price” should be interpreted. One interpretation is that a gain or loss should remain unrecognised until all market inputs become observable. Another interpretation is that it permits the recognition of a ‘day 1’ gain or loss in profit or loss on a systematic basis over time, even in the absence of any observable transaction data to support such a treatment. Indeed, some constituents asked the IASB to clarify whether straight-line amortisation was an appropriate method of recognising the difference. The Board decided not to do this. It concluded that, although straight-line amortisation might be an appropriate method in some cases, it will not be appropriate in others. This would appear to suggest that an unrecognised ‘day 1’ gain or loss could be amortised either on a straight line basis or on another rational basis that reflects the nature of the financial instrument (for example, a non-linear amortisation for some optionbased derivatives).

It should be noted that an unrecognised ‘day 1’ gain or loss is not separately identified in the balance sheet. However, IFRS 7 requires disclosure of the unrecognised amount, together with the change in the amount previously deferred, and also the entity’s accounting policy for determining when amounts deferred are recognised in profit or loss.

Transaction costs and fees

Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.

Transaction costs include fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.

Internal costs as transaction costs Question : Can other internal costs, not being administrative or holding costs, be classified as transaction costs? Solution: Provided that they are incremental and directly attributable to the acquisition, issue or disposal of a financial asset or financial liability, such costs could be classified as transaction costs. However, in practice, other than payments made to employees acting as selling agents (common in insurance contracts that are accounted for under IFRS 9 as financial instruments), salary costs of employees that would be incurred irrespective of whether the loan was granted are not incremental, and neither are allocated indirect administrative costs or overheads.

Transaction costs are accounted for as follows:

• When a financial asset or financial liability is not measured at FVTPL, transaction costs that are directly attributable to the acquisition or issue are added to or deducted from the initial fair value. For financial assets, such costs are added to the amount originally recognised. For financial liabilities, such costs are deducted from the amount originally recognised. This applies to all financial instruments not carried at FVTPL, including instruments carried at FVOCI. For debt instruments, the transaction costs are recognised as part of interest income using the effective interest method.

• For financial instruments that are measured at FVTPL, transaction costs are not added to or deducted from the initial fair value, but they are immediately recognised in profit or loss on initial recognition.

• Transaction costs expected to be incurred on a financial instrument’s transfer or disposal are not included in the financial instrument’s measurement.

Treatment of transaction costs of an asset not measured at fair value through profit or loss Question: An entity acquires an investment in an equity instrument that it designates at fair value through OCI (FVOCI ). Its fair value on origination is C100. Purchase commission of C2 is also payable. At the end of the entity’s financial year, the asset’s quoted market price is C105. If the asset were to be sold, a commission of C4 would be payable. How are the transaction costs treated on initial recognition and on sale? Solution: The asset is not classified initially at fair value through profit or loss (FVTPL), so the entity recognises the financial asset at its fair value and adds the purchase commission (that is, a total of C102). At the end of the entity’s financial year, the asset is recorded at C105, without regard to the commission of C4 payable on sale. The change in fair value of C3 recognised in other comprehensive income includes the purchase commission of C2 payable at the acquisition date. Transaction selling costs are not a subsequent change in fair value that IFRS 9 permits to be recognised in OCI, because transaction costs are not deducted in determining fair value (or ‘gains and losses’, as referred to in paragraph 5.7.1 of the standard). IFRS 9 does not otherwise require or permit transaction costs on sale of an equity instrument designated at FVOCI to be recognised in OCI or equity. Therefore, if the asset were sold, the commission payable of C4 would be recognised as an expense in profit or loss, in accordance with IAS 1. However, in some situations, judgement might be required in determining what is a transaction cost on disposal and what is part of the financial instrument’s fair value.

Allocation of transaction costs to a convertible instrument that contains a conversion option as an embedded derivative Question: An entity, with functional currency of C, issues a five-year, euro-denominated convertible bond for C100. Transaction costs of C2 were incurred by the issuer. The host liability is to be accounted for at amortised cost. The fair value of the embedded derivative on initial recognition was C20. How are the transaction costs treated, and what is the impact of the embedded derivative? Solution: Transaction costs relating to issuance of a convertible instrument, for which the conversion feature is classified as an embedded derivative, should be allocated to the host liability and the embedded conversion option in either of the following ways (that is, there is an accounting policy choice): ·        Approach 1 – The convertible bond represents a liability in its entirety, because the conversion feature fails the ‘fixed for fixed’ requirement for equity classification. On initial recognition, the financial liability (that is, the entire instrument) should be recognised at fair value less transaction costs that are directly attributable to its issuance, since the instrument is not at FVTPL. The embedded derivative’s fair value at initial recognition is C20, so the host liability is initially recognised at C78 (C100 – C20 – C2), and there is no impact on profit or loss. ·        Approach 2 – Transaction costs are allocated to each component in proportion to the allocation of proceeds. Therefore, costs allocated to the embedded derivative are charged to profit or loss on initial recognition, and those allocated to the host contract are deducted from its initial carrying amount. Accordingly, the embedded derivative is recognised initially at C20, with one-fifth (20/100) of the transaction costs (that is, C0.40) being recognised in profit or loss. The host liability is recognised initially at C78.40 (C100 – C20 – (80/100) × C2).

Origination fees on financial instrument measured at fair value through profit or loss Question: Can origination fees received for a loan commitment be recognised in profit or loss if the loan commitment is measured at fair value through profit or loss? Solution: Where origination fees relate to financial instruments measured at FVTPL, these fees can be taken immediately to profit or loss. However, this is only permitted where the instrument’s initial fair value (excluding the origination fees) is evidenced by comparison with other observable current market transactions in the same instrument, or it is based on a valuation technique whose variables include only data from observable markets. Without such evidence, it will not be possible to distinguish between the origination fees and the fair value of the instrument itself, and so it would not be appropriate to treat the origination fees as a separate transaction.

Fees that are an integral part of the effective interest rate

Fees that are an integral part of the effective interest rate are treated as an adjustment to the effective interest rate. The standard deals specifically with three types of fees which are included in the effective interest rate:

• Origination fees received by the entity relating to the creation or acquisition of a financial asset.

Such fees might include compensation for activities such as evaluating the borrower’s financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating the terms of the instrument, preparing and processing documents and closing the transaction. These fees are an integral part of generating an involvement with the resulting financial instrument.

• Commitment fees received to originate a loan, when the loan commitment is not measured at fair value through profit or loss and it is probable that the entity will enter into a specific lending arrangement.

Commitment fees are fees that are charged by the lender for entering into an agreement to make or acquire a loan. Sometimes, they are referred to as facility fees for making a loan facility available to a borrower. These fees are regarded as compensation for an ongoing involvement with the acquisition of a financial instrument. If the commitment expires without the entity making the loan, the fee is recognised as revenue on expiry.

• Origination fees paid on issuing financial liabilities measured at amortised cost.

These fees are an integral part of generating an involvement with a financial liability. An entity distinguishes fees and costs that are an integral part of the effective interest rate for the financial liability from origination fees and transaction costs relating to the right to provide services, such as investment management services, which are origination fees for service contracts and not origination fees for financial liabilities.

Examples of loan origination fees Loan origination fees might consist of: ·        Fees that are charged to the borrower as ‘pre-paid’ interest or to reduce the loan’s nominal interest rate (explicit yield adjustments). ·        Fees to compensate the lender for origination activities, such as: evaluating the borrower’s financial condition; evaluating and recording guarantees, collateral and other security arrangements; negotiating the instrument’s terms; preparing and processing documents; and closing the transaction. ·        Other fees that relate directly to the loan origination process (for example, fees that are paid to the lender as compensation for granting a complex loan or agreeing to lend quickly).

Accounting for loan origination fees received Question: Entity A grants a loan to entity B for C100,000 on 1 January 20X1. The loan is repayable at 31 December 20X5. Interest of 8%, that is equal to the market rate for this entity, is payable annually. The loan origination fees amount to C2,000, and they are paid by entity B to entity A on 1 January 20X1. How should entity A account for the loan origination fees? Solution: Loan origination fees charged by entity A are an integral part of establishing a loan. These fees are deferred and recognised as an adjustment to the effective yield. The effective yield is the interest needed to discount all of the cash flows (that is, C8,000 for five years and the principal amount of C100,000) to the present value of C98,000. In this case, the effective yield obtained by a discounted cash flow calculation is approximately 8.51%, and so the entity recognises finance income at 8.51% on the carrying amount in each period.

Accounting for loan commitment fees received Question : How should an entity account for loan commitment fees received? Solution: The accounting depends on whether or not it is probable that the entity will enter into a specific lending arrangement, and whether the loan commitment is measured at fair value through profit or loss. If the loan commitment is measured at fair value through profit or loss, the commitment fee is recognised directly in profit or loss, provided that the fair value of the loan commitment can be determined on observable market data or is directly observable in the market. Where the loan commitment is not measured at fair value through profit or loss, and it is probable that the entity will enter into the lending agreement, the commitment fee received is regarded as compensation for an ongoing involvement with the acquisition of a financial instrument, and it is deferred and recognised as an adjustment to the effective interest rate. If the commitment expires without the entity making the loan, the fee is recognised as revenue on expiry. The loan commitment fee might be directly related to the undrawn portion of the loan commitment and, as such, it changes based on the portion of the unused commitment at that time. In such circumstances, the fee is not related to the amount being lent, and so it would not be deferred and included as part of the effective interest rate when the commitment is drawn. The fee relates to a service being provided by the lender and, as such, it should be accounted for as a service in accordance with IFRS 15. If the loan commitment is not measured at fair value through profit or loss, and it is unlikely that a specific lending arrangement will be entered into, the commitment fee is recognised in line with the requirements of IFRS 15.

