Changes in contractual provisions

Last update 01/12/2019

Changes in contractual provisions – How do you account for contractual provisions in a financial instruments contract that change the timing or amount of contractual cash flows?

Contractual cash flows of some financial assets may change over their lives. For example, an asset may have a floating interest rate. Also, in many cases an asset can be prepaid or its term extended. [IFRS 9 B4.1.10, IFRS 9 B4.1.12] Changes in contractual provisions

For such assets, an entity determines whether the contractual cash flows that could arise over the life of the instrument meet the SPPI criterion. It does so by assessing the contractual cash flows that could arise both before and after the change in contractual cash flows.

In some cases, contractual cash flows may change on the occurrence of a contingent event. In these cases, an entity assesses the nature of the contingent event. Although the nature of the contingent event in itself is not a determinative factor in assessing whether the contractual cash flows meet the SPPI criterion, it may be an indicator.

IFRS 9 provides the following examples of contractual terms that change the timing or amount of contractual cash flows and meet the SPPI criterion.

Contractual changes in timing or amount of cash flows that meet the SPPI test [IFRS 9 B4.1.11]

Variable interest rate

Changes in contractual provisions

A variable interest rate that consists of consideration for:

the time value of money;
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);
other basic lending risks (e.g. liquidity risk) and costs (e.g. administrative costs); and
a profit margin.

Prepayment feature

Changes in contractual provisions

A prepayment feature:

that permits the issuer (i.e. the debtor) to prepay a debt instrument or permits the holder (i.e. the creditor) to put the debt instrument back to the issuer before maturity; and
whose 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.

Term extension feature

Changes in contractual provisions

A term extension feature that:

permits the issuer or the holder to extend the contractual term of a debt instrument – i.e. an extension option; and
results 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.

An instrument whose interest rate is reset to a higher rate if the debtor misses a particular payment may meet the SPPI criterion because of the relationship between missed payments and an increase in credit risk. [IFRS 9 B4.1.10]

This can be contrasted with contractual cash flows that are indexed to the debtor’s performance – e.g. net income. In such cases, the contractual feature would generally reflect a return that is inconsistent with a basic lending arrangement and would not meet the SPPI criterion – unless the indexing results in an adjustment that only compensates the holder for changes in the credit risk of the instrument. [IFRS 9 B4.1.10, IFRS 9 B4.1.13]

Variable compensation for credit risk Changes in contractual provisions

In many cases, the component of a variable interest rate that represents compensation for credit risk is fixed at initial recognition. However, in some cases this may not be the case and the compensation for credit risk may vary in response to perceived changes in the creditworthiness of the borrower – e.g. if covenants are breached. [IFRS 9 B4.1.11]

If there are variations in the contractual cash flows of an instrument related to credit risk, then an entity considers whether the variations can be regarded as compensation for credit risk, and therefore whether the instrument may meet the SPPI criterion.

Prepayment at fair value with ‘make-whole’ clauses Changes in contractual provisions

A bond may contain a ‘make-whole’ clause – e.g. on early termination, the exercise price is based on the higher of:

the fair value of future payments of principal and interest; and
the principal amount plus accrued interest.

In this case, it appears that it is possible that the SPPI criterion may be met. This is because the additional amount payable under the make-whole clause if the fair value is higher may represent reasonable additional compensation for early termination.

Mutual agreement to make changes to the contract Changes in contractual provisions

Sometimes, a contract may include a clause that provides for the parties to mutually agree to make specified changes to the terms of the contract at some point in the future. It appears that if a change of terms is subject to the future free and unconstrained mutual agreement of both parties, then it is not a cash flow characteristic that is included in the initial SPPI assessment. Such a clause would not preclude the contract from meeting the SPPI criterion.

Changes in contractual provisions

Related posts: