International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  because that rate is considered ‘normal’ in a particular market. For example, if an

  interest rate is reset every year but the reference rate is always a 15-year rate, it would

  be difficult for an entity to conclude that such a rate provides consideration for only the

  passage of time, even if such pricing is commonly used in that particular market.

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  Accordingly the IASB believes that an entity must apply judgement to conclude whether

  the stated time value of money element meets the objective of providing consideration

  for only the passage of time. [IFRS 9.BC4.178].

  It could be argued that the standard is not entirely clear as to the status of benchmark

  rates such as LIBOR. For such rates, the consideration for credit risk is neither fixed,

  nor varies over time to reflect the specific credit risk of the obligor, but instead varies

  to reflect the credit risks associated with a class of borrowers. However, this seems to

  be a purist approach and given that LIBOR is widely used as a benchmark rate in capital

  markets at present and is cited in the standard as an example of a rate that would satisfy

  the criteria of the contractual cash flow characteristics test, it would seem that this is

  not an issue.

  Interest may include profit margin that is consistent with a basic lending arrangement.

  But elements that introduce exposure to risks or variability in the contractual cash flows

  that are unrelated to lending (such as exposure to equity or commodity price risk) are

  not consistent with a basic lending arrangement. The IASB also noted that the

  assessment of interest focusses on what the entity is being compensated for e.g. basic

  lending risk or something else, rather than how much the entity receives.

  [IFRS 9.BC4.182(b)].

  6.3

  Contractual features that normally pass the test

  The most common instruments that normally pass the test are plain vanilla debt

  instruments which are acquired at par, have a fixed maturity and pay interest that is

  fixed at inception. Instruments that pay variable interest also normally pass the test,

  although further consideration is required in that case (see 6.4.4 below).

  There are several features that are common in many financial assets and which would

  not usually cause the contractual cash flow characteristics test to be failed. This section

  describes some of those features and instruments that are normally unproblematic but

  also highlights cases that might result in an asset failing the contractual cash flow

  characteristics test. Features that are more complex and need more consideration are

  described in 6.4 below.

  6.3.1

  Conventional subordination features

  In many lending transaction the instrument is ranked relative to amounts owed by the

  borrower to its other creditors. An instrument that is subordinated to other instruments

  may be considered to have contractual cash flows that are payments of principal and

  interest on the principal amount outstanding if the debtor’s non-payment arises only on

  a breach of contract and the holder has a contractual right to unpaid amounts of

  principal and interest on the principal amount outstanding even in the event of the

  debtor’s bankruptcy.

  For example, a trade receivable that ranks its creditor as a general creditor would

  qualify as having payments of principal and interest on the principal amount

  outstanding. This is the case even if the debtor has issued loans that are collateralised,

  which in the event of bankruptcy would give that loan holder priority over the claims

  of the general creditor in respect of the collateral but does not affect the contractual

  right of the general creditor to unpaid principal and other amounts due. [IFRS 9.B4.1.19].

  Financial

  instruments:

  Classification

  3617

  On the other hand, if the subordination feature limits the contractual cash flows in any

  other way or introduces any kind of leverage, the instrument would fail the contractual

  cash flow characteristics test.

  6.3.2

  Full recourse loans secured by collateral

  The fact that a full recourse loan is collateralised does not in itself affect the analysis of

  whether the contractual cash flows are solely payments of principal and interest on the

  principal amount outstanding. [IFRS 9.B4.1.13 Instrument D]. However, a full recourse loan

  may, in substance, be non-recourse if the borrower has limited other assets, in which

  case an entity would need to assess the particular underlying assets (i.e. the collateral)

  to determine whether or not the contractual cash flows of the loan are payments of

  principal and interest on the principal amount outstanding. [IFRS 9.B4.1.17]. If there is

  insufficient collateral in the borrower to ensure that payments of the contractual cash

  flows are made then the loan may fail the contractual cash flow characteristics test.

  However if sufficient equity or collateral is available then the contractual cash flow

  characteristics test may be met (see Example 44.31 below). Judgement may be necessary

  in determining whether there is adequate collateral or equity to ensure that all the

  contractual cash payments will be made.

  6.3.3

  Bonds with a capped or floored interest rate

  Some bonds may have a stated maturity date but pay a variable market interest rate that

  is subject to a cap or a floor. The contractual cash flows of such instrument could be

  seen as being an instrument that has a fixed interest rate and an instrument that has a

  variable interest rate.