Accounting for loan commitment fees paid Question: How should a borrower account for loan commitment fees paid? Solution: The borrower’s accounting mirrors that of the lender, as discussed. Therefore, to the extent that there is evidence that it is probable that some or all of the facility will be drawn down, the facility fee is accounted for as a transaction cost under IFRS 9. Where this is the case, the facility fee is deferred and treated as a transaction cost when draw-down occurs; it is not amortised prior to the draw-down. For example, draw-down might be probable if there is a specific project for which there is an agreed business plan. If a facility is for C20 million, and it is probable that only C5 million of the facility will be drawn down, a quarter of the facility fee represents a transaction cost of the C5 million loan, and it is deferred until draw-down occurs. To the extent that there is no evidence that it is probable that some or all of the facility will be drawn down, the facility fee represents a payment for liquidity services – that is, to secure the availability of finance on pre-arranged terms over the facility period. As such, to the extent that draw-down is not probable, the facility fee is capitalised as a prepayment for services, and it is amortised over the period of the facility to which it relates. The availability of finance on pre-arranged terms provides benefit to an entity in a similar way to an insurance policy. If finance is needed in the future due to unforeseen events, the facility in place ensures that an entity can obtain this finance on known terms, regardless of the economic environment in the future.

Some contracts involve both the origination of one or more financial instruments and the provision of investment management services. In such cases, an entity distinguishes between fees and transaction costs relating to the financial instrument’s origination and the costs of securing the right to provide investment management services.

Fees that are not part of the effective interest rate

Fees that are not an integral part of the effective interest rate for a financial instrument include:

• Fees charged for servicing a loan. These are recognised as revenue as the services are provided.
• Commitment fees to originate a loan when the loan commitment is not measured at fair value through profit or loss and it is unlikely that a specific loan will be made. These are recognised on a time basis over the commitment period.
• Loan syndication fees received by an entity that arranges a loan and retains no part of the loan package for itself (or retains a part at the same effective interest rate for comparable risk as other participants).
• Investment management fees.

Fees received which are not part of the effective interest rate are accounted for under IFRS 15. For these fees, the general model of revenue recognition is applied as explained. For the entity paying the fees, the fees paid should be accounted for following their economic substance, which might be an expense or a reduction of income, or some other type of asset. Revenue previously within the scope of, and recognised in accordance with, IAS 18 must be re-assessed on initial application of IFRS 15, because changes might result.

Examples of fees that are not part of the effective interest rate (EIR) Some common examples of fees which are not part of the EIR are: ·        Commissions received on the allotment of shares. ·        Placement fees received for arranging a loan between a borrower and an investor. ·        An upfront payment from a fund manager for signing up a new customer received by a financial broker. ·        Management fees paid for services such as investment advice or research services. ·        Performance or incentive fees paid to an investment manager if it achieves a performance in excess of a specified minimum during a specified period. Fees that would not form part of the EIR would be accounted for under IFRS 15. Revenue should be recognised when the identified performance obligation(s) has been satisfied (for example, when the shares have been allotted or the loan arranged). Revenue is recognised at a point in time, on satisfaction of a performance obligation, only if none of the criteria for satisfying a performance obligation over time are met. For example, on M&A transactions/deals, a bank will need to assess whether the customer benefits from advice provided by the bank as the advice is provided, or if there is no benefit for the customer unless the deal is completed. The contractual terms of each transaction should be analysed. The amount of revenue recognised should be measured in accordance with IFRS 15 and, in particular, revenue arising from variable consideration should only be recognised to the extent that it is highly probable that a significant reversal of revenue will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Accounting for upfront fees Receipt of upfront fees is common in the financial services sector. For example, within the investment management industry, a financial broker might receive an upfront payment from a fund manager for signing up a new customer. Receipt of upfront fees in such circumstances can be further complicated where the financial broker is also the fund manager, in which case whether the upfront fees are deferred or recognised immediately will depend on whether there is a distinct service provided upfront. Specifically within the asset manager industry, upfront fees are often associated with front-end loaded distribution. Front-end loaded distribution means that an initial sales fee is paid by the investor to the distribution entity on subscription to the fund (that is, the investor bears the fee on the front end). This fee compensates the distribution entity, with the subscription amount, net of such fee, being contributed to the fund. An asset manager that is also a distribution entity might also need to consider whether revenue needs to be allocated from the overall transaction price where the asset manager provides distribution services, but does not receive any specific upfront fees. The accounting for front-end fees will depend on conclusions regarding who the asset manager’s customer is and whether there are multiple performance obligations. If the relationship between the customer and the asset manager is viewed as a single performance obligation (that is, managing an investor’s money and the related activities), the distribution activity might be one of several different activities that are part of this contractual relationship with the customer. Accordingly, an asset manager would recognise a front-end load fee over the estimated period that the investor is expected to remain in the fund. If the relationship with the customer is considered to include multiple performance obligations (for example, finding investors, managing assets, and entering into contracts with third parties), the associated distribution services might qualify as a distinct service and therefore a separate performance obligation. An upfront fee received for distribution services would be recognised immediately, as long as the service is complete and the manager (distributor) does not have any ongoing distribution responsibility tied to the fee. Where it is concluded that no initial service (and therefore performance obligation) has been provided, associated upfront fees will be grouped with other activities and deferred over the period that the investor is expected to remain invested in the fund.

Management and performance fees An investment manager generally provides a number of services, including investment advice, research services and certain administrative services, under an investment advisory agreement to an investment fund in return for a fee. The fee is typically a fixed or a reducing percentage of the fund’s average net assets. This type of fee is usually called a management fee. Recognition of revenue from management fees are within the scope of IFRS 15, and revenue is recognised when the relevant performance obligation is satisfied, after having given consideration to, among other things, variable consideration. Fees could also be based on performance; these fees are known as incentive or performance fees. A performance fee is paid to the investment manager if it achieves a performance in excess of a specified minimum during a specified period (the performance period). The amount of the performance fee payable to the manager, if this condition is met, might be an absolute share of the fund’s performance or a share of performance in excess of a specified benchmark, such as the FTSE 100 index or Standard and Poor’s 500 index. There are numerous permutations of how these fees are calculated, including the benchmark used and the performance period. Recognition of revenue from performance fees are within the scope of IFRS 15, and revenue is recognised when the relevant performance obligation is satisfied, after having given consideration to, among other things, variable consideration. A performance period / contractual measurement period might not coincide with a reporting period. For example, an investment manager prepares interim financial statements for the six-month period ended 30 June 20X7, and the performance period is for the 12 months ending 31 December 20X7. In this case, the performance fee will only be received if the investment manager achieves the performance condition at the end of the 12-month period. Therefore, in many cases, the performance fees will be constrained until this contractual measurement period is completed. This means that the revenue will generally not be recognised in full in the interim periods (for example, at the end of each quarter). In these circumstances, an entity includes some or all of an amount of variable consideration in the transaction price only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved. However, management will need to determine if there is a portion (a minimum amount) of the variable consideration that should be recognised prior to the end of the contractual measurement period. The full amount of the fee will likely be recognised as of the end of the contractual measurement period, when the asset manager becomes entitled to an amount that is fixed. In certain cases, the full amount of the fee will be recognised only on a crystallisation event (for example, redemptions), because the amount becomes fixed at that time and is no longer subject to reversal.

Settlement date accounting for regular way transactions

When an entity uses settlement date accounting for an asset that is subsequently measured at amortised cost, the asset is recognised initially at settlement date, but it is measured at the fair value on trade date. This is an exception to the general rule (in para 42.94 ) that a financial asset should be recognised at its fair value on initial recognition. Any subsequent change in fair value between trade date and settlement date is not recognised (other than impairment losses).

Where an entity uses settlement date accounting for an asset that is subsequently measured at fair value, any change in fair value between trade date and settlement date is recognised: in profit or loss, for assets classified as at FVTPL; or in other comprehensive income, for assets classified as FVOCI.

Where assets measured at fair value are sold on a regular way basis, the change in fair value between trade date (that is, the date on which the entity enters into the sales contract) and settlement date (that is, the date on which proceeds are received) is not recorded, because the seller’s right to changes in fair value ceases on the trade date.

Subsequent measurement at amortised cost and the effective interest method

The amortised cost of a financial asset or financial liability is defined as the amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance.

The effective interest method is a method used in calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period:

• The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the financial instrument’s expected life to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. The effective interest rate is sometimes termed the yield to maturity or to the next repricing date, and it is the internal rate of return of the financial asset or liability for that period.
• When calculating the effective interest rate, an entity should estimate cash flows, considering all of the financial instrument’s contractual terms (for example, pre-payment, call and similar options), but it should not consider expected credit losses. Expected or future credit losses (defaults) should not be included in estimates of cash flows, because this would be a departure from the expected loss model for impairment recognition.
• The calculation should include all fees paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts.

Estimation of cash flows

The effective interest method uses estimated future cash flows through the expected life of the financial instrument based on all of the financial instrument’s contractual terms, rather than contractual cash flows. However, the financial instrument’s expected life cannot exceed its contracted life. This applies not only to individual financial instruments, but also to groups of financial instruments, to achieve consistency of application. Since the cash flows are often outlined in a contract, or linked in some other way to the financial asset or financial liability in question, there is a presumption that the future cash flows can be reliably estimated for most financial assets and financial liabilities, in particular for a group of similar financial assets or similar financial liabilities. For example, for a portfolio of pre-payable mortgage loans, financial institutions often estimate pre-payment patterns, based on historical data, and they build the cash flows arising on early settlement (including any pre-payment penalty) into the effective interest rate calculation.

In rare cases, it might not be possible to estimate reliably the cash flows of a financial instrument (or group of financial instruments). In those rare cases, the entity should use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

The standard requires that, in estimating the future cash flows, all of the instrument’s contractual terms, including pre-payment, call and similar options, should be considered. Debt instruments often contain prepayment, call and put options. For financial liabilities, the entity must first determine whether such options need to be separately accounted for as embedded derivatives. Separate accounting for the embedded derivative will not be necessary if the embedded derivative is regarded as closely related to the debt host. For financial assets, embedded derivatives are not separated; rather, the whole contract is included the classification framework of IFRS 9.

The cash flows are estimated based on the contractual terms of the contract, excluding any separated embedded derivatives but including embedded derivatives which are not separated. In practice, this means that, if a pre-payment or extension option is regarded as closely related and not separately accounted for, the entity, in determining the instrument’s expected life, needs to assess whether the option is likely to be exercised in estimating the future cash flows at inception. Furthermore, this assessment should continue in subsequent periods until the debt instrument is settled, because the likelihood of the option being exercised will affect the timing and amount of the future cash flows and will have an immediate impact in profit or loss. On the other hand, if a pre-payment or extension option is accounted for as a separate derivative, such considerations are not necessary, because doing otherwise would result in double counting the effects of the embedded derivative in profit or loss, given that the likelihood of the option being exercised will be reflected in its fair value. In that situation, the effective interest rate is based on the instrument’s contractual term, after excluding the option.

