[IFRS 9.B4.1.11]
(a) a variable interest rate that is consideration for the time value of money and for
the credit risk associated with the principal amount outstanding during a particular
period of time (the consideration for credit risk may be determined at initial
recognition only, and so may be fixed) and other basic lending risks and costs, as
well as a profit margin (which are also likely to be fixed);
(b) a contractual term that permits the issuer (i.e. the debtor) to prepay a debt
instrument or permits the holder (i.e. the creditor) to put a debt instrument back
to the issuer before maturity and the prepayment amount substantially represents
unpaid amounts of principal and interest on the principal amount outstanding,
which may include reasonable additional compensation for the early termination
of the contract; and
(c) a contractual term that permits the issuer or holder to extend the contractual term
of a debt instrument (i.e. an extension option) and the terms of the extension
option result in contractual cash flows during the extension period that are solely
payments of principal and interest on the principal amount outstanding, which
may include reasonable additional compensation for the extension of the contract.
Unfortunately, neither the standard itself nor the Basis for Conclusions specify what the
IASB meant by ‘reasonable additional compensation’, although it seems clear that the
IASB regards compensation to mean a payment by the party exercising the prepayment
option to the other party. It also seems appropriate to include as reasonable additional
compensation direct or indirect costs attributable to early termination or extension,
ranging from costs for the additional paper work to costs for adjusting a bank’s hedging
relationships. Penalties, imposed by the lender on the borrower with the aim of
reducing the lender’s interest rate risk and discouraging the borrower from prepaying
the debt, could also, in certain circumstances, be considered to be reasonable additional
compensation. This would be dependent on facts and circumstances such as whether
the penalty clause was genuine and the expectation of whether the penalty would be
triggered. If the borrower is not expected to exercise the prepayment option except in
extremely rare or highly abnormal situations then the penalty feature would not be
genuine and the asset would pass the contractual cash flows test. [IFRS 9.B4.1.18].
6.4.4.A
Prepayment – negative compensation
A financial asset can still meet the SPPI condition and be eligible for classification at
amortised cost even if the contractual prepayment amount is more or less than the
unpaid amounts of the principal and interest. This is because IFRS 9 contemplates
either the borrower or the lender terminating the contract early. If the borrower
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terminates the loan early, the borrower may have to compensate the lender and the
prepayment amount might be more than the unpaid amount of principal and interest. If
the lender terminates the loan early, then the lender may need to compensate the
borrower and so, in this case, the prepayment amount might be less than the unpaid
amounts of principal and interest. In other words, with these asymmetrical break
clauses, depending upon which party terminates the contract early, ‘reasonable
additional compensation’ can include a prepayment amount which is more or less that
the unpaid amounts of principal and interest.
But this is not the case with a symmetrical break clause which results in the party
triggering early termination of the loan receiving rather than paying compensation
(‘negative compensation’). This could occur if the current market interest rate is higher
than the effective interest rate of the debt instrument. In that case, with a symmetrical
break clause, a prepayment by the borrower will be less than the unpaid amounts of
principal and interest and therefore lead to the lender effectively compensating the
borrower for the increase in interest rates even if the borrower chooses to prepay the
debt instrument. Such a feature would fail the contractual cash flow test and result in
the instrument being measured at fair value through profit and loss.
In October 2017, the IASB issued a narrow scope amendment to IFRS 9 to address this
issue. The amendment clarified that a financial asset with a symmetrical prepayment
option can be measured at amortised cost or fair value through other comprehensive
income. A financial asset meets the contractual cash flow requirements if a contractual
term permits (or requires) the issuer to prepay, or the holder to put back to the issuer,
a debt instrument before maturity and the prepayment amount substantially represents
unpaid amounts of principal and interest on the principal amount outstanding including
reasonable compensation for the early termination of the contract, which irrespective
of the event or circumstance that causes the early termination of the contract, may be
paid or received. For example a party may pay or receive reasonable compensation
when it chooses to terminate the contract early or otherwise causes the early
termination to occur. [IFRS 9.B4,1.12A].
This condition ensures that the amendment only captures those financial assets that
would otherwise have contractual cash flows that are solely payments of principal and
interest but do not meet that criterion solely because a prepayment feature may give
rise to negative compensation.
