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].
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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
>
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
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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
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 715