Fixed-interest loan repayable at maturity with a prepayment feature Question: On 1 January 20X5, entity A originates a 10-year 7% C1 million loan. The loan carries an annual interest rate of 7% payable at the end of each year, and it is repayable at par at the end of year 10. Entity A charges a 1.25% (C12,500) non-refundable loan origination fee to the borrower, and it also incurs C25,000 in direct loan origination costs. The contract specifies that the borrower has an option to pre-pay the instrument and that no penalty will be charged for pre-payment. The contract meets the SPPI criteria (see para 42.43 ). At inception, the entity expects the borrower not to pre-pay. What is the carrying amount on initial recognition, and what impact does the pre-payment feature have on the amortised cost calculations? Solution: The initial carrying amount of the loan asset is calculated as follows: C Loan principal 1,000,000 Origination fees charged to borrower (12,500) Origination costs incurred by lender 25,000 Carrying amount of loan 1,012,500   Because the entity expects the borrower not to pre-pay, the amortisation period is equal to the instrument’s full term. In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate necessary to equate 10 annual payments of C70,000 and a final payment at maturity of C1 million to the initial carrying amount of C1,012,500 is approximately 6.823%. The carrying amount of the loan over the period to maturity will, assuming that the entity continues to expect the borrower not to pre-pay, be as follows: Cash inflows (coupon) Interest income @ 6.8235% Amortisation of net fees Carrying amount C C C C 1 Jan 20X5 1,012,500 31 Dec 20X5 70,000 69,083 912 1,011,588 31 Dec 20X6 70,000 69,025 975 1,010,613 31 Dec 20X7 70,000 68,959 1,041 1,009,572 31 Dec 20X8 70,000 68,888 1,112 1,008,460 31 Dec 20X9 70,000 68,812 1,188 1,007,272 31 Dec 20Y0 70,000 68,731 1,269 1,006,003 31 Dec 20Y1 70,000 68,644 1,356 1,004,647 31 Dec 20Y2 70,000 68,552 1,448 1,003,199 31 Dec 20Y3 70,000 68,453 1,547 1,001,652 31 Dec 20Y4 70,000 68,348 1,652 1,000,000 700,000 687,500 12,500 31 Dec 20Y4 Repayment of principal (1,000,000) 31 Dec 20Y4 Carrying value of loan Nil The effective interest income for the period is calculated by applying the effective interest rate of 6.823% to the loan’s amortised cost at the end of the previous reporting period. The annual interest income decreases each year, to reflect the decrease in the asset’s carrying value as the initial net fee is amortised. So the difference between the calculated effective income for a given reporting period and the loan’s coupon is the amortisation of the transaction costs during that reporting period. The loan’s amortised cost at the end of the previous period less amortisation in the current reporting period gives the loan’s amortised cost at the end of the current period. By maturity date, the net fees received are fully amortised and the loan’s carrying amount is equal to the face amount, which is then repaid in full.

Fixed-interest loan repayable in equal annual instalments with a pre-payment feature Question: On 1 January 20X5, entity A originates a 10-year 7% C1 million loan. The loan is repaid in equal annual payments of C142,378, through to the maturity date at 31 December 20Y4. Entity A charges a 1.25% (C12,500) nonrefundable loan origination fee to the borrower, and it also incurs C25,000 in direct loan origination costs. The contract specifies that the borrower has an option to pre-pay the instrument and that no penalty will be charged for pre-payment. The contract meets the SPPI criteria. At inception, the entity expects the borrower not to pre-pay. What is the carrying amount on initial recognition, and what impact does the pre-payment feature have? Solution: C Loan principal 1,000,000 Origination fees charged to borrower (12,500) Origination costs incurred by lender 25,000 Carrying amount of loan 1,012,500 In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate necessary to equate 10 annual payments of C142,378 to the initial carrying amount of C1,012,500 is approximately 6.7322%. The carrying amount of the loan over the period to maturity will, therefore, be as follows: Cash inflows Interest Income @ 6.7322% Carrying amount C C C 1 Jan 20X5 1,012,500 31 Dec 20X5 142,378 68,164 938,286 31 Dec 20X6 142,378 63,167 859,075 31 Dec 20X7 142,378 57,835 774,531 31 Dec 20X8 142,378 52,143 684,296 31 Dec 20X9 142,378 46,068 587,987 31 Dec 20Y0 142,378 39,584 485,193 31 Dec 20Y1 142,378 32,664 375,479 31 Dec 20Y2 142,378 25,278 258,379 31 Dec 20Y3 142,378 17,395 133,396 31 Dec 20Y4 142,378 8,982 – 1,423,780 411,280

Fixed-interest loan with interest step-up Question: On 1 January 20X5, entity A originates a five-year debt instrument for a C1 million loan that is repayable at maturity. The contract provides for 5% interest in year 1 that increases by 2% in each of the following four years. Entity A also receives C25,000 in loan origination fees. The entity has concluded that the loan meets the SPPI criteria. What is the carrying amount on initial recognition, and what impact does the interest step-up feature have? Solution: The loan’s initial carrying amount is calculated as follows: C Loan principal 1,000,000 Origination fees charged to borrower (25,000) Carrying amount of loan 975,000 In calculating the effective interest rate that will apply over the term of the loan at a constant rate on the carrying amount, the discount rate that is necessary to equate five annual step-up payments and a final payment at maturity of C1 million to the initial carrying amount of C975,000 is approximately 9.2934%. Interest income @ 9.2934% Cash inflows (coupon) Carrying amount C C C 1 Jan 20X5 975,000 31 Dec 20X5 90,610 50,000 1,015,610 31 Dec 20X6 94,385 70,000 1,039,995 31 Dec 20X7 96,651 90,000 1,046,646 31 Dec 20X8 97,268 110,000 1,033,914 31 Dec 20X9 96,086 130,000 1,000,000 475,000 450,000

Issuer call option in debt instrument Question: Entity A issues a fixed-rate loan for C1 million and incurs issue costs of C30,000, resulting in an initial carrying value of C970,000. The loan carries an interest rate of 8% per annum, and it is repayable at par at the end of year 10. However, under the contract, entity A can call the loan at any time after year 4 by paying a fixed premium of C50,000. How is the embedded issuer-only call feature accounted for by the issuer? Solution: It is first necessary to determine whether the call option is closely related to the host debt instrument. Since the fixed premium is required to be paid whenever the call option is exercised after year 4, it might or might not be equal to the present value of any interest lost during the remaining term after exercise of the option. Furthermore, because the call option’s exercise price is C1,050,000 (inclusive of the premium), it is unlikely to be approximately equal to the debt instrument’s amortised cost in year 4, or at any time subsequently. Therefore, the call option has to be separated from the host debt contract and accounted for separately. This assumes that the expected life of the instrument is the full 10-year term. However, if the expected life is assumed to be four years, the 10-year loan with a call option after four years is economically equivalent to a four-year loan with a six-year extension option. Since there is no concurrent adjustment to the interest rate after four years, the term extension option would not be closely related, and it would need to be accounted for separately. Therefore, whichever way the loan and option are viewed, the embedded derivative is separated. Even though the option is out of the money at inception, because the option’s exercise price is greater than the debt instrument’s carrying value, it has a time value. Suppose that the option’s fair value is C20,000 at inception. Since the value of a callable bond is equal to the value of a straight bond less the value of the option feature, the accounting entries at inception would be as follows: Dr Cr C C Embedded option (derivative asset) 20,000 Cash 970,000 Debt instrument (host) 990,000   Since the call option will be fair valued and accounted for separately, with fair value movements taken to profit or loss, it has no impact on the entity’s estimate of future cash flows; accordingly, the amortisation period will be the debt host’s period to original maturity. On this basis, the effective interest rate amounts to 8.15%. The amortisation schedule is shown below: Opening amortised cost Interest expense @ 8.15% Cash payments Closing amortised cost C C C C Year 1 990,000 80,685 80,000 990,685 Year 2 990,685 80,741 80,000 991,427 Year 3 991,427 80,802 80,000 992,228 Year 4 992,228 80,867 80,000 993,095 Year 5 993,095 80,938 80,000 994,033 Year 6 994,033 81,014 80,000 995,047 Year 7 995,047 81,097 80,000 996,144 Year 8 996,144 81,186 80,000 997,330 Year 9 997,330 81,283 80,000 998,613 Year 10 998,613 81,387 1,080,000 –   The entity would recognise interest expense in profit or loss and the loan’s amortised cost in the balance sheet each year, in accordance with the above amortisation schedule. In years 1 and 2, there is no change in interest rate since inception for an instrument of similar maturity and credit rating. The option’s fair value (time value) at the end of year 2 is C10,000. The decrease in fair value of C10,000 since inception will be reported in profit or loss, and the option will be recorded at C10,000 at the end of year 2. At the end of year 3, interest rates have fallen, and the option’s fair value increases to C18,000. The increase in value of C8,000 will be recorded in profit or loss, and the option will be recorded at its fair value of C18,000 at the end of year 3. At the end of year 4, interest rates have fallen further. The option’s fair value increases to C30,000, and the entity decides to repay the loan at the end of year 4. The accounting entries, to reflect the change in the option’s fair value and the loan’s early repayment at the end of year 4, are as follows: Dr Cr C C Embedded option 12,000 Profit or loss 12,000 Early repayment of loan Debt instrument (host) 993,095 Embedded option (derivative asset) 30,000 Cash 1,050,000 Loss on derecognition of liability 86,905 The loss of C86,905 in profit or loss reflects the fact that the fair value of the host contract has gone up in value as interest rates have fallen compared to its carrying value at amortised cost. The fair value of the host contract is C1,080,000, which is the net present value of the host contract’s cash flows (excluding the embedded option). The market rate of interest that discounts the interest payments of C80,000 for the next six years, plus the principal repayment of C1,000,000 at maturity to the fair value of the host, is 6.95%, indicating a significant fall in value compared to the instrument’s stated interest rate of 8%. Suppose that, instead of an additional premium or penalty payable on early exercise, the option’s exercise price is the fair value of the loan at each exercise date. In other words, the exercise price of the pre-payment option is a ‘market adjusted value’. A market adjusted value is calculated by discounting the contractual guaranteed amount payable at the end of the specified term to present value, using the current market rate that would be offered on a new loan with a similar credit rating and having a maturity period equal to the remaining maturity period of the current loan. As a result, the market adjusted value might be more or less than the loan principal, depending on market interest rates at each option exercise date. In that situation, the pre-payment option enables the issuer simply to pay off the loan at fair value at the pre-payment date. Since the holder receives only the market adjusted value, which is equal to the loan’s fair value at the date of pre-payment, the pre-payment option (the embedded derivative) has a fair value of zero at all times. Since the pre-payment option, on a stand-alone basis, would not meet the definition of a derivative, it cannot be an embedded derivative, and the loan is simply carried at its amortised cost as above, on the assumption that the loan is not going to be pre-paid. If, however, the entity expects to pre-pay the loan, the loan would be amortised over its expected life.