  These both represent payments of principal and interest on the principal amount

  outstanding as long as 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.

  Therefore, such an instrument can have cash flows that are solely payments of principal

  and interest on the principal amount outstanding. A feature such as an interest rate cap

  or floor may reduce cash flow variability by setting a limit on a variable interest rate or

  increase the cash flow variability because a fixed rate becomes variable.

  [IFRS 9.B4.1.13 Instrument C]. If there is no leverage and no mismatch of term with respect to

  interest then the instrument should pass the contractual cash flows characteristics test.

  There is no requirement to determine whether or not the cap or floor is in the money

  on initial recognition.

  Caps and floors will generally pass the contractual cash flows test without further

  analysis, apart from some instruments, namely those with features that create leverage.

  These ‘exotic’ instruments would require detailed assessment and judgement. An

  instrument with a floor which is deeply in the money at origination is not seen as a

  problem for passing the contractual cash flows characteristics test.

  We assume that a variable rate debt instrument that is subject to both a cap and a floor

  (known as a collar) would also satisfy the contractual cash flow characteristics test for

  the same reasons.

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  In many jurisdictions interest rates on loans are capped by law to a multiple of an
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  absolute interest or index rate. Whereas a capped interest rate meets the contractual

  cash flow characteristic test when the interest reflects the time value of money as

  discussed above, in some cases the cap is referenced to a multiple of an index rate, so

  it can be argued that the cap introduces leverage into the instrument. However it can

  also be argued that the feature is not intended to introduce leverage into the market but

  to protect consumers, as a cap it will only reduce interest rates and does not introduce

  volatility such as exposure to changes in equity prices or commodity prices. IFRS 9 also

  permits interest rates that are regulated to meet the contractual cash flow characteristic

  test if the interest rate represents consideration that is broadly consistent with the

  passage of time. [IFRS 9.B4.1.9E]. If the cap is introduced by the regulator to protect

  consumers by providing an estimate of the fair market interest rate it could be

  considered to represent consideration for the passage of time (see 6.4.3 below).

  6.3.4

  Lender has discretion to change the interest rate

  In some instances, the lender may have the right to unilaterally adjust the interest rates of its

  loans in accordance with its own business policy. However, should the borrower disagree

  with the new rate, it has the right to terminate the contract and prepay the loan at par.

  Such a feature does not per se result in the loans failing the contractual cash flow

  characteristic test. However, whether the loan passes the test depends on facts and

  circumstances which require assessment on a case-by-case basis, specifically whether

  interest represents considerations for the time value of money, credit risk and other

  basic lending risk and costs, as well as a profit margin. As such an entity might consider

  whether the change in interest rate applies to all similar loans, including new loans and

  the ones in issue, or only to one or certain individual borrowers (this excludes changes

  in interest rates due to changes in the credit spread of the borrower).

  Note that in practice the bank is likely to be restricted as to how much it can increase

  the interest rate, since if it is too high the borrower will prepay and the bank is unlikely

  to remain competitive. However the lender will still need to assess whether the loan

  passes the contractual cash flows characteristic test.

  6.3.5

  Unleveraged inflation-linked bonds

  For some financial instruments, payments of principal and interest on the principal

  amount outstanding are linked to an inflation index of the currency in which the

  instrument is issued. The inflation link is not leveraged. Linking payments of principal

  and interest on the principal amount outstanding to an unleveraged inflation index

  resets the time value of money to a current level. In other words, the interest rate on

  the instrument reflects ‘real’ interest. Thus, the interest amounts are consideration for

  the time value of money on the principal amount outstanding.

  We believe measurement at amortised cost is possible even if the principal of an

  inflation-indexed bond is not protected, provided the inflation link is not leveraged.

  Payments on both the principal and interest will be inflation-adjusted and

  representative of ‘real’ interest which is consideration for the time value of money on

  the principal amount outstanding. However, if the interest payments were indexed to

  another variable such as the debtor’s performance (e.g. the debtor’s net income) or an

  Financial

  instruments:

  Classification

  3619

  equity index, the contractual cash flows are not payments of principal and interest on

  the principal amount outstanding (unless it can be demonstrated that the indexing to

  the debtor’s performance results in an adjustment that only compensates the holder for

  changes in the credit risk of the instrument, such that contractual cash flows will

  represent only payments for principal and interest). That is because the contractual cash

  flows reflect a return that is inconsistent with a basic lending arrangement (see 6 above).