The IASB noted that compensation that reflects the effect of the change in the relevant
market interest rate (e.g. interest lost as a result of early terminating the contract) did
not introduce any contractual cash flows that were different from cash flows which
were already accomodated by the existing exemption for prepayments which contain
positive compensation. [IFRS 9.BC4.225].
The IASB also noted that some financial assets are prepayable at their current fair value
and others are prepayable at an amount that includes the fair value cost to terminate an
associated hedging instrument. The IASB acknowledged that there may be
circumstances in which such features meet the contractual cash flow requirements. It
provided, as an example, the case when the calculation of the prepayment amount is
intended to approximate to unpaid amounts of principal and interest plus or minus an
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amount that reflects the effect of the change in a relevant benchmark interest rate.
However the IASB also noted that this will not always be the case. [IFRS 9.BC4.232].
Therefore, an entity will have to assess the specific contractual cash flows for such
instruments rather than automatically assuming that they will meet the contractual cash
flow requirements.
The narrow scope amendment only applies to situations where the compensation is
symmetrical and the signage is negative. Prepayments that include cash flows that
reflect changes in an equity or commodity index will not meet this requirement.
The amendment is effective for annual periods beginning on or after 1 January 2019
with retrospective application required. Earlier application
is permitted.
USB Group AG, in its 2018 interim consolidated financial statements, considered the
classification of instruments with two-way compensation clauses.
Extract 44.1: UBS Group AG (2018 interim consolidated financial statements)
Notes to the UBS Group AG interim consolidated financial statements (unaudited) [extract]
19
Transition to IFRS 9 as of 1 January 2018 [extract]
Contractual cash flow characteristics
In assessing whether the contractual cash flows are SPPI, the Group considers whether the
contractual terms of the financial asset contain a term that could change the timing or amount of the
contractual cash flows arising over the life of the instrument, which could affect whether the
instrument is considered to meet the SPPI criteria.
For example, the Group holds portfolios of private mortgage contracts and corporate loans in Personal &
Corporate Banking that commonly contain clauses that provide for two-way compensation if prepayment occurs.
The amount of compensation paid by or to UBS reflects the effect of changes in market interest rates. The Group
has determined that the inclusion of the change in market interest rates in the compensation amount is reasonable
for the early termination of the contract, and therefore results in contractual cash flows that are SPPI.
The IASB issued a webcast in June 2018, clarifying that a prepayment feature must be
analysed to determine whether it gives rise to contractual cash flows that meet the
contractual cashflows characteristics test, rather than relying on how the feature is
labelled or whether it is likely to be triggered or whether it reflects market practice. It
also confirmed that in order to be eligible to be measured at amortised cost or fair value
through other comprehensive income a prepayable financial asset must meet the
criteria outlined above or all the conditions relating to assets originated at a premium
or discount described in 6.4.4.B below.
6.4.4.B
Prepayment – assets originated at a premium or discount
The strict application of the definition of principal in 6.1 above would mean that debt
instruments originated or acquired at a premium or discount, and which are prepayable
at par, have to be measured at fair value through profit or loss. This is because, if the
issuer prepays, the holder may receive a gain that is less than or in excess of a basic
lending return. The IASB, however, decided to provide a narrow scope exception.
Financial assets originated or acquired at a premium or discount that would otherwise
have cash flows that are principal and interest, except for the effect of a prepayment
option, are deemed to meet the above conditions, but only so long as: [IFRS 9.B4.1.12]
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(a) the prepayment amount substantially represents the contractual par amount and
accrued (but unpaid) interest, which may include reasonable additional
compensation for the early termination of the contract; and
(b) the fair value of the prepayment feature on initial recognition of the financial asset
is insignificant.
As a result of the amendment for prepayments with negative compensation, discussed
above, the IASB also amended the criteria for a) to clarify that reasonable compensation
includes compensation paid or received for the early termination of a contract.
[IFRS9.B4.1.12A]. The amendment is effective for periods beginning after 1 January 2019
with early adoption permitted.
The conditions described above apply regardless of whether (i) the prepayment
provision is exercisable by the issuer or by the holder; (ii) the prepayment provision is
voluntary or mandatory; or (iii) the prepayment feature is contingent.