Purchased or originated credit-impaired financial assets

In some cases, a financial asset is considered credit-impaired at initial recognition because the credit risk is very high and, in the case of a purchase, it is acquired at a deep discount. For such assets (referred to in IFRS 9 as ‘purchased or originated credit-impaired’), an entity is required to include the initial expected credit losses in the estimated cash flows when calculating the credit-adjusted effective interest rate. Accordingly, the effective interest rate of a purchased credit-impaired loan would be the discount rate that equates the present value of the expected cash flows (this would be less than the contractual cash flows specified in the loan agreement, because of expected credit losses) with the purchase price of the loan. The alternative of not including such credit losses in the calculation of the effective interest rate means that the entity would recognise a higher interest income than that inherent in the price paid.

Amortisation period

Consistent with the estimated cash flow approach, the standard requires fees, points paid or received, transaction costs and other premiums or discount that are integral to the effective interest rate to be amortised over the instrument’s expected life or, where applicable, a shorter period. A shorter period is used when the variable (for example, interest rates) to which the fee, transaction costs, discount or premium relates is repriced to market rates before the instrument’s expected maturity. But if the premium or discount relates to elements which are not repriced to the market rate at the next repricing date, it will be amortised over the instrument’s expected life. For example:

• If the premium or discount on a floating-rate instrument reflects interest that has accrued on the instrument since interest was last paid, or changes in the market interest rate since the floating interest rate was reset to market rates, it will be amortised to the next date when the floating rate is repriced to the market rate.
• If the premium or discount results from changes in the credit spread over the floating rate specified in the instrument and the credit spread is not reset to market rates, it is amortised over the expected life of the instrument. This is because the date on which the interest rate is next reset will not lead to a market-based repricing date of the entire instrument.

Amortisation of discount over the period to the next repricing date Question: On 15 May 20X6, an entity acquires a C100 nominal five-year floating-rate bond that pays quarterly interest at 3 month LIBOR + 50 basis points for C99.25. LIBOR, at the last reset date on 30 March 20X6, was 4.50%, which determines the interest that would be paid on the bond on 30 June 20X6. On the purchase date, LIBOR was 4.75%. How is the interest reset accounted for? Solution : The discount of 0.75 (5.25% − 4.50%) is amortised to the next repricing date (that is, 30 June 20X6).

Amortisation of discount over the expected life of the instrument Question: A 20-year bond is issued at C100, it has a principal amount of C100, and it requires quarterly interest payments equal to current 3 month LIBOR plus 1% over the instrument’s life. The interest rate reflects the market-based rate of return associated with the bond issue at issuance. Subsequent to issuance, the loan’s credit quality deteriorates, resulting in a rating downgrade. So the bond trades at a discount. Entity A purchases the bond for C95 and measures it at amortised cost. How is the discount treated, given that there is a credit downgrade? Solution : The discount of C5 is amortised to net profit or loss, over the period to the bond’s maturity and not to the next date when interest rate payments are reset, because there is no adjustment to the variable rate as a result of the change in credit risk of the issuer. There is no specific guidance in the standard as to how amortisation schedules for transaction costs incurred in originating or acquiring a floating rate instrument should be calculated. Any methodology that provides a reasonable basis of amortisation could be used. For example, entities might find it appropriate to amortise the fees and costs by reference to the interest rate at inception, ignoring any subsequent changes in rates, or to simply adopt a straight-line amortisation method.

Changes in estimated cash flows and modifications

In respect of changes in estimated cash flows, the cash flows that are discounted to arrive at the effective interest rate are estimated cash flows that are expected to occur over the instrument’s expected life. However, in practice, actual cash flows might not occur in line with expectations. There can be a variation in the amount, timing or both. The cash flows of a financial instrument can change for several different reasons.

How should an entity account for changes to the cash flows on a debt instrument measured at amortised cost or fair value through other comprehensive income (FVOCI)? The guidance below addresses the accounting for changes to the cash flows of a debt instrument measured at amortised cost or FVOCI. In certain situations, a financial liability accounted for at amortised cost by the issuer might be accounted for at fair value through profit or loss by the holder. In those scenarios, the guidance below only applies to the issuer. The cash flows of a financial instrument can change for several different reasons. IFRS 9 provides guidance on how to treat changes in cash flows, depending on the nature of the change. The flow chart below can be used to determine which of IFRS 9’s requirements apply. Note 1 – For loans that are pre-payable at par (or with only an insignificant amount of compensation), careful analysis might be required to determine the substance of a change in cash flows. Section 1 – When does a change in cash flows that arises under the terms of a contract fall within IFRS 9 (floating-rate instruments/components)? IFRS 9 states that “For floating-rate assets and floating-rate liabilities, periodic re-estimation of cash flows to reflect the movements in the market rates of interest alters the effective interest rate. If a floating-rate financial asset or a floating-rate financial liability is recognised initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability”. It follows that the standard applies to ‘floating-rate’ financial assets and liabilities. A floating-rate instrument is one whose original contractual terms contain a provision such that the cash flows will (or might) be reset to reflect movements in market rates of interest. Market rates of interest comprise different components, typically: the time value of money as represented by a benchmark rate (such as LIBOR); credit and other spreads; and a profit margin. So, if the contract provides for the cash flows of an instrument to be reset to reflect changes in any or all of these components, IFRS 9 applies to those changes. Examples are: a change in the benchmark rate (such as LIBOR) for a loan whose stated interest rate is LIBOR + 2%; a ‘ratchet loan’ whose credit spread is reset to reflect changes in the credit risk of the borrower; and a loan with a cross-selling clause whose profit margin is adjusted if other loans are taken out by the same borrower. The frequency of reset, and whether the timing of the reset is in the control of one or other party or at pre-specified intervals/events, does not affect whether the standard applies. So a loan whose initial interest rate is first reset after a long specified period (for example, two years), and then resets more frequently (for example, monthly), falls within the standard, provided that, each time the rate is reset, the rate charged until the next reset date is a market rate for that period. Similarly, loans whose rate is reset at the discretion of the lender, such as credit cards or loans whose stated rate is the lender’s base rate or standard variable rate, fall within the standard, provided that the rate reflects the time value of money and credit risk of the instrument. Most commonly, the reset feature in the contract is expressed as a repricing of the coupon. It would be acceptable to apply the standard to other contractual terms that have the same effect. An example is a fixed-rate loan pre-payable by the borrower at par (or with only an insignificant amount of compensation) at any time, where the effect of this feature enables the borrower to have the lender agree to reset the cash flows to the then market rate. Section 2 – When does a change in cash flows that arises under the terms of a contract fall within IFRS 9 (other instruments/components)? For financial instruments that are not floating-rate financial assets or liabilities subject to IFRS 9 (see Section 1), the requirements apply to changes in the actual or expected cash flows under the original contractual terms. IFRS 9 states that “The entity recalculates the gross carrying amount of the financial asset or amortised cost of the financial liability as the present value of the estimated future contractual cash flows that are discounted at the financial instrument’s original effective interest rate … The adjustment is recognised in profit or loss as income or expense” . It follows that the standard applies in cases where the contract provides for the cash flows to be reset but the amount of the reset does not reflect movements in market rates of interest. Examples are a profit-participating loan (whose coupon varies with the net profits of the borrower), and a bail-in bond (whose contractual payments are reduced when the borrower breaches a specified regulatory capital ratio). Section 3 – Modifications of financial assets and liabilities IFRS 9 applies to renegotiations and other modifications of the terms of a financial instrument, and requires that “When the contractual cash flows of a financial asset are renegotiated or otherwise modified and the renegotiation or modification does not result in the derecognition of that financial asset in accordance with this Standard, an entity shall recalculate the gross carrying amount of the financial asset and shall recognise a modification gain or loss in profit or loss”. IFRS 9 states that the accounting for modified financial liabilities mirrors that of modified financial assets. It follows that a change to the terms that results from a renegotiation or other modification is accounted for under IFRS 9, even if that change results in the cash flows being reset to reflect movements in market rates of interest. An example is a loan whose terms are renegotiated to remove or amend a covenant in return for higher coupon payments. Another example is a loan that is renegotiated to reduce the contractual cash flows because the borrower is in financial difficulty.

Changes in cash flows due to ‘green variability’ Question: Entities might issue bonds or obtain loans where the interest rate is linked to certain sustainability performance objectives (sometimes called environmental, social and governance or ‘ESG’ metrics). The contractual terms of these products provide that cash flows vary depending on these sustainability-linked measures (referred to as ‘green variability’). Examples of green variability are provided. In the case of a financial liability measured at amortised cost where it is concluded that the green variability is not an embedded derivative that is required to be accounted for separately, how should the green variability be reflected in the amortised cost measurement of the financial liability? Solution: As per previous FAQ, assuming the sustainability-linked measure is a feature of the original contract, the treatment of changes in expected cash flows due to the sustainability-linked measure will depend on whether the change reflects movements in market rates of interest. Where these changes in expected cash flows reflect movements in market rates of interest, then IFRS 9 should be applied. This would generally only be expected when the green variability reflects credit risk and when the interest rate movement from the sustainability-linked measure is commensurate with the change in credit risk. Applying the standard would often have no significant effect on the carrying amount of the liability and result in changes in the market rate of interest being reflected in the period in which the change occurs. Where these changes in expected cash flows do not reflect movements in market rates of interest, IFRS 9 should be applied, that is, the gross carrying amount should be adjusted. The gross carrying amount is recalculated as the present value of the estimated future contractual cash flows that are discounted at the original effective interest rate. Any adjustment should be immediately recognised as income/expense in profit or loss.