  [IFRS 9.B4.1.13 Instrument A].

  Example 44.15: Unleveraged inflation linked bond

  Entity A invests in euro-denominated bonds with a fixed maturity issued by Entity B. Interest on the bond is

  linked directly to the inflation index of Eurozone Country C, which is Entity B’s principal place of business.

  The question arises whether Entity A can measure the euro bonds at amortised cost or fair value through other

  comprehensive income given that interest is not linked to the inflation index of the entire Eurozone area.

  The bond is denominated in euros and Eurozone Country C is part of the Eurozone, therefore, we consider

  the inflation link to be acceptable. The inflation index reflects the inflation rate of the currency in which the

  bond is issued since it is the inflation index of Entity B’s economic environment, and the euro is the currency

  for that economic environment.

  By linking the inflation index to the inflation rate of Eurozone Country C, Entity B is reflecting ‘real’ interest

  for the economic environment in which it operates. Hence, in these circumstances, Entity A may regard the

  interest as consideration for the time of value of money and credit risk associated with the principal amount

  outstanding on the bond.

  6.3.6

  Features which compensate the lender for changes in tax or other

  related costs

  Some loans include clauses which require the borrower to compensate the lender for

  changes in tax or regulatory costs during the life of the loan. The interest rate for such

  loans is usually set at a rate which takes into account the specific tax or regulatory

  environment, e.g. interest receivable may be exempt from tax and the lender will

  consequently offer the borrower a below market rate. Any change to the tax laws which

  affect such an arrangement could result in a loss to the lender as tax could become

  deductible from interest receivable. The compensation clause is therefore intended to

  make the lender whole in the event of such a change. As the effect of the clause is to

  enable the lender to maintain its profit margin it can be considered to be consistent with

  a normal lending arrangement.

  6.4

  Contractual features that may affect the classification

  Sometimes, contractual provisions may affect the cash flows of an instrument such that

  they do not give rise to only a straightforward repayment of principal and interest. An

  entity is required to carefully assess those features in order to conclude whether or not

  the instrument passes the contractual cash flow characteristics test. It is important to

  note that the standard grants an exception for all features that are non-genuine or have

  only a de minimis impact, and can be disregarded when making the assessment

  (see 6.4.1 below).

  Furthermore, the standard allows the time value of money element of interest to be

  what is referred to as ‘modified’ but only when the resulting cash flows could not be

  significantly different from an instrument that has an unmodified time value of money

  element (see 6.4.2 below). It also allows regulated interest rates as long as they provide

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  conside
ration that is broadly consistent with the passage of time and do not introduce

  risks that are inconsistent with a basic lending arrangement (see 6.4.3 below).

  An instrument may have other features that change the timing or amount of contractual

  cash flows which need to be assessed whether they represent payments of principal and

  interest on the principal outstanding. Examples of such features are variable interest rates,

  interest rates that step up, prepayment and extension options (see 6.4.4 below).

  Lastly, there are features that most likely result in an instrument failing the contractual

  cash flow characteristics test because they introduce cash flow volatility caused by risks

  that are inconsistent with a basic lending arrangement (see 6.4.5 below).

  6.4.1

  De minimis and non-genuine features

  A contractual cash flow characteristic does not affect the classification of the financial

  asset if it could have only a de minimis effect on the contractual cash flows of the

  financial asset.

  In addition, if a contractual cash flow characteristic could have an effect on the

  contractual cash flows that is more than de minimis (either in a single reporting period

  or cumulatively) but that cash flow characteristic is not genuine, it does not affect the

  classification of a financial asset. A cash flow characteristic is not 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. [IFRS 9.B4.1.18].

  Although the ‘de minimis’ and ‘non-genuine’ thresholds are a high hurdle, allowing

  entities to disregard such features will result in more debt instruments qualifying for the

  amortised cost or fair value through other comprehensive income measurement

  categories. The terms will need to be interpreted by preparers in analysing the impact

  of the contractual cash flow characteristics test on the debt instruments they hold.

  6.4.1.A

  De minimis features

  The standard does not prescribe whether a qualitative or a quantitative analysis should

  be performed to determine whether a feature is de minimis or not. While de minimis is

  not defined in IFRS 9, one dictionary definition is ‘too trivial to merit consideration’.

  Implicit in this definition is that if an entity has to consider whether an impact is de