the option of leaving the fund at any time. The price at which new entrants invest in the fund or leavers exit
the fund is normally based on the fair value of the fund’s assets. Given that investors enter and exit the fund
at a price based on fair value, the cash flows of an investment in such a fund are not solely payments of
principal and interest.
In addition, such investments would not normally qualify for the option for equity instruments, to present
gains and losses in other comprehensive income, as they do not normally meet the definition of an equity
instrument from the perspective of the fund (i.e. the issuer). See also 8 below.
6.4.6 Loan
commitments
Where a loan commitment is granted long periods may elapse before the commitment
is drawn down. The question therefore arises as to whether the drawdown of loans
3634 Chapter 44
under an irrevocable loan commitment should be assessed for classification based on
when the loan commitment came into being or when the loan was actually drawn down.
IFRS 9 requires that an entity shall recognise a financial asset in its statement of
financial position when the entity becomes party to the contractual provisions of the
instrument. When an entity first recognises a financial asset it shall classify it in
accordance with IFRS 9. [IFRS 9.3.1.1]. As the issuer of the irrevocable loan commitment
becomes a party to the entire contractual cash flows of the loan at grant date it could
be argued that any drawdowns could be treated as continuations of the original facility
and that any loans drawn down should be classified on the basis of the criteria applying
at the date of the origination of the loan commitment. Such an interpretation is
consistent with how the time value of money on loan commitments are calculated
under the expected credit loss method, ‘a financial asset that is recognised following a
draw down on a loan commitment shall be treated as a continuation of that commitment
instead of as a new financial instrument’. [IFRS 9.B5.5.47].
However if a long period elapses between the origination of the irrevocable loan
commitment and draw down it is possible that conditions affecting the assessment of
classification might have changed considerably, for instance where a bank grants a loan
commitment to an SPE and the SPE has sufficient equity at the date the commitment is
originated but does not at the time the loan is drawn down. This is something that could
be usefully clarified by the Interpretations Committee or the Board.
6.5 Non-recourse
assets
A financial asset may have contractual cash flows that are described as principal and
interest but those cash flows do not, in economic substance, represent the payment of
principal and interest on the principal amount outstanding. [IFRS 9.B4.1.15]. For example,
under some contractual arrangements, a creditor’s claim is limited to specified assets of
the debtor or the cash flows from specified assets (described in the standard as a ‘non-
recourse’ financial asset). Another example given in the standard is contractual terms
stipulating that the financial asset’s cash flows increase as more automobiles use a
particular toll road. Those contractual cash flows are inconsistent with a basic lending
arrangement. [IFRS 9.B4.1.16]. As a result, the instrument would not pass the contractual
cash flow characteristics test unless such a feature is de minimis or non-genuine.
[IFRS 9.B4.1.18].
However, the fact that a financial asset is non-recourse does not in itself necessarily
preclude the financial asset from passing the contractual cash flow characteristics test
(see also 6.3.2 above). Furthermore, conventional subordination features do not
preclude an asset from passing the test (see 6.3.1 above).
The non-recourse provision in IFRS 9 is intended to prevent instruments that are linked
to the performance of another asset from being classified as amortised cost or FVOCI.
Where an asset is non-recourse the creditor is required to assess (‘look through to’) the
particular underlying assets or cash flows to determine whether the contractual cash
flows characteristics test is being met. [IFRS 9.B4.1.17]. When assessing a non-recourse
asset, various factors could be considered, such as:
Financial
instruments:
Classification
3635
• nature of borrower and its business;
• adequacy of loss absorbing capital (particularly for SPEs);
• pricing of the loan (may indicate returns above a lending return);
• performance figures such as Loan to Value ratios (LTVs), Debt Service Coverage
Ratios (DSCR) and Interest Coverage Ratios (ICR);
• expected source of repayment; or
• existence of other forms of economic recourse such as guarantees.
The following examples illustrate instruments which normally fail the contractual cash
flow characteristics test because their cash flows are not solely payments of principal
and interest on the principal amount outstanding.
Example 44.31: Non-recourse loans
Under some contractual arrangements, a creditor’s claim is limited to specified assets of the debtor or the
cash flows from specified assets (described in the standard as a ‘non-recourse’ financial asset).