Floating-rate instruments

For floating-rate financial assets and floating-rate financial liabilities, periodic re-estimation of cash flows, to reflect the movements in the market rates of interest, alters the effective interest rate. If a floating-rate financial asset or a floating-rate financial liability is recognised initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability. This means that the effective yield will always equal the rate under the interest rate formula (for example, LIBOR + 1%) in the instrument. The effect is that the carrying amount remains unchanged by the process of re-estimating future cash flows and the effective interest rate. The result is that changes in LIBOR are reflected in the period in which the change occurs.

Detailed discussion on inflation-linked bond Entities sometimes issue or invest in debt instruments whose payments (principal and interest) are linked to the change in an inflation index of the period. For the issuer, such an inflation-linked bond needs to be assessed, to determine if the inflation-linking mechanism is a closely related embedded derivative that does not need to be recognised and measured separately under IFRS 9; whereas the holder needs to assess whether the bond meets the SPPI criterion. Given that the standard is not clear as to how the effective interest rate method applies for instruments with variable cash flows, the IFRIC was asked to provide guidance on how to apply the effective interest rate method to a financial instrument whose cash flows are linked to changes in an inflation index. The IFRIC noted that IAS 39 provide the relevant application guidance. As such, there are two possible approaches to account for changes in estimated future cash flows for an inflation-linked bond where the inflation linking mechanism has been found to be closely related or to meet the SPPI criterion: ·        Applying the guidance in IFRS 9, under which the bond is treated as a floating-rate debt instrument, with the inflation link being part of the floating-rate mechanism. The EIR at initial recognition is determined as the rate that sets the estimated future cash flows to be paid on the bond, based on the expected level of the inflation index over the expected term of the bond to equal the fair value of the bond (usually, the issue proceeds). However, if, in subsequent periods, there is a change in inflation expectations, the entity reflects these changes by adjusting both the expected future cash flows on the debt and the EIR. It follows that such changes in the entity’s expectations of future inflation result in no adjustment to the carrying amount of the debt and no gain or loss. ·        Applying the guidance in IFRS 9, under which the EIR is determined at inception, in the same way as above. However, if, in subsequent periods, there is a change in the level of the inflation expectations for the bond’s remaining term, the entity revises its estimates of the future cash flows to be paid on the bond accordingly. It recalculates the bond’s carrying amount by discounting the revised estimated cash flows using the original EIR. The resulting adjustment to the bond’s carrying amount is recognised immediately in the income statement as a gain or loss. The result is that a gain or loss is recognised in the current period for changes in the entity’s expectations of the future level of the inflation index. Judgement is required to determine whether an instrument is a floating-rate instrument within the scope of IFRS 9.

For instruments other than floating-rate financial assets and floating-rate financial liabilities, IFRS 9 requires that, if an entity revises its cash flow estimates, it should adjust the carrying amount of the financial asset or financial liability (or group of financial instruments), to reflect the revised estimated cash flows. The entity recalculates the carrying amount by computing the present value of estimated future cash flows discounted at the financial instrument’s original effective interest rate. Where the effective interest rate has been revised from the application of fair value hedge accounting, the revised effective interest rate is used in the calculation. The adjustment is recognised in profit or loss as income or expense.

Changes in estimated cash flows Question: The facts are the same as in FAQ 42.118.1 , except that, on 1 January 20Y1, entity A revises its estimates of cash flows, because it now expects that, as a result of a significant fall in interest rates during the previous period, the borrower is likely to exercise its option to pre-pay. Accordingly, entity A anticipates that 40% of the loan is likely to be repaid by the borrower in 20Y1, with the remaining 60% progressively at 20% in the following three years to maturity. How is the change in estimated cash flows to be accounted for? Solution: Differences from the original estimates present a problem for the effective interest rate. If the variation is ignored, either the asset or liability will amortise before all of the cash flows occur, or a balance might remain after the last cash flow. As such, the carrying amount should be adjusted to the net present value of the re-estimated cash flows. The revised cash flows are shown below. In accordance with IFRS 9, the opening balance at 1 January 20Y1 is adjusted. The adjusted amount is calculated by discounting the amounts that the entity expects to receive in 20Y1 and subsequent years using the original effective rate of 6.823%. This results in the adjustment shown below. The adjustment is recognised in profit or loss in 20Y1. Carrying amount 1 Jan 20Y1 Opening amortised carrying amount before revision 1,006,003 Adjustment for changes in estimate – profit or loss 2,563 1 Jan 20Y1 Adjusted amortised carrying amount after revision 1,003,440 Opening amortised carrying amount Interest income @ 6.823% Cash inflows (coupon + repayment of principal) Closing amortised carrying amount C C C C 31 Dec 20Y1 1,003,440 68,465 70,000 + 400,000 601,905 31 Dec 20Y2 601,905 41,068 42,000 + 200,000 400,973 31 Dec 20Y3 400,973 27,358 28,000 + 200,000 200,331 31 Dec 20Y4 200,331 13,669 14,000 + 200,000 −

Accounting for repricing of fixed interest loans Question: The terms of some loans allow the borrower to choose either a fixed interest rate or a floating interest rate (including a spread), and to switch between fixed and floating interest rates during the tenure of the loan. If a fixed interest rate is selected by the borrower, the rate can be fixed for any period from one year or less to the full tenure of the loan. This means that the loan might reprice a number of times during the tenure of the loan. For example, in the case of a 20-year home loan, on origination the borrower might choose to fix the interest rate for an initial term of 10 years at, say, 4% (being the 10-year fixed market interest rate prevailing at the origination of the loan). At the end of year 10, in accordance with the terms of the loan contract, the interest rate is then re-fixed to a new market fixed or floating interest rate, as selected by the borrower. For example, at the end of year 10, the borrower might opt to fix the interest rate for a further five years at the then prevailing five-year fixed interest rate. In addition, the loan contract permits the borrower to break a fixed interest rate period at any time, and to re-fix the interest rate to a new market fixed or floating interest rate. Continuing with the same example, if, at the end of year 6, market interest rates for a 10-year loan have fallen from 4% to 3%, the borrower can choose to ‘break’ the prevailing 10-year fixing period, and to re-fix the interest rate to a new market fixed or floating interest rate, say a fixed rate of 3% for a further 10 years (years 7–17). A borrower that chooses to ‘break and re-fix’ in this way is required to pay a market-based cash penalty at the date of the re-fixing that reflects interest forgone by the lender (in this example, the additional 1% that would have been received by the lender over years 7–10). Should such a ‘break and re-fix’ of the prevailing fixing period and fixed rate be accounted for under IFRS 9? Solution: The entity has an accounting policy choice between applying IFRS 9. The chosen policy should be applied consistently and appropriately disclosed. IFRS 9 does not define the term ‘floating-rate’ in the context of the standard. In the absence of explicit guidance, there are two views that could be applied. One view is that such a loan should be treated as a floating-rate instrument that falls within the scope of the standard. This is because the loan contract provides for the interest rate to be adjusted (at the option of the borrower) to reflect movements in market rates of interest. This view is consistent with the notion that a floating-rate instrument is one that does not have a predetermined rate (or rates) of interest specified for the entire life of the instrument. At the date when the borrower chooses to ‘break and re-fix’, the effective interest rate (EIR) of the loan is reset to the new market rate (that is, to 3% in the example above). Interest is thereafter recognised at this new rate until such time (if any) that the borrower chooses to ‘break and re-fix’ the loan a second time or the new fixing period comes to an end (that is, at the end of year 17 in the example above). In addition, the penalty paid by the borrower is amortised over the remaining term of the original fixing period (that is, years 7–10 in the example above) in accordance with paragraph B5.4.4, because this is the period to which it relates. In this example, this will result in the total interest recognised in years 7–10 (including amortisation of the penalty) approximating the initial fixed rate of 4%. The alternative view is that such a loan should be treated as a fixed-rate instrument during the period or periods that the interest rate is fixed (that is, years 1–10 in the example above). Furthermore, because a penalty is paid by the borrower, the interest rate is arguably not being reset to reflect market interest rates. Under this view, the entity would apply paragraph B5.4.6 to any re-estimation of future cash flows that is made during a fixed period. In the example above, the EIR would continue to be 4% for years 7–10, and this would result in the lender recognising a loss (and the borrower recognising a gain) for the 1% difference in rates over years 7– 10. This would be offset by the cash penalty that would be recognised by the lender as a gain (and by the borrower as a loss).

Modification or renegotiation of financial assets and financial liabilities

Following a modification or renegotiation of a financial asset or financial liability that does not result in derecognition, an entity is required to recognise any modification gain or loss immediately in profit or loss. Any gain or loss is determined by recalculating the gross carrying amount of the financial asset by discounting the new contractual cash flows using the original effective interest rate. Where the effective interest rate has been revised from the application of fair value hedge accounting, the revised effective interest rate is used in the calculation. Costs and fees of modifying the terms of the financial asset are spread forward by adjusting the effective interest rate.

Accounting for gain or loss on debt modification Question: An entity has a specific borrowing to finance a qualifying asset. The borrowing cost is capitalised in accordance with IAS 23. The specific borrowing is modified in such a way that this does not result in derecognition. In accordance with IFRS 9, the entity recalculates the borrowing’s carrying amount by discounting the new modified cash flows at the original effective interest rate. Should management capitalise the modification gain or loss under IAS 23? Solution: Management has an accounting policy choice. There are two valid views on how to account for the modification gain or loss on a specific borrowing relating to a qualifying asset under IAS 23: ·        No capitalisation: IAS 23 specifically refers to ‘borrowing costs’ including ‘interest expense calculated using the effective interest method as described in IFRS 9’. This can be interpreted narrowly to exclude a modification gain or loss, with the result that such a gain or loss should be recognised in profit or loss. ·        Capitalisation: the alternative view is that a modification gain or loss is the result of cash flows discounted using the original effective interest rate and is therefore part of applying the effective interest rate method. Also, the list of possible borrowing costs in IAS 23 is not exhaustive, and so the modification gain/loss can be included under borrowing costs as an ‘other cost an entity incurs in connection with the borrowing of funds’ in accordance with IAS 23. Where this view is applied, only the portion that relates to the acquisition, construction or production period is capitalised, with the remainder recognised in profit or loss. Both views are acceptable, and so an accounting policy choice should be made. The chosen policy should be applied consistently to all modification gains or losses on specific borrowings to finance qualifying assets, and it should be disclosed.

