IFRS 9 The Solely Payments of Principal and Interest Test is a necessary condition (see IFRS 9 Classification and Measurement of Financial Instruments) for classifying loans and receivables at Amortized Cost or FVOCI. This means that the contractual payments give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding.
The classification of non-equity instruments (financial assets) under IFRS 9 is dependent on two key criteria:
- The business model within which the asset is held (the business model test), and
- The contractual cash flows of the asset (the SPPI test).
We discuss the key aspects the SPPI test below. Instruments that fail this test are classified and measured at FVPL.
Meaning of principal and interest
IFRS 9 defines principal as the fair value of a financial asset at initial recognition, which may change over the life of a financial instrument (for example, if there are repayments of principal). Interest is the 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 other basic lending risks (e.g., liquidity risks) and costs (e.g., administrative costs), as well as a profit margin.
Observe: The objective of the SPPI test is to determine whether an arrangement pays only interest and principal, as defined, not to quantify their respective amounts. Ordinarily, it should be possible to establish this by considering the nature of the lender’s rights to cash flows, and the cash flows risks and volatility to which the lender is exposed.
IFRS 9 provides general guidance, discussed below, to assist in this evaluation. As a general rule, loans and receivables that require only fixed payments on fixed dates, or only fixed and variable payments where the amount of the variable payment for a period is determined by applying a floating market rate of interest for that period (e.g., the BA rate, the prime rate, or LIBOR) plus a fixed spread to a specified reference amount (such as a stated maturity amount) will have payments that meet the SPPI test.
IFRS 9 states that in concept, instruments which are not loans and receivables in legal form still might pass the SPPI test.
Factors to consider in applying the SPPI test
IFRS 9 identifies the following factors as being relevant in applying the SPPI test:
- Whether payment terms are “not genuine” or “de minimis”
- Rights in bankruptcy or when non-payment happens
- Arrangements denominated in a foreign currency IFRS 9 The Solely Payments of Principal and Interest Test
- Prepayment and term extending options
- Other contingent payment features
- Non-recourse arrangements IFRS 9 The Solely Payments of Principal and Interest Test
- The time value of money element of interest
- Contractually linked instruments (tranches) and negative interest rates
1. Whether payment terms are “not genuine” or “de minimis” IFRS 9 The Solely Payments of Principal and Interest Test
Contract terms that are not genuine or de minimis should not be considered in applying the SPPI test. A payment term is not genuine if it affects an instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. It is de minimis only if it is de minimis in every reporting period and cumulatively over the life of the financial instrument.
2. Rights in bankruptcy or when non-payment happens IFRS 9 The Solely Payments of Principal and Interest Test
An instrument has contractual cash flows that are solely payments of interest and principal only if the debtor’s non-payment is a breach of contract and the holder has a contractual right to unpaid amounts of principal and interest in the event of the debtor’s bankruptcy.
|Observe: Consider an investment in preferred shares that is mandatorily redeemable at par plus accrued dividends. Typically on bankruptcy such shares are entitled to a priority claim in any remaining net assets up to their preference amount, but not a fixed legal claim on the preference amount itself. Accordingly, investments in mandatorily redeemable preference shares may fail the SPPI test.|
3. Arrangements denominated in a foreign currency IFRS 9 The Solely Payments of Principal and Interest Test
Principal and interest determinations should be assessed in the currency in which loan payments are denominated.
Observe: This guidance applies only to lending arrangements where all payments are denominated in the same foreign currency. It is not relevant to arrangements with what would have been considered embedded foreign currency derivatives under IAS 39. IFRS 9 The Solely Payments of Principal and Interest Test
4. Prepayment and term extending options IFRS 9 The Solely Payments of Principal and Interest Test
IFRS 9 states that a contract term that permits the issuer to prepay a debt instrument, or the holder to put a debt instrument back to the issuer before maturity, does not violate the SPPI test in the following situations:
- The prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding; or
- The prepayment amount substantially represents the contractual paramount and accrued but unpaid contractual interest, the instrument was acquired or originated at a premium or discount to the contractual paramount, and when the instrument is initially recognized, the fair value of the prepayment feature is insignificant.
In both cases, the prepayment amount can include reasonable additional compensation for the early termination of the contract.
Similarly, the SPPI test is not violated if an arrangement includes an option that allows the issuer or borrower to extend the contractual term of a debt instrument and the terms of the option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding. Payments may include a reasonable amount of additional compensation for the extension of the contract.