[IFRS 9.B4.1.16]. In such cases, the contractual cash flows may reflect a return that is inconsistent with a basic
lending arrangement; e.g. if the contractual terms stipulate that the financial asset’s return effectively varies
on the basis of the performance of an underlying asset, the contractual cash flows do not represent the
payment of principal and interest on the principal amount outstanding.
However, the fact that a financial asset is non-recourse does not in itself necessarily preclude the financial
asset from passing the contractual cash flow characteristics test. In such situations, the creditor is required to
assess (‘look through to’) the particular underlying assets or cash flows to determine whether the contractual
cash flows of the financial asset being classified are payments of principal and interest on the principal
amount outstanding. If the terms of the financial asset give rise to any other cash flows or limit the cash flows
in a manner inconsistent with payments representing principal and interest, the financial asset fails the
contractual cash flow characteristics test. Whether the underlying assets are financial assets or non-financial
assets does not in itself affect this assessment. [IFRS 9.B4.1.17].
Non-recourse loans need careful consideration and many instruments that are non-recourse will fail the test.
The following examples illustrate how the guidance above might be applied to non-recourse instruments that
are common in practice and under which circumstances those instruments pass the contractual cash flow
characteristics test:
(a) Project finance loans
Where a loan is given for the construction and maintenance of a toll road and the payments of cash flows
to the lender are reduced or cancelled if less than a certain number of vehicles travel on that road, the
loan is unlikely to pass the contractual cash flow characteristics test. Similarly, a loan with cash flows
specifically referenced to the performance of an underlying business will not pass the test.
In other case
s, where there is no such reference and there is adequate equity in the project to absorb
losses before affecting the ability to meet payments on the loan, it may well pass the contractual cash
flow characteristics test. In these cases the adequacy of equity to absorb losses will be key.
(b) Loans to a special purpose entity (SPE)
Where a loan is provided to an SPE that funds the acquisition of other assets, whether that loan passes the
contractual cash flow characteristics test will depend on the specific circumstances of the arrangement.
If the assets of the SPE are all debt instruments which would themselves pass the contractual cash flow
characteristics test, the loan to the SPE might well pass it too. Further, if, the SPE uses the loan from
the entity to fund investments in assets which will not themselves pass the contractual cash flow
characteristics test, such as equity securities or non-financial assets, but the SPE has sufficient equity to
cover the losses on its investments, the loan may again pass the contractual cash flow characteristics
test. However, if the loan is the only source of finance to the SPE so that it absorbs any losses from the
equity securities, it would not pass the contractual cash flow characteristics test. Whether the loan is
3636 Chapter 44
legally non-recourse does not matter in this scenario because the SPE has limited other assets to which
the lender can have recourse. Therefore the SPE must have adequate equity for the interest to represent
compensation for basic lending risk.
(c) Mortgages
There are many different types of mortgage loans and some are structured so that in the event of default
the lender has legal recourse only to the property provided as collateral and not to the borrower. This
type of arrangement is common in some states of the USA. Other mortgages may, in substance, be non-
recourse if the borrower has limited other assets.
In general, we do not believe that IFRS 9 was intended to require all normal collateralised loans such as
mortgages to be accounted for at fair value through profit or loss. Consequently, if a loan is granted at
a rate of interest that compensates the lender for the time value of money and for the credit risk
associated with the principal amount, it would in our view usually pass the contractual cash flow
characteristics test, whether or not it is legally non-recourse.
However, at inception, if the expected repayment of a loan is primarily driven by future movements in
the value of the collateral so that the loan is, in substance, an investment in the real estate market, then
measurement at amortised cost or fair value through other comprehensive income classification would
most likely be inappropriate.
The contractual cash flow characteristics are assessed at initial recognition of the asset.
If at initial recognition the asset is full recourse there is no need to reassess whether
there is any change thereafter.
Other loans could also be considered to be in substance non-recourse if the borrower
has limited resources with which to repay the loan. Under certain circumstances
impaired loans backed by collateral could also be considered to be non-recourse in
substance, such as if the lender could only recover the loan by realising the collateral.
This would in substance be similar to the lender buying the collateral directly.