Perpetual debt instruments

It is not uncommon for entities to issue debt instruments on terms with no redemption date, but on which interest payments are made, usually at a fixed rate or a variable market-based rate (for example, a fixed margin over LIBOR) in perpetuity. At initial recognition, assuming that there are no transaction costs, the debt instrument will be recorded at its fair value, which is the amount received by the borrower. The difference between this initial amount and the maturity amount (which is zero if the interest rate at inception is the market rate for that instrument) will never be amortised, since there is no repayment of principal. This means that, at each reporting date, the debt instrument will be recorded at its principal amount, which is also its amortised cost. This is because the amortised cost, which is the present value of the stream of future cash payments discounted at the effective interest rate (fixed for fixed-rate instruments or variable for floating-rate instruments) equals the gross carrying amount in each period.

If, on the other hand, the entity incurs transaction costs, the debt instrument will be recorded in each reporting period at its initial amount, which is the amount received less transaction costs. The result is that the transaction costs are never amortised, but they are reflected in the carrying amount indefinitely.

Sometimes, perpetual debt instruments are repackaged in such a way that the principal amount is effectively repaid. One way of achieving this is to pay a high rate of interest for a number of years (the primary period), which then falls to a negligible amount. If the interest were simply charged to profit or loss, the borrower would bear an artificially high interest expense during the primary period, and little or no interest expense thereafter, in perpetuity. Such treatment might reflect the form of the loan agreement, but not its substance. From an economic perspective, some or all of the interest payments are repayment of principal, and they should be accounted for as such.

Perpetual debt instrument with decreasing interest Question: An entity issues a perpetual bond for C100,000, on which interest at 14% is paid annually for the first 10 years, and thereafter at a nominal rate of 0.125%. How should it apply the EIR model? Solution: It is clear that, at the end of the 10-year period, the bond has little or no value. The principal amount is repaid, in effect, over the initial 10-year primary period. Consequently, the interest payments during the primary period represent a payment for interest and repayment of capital. The effective interest rate calculated on the basis of C14,000 for 10 years, followed by C125 in perpetuity, is 6.84%. Opening amortised cost Interest expense @ 6.84% Cash payments Closing amortised cost C C C C Year 1 100,000 6,840 14,000 92,840 Year 2 92,840 6,350 14,000 85,190 Year 3 85,190 5,827 14,000 77,017 Year 4 77,017 5,268 14,000 68,285 Year 5 68,285 4,671 14,000 58,956 Year 6 58,956 4,033 14,000 48,989 Year 7 48,989 3,351 14,000 38,340 Year 8 38,340 2,622 14,000 26,962 Year 9 26,962 1,844 14,000 14,806 Year 10 14,806 1,013 14,000 1,819 41,819 140,000 Although the carrying value at the end of year 10 is small, an amount of C100,000 might be repayable if the entity went into liquidation. In practice, however, there will usually be arrangements to enable the entity to repurchase the debt instrument for a nominal amount, and so extinguish any liability on it.

Fair value through other comprehensive income

If an investment in a debt instrument is measured at FVOCI, all movements in the fair value should be taken through other comprehensive income, except for the recognition of impairment gains or losses, interest revenue in line with the effective interest method, gains and losses arising on derecognition, and foreign exchange gains and losses, which are recognised in profit or loss. The subsequent measurement of such an instrument is complicated by the fact that fair value changes should be split in the interest income on an effective interest basis (which are recognised in profit or loss) and fair value gains losses (which are recognised in other comprehensive income). See example 14 included in the illustrative examples of IFRS 9 for a detailed example of the interaction between the FVOCI measurement category and foreign currency denomination, fair value hedge accounting and impairment.

Derecognition

Where a debt instrument is carried at amortised cost or FVOCI, a gain or loss is recognised in profit or loss when the financial liability is derecognised.

Allocating original cost balance to carrying value in case of partial disposal or impairment for identical debt securities Question: In a portfolio of identical debt securities measured at amortised cost or FVOCI, an entity might acquire and dispose of the same security in different-sized tranches at different dates and at different prices. What method should be used to determine: the date of initial recognition, when making an assessment of significant increases in credit risk for impairment purposes; and the cost, when calculating the gain or loss on derecognition of part of the portfolio? Solution: IFRS 9 does not specify whether such identical (or fungible) financial assets should be considered individually or in aggregate, and, if in aggregate, which measurement basis is appropriate for calculating the gain or loss on derecognition or for determining the date of initial recognition for impairment purposes. This is in contrast to IAS 2, which specifies the use of weighted average or FIFO in most circumstances for inventories. In practice, entities could opt, as an accounting policy choice, for any one of the following methods (which should be applied consistently for both impairment and derecognition and should be disclosed): Proportional allocation (that is, on derecognition, each tranche of securities acquired is reduced proportionately by the number of securities derecognised). First in, first out (FIFO). Last in, first out (LIFO). Specific identification (although, in many cases, this might not be possible to achieve, because the different tranches of the portfolio are fungible and, as such, do not have unique identifiers). However, a weighted average approach is not appropriate. This is because IFRS 9 requires the assessment of significant increases in credit risk to be carried out by considering the risk of a default occurring at the date of initial recognition. Using an average risk of a default occurring, for instruments acquired at different points in time, could obscure a significant increase in credit risk that could have occurred on some, but not all, of the tranches of securities. Within a group, portfolios might have a different nature (for example, an FVOCI portfolio held for liquidity purposes versus an amortised cost portfolio held for long-term strategic investment purposes). In this instance, it might be possible to justify using different cost formulae within an entity for the same securities. However, whatever cost formula is used, it should be used for both impairment and the measurement of gains and losses on disposal.

Subsequent measurement at fair value

Interaction between IFRS 13 and IFRS 9 on initial recognition at fair value Question: How do IFRS 13 and IFRS 9 interact on initial recognition of financial instruments at fair value? Solution: IFRS 9 prohibits immediate recognition of ‘day 1’ profit or loss in the income statement, unless specific criteria are met. Where the transaction price differs from fair value, initial recognition of financial instruments should be based on the transaction price, adjusted to defer the difference between the fair value at initial recognition and the transaction price. Entities are generally prohibited from recognising a ‘day 1’ profit or loss under IFRS 9. The only exception to the above occurs if the fair value is evidenced by comparison with other observable current market transactions in the same instrument, or it is based on a valuation technique whose variables include only data from observable markets. In such situations, the entity is required to use fair value. Consequently, the difference between the estimated fair value using a valuation technique and the transaction price results in the immediate ‘day 1’ recognition of a gain or loss. The IASB concluded that these conditions were necessary and sufficient to provide reasonable assurance that this fair value was genuine, for the purposes of recognising ‘day 1’ gains or losses.

Subsequent measurement of foreign currency financial instruments

Financial instruments are often denominated in foreign currencies. The way in which changes in foreign exchange rates should be dealt with is covered in IAS 21. The measurement principles of IFRS 9 generally do not override these rules, except in the area of hedge accounting.

Under IAS 21, all transactions in foreign currencies are initially recognised at the spot exchange rate at the date of the transaction. The spot exchange rate is the exchange rate for immediate delivery. It follows that, on initial recognition, all foreign currency financial instruments are translated at the spot rate into the entity’s functional currency, irrespective of whether the instrument is carried at amortised cost or fair value.

Gains and losses associated with financial instruments, such as interest income and expense and impairment losses, are recognised at the spot exchange rate at the dates on which they arise. Dividends should be recognised in profit or loss when the shareholder’s right to receive payment is established. The exchange rate ruling at that date, which is normally the dividend declaration date, is used to record the income. Entities are permitted to use an average rate where it represents an approximation of the spot rate in that period.

The subsequent measurement of foreign currency financial assets and liabilities will depend on whether the assets and liabilities are monetary or non-monetary in nature. Monetary items are units of currency held, and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. It follows that financial assets and liabilities that are debt instruments are monetary items. Derivative financial instruments are also monetary items, since they are settled at a future date, even though the underlying might be non-monetary. Non-monetary items are all items other than monetary items. In other words, the right to receive (or an obligation to deliver) a fixed or determinable number of units of currency is absent in a non-monetary item. This is the case for financial assets that are equity instruments.

Monetary financial assets

IAS 21 requires an entity to translate its foreign currency monetary items outstanding at the balance sheet date, using the closing spot rate at that date.

Exchange differences arising on the translation of monetary items, or on the settlement of monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements, are recognised in profit or loss in the period in which they arise.

Exchange differences on monetary items that are designated as hedging instruments in cash flow hedges or net investments in foreign entities are recognised in other comprehensive income, to the extent that the hedge is effective.

Exchange differences on a foreign currency monetary financial asset measured at FVOCI are recognised partly in profit or loss and partly in other comprehensive income. For the purpose of recognising foreign exchange gains and losses under IAS 21, the asset is treated as if it were carried at amortised cost in the foreign currency. Accordingly, foreign exchange differences on the amortised cost balance and those arising from changes in amortised cost (such as interest calculated using the effective interest method and impairment losses) are recognised in profit or loss. All other gains and losses (that is, changes in fair value, including exchange differences thereon) are recognised in other comprehensive income. See example 14 included in the illustrative examples of IFRS 9 for a detailed example of the interaction between the FVOCI measurement category and foreign currency denomination, fair value hedge accounting and impairment.

Dual currency bond

Dual currency bonds are bonds that are denominated in one currency, but they pay interest in another currency at a fixed exchange rate. For example, an entity with pound sterling as its functional currency might issue a debt instrument that provides for the annual payment of interest in euros and the repayment of principal in pound sterling. Sometimes, both the interest payments and the principal repayments might be denominated in currencies that are different from the entity’s functional currency. For example, an entity with pound sterling as its functional currency might issue a euro-denominated bond that pays interest in US dollars. As explained in chapter 41 para 46, for the issuer, IFRS 9 does not permit such embedded foreign currency derivatives to be separated from the host debt instrument, because IAS 21 requires foreign currency gains and losses to be recognised in profit or loss. For the holder, a dual currency bond might fail the SPPI test (see para 42.45 ).

