contractual cash flows and selling financial assets are integral to achieving the business model’s objective
and the financial assets are measured at fair value through other comprehensive income.
[IFRS 9.B4.1.4 Example 4]. The frequent and significant sales activity does not necessarily mean that the
portfolio is held for trading because under the business model objective above, assets are not sold with the
intention of short-term profit taking.
Example 44.11: Opportunistic portfolio management
A financial institution holds a portfolio of financial assets. The entity actively manages the return on the
portfolio on an opportunistic basis trying to increase the return, without a clear intention of holding the
financial assets to collect contractual cash flows (although it might end up holding the assets if no other
investment opportunities arise). That return consists of collecting contractual payments as well as gains and
losses from the sale of financial assets.
As a result, the entity holds financial assets to collect contractual cash flows and sells financial assets to
reinvest in higher yielding financial assets. In the past, this strategy has resulted in frequent sales activity and
such sales have been significant in value. It is expected that the sales activity will continue in the future.
The entity achieves the objective stated above by both collecting contractual cash flows and selling financial
assets. Both collecting contractual cash flows and selling financial assets are integral to achieving the business
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model’s objective and, thus, the financial assets are measured at fair value through other comprehensive income.
[IFRS 9.B4.1.4C Example 6].
In some cases, entities may manage a portfolio to manage its yield. In such cases, the portfolio manager may
be remunerated based on the overall yield of the portfolio and fair value gains or losses may not be considered
in his or her remuneration. Furthermore, management’s documented strategy and defined key performance
indicators may emphasise optimising long-term yield rather than fair value gains or losses and accordingly,
the entity’s management reporting focuses on yield rather than fair value of the debt instruments within the
portfolio. However, in our view, the fact that it is not the entity’s objective to realise fair value gains or losses
is not sufficient in itself to be able to conclude that measurement at amortised cost is appropriate as the
business model objective is not only holding financial assets to collect contractual cash flows but also results
in sales which are more than infrequent and significant in value. Thus, such a portfolio would be measured
at fair value through other comprehensive income.
Example 44.12: Replication portfolios
Fact pattern 1: Insurance company
An insurer holds financial assets in order to fund insurance contract liabilities. The insurer uses the proceeds
from the contractual cash flows on the financial assets to settle insurance contract liabilities as they come
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.
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 come due and 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 and it follows that the financial assets are measured at
fair value through other comprehensive income. [IFRS 9.B4.1.4C Example 7].
Fact pattern 2: Bank
A bank allocates investments into maturity bands to match the expected duration of customers’ time deposits.
The invested assets have a similar maturity profile and amount to the corresponding deposits. The target ratio
of assets to deposits for each maturity band has pre-determined minimum and maximum levels. For example,
if the ratio exceeds the maximum level because of an unexpected withdrawal of deposits, the bank will sell
some assets to reduce the ratio.
Meanwhile, new assets will be acquired when necessary (i.e. when the ratio of assets to deposits falls below
the pre-determined minimum level). The expected repayment profile of the deposits would be updated on a
quarterly basis, based on changes in customer behaviour.
The question is whether adjusting the assets/deposits ratio by selling assets to correspond with a change in
the expected repayment profile of the deposits would mean that the business model is inconsistent with the
objective of holding to collect the contractual cash flows. In these circumstances, an analogy can be drawn
to the insurance company above.
If the bank has a good track record of forecasting its deposit repayments, so that sales are expected to be
infrequent, it is possible that the objective of the business model is to hold the investments to collect
contractual cash flows. But, if significant sales take place each year, it is likely to be difficult to rationalise
such practice with this objective. Due consideration will also need to be given to the magnitude of sales and
the reasons for the sales.
Example 44.13: Loans that are to be sub-participated
An entity originates loans so that it holds part of the portfolio to maturity, but ‘sub-participates’ a portion of
the loans to other banks, so that it transfers substantially all the risks and rewards and so achieves
derecognition. The question arises whether, for the purposes of application of IFRS 9, the entity has one
business model or two.