Where an SPE issues non-recourse notes and uses the funding to buy an asset which is
pledged as collateral for the non-recourse notes, the question arises as to how to assess
whether ‘a creditor’s claim is limited to specified assets of the debtor or the cash flow
from specified assets’ and whether ‘the terms of the financial asset give rise to any other
cash flows or limit the cash flows in a manner inconsistent with payments representing
principal and interest’. In these cases the question revolves around whether the SPE
has adequate equity such that interest represents compensation for the basic lending
risks rather than asset risks.
6.6
Contractually linked instruments
In some types of transactions, an entity may prioritise payments to the holders of
financial assets using multiple contractually linked instruments that create
concentrations of credit risk (known as 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. [IFRS 9.B4.1.20]. As this
guidance should be applied to ‘multiple contractually linked instruments’ an investment
in a single tranche securitisation would not be assessed under this test. Also the Basis
for Conclusions refers to classic waterfall structures with different tranches, rather than
a single tranche. [IFRS 9.BC4.26].
Financial
instruments:
Classification
3637
These types of arrangements can concentrate credit risk into certain tranches of a
structure. Essentially such investments contained leveraged credit risk and accordingly,
the IASB believes that measuring such investments at amortised cost or fair value
through other comprehensive income may be inappropriate in certain circumstances.
Where a structure has in issue only a single tranche, it may be more appropriate to view
an investment in that tranche as a non-recourse loan (see 6.5 above) rather than a
contractually linked instrument.
In some cases, where an entity transfers assets to a securitization vehicle while retaining
all the junior tranche, the transferee may determine that it needs to consolidate the
structure. In that case, the transferee will continue to recognise the transferred asset
and will recognise a liability equivalent to the proceeds of the senior notes, but will not
recognise the junior note separately. It could be argued therefore, if the securitization
vehicle only had two tranches, that the consolidation of the structure results in only the
senior tranche being accounted for and raises the question of whether the senior
tranche is a non-recourse asset rather than a contractually linked instrument. This is
not generally regarded as being the case as looking at the legal form of the arrangement,
it is clear that contractually the structure contains two tranches and it is just the
accounting treatment in the books of the transferee, while it consolidates the structure,
which gives the appearance that the structure has a single tranche. As such this type of
structure would still be regarded as issuing multiple contractually linked instruments
rather than a single non-recourse instrument. In multi-tranche transactions that
concentrate credit risk in the way described above, a tranche is considered to have cash
flow characteristics that are payments of principal and interest on the principal amount
outstanding only if the following three criteria are met: [IFRS 9.B4.1.21]
(a) the contractual terms of the tranche being assessed for classification (without
looking through to the underlying pool of financial instruments) give rise to cash
flows that are solely payments of principal and interest on the principal amount
> outstanding (e.g. the interest rate on the tranche is not linked to a commodity index);
(b) the underlying pool of financial instruments must contain one or more instruments
that have contractual cash flows that are solely payments of principal and interest
on the principal amount outstanding (the primary instruments) and any other
instruments in the underlying pool must either: [IFRS 9.B4.1.23-25]
(i) reduce the cash flow variability of the primary instruments in the pool and,
when combined with the primary instruments in the pool, result in cash flows
that are solely payments of principal and interest on the principal amount
outstanding; or
(ii) align the cash flows of the tranches with the cash flows of the underlying
primary instruments in the pool to address differences in and only 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.
For these purposes, when identifying the underlying pool of financial instruments,
the holder should ‘look through’ the structure until it can identify an underlying
3638 Chapter 44
pool of instruments that are creating (rather than passing through) the cash flows.
[IFRS 9.B4.1.22].
(c) the exposure to credit risk in the underlying pool of financial instruments inherent
in the tranche is equal to, or lower than, the exposure to credit risk of all of the
underlying pool of instruments (for example, the credit rating of the tranche is
equal to or higher than the credit rating that would apply to a single borrowing that
funded the underlying pool).
If the instrument in the pool does not meet the conditions in (b) above then the
instrument fails the contractual cash flow test. In making this assessment, a detailed
instrument-by-instrument analysis of the pool may not be necessary, however an entity
must use judgement and perform sufficient analysis to determine whether the
instruments in the pool meet the conditions in (b) above. [IFRS 9.B4.1.25].
If the holder cannot assess whether a financial asset meets criteria (a) to (c) above at
initial recognition, the tranche must be measured at fair value through profit or loss.
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 719