Accounting for dual currency bonds Question: On 1 January 20X5, an entity with pound sterling functional currency issues a €5 million bond, repayable in three years’ time. The bond pays fixed interest at 6% per annum in US dollars, calculated on a notional dollar equivalent of the proceeds raised in euros. There is no issue cost. The entity has concluded that the loan meets the SPPI criteria. The following exchange rates are relevant:   01 Jan 20X5 31 Dec 20X5 31 Dec 20X6 31 Dec 20X7 £1= Spot rate €1.4142 €1.4530 €1.4852 €1.3571 Average rate €1.4627 €1.4673 €1.4621 £1 = Spot rate $1.9187 $1.7208 $1.9591 $1.9973 Average rate $1.8207 $1.8429 $2.0018 €1 = Spot rate $1.3569 What impact does the dual currency nature of the bond have on the primary financial statements? Solution: We believe that the most appropriate accounting treatment, in line with paragraph 28 of IAS 21, for the issuer would be to analyse the bond into its two components: the interest component that exposes the entity to US dollar exchange rate risk; and the principal component that exposes the entity to euro exchange rate risk. Each component would be recognised at its fair value at initial recognition, being the present value of the future payments to be made on the respective components. This means that the entity would have an instalment bond with annual payments denominated in US dollars for the US dollar interest payments, and a zero-coupon bond denominated in euros for the euro principal payment. The carrying amount of each component would be translated to pound sterling at each period end, using the closing exchange rate, and the resulting exchange differences would be recognised in the income statement. Analysing the dual currency bond into its two components, for measurement purposes, reports the foreign currency risk on the principal on a discounted basis, recognising that the euro payment is not due until redemption; and it also captures the foreign exchange risk associated with the dollar interest cash flows inherent in the bond. The analysis is consistent with the rationale for not separating the foreign currency embedded derivative in line with IFRS 9. In accordance with the treatment discussed above, the amounts that should be recognised in the income statement and the balance sheet at the end of each period are shown below: £ € US$ Proceeds received 5,000,000 6,784,500 Interest payable @ 6% pa on USD amount 407,070 Zero coupon bond = PV of € principal repayment at the end of year 3 discounted at 6% 2,968,531 4,198,096 Instalment bond = PV of 3 yearly USD interest payments discounted at 6% 567,104 1,088,103 Proceeds received for the single bond 3,535,635 Note that the discounting is carried out at 6%, assuming a flat yield curve. The actual proceeds of €5,000,000, translated at the spot rate at 1 January 20X5, are actually £3,535,568. The small difference of £67 is due to the effect of discounting and cross-exchange rate, and it is ignored. Amortisation of instalment bond Balance brought forward Finance cost @ 6% Cash Payments Balance carried forward US$ US$ US$ 31/12/20X5 746,319 407,070 65,286 1,088,103 31/12/20X6 384,028 407,070 44,779 746,319 31/12/20X7 384,028 23,042 407,070 0   Balance brought forward Finance cost at average rate Payment at spot rate Balance carried forward Re-translated US$ @ year end rate Exchange difference £ £ £ £ £ £ 31 Dec 20X5 567,104 35,858 236,559 366,403 433,705 67,301 31 Dec 20X6 433,705 24,298 207,784 250,219 196,023 (54,196) 31 Dec 20X7 196,023 11,510 203,810 3,723 0 (3,723) 71,666 648,153 9,382 Amortisation of zero-coupon bond Balance brought forward Finance cost @ 6% Cash Payments Balance carried forward € € € € 31/12/20X5 4,198,096 251,886 4,449,982 31/12/20X6 4,449,982 266,999 0 4,716,981 31/12/20X7 4,716,981 283,019 5,000,000 0   Balance brought forward Finance cost at average rate Payment at spot rate Balance carried forward Re-translated US$ @ year end rate Exchange difference £ £ £ £ £ £ 31/12/20X5 2,968,531 172,206 3,140,737 3,062,617 (78,120) 31/12/20X6 3,062,617 181,966 3,244,583 3,175,991 (68,592) 31/12/20X7 3,175,991 193,570 3,684,327 (314,766) 0 314,766 547,742 3,684,327 168,054 Amortisation of single bond Opening balance sheet Finance cost @ 6% Cash Payments Balance carried forward € € € € 31/12/20X5 3,535,635 208,064 (10,819) 236,559 3,496,322 31/12/20X6 3,496,322 206,264 (122,788) 207,784 3,372,013 31/12/20X7 Income statement Cash payment s Finance cost Exchange gain/(loss ) £ £ £ £ £ 31/12/20X5  31/12/20X6      31/12/20X7 3,372,013 205,081 311,043 3,888,137 0 619,409 177,436 4,332,480 These amounts are calculated by adding the bond’s two components together.

Equity investments

Equity investments are recognised at fair value, using the exchange rates at the date when the fair value was determined. Equity investments are not monetary items (see chapter 49 para 28). Where a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss should also be recognised in other comprehensive income.

Impairment of foreign currency financial asset

Measuring impairment losses on financial assets that are denominated in foreign currency is, in principle, no different from measuring those that are denominated in the entity’s functional currency. Thus, for a foreign currency financial asset that is carried at amortised cost, the expected future cash flows denominated in the foreign currency are discounted at the financial asset’s original effective interest rate. This amount is then translated into the entity’s functional currency using the foreign exchange rate at the date when the impairment is recognised. The difference between the translated present value and the carrying amount in the entity’s functional currency is the impairment loss that is recognised in profit or loss. Similarly, if, in a subsequent period, circumstances change so that the impairment loss is reversed, in whole or in part, the reversal should be measured using the foreign exchange rate at the date when the reversal is recognised.

For foreign currency monetary assets measured at FVOCI, past impairment losses recognised in profit or loss are reversed through profit or loss. Again, the exchange rate at the date of the reversal should be used to measure the amount of the reversal. Since, for the purposes of recognising foreign exchange gains and losses under IAS 21, a monetary asset measured at FVOCI is treated as if it were carried at amortised cost in the foreign currency, all exchange differences arising on the reversal should be recognised in profit or loss.

Financial assets held in foreign operations

An entity might have financial assets that are measured both at FVTPL and at FVOCI. Where such an entity is a foreign operation that is a subsidiary, its financial statements are consolidated with those of its parent. In that situation, IFRS 9 applies to the accounting for financial instruments in the financial statements of the foreign operation, and IAS 21 applies in translating the financial statements of a foreign operation, for incorporation in the reporting entity’s consolidated financial statements. Under IAS 21, all exchange differences resulting from translating the financial statements of a foreign operation are recognised in equity, until disposal of the net investment. This would include exchange differences arising from financial instruments carried at fair value, which would include both financial assets measured as at FVTPL and FVOCI.

Financial instruments held in a foreign entity: interaction between IFRS 9 and IAS 21 Question: Entity A is domiciled in the UK, and its functional currency and presentation currency is pound sterling. Entity A has a foreign subsidiary, entity B, in France, whose functional currency is the euro. Entity B is the owner of a debt instrument, which is held for trading, and so it is carried at FVTPL under IFRS 9. In entity B’s financial statements for 20X5, the fair value and the carrying amount of the debt instrument is €400. In entity A’s consolidated financial statements, the asset is translated into pound sterling at the spot exchange rate applicable at the balance sheet date (say, €1 = £0.50). Thus, the carrying amount in the consolidated financial statements is £200. At the end of 20X6, the fair value of the debt instrument has increased to €440. Entity B recognises the trading asset at €440 in its balance sheet, and it recognises a fair value gain of €40 in its income statement. During the year, the spot exchange rate has increased from €1 = £0.50 to €1 = £0.75, resulting in an increase in the instrument’s fair value from £200 to £330 (€440 @ 0.75). Therefore, entity A recognises the trading asset at £330 in its consolidated financial statements. How is the gain on the financial instrument recognised in the consolidated income statement? Solution: Since entity B is a foreign entity, entity A translates the income statement of entity B, in accordance with IAS 21, “at the exchange rates at the dates of the transactions”. The fair value gain has accrued through the year, so entity A uses the average rate of €1 = £0.625 as a practical approximation. Therefore, while the fair value of the trading asset has increased by £130 (£330 − £200), entity A recognises only £25 (€40 @ 0.625) of this increase in consolidated profit or loss. The resulting exchange difference – that is, the remaining increase in the debt instrument’s fair value of £105 (£130 − £25) – is recognised in other comprehensive income and classified as equity until the disposal of the net investment in the foreign operation.

Effective date and transition

The classification and measurement requirements in IFRS 9 are generally applied retrospectively. However, IFRS 9 provides relief from restating comparative information, by instead requiring entities to provide the disclosures set out in paragraphs 42I to 42S of IFRS 7. The entity can restate prior periods if, and only if, it is possible to do so without the use of hindsight. If an entity does not restate prior periods, it recognises, in the opening retained earnings (or other component of equity, as appropriate), any difference between the previous carrying amount and the carrying amount at the beginning of the annual reporting period that includes the date of initial application. However, if an entity restates prior periods, the restated financial statements must reflect all of the requirements in IFRS 9.

Application of the restatement option without the use of hindsight Question: IFRS 9 does not require entities to restate prior periods, but it permits restatement only if it is possible without the use of hindsight. Take, for example, a foreign private issuer (‘FPI’) IFRS reporter that is required to present more than one year of comparative information. The FPI is considering adopting IFRS 9 on 1 January 20X3. Although it can restate 20X2 comparatives without the use of hindsight, it does not have the necessary information to restate 20X1 in the same way. Therefore, in order to restate 20X1, it would need to use hindsight. Does IFRS 9 prohibit the FPI from restating 20X2 in this scenario, given that it cannot also restate 20X1 without the use of hindsight? Solution: No. IAS 8 states that, where it is impracticable to determine the period-specific effects of changing an accounting policy on comparative information for one or more prior periods presented, the entity should apply the new accounting policy to the carrying amounts of assets and liabilities as at the beginning of the earliest period for which retrospective application is practicable. By making the distinction between prior periods for the purposes of restatement and stating that entities should apply the new accounting policy prospectively from the earliest date practicable, IAS 8 confirms that, in this example, IFRS 9 is not a ‘catch-all provision’ – that is, it does not prohibit restatement for 20X2, even though 20X1 cannot be restated without the use of hindsight.