This exception would allow some financial assets that otherwise do not have
contractual cash flows that are solely payments of principal and interest to be measured
at amortised cost or fair value through other comprehensive income (subject to the
assessment of the business model in which they are held). In particular, the IASB
observed that this exception will apply to many purchased credit-impaired financial
assets with contractual prepayment features. If such an asset was purchased at a deep
discount, the contractual cash flows would not be solely payments of principal and
interest if, contractually, the asset could be repaid immediately at the par amount.
However, that contractual prepayment feature would have an insignificant fair value if
it is very unlikely that prepayment will occur. [IFRS 9.BC4.193]. Prepayment might be very
unlikely because the debtor of a credit-impaired financial asset might not have the
ability to prepay the financial asset.
Similarly, the IASB observed that this exception will apply to some prepayable financial
assets that are originated at below-market interest rates. For example, this scenario may
arise when an entity sells an item (for example, an automobile) and, as a marketing
incentive, provides financing to the customer at an interest rate that is below the
prevailing market rate. At initial recognition the entity would measure the financial asset
at fair value and, as a result of the below-market interest rate, the fair value would be
at a discount to the contractual par amount. The IASB observed that in that case a
contractual prepayment feature would likely have an insignificant fair value because it
is unlikely that the customer will choose to prepay; in particular, because the interest
rate is below-market and thus the financing is advantageous. [IFRS 9.BC4.194].
For instruments that are initially recognised at a discount, the fair value of the
prepayment option will usually be insignificant, because the discount is a function of
either an increased credit risk of the borrower (as in the first example above) or a
below-market interest rate (as in the second example), and in each case the prepayment
option is unlikely to be exercised and so will have little fair value.
For instruments that are initially recognised at a premium, because the coupon rate is
above the current market rate, the application of this guidance is more difficult. While
the prepayment option will likely have a more than insignificant fair value, this will
usually also be reflected in the fair value at which the asset is acquired. For instance, an
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investor is unlikely to pay above par for a bond that pays an above market rate of
interest if it can be prepaid at par at any time. It would seem that in order for the
prepayment option to be relevant for the asset’s classification, it would need to be
constrained. The expectation would be that the borrower will exercise the option at
the earliest opportunity as it will be in the economic interest of the borrower to do so.
An example would be a bond that pays an above market rate of interest, with a
remaining maturity of five years that can be prepaid but only after three years. Hence
the bond will have an initial fair value greater than par due to the above market rate for
the first three years, but will amortise to par after three years as the borrower is highly
likely to exercise the prepayment option after three years. Consequently the
prepayment amount will substantially represent unpaid
amounts of principal and
interest on the principal amount outstanding at the point the option is exercised and
will therefore pass the contractual cash flow test. [IFRS 9.B4.1.11(b)]. This assessment will
be performed only when the asset is first recognised. For example:
Example 44.20: Prepayable corporate loan recognised at a premium to par
Bank A buys a loan with a notional amount of £10m from another bank for £11m. The loan is to a corporate
and has ten years remaining to maturity and the issuer has the right to prepay the loan at par in five years’ time.
The loan is acquired at a premium as interest rates have fallen significantly since the loan was first advanced.
Bank A believes that exercise of the prepayment option will be beneficial to the corporate issuer and that the
borrower is highly likely to exercise the option. It therefore concludes that the premium on the loan should
be amortised over the following five years and not over the full remaining contractual term of ten years. It
further concludes that when the prepayment option is exercised it will substantially represent unpaid amounts
of principal and interest on the principal amount outstanding and consequently classifies the loan as an
amortised cost instrument.
However it is possible that the borrower may not exercise the option even if it is
beneficial to do so and this makes the assessment more complicated. If there is
uncertainty over whether the prepayment option will be exercised then the contractual
cash flow test may not be met and neither classification as amortised cost nor fair value
thorough other comprehensive income can be applied unless the fair value of the
prepayment amount is insignificant. [IFRS 9.B4.1.11(c)].
This is particularly likely to be an issue with retail loans as, collectively, retail borrowers
can act irrationally and not in accordance with their own best economic interests. Such
behavioural factors are likely to force any entity acquiring a portfolio of retail loans at
a premium to have to assess whether the fair value of the prepayment feature is
insignificant or not. In practice this will probably mean that the entity will need to
compare the fair value of the retail loans with the fair value of similar hypothetical
instruments without the prepayment option and determine whether the difference is
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