Observe: Often under IAS 39 entities did not compute the fair value of prepayment options where loans were pre-payable at par because generally such prepayment options were considered closely related to the host contract and thus not an embedded derivative that has to be measured at FVPL. By contrast, IFRS 9 requires that the entity assess whether the fair value of the prepayment feature is significant for loans acquired or issued at a premium or discount and therefore adds to the complexity of the analysis for the classification of such instruments. Entities will need to develop a policy to assess “significance” in this context.
5. Other contingent payment features IFRS 9 The Solely Payments of Principal and Interest Test
Lending agreements often include contingent payment terms, which could change the timing or amount of contractual cash flows for reasons other than changes in market rates of interest, prepayments or term extensions. IFRS 9 gives two such examples:
- A contractual term where the interest rate specified in the arrangement resets to a higher rate if the debtor misses a particular number of payments.
- A contractual term where the specified interest rate resets to a higher rate if a specified equity index reaches a particular level.
For such features, IFRS 9 states that an entity must assess whether the contractual cash flows that could arise both before, and after, such a change to determine whether the contract terms give rise to cash flows that are solely payments of principal and interest. It also states that while the nature of the contingent event (i.e., the trigger) is not a determinative factor, it may be an indicator. For example, it is more likely that the interest rate reset in the first case results in payments that are solely payments of principal and interest because of the relationship between the missed payments and an increase in credit risk.
Observe: In the Basis for Conclusions, the IASB emphasizes that all contingent payment features should be assessed the same way; that is, there should be no difference in the way prepayment and other contingent payment features are evaluated. As a result, it is always appropriate to consider whether a contingent payment feature has a significant impact on cash flows.
It rarely will be the case that an entity will be able to form a judgment whether the SPPI test is met in contingent payments arrangements without considering the nature of the contingent event. In the second case in the IASB example, for instance, the increase in the interest rate as the result of the change in the equity index would most likely be viewed as a return for accepting equity price exposure rather than interest income, notwithstanding that it only changes the interest rate. In effect, the lender is taking a position on the future direction of equity prices, which is not consistent with a basic lending arrangement.
6. Non-recourse arrangements IFRS 9 The Solely Payments of Principal and Interest Test
IFRS 9 emphasizes that the fact that a financial asset may have contractual cash flows that in form qualify as principal and interest does not necessarily mean that the asset will pass the SPPI test. Lending arrangements where a creditor’s claim is limited to specified assets of the debtor or the cash flows from specified assets (so-called “non-recourse” financial assets) may not, for example. For such arrangements, the lender must “look through” to the underlying assets or cash flows in making this determination. If the terms of the financial asset give rise to any other cash flows or otherwise limit the cash flows, the asset does not meet the SPPI test.
Observe: Consider a non-recourse loan whose principal amount finances 100% of the cost of a portfolio of equity instruments that will be sold when the loan is due. In this situation, a decline in the value of the portfolio below its cost will reduce the cash flows available to repay the lender; i.e., under the terms of the arrangement the lender is exposed to changes in the value of the equity portfolio (in effect, the lender has written a put option on the portfolio). The SPPI test thus is not met.
7. The time value of money element of interest IFRS 9 The Solely Payments of Principal and Interest Test
IFRS 9 states that in determining whether a particular interest rate provides consideration only for the passage of time, an entity applies judgment 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 addresses the example where the tenor of a floating rate loan is modified so that it does not correspond exactly to the interest rate reset period. For example, the interest rate resets every month to a one year rate or to an average of particular short- and long-term rates rather than the one month rate. It states that this feature introduces a variability in cash flows that is not consistent with a basic lending arrangement. In such circumstances, the entity must consider whether the modification is significant by performing a qualitative or quantitative assessment.
The objective is to establish on an undiscounted basis how different the asset’s contractual cash flows could be from the cash flows that would arise if there was a perfect link between the interest rate and the period for which the rate is set. A difference may be significant if it could be significant in a single reporting period or cumulatively over the life of the instrument. If a difference is significant, the SPPI test is not met.
IFRS 9 contains: IFRS 9 The Solely Payments of Principal and Interest Test
- complex requirements for debt instruments issued in tranches whose terms create concentrations of credit risk (i.e., lower ranking tranches absorb the first dollars of credit risk before higher ranking tranches often occurring in interests held in securitizations; and
- a special exception for loans that pay a negative interest rate.
See also: The IFRS Foundation