Impact on transition to IFRS 9 when the modification of financial asset guidance is applied Question: Bank A has a fixed-rate mortgage portfolio measured at amortised cost. Prior to the adoption of IFRS 9, some of these mortgages were renegotiated. Bank A assessed the renegotiation under IAS 39, and it concluded that the resulting change in terms should be treated as a modification which does not lead to derecognition Given that there is no clear guidance on the treatment of gains or losses as a result of financial assets that have been modified under IAS 39, bank A’s accounting policy under IAS 39 is to account for any resulting change in the expected future cash flows by adjusting the effective interest rate prospectively, rather than by adjusting the carrying amount of the loan. IFRS 9 introduces new guidance on measuring financial assets that have been modified. Under IFRS 9, the carrying amount is recalculated by discounting the modified contractual cash flows using the original effective interest rates. Any difference between this recalculated amount and the existing gross carrying amount is recognised in profit or loss as a modification gain or loss. Since IFRS 9 requires retrospective application, what is the impact on the date when bank A transitions to IFRS 9? Solution: Because bank A currently treats modification gains and losses by adjusting the effective interest rate prospectively, at transition date, there will be a one-off ‘catch up’ impact. Bank A will need to re-assess, at the time of modification, the change in carrying value of the asset using the original effective interest rate. This change will be partially offset by an offsetting change in amortisation, between the period of modification up to the transition date, because the original effective interest rate will be used to amortise the modified loans during this period. The difference in the carrying amounts, after taking into account this amortisation, is recognised in retained earnings.

Impact on transition to IFRS 9 when the modification of financial liabilities guidance is first applied The requirements in IFRS 9 for the modification of financial liabilities apply from the same date as IFRS 9 itself, namely annual periods beginning on or after 1 January 2018. There are no specific transition rules in connection with the requirement to apply to modified financial liabilities that do not result in derecognition, and so the general IFRS 9 transition rules will apply. That is: “An entity shall apply this Standard retrospectively, in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, except as specified. This Standard shall not be applied to items that have already been derecognised at the date of initial application.” IAS 8 requires a new IFRS to be applied retrospectively (other than where the new IFRS has specific transitional provisions). The only exception to retrospective application is when it is impracticable to determine either the period-specific effects or the cumulative effect of the change. IAS 8 defines impracticable as ‘the entity cannot apply it after making every reasonable effort to do so’. Retrospective application might be complicated if an entity has had multiple renegotiations of a financial liability and had previously applied IAS 39 to revise the effective interest rate (EIR) where the renegotiation did not result in derecognition. If, for example, a loan had had two such renegotiations in previous years, the implications of applying the requirements in IFRS 9 to the original and subsequent modification would be as follows: ·        Application of paragraph AG62 of IAS 39 to the first renegotiation would have resulted in the EIR being adjusted. On adoption of IFRS 9, this would need to be revisited andapplied to this first renegotiation, which would result in the EIR not being adjusted. ·        Hence, on the second renegotiation, under IAS 39 the EIR used in the 10% test would have been the adjusted EIR. On adoption of IFRS 9, this would need to be revisited, because IFRS 9 requires use of the original (unadjusted) EIR. ·        Hence, the conclusion on whether the second renegotiation passes or fails the 10% test, and so does or does not result in derecognition, might change when IFRS 9 is adopted. This is the case for all subsequent renegotiations. Footnotes: 1 IFRS 9 makes it clear that the requirements also apply to modifications of financial liabilities.

IFRS 9 introduces the concept of a ‘date of initial application’. This date is important for:

• identifying the assets and liabilities to which IFRS 9 should be applied (the standard is not applied to assets derecognised by the date of initial application);
• assessing the business model;
• designations or de-designations for using the fair value option;
• designations of non-trading equity investments at FVOCI; and
• reclassification of financial assets and financial liabilities between measurement categories.

For example, at the date of initial application, an entity assesses the business model for holding a particular asset, on the basis of the facts and circumstances that exist at that date. The resulting classification is then applied retrospectively, irrespective of the entity’s business model in prior reporting periods. Similarly, at the date of initial application, an entity might designate a financial asset or financial liability at FVTPL, or an investment in an equity instrument at FVOCI, on the basis of the facts and circumstances that exist at that date. That classification is then applied retrospectively.

The date of initial application is the date when an entity first applies the requirements of IFRS 9. Depending on the entity’s chosen approach to applying IFRS 9, the transition can involve one, or more than one, date of initial application for different requirements.

The 2011 amendments to IFRS 9 also clarify that the definition of ‘reporting period’ relates to the annual reporting period that includes the date of initial application.

Guidance on transitioning from available for sale (AFS) to amortised cost under IFRS 9 Question: Management has decided to apply IFRS 9 on 1 January 20X1 (the date of initial application); it does not need to restate its comparatives, as is permitted under IFRS 9, but it is required to give the disclosures set out in paragraphs 42L to 42O of IFRS 7. The entity has a debt instrument that is accounted for as ‘available for sale’ (AFS) under IAS 39. On the date of initial application of IFRS 9, it is determined that the asset is held to collect the contractual cash flows, and that those cash flows represent SPPI; so the asset will be measured at amortised cost under IFRS 9. How should the asset be accounted for on transition to IFRS 9? Solution: On the transition date, 1 January 20X1, the debt instrument should be measured at amortised cost (as if it had always been measured at amortised cost since it was initially recognised by the entity). Any existing AFS reserve is reclassified against the carrying value at 1 January 20X1.

Guidance on transitioning from AFS to FVTPL for equities Question: Management has decided to apply IFRS 9 on 1 January 20X3 (the date of initial application); it does not need to restate its comparatives, as is permitted under IFRS 9, but it is required to give the disclosures set out in paragraphs 42L to 42O of IFRS 7. On the date of initial application, management decides that its holding of equity investments will be classified as FVTPL. The original cost of these equities was C100. At 31 December 20X1, fair value was C30, so the AFS reserve was negative C70. It was determined at that date that those equities were impaired, so C70 was reflected in the income statement. At 31 December 20X2, the fair value of the equities is C55. The entity is not restating its comparatives for 20X2. How should the asset be accounted for on transition to IFRS 9? Solution: In 20X3, when it first applies IFRS 9 and measures the equities at FVTPL, any amounts accumulated in the OCI reserve (C25) would be reclassified to retained earnings as at 1 January 20X3.

Guidance on transitioning from FVTPL to amortised cost Question: Management has decided to apply IFRS 9 on 1 January 20X1 (the date of initial application); it does not need to restate its comparatives, as is permitted under IFRS 9, but it is required to give the disclosures set out in paragraphs 42L to 42O of IFRS 7. The entity has a debt instrument that was held at FVTPL under IAS 39. On the date of initial application of IFRS 9, it is determined that the asset is held to collect its cash flows, and that its cash flows represent SPPI. How should the asset be accounted for on transition to IFRS 9? Solution: On transition, the debt instrument is measured at amortised cost (as if it had always been measured at amortised cost since it was initially recognised by the entity). Any difference between that amount and its fair value under IAS 39 will be reflected in opening retained earnings at 1 January 20X1.

Guidance on transitioning from FVTPL to FVOCI Question: Management has decided to apply IFRS 9 on 1 January 20X1 (the date of initial application); it does not need to restate its comparatives, as is permitted under IFRS 9, but it is required to give the disclosures set out in paragraphs 6L to 6O of IFRS 7. The entity has an equity investment that it classifies as FVTPL under IAS 39. On the date of initial application of IFRS 9, management decides that it will classify the equity investment as FVOCI, because it is not held for trading. How should the asset be accounted for on transition to IFRS 9? Solution: On transition, this measurement has to be applied retrospectively, so a reserve will be created (that is, reclassified from opening retained earnings at 1 January 20X1) in OCI, based on the difference between the instrument’s original cost (adjusted for special dividends, if any, that should be classified in OCI under IFRS 9) and its fair value at the opening balance sheet date.

Guidance on accounting for AFS instruments disposed of before period of adoption Question: Management has decided to apply IFRS 9 on 1 January 20X2 (the date of initial application). On 30 June 20X1, the entity disposed of an AFS debt security (original cost C100, and FV on date of disposal of C110), and it recognised a gain of C10 as a result of reclassifying the AFS reserve to profit or loss. How should the asset be accounted for on transition to IFRS 9? Solution: There are no adjustments to be made for that AFS investment when the entity adopts IFRS 9 in its 20X2 financial statements; this is because IFRS 9 is not applied to financial assets that have already been derecognised before the date of initial application. The entity would apply the same AFS accounting to that debt security as it had under IAS 39 in its 20X1 financial statements.

IAS 39 reclassification amendment (2008) Question: The transition provisions in IFRS 9 require an entity to apply the standard retrospectively, with a few exceptions. The reclassification amendment of October 2008 allowed certain instruments to be reclassified out of held for trading and AFS to loans and receivables; on reclassification, the fair value at the date of reclassification becomes the new amortised cost of the reclassified assets. How should such assets be accounted for on transition to IFRS 9? Solution: On initial application of IFRS 9, assuming that these reclassified assets will continue to be measured at amortised cost, management is required to go back to the assets’ initial recognition and measure them as if they had always been measured at amortised cost under IFRS 9. Their amortised cost for IFRS 9 will not, therefore, be the same amortised cost that was determined when they were reclassified under IAS 39.

Guidance on transition for portfolios in ‘run-off’ Question: On transition to IFRS 9, an entity has a portfolio in ‘run-off’ where it has stopped trading in certain products because the market has become illiquid (for example, certain asset-backed securities). The entity’s intention is to maximise the recovery of the portfolio, either by holding the positions and collecting coupons and principal payments, or by selling the positions if a good price can be obtained in the market. Can the entity classify the portfolio in ‘run-off’ as hold to collect? Solution: No. Opportunistic sales might be made to liquidate the portfolio in a quicker fashion if advantageous pricing is available. Assuming that these sales are not justified on the basis of credit deterioration, this is not consistent with a held to collect, amortised cost business model. Such a portfolio is likely to be measured at FVOCI.