Source: KPMG Corporate Treasury News, Edition 47, September 2015
Based on the newsletter contribution which appeared on September 24, 2014, entitled ‘IFRS 9 Classification and Measurement – A Paradigm Change?’, an example is given to present the practical effects on the balance sheet presentation of financial assets for industrial entities arising from transition from IAS 39 to IFRS 9.
IFRS 9 envisages a principles-based classification of financial instruments. Depending on the two significant classification conditions – the business model and the so-called SPPI criterion (solely payments of principal and interest) – financial assets are to be classified in one of the following measurement categories of IFRS 9:
In this regard, the focus is on the SPPI criterion in which contractual cash flows derived from a financial asset solely consist of the principal and interest on the outstanding nominal amount. In addition to compensation for the time value of money and credit risk, interest may contain the following components:
• Premium for the liquidity risk
• Administrative expenses
• Cost of equity
• Profit margin
All contractual agreements which are not consistent with this definition and/or are not a fundamental part of a basic lending agreement result in measurement through profit or loss at fair value. As a result of this strict interpretation of interest and principal, this classification condition has a key bearing on the classification of financial assets in accordance with IFRS 9. In contrast to the determination of the business model, the assessment of the SPPI criterion has also to be made at the level of the individual contract.
For instance, the modified time value of money represents a challenge for the analysis of these contracts. Such circumstances arise when there is divergence between the tenor and fixing period of the underlying interest of a financial instrument. It is necessary to assess whether the interest calculation, despite modification of the tenor, is consistent with the SPPI criterion. For this, the undiscounted cash flows of the financial asset need to be compared with those of a comparable instrument that is not subject to any modification, and examined for materiality.
There are further exceptions for rights of termination and agreements to defer payments. These correspond to a basic lending agreement where the repayment amount mainly comprises the outstanding principal and the interest on the principal. For rights of termination on financial instruments which are received with a premium or discount against the contractual capital amount, the IASB envisages an additional test in order to fulfil the SPPI criterion. In accordance with IFRS 9, the fair value of the early repayment option must be insignificant at the date of addition.
If, in turn, the agreement of a clause deviates from the basic idea of a simple lending agreement, this does not necessarily mean that the financial asset has to be assigned to the FVTPL category. Ultimately, the substance of the agreement determines which category the financial asset is assigned to. Agreements thus do not have an adverse effect on the SPPI criterion if they merely exert an extremely minor influence on cash flows (de minimis) or where occurrence is improbable (not genuine).
Especially in the case of a heterogeneous portfolio of financial instruments, the revised requirements of classification according to IFRS 9 entail analysis that should not be underestimated. Application of the SPPI criterion is not carried out as a one-off in the course of first-time adoption of IFRS 9 but is also implemented in the continuation categorization process. Due to the high level of detail in processes and the imprecisely defined materiality in the standard, entities are recommended to tackle implementation at an early stage.
Author: Dr. Christoph Lippert, Manager, firstname.lastname@example.org
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