We are nearing the end of 2016, which means that the mandatory adoption of IFRS 9 is just over a year away! That means if you haven’t yet begun your implementation of this new financial instruments standard, it’s time to start moving.
Classification and measurement of financial assets is one part of the comprehensive standard on financial instruments (IFRS 9), but also an area that will impact almost all entities, whether you hold trade receivables, debt and equity investments, or loans. Under IFRS 9, financial assets are classified into one of three* categories:
- Amortized cost
- Fair value through OCI (FVOCI)
- Fair value through P&L (FVPL)
These categories are presented in this order as the guidance stipulates that entities must “earn” the right to classify their “debt” financial assets at amortized cost. If not “earned”, then FVOCI may be possible, and finally, if neither qualifies, FVPL is, by default, the category that applies.
Note that equity and derivative financial assets are classified as FVPL in almost all instances, with the exception of certain equity financial assets that are elected to be classified as FVOCI; however, for these instruments, there is “no recycling” of unrealized or realized gains or losses through P&L. We’ll save equity securities for another blog down the road!
Classification of Debt Financial Assets
In order for a financial asset with the characteristics of debt to be classified as either amortized cost or FVOCI, two assessments must be made. One of these assessments, the “contractual cash flow characteristics” test is quite objective and rules-based, while the other assessment, the “business model” assessment is very subjective and principals-based. As consideration of the objective test on cash flow characteristics often will result in a definitive classification, we recommend you consider this first, even though within IFRS 9 it is addressed second.
This chart from one of our IFRS 9 courses lays out the process for analysis, highlighting the considerations for financial assets with debt characteristics.
Contractual Cash Flow Characteristics (a.k.a. SPPI) Test
In order for a financial asset to be classified as either amortized cost or FVOCI, the asset must have contractual cash flows that represent “solely payments of principal and interest” (SPPI) on the principal amount outstanding. In other words, a financial asset must have a principal amount, and payments earned over the life of the instrument for interest that are contractual.
For this reason, equity and derivative instruments are clearly eliminated from amortized cost or FVOCI classification. However, debt securities may qualify. IFRS 9 specifically defines what it means by SPPI and therefore, this assessment is generally an objective one that requires an understanding of the specific terms of the financial instrument’s contractual terms.
Principal should be quite straightforward and represents the fair value of the financial asset at initial recognition. But it may change over the life of the asset, such as the case when principal payments are repaid over the life of the instrument (e.g. an amortizing loan).
Interest, on the other hand, is more interesting. As defined by IFRS 9, interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time, and for the basic lending risks and costs, as well as a profit margin. This means that compensation for anything other than these factors that are generally consistent with a “plain vanilla” lending arrangement would likely cause the instrument to fail the SPPI test.
Below are some examples of typical securities and whether or not they pass the SPPI test:
Typical instruments that pass the SPPI test:
- Fixed rate trade receivables, debt securities and loans
- Variable rate instruments that are tied to a typical interest rate benchmark (e.g. LIBOR, US Treasury, etc.) where the rate is in line with the term of the instrument until the next interest reset date
Typical instruments that will require close assessment and may fail the SPPI test:
- Bonds that pay interest based on the change in price of a stock or stock index
- Loans whose interest is variable and based on revenues for a given period
- Convertible bonds
- Other “hybrid instruments” that would have required separation of its embedded derivative under IAS 39
Generally speaking, those instruments that were determined to have embedded derivatives requiring separation under IAS 39 will likely fail the SPPI test under IFRS 9; however, there may be other instruments that did not require separation under IAS 39 that will also fail the SPPI test.
In order to make this assessment, each financial asset debt contract must be reviewed and its contractual terms must be analyzed to determine whether or not the SPPI test has been met. Although this assessment is more objective in nature, special consideration may need to be given to features such as prepayments, extensions, credit protective measures, and others that may or may not impact the assessment.
If it is determined that the contractual cash flows from the financial asset represent payments solely related to principal and interest, then the second assessment must be performed.
Business Model Assessment
Unlike the SPPI test, the business model assessment requires more judgment and is based on how an entity “manages” its financial assets to general cash flows. The business model may be identified as:
- “to hold and collect contractual cash flows” – in which case amortized cost classification is appropriate
- “to hold and collect contractual cash flows AND to sell financial assets” – in which case FVOCI is appropriate
- Neither of the above – in which case FVPL classification is appropriate
This business model assessment is determined by “key management personnel”, which should be a higher level of aggregation representing the level at which the assets are managed to achieve a particular business objective.
The fact that this assessment be performed at a higher level means that not every asset in the portfolio need meet the business model itself, but rather the portfolio as a whole. Therefore, some sales prior to a financial asset’s maturity may not tarnish the portfolio’s business model “to hold and collect contractual cash flows”. In other words, the strict restrictions of the old IAS 39 category “held to maturity” no longer exist! However, the more sales that occur within the portfolio, the more difficult it is to assert the overall business objective is “to hold and collect contractual cash flows” or maybe even “to hold and collect contractual cash flows AND to sell financial assets”.
As you can see, judgment will need to be applied, as there are no definitive rules to assist with the business model assessment. However, IFRS 9 does state that the business model is a “matter of fact” and not merely an assertion. In other words, an entity’s actions should be observed that support the business model and its objectives for the financial assets!
Let us know if we can help
In our IFRS Update and Hot Topics course, we provide a variety of examples to help reinforce this combination of objective and subjective considerations that must be made to properly classify financial assets under IFRS 9. Let us know if you have any questions and we’d be happy to make sure your IFRS 9 implementation is getting started on the right foot!
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