Last update 22/12/2019
IFRS 9-The SPPI test explained by example – The solely payments of principal and interest (SPPI) test requires that the contractual terms of the financial asset (as a whole) give rise to cash flows that are solely payments of principal and interest on the principal amounts outstanding ie cash flows that are consistent with a basic lending arrangement.
In this case, interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.
In order to meet this condition, there can be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Leverage is generally viewed as any multiple above one. IFRS 9-The SPPI test explained by example
However, unlike leverage, certain contractual provisions will not cause the ‘solely payments of principal and interest’ test to be failed. For example, contractual provisions that permit the issuer to pre-pay a debt instrument or permit the holder to put a debt instrument, back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest as long as the following certain conditions are met: IFRS 9-The SPPI test explained by example
- The pre-payment 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). IFRS 9-The SPPI test explained by example
Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument are also regarded as being solely payments of principal and interest, provided during the term of the extension the contractual cash flows are solely payments of principal and interest as well (for example, the interest rate does not step up to some leveraged multiple of LIBOR) and the provision is not contingent on future events. IFRS 9-The SPPI test explained by example
IFRS 9-The SPPI test explained by example!!!
Here are some examples to obtain an understanding for the IFRS reasoning: IFRS 9-The SPPI test explained by example
Loan with zero interest and no fixed repayment terms
Relevant IFRS paragraphs [IFRS 9.B4.1.7] – [IFRS 9.B4.1.9] IFRS 9-The SPPI test explained by example
Parent A provides a loan to Subsidiary B. The loan is classified as a current liability in Subsidiary B’s financial statements and has the following terms:
- No interest; IFRS 9-The SPPI test explained by example
- Repayable on demand of Parent A. IFRS 9-The SPPI test explained by example
Question: Does the loan meet the SPPI contractual cash flows characteristic test?
Answer: Yes.
The terms provide for the repayment of the principal amount of the loan on demand. The solely payments of principal and interest (SPPI) test
Loan with zero interest repayable in 5 years
Parent A provides a loan of CU10 million to Subsidiary B. The loan has the following terms: The solely payments of principal and interest (SPPI) test
- No interest;
- Repayable in five years.
Question:
Does the loan meet the SPPI contractual cash flows characteristic test?
Answer: Yes.
The principal (fair value) is CU10 million discounted to its present value using the market interest rate at initial recognition. The final repayment of CU10 million represents a payment of principal and accrued interest.
Loan with interest rate cap
Entity B lends Entity C CU5 million for five years, subject to the following terms:
- Interest is based on the prevailing variable market interest rate;
- Variable interest rate is capped at 8%;
- Repayable in five years.
Question: Does the loan meet the SPPI contractual cash flows characteristic test?
Answer: Yes.
Contractual cash flows of both a fixed rate instrument and a floating rate instrument are payments of principal and interest as long as the interest reflects consideration for the time value of money and credit risk. Therefore, a loan that contains a combination of a fixed and variable interest rate meets the contractual cash flow characteristics test.
Loan with profit linked element
Entity D lends Entity E CU500 million for five years at an interest rate of 5%.
Entity E is a property developer that will use the funds to buy a piece of land and construct residential apartments for sale. In addition to the 5% interest, Entity D will be entitled to an additional 10% of the final net profits from the project.
Question: Does the loan meet the SPPI contractual cash flows characteristic test?
Answer: No.
The profit linked element means that the contractual cash flows do not reflect only payments of principal and interest that consist of only the time value of money and credit risk. Therefore, the loan will fail the requirements for amortised cost classification. Entity D will account for the loan at fair value through profit or loss.
See also: The IFRS Foundation