The entity could consider the activities of lending to hold and lending to sell or sub-participate as two separate
business models, requiring different skills and processes. Whilst the financial assets resulting from the former
Financial
instruments:
Classification
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would typically qualify for amortised cost measurement, those from the latter would probably not and would,
therefore, most likely need to be measured at fair value through profit or loss. This split approach is likely to
be acceptable as long as the entity is able to forecast with reasonable confidence that it will indeed hold the
assets (or the proportion of a group of identical assets) that it determines to be measured at amortised cost.
If a loan is assessed, in part, to be sold or sub-participated, this raises the additional issue of whether a single
financial asset can be classified into two separate business models. It was common under IAS 39 – Financial
Instruments: Recognition and Measurement – for loans to be classified in part as held for trading and in part
at amortised cost and we see this practice continuing under IFRS 9.
In some cases, an entity may fail to achieve the intended disposal, having previously classified a portion of
a loan at fair value through profit or loss because of the intention to sell.
The standard requires classification to be determined in accordance with the business model applicable at the
point of initial recognition of the asset. In this example, the fact that the entity fails to achieve an intended
disposal does not trigger a reclassification in accordance with
the standard as the threshold for reclassification
is a very high hurdle. Therefore, loans or portions of loans that the entity fails to dispose of would continue
to be recorded at fair value through profit or loss.
Example 44.14: Portfolio managed on a fair value basis
An entity manages a portfolio and measures its performance on a fair value basis and makes decisions based
on the fair value of the financial assets. Such an objective typically results in frequent sales and purchases of
financial assets.
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 addition, a portfolio of financial assets that meets the definition of held for trading is not
held to collect contractual cash flows or held both to collect contractual cash flows and to sell financial assets.
The entity is primarily focused on fair value information and uses that information to assess the assets’
performance and to make decisions.
Even though the entity will collect contractual cash flows while it holds financial assets in the fair value
through profit or loss category, this is only incidental and not integral to achieving the business model’s
objective. Consequently, such portfolios of financial assets must be measured at fair value through profit or
loss. [IFRS 9.B4.1.5].
6 CHARACTERISTICS
OF
THE CONTRACTUAL CASH
FLOWS OF THE INSTRUMENT
The assessment of the characteristics of a financial asset’s contractual cash flows aims
to identify whether they are ‘solely payments of principal and interest on the principal
amount outstanding’. Hence, the assessment is colloquially referred to as the ‘SPPI test’.
The contractual cash flow characteristics test is designed to screen out financial assets
on which the application of the effective interest method either is not viable from a
pure mechanical standpoint or does not provide useful information about the
uncertainty, timing and amount of the financial asset’s contractual cash flows.
Because the effective interest method is essentially an allocation mechanism that spreads
interest revenue or expense over time, amortised cost is only appropriate for simple cash
flows that have low variability such as those of traditional unleveraged loans and receivables,
and ‘plain vanilla’ debt instruments. Accordingly, the contractual cash flow characteristics
test is based on the premise that it is only when the variability in the contractual cash flows
maintains the holder’s return in line with a ‘basic lending arrangement’ that the application
of effective interest method provides useful information. [IFRS 9.BC4.23, 158, 171, 172].
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In this context, the term ‘basic lending arrangement’ is used broadly to capture both
originated and acquired financial assets, the lender or the holder of which is looking to
earn a return that compensates primarily for the time value of money and credit risk.
However, such an arrangement can also include other elements that provide
consideration for other basic lending risks such as liquidity risks, costs associated with
holding the financial asset for a period of time (e.g. servicing or administrative costs)
and a profit margin. [IFRS 9.B4.1.7A, BC4.182(b)].
In contrast, contractual terms that introduce a more than de minimis exposure (see 6.4.1
below) to risks or volatility in the contractual cash flows that is unrelated to a basic
lending arrangement, such as exposure to changes in equity prices or commodity prices,
do not give rise to contractual cash flows that are solely payments of principal and
interest on the principal amount outstanding. [IFRS 9.B4.1.7A, B4.1.18].
The IASB noted that it believes that amortised cost would provide relevant and useful
information as long as the contractual cash flows do not introduce risks or volatility that
are inconsistent with a basic lending arrangement. [IFRS 9.BC4.180].
The following sections cover the main aspects of the contractual cash flow
characteristics test, starting with the meaning of the terms ‘principal’ and ‘interest’ in 6.1
and 6.2 below, and discusses instruments that normally pass the test at 6.3 below. So
called ‘modified’ contractual cash flows and their effect on the contractual cash flow
characteristics test are dealt with in 6.4 below. Non-recourse assets are separately
covered in 6.5 below and contractually linked instruments in 6.6 below.
6.1
The meaning of ‘principal’
‘Principal’ is not a defined term in IFRS 9. However, the standard states that, for the
purposes of applying the contractual cash flow characteristics test, the principal is ‘the
fair value of the asset at initial recognition’ and that it may change over the life of the
financial asset (for example, if there are repayments of principal). [IFRS 9.4.1.3(a), B4.1.7B].
The IASB believes that this usage reflects the economics of the financial asset from the
perspective of the current holder; in other words, the entity would assess the
contractual cash flow characteristics by comparing the contractual cash flows to the
amount that it actually invested. [IFRS 9.BC4.182(a)].
For example: Entity A issued a bond with a contractually stated principal of CU1,000.
The bond was originally issued at CU990. Because interest rates have risen sharply
since the bond was originally issued, Entity B, the current holder of the bond, acquired
the bond in the secondary market for CU975. From the perspective of entity B, the
principal amount is CU975. The principal will increase over time as the discount of 25
amortises out until it reaches the contractual amount of CU1,000 at the bond’s maturity.
The principal is, therefore, not necessarily the contractual par amount, nor (when the
holder has acquired the asset subsequent to its origination) is it necessarily the amount
that was advanced to the debtor when the instrument was originally issued.
The description of ‘principal’ as the fair value of an instrument on initial recognition
avoids a concern that any financial asset acquired or issued at a substantial discount
would be leveraged and hence would not have economic characteristics of interest.
Financial
instruments:
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3615
A clear understanding of what the standard means by ‘principal’ is also necessary for
the appropriate and consistent application of the contractual cash flow characteristics
test to prepayable financial assets (see 6.4.4 below).
6.2
The meaning of ‘interest’
IFRS 9 states that the most significant elements of interest within a basic lending
arrangement are typically the consideration for the time value of money and credit risk.
In addition, interest may 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. Furthermore, interest may
include a profit margin that is consistent with a basic lending arrangement.
In extreme economic circumstances, interest can be negative if, for example, the
holder
of a financial asset effectively pays a fee for the safekeeping of its money for a particular
period of time and that fee exceeds the consideration the holder receives for the time
value of money, credit risk and other basic lending risks and costs.
However, contractual terms that introduce exposure to risks or volatility in the
contractual cash flows that is unrelated to a basic lending arrangement, such as exposure
to changes in equity prices or commodity prices, do not give rise to contractual cash
flows that are solely payments of principal and interest on the principal amount
outstanding. An originated or a purchased financial asset can be a basic lending
arrangement irrespective of whether it is a loan in its legal form. [IFRS 9.4.1.3(b), B4.1.7A].
The IASB notes that the assessment of interest focuses on what the entity is being
compensated for (i.e. whether the entity is receiving consideration for basic lending
risks, costs and a profit margin or is being compensated for something else), instead of
how much the entity receives for a particular element. For example, the Board
acknowledges that different entities may price the credit risk element differently.
[IFRS 9.BC4.182(b)]. Although two entities may receive different amounts for the same
element of interest, e.g. credit risk, they could both conclude that their consideration
for credit risk is appropriate within a basic lending arrangement.
Time value of money is the element of interest that provides consideration for only the
passage of time. That is, the time value of money element does not provide
consideration for other risks or costs associated with holding the financial asset. To
make this assessment, 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. [IFRS 9.B4.1.9A].
The IASB also notes that, as a general proposition, the market in which the transaction
occurs is relevant to the assessment of the time value of money element. For example,
in Europe, it is common to reference interest rates to LIBOR and in the United States it
is common to reference interest rates to the prime rate. However, a particular interest
rate does not necessarily reflect consideration for only the time value of money merely
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