Contractual cash flow assessment approach

The staffs proposed approach would be that a financial asset could be eligible for a measurement category other than fair value through profit or loss ('FVTPL') (presuming the business model criterion is also met) if the contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Features in an instrument that are other than solely principal and interest would result in classification at FVTPL. The assessment would be made at initial recognition and would not be reassessed for subsequent reclassification based on the terms of the instrument.

The staff described the proposed approach as using 'building blocks' of principal and compensation for the time value of money and the associated credit risk. If an asset includes a feature other than a building block, even if that feature is expected to be insignificant, then the instrument must be measured at FVTPL. However, if the financial asset contains only the relevant building blocks but the relationship between the building blocks is modified, then the entity would need to consider the effect of the modification in determining whether the asset's cash flows are still solely principal and interest. An example of the building blocks being modified would be an asset with annual interest rate resets but the interest rate resets based on a three year rate. The IASB staff noted that this approach was broadly consistent with IFRS 9 but expands the notion of principal and interest by permitting consideration of the effect of modifications of the relationship between building blocks which they believe will help to address some of the practice issues raised.

The boards tentatively decided that a financial asset could be eligible for a measurement category other than FVTPL (presuming the business model criterion is also met) if the contractual terms of the financial asset result in cash flows that are solely payments of principal and interest on the principal amount outstanding. Principal is the amount transferred at initial recognition while interest is consideration for the time value of money and the associated credit risk. If a financial asset contains a component other than principal or compensation for time value of money and credit risk, then the financial asset must be measured at FVPL. If the financial asset only contains components that are principal and consideration for the time value of money and credit risk, but the relationship between them is modified, an entity would need to consider the effect of the modification when assessing whether the cash flows on the financial asset are still consistent with the notion of being solely principal and interest. If the financial asset only contains components that are principal and the consideration for the time value of money and credit risk, and the relationship between them is not modified, the financial asset could be eligible for a measurement category other than FVTPL.

Contingent cash flows

The Boards then discussed how contingent features on an instrument should be considered in the cash flow characteristics assessment. The staff highlighted the importance of distinguishing between variable cash flows and contingent cash flows. In the staff's view, variable cash flows are consistent with the notion of principal and interest if the variability reflects only changes in the time value of money and the associated credit risk while contingent cash flows arise or cease as a result of an uncertain future event. The staff believes that contingent cash flows can be either solely principal and interest or not solely principal and interest. To illustrate the difference, the staff used the example of an entity issuing private placement debt with the understanding that the debt will be offered publicly in the next year. If the public offering does not occur and the interest rate resets to a market rate for comparable private debt, this would be consistent with the notion of solely principal and interest as the contingency is introduced to appropriately price the credit (and liquidity) risk of the asset. However, if the public offering does not the occur and the interest rate resets to a punative rate for the remaining life of the instrument, then the feature has been introduced to induce the public offering and does not represent compensation for time value of money or credit risk.

One of the FASB members noted the agenda paper referenced liquidity risk in a footnote to credit risk. He suggested that if the Boards want to include liquidity risk as one of the 'building blocks' then it should be specifically included rather than being included as a component of another risk.

The boards tentatively decided that contractual terms which change the timing or amount of payments of principal and interest would not preclude the financial asset from being eligible for a measurement category other than FVTPL if the variability reflects only changes in the time value of money and the associated credit risk of the instrument. The boards also tentatively decided that the probability of contingent cash flows that are not solely principal and interest should not be considered. Financial assets that contain contingent cash flows that are not solely principal and interest would be measured at FVTPL unless they relate to non-genuine features. For the IASB, this does not represent a change to IFRS 9.

Economic relationship between principal and interest

As noted above, the Boards tentatively decided that if the relationship between the 'building blocks' are modified, then an entity would need to consider the effect on the modification to determine whether the cash flows represent solely principal and interest. The staff noted that examples of features which could be subject to this assessment could include interest rate mismatches and use of leverage. The staff suggested that in order to perform this assessment, an entity would need a benchmark instrument with contractual cash flows that are solely principal and interest. This benchmark instrument would need to have the same credit quality and terms, except for the term under evaluation. The staff proposed that if the different between the cash flows of the benchmark instrument and instrument being assessed with the modified feature is more than insignificant then the instrument must be measured at FVTPL as it contains cash flows that are not solely principal and interest. The staff did not propose quantifying an insignificant deviation of cash flows as they believe an entity must apply judgement in making this assessment. However, the staff did note that the threshold would be considerably lower than the 'double-double' test.

One of the IASB members questioned the staff on what sort of application guidance would be provided raising the concern of trying to reduce divergence in application. The staff noted that the analysis of leverage and of 'Instrument B' in the application guidance to IFRS 9 could be further clarified.

One of the FASB members noted that this would be a big change from the double-double test and that the FASB would need to think about the appropriate application guidance that would be required.

The Boards tentatively decided an entity would need to compare a financial asset with modified features (eg, a variable interest rate that does not match the interest rate reset period) to a benchmark instrument that contains features that are solely principal and interest to assess the effect of the modification. An appropriate benchmark instrument would be a contract of the same credit quality and with the same terms, except for the contractual term under evaluation. The boards also tentatively decided that if the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, the instrument must be measured at FVTPL as its contractual cash flows do not represent solely principal and interest.

Prepayment and extension options

The Boards next discussed the impact of prepayment and extension options on financial assets subject to the contractual cash flow characteristics test. The staff noted that if prepayment and extension options are exercised they change the maturity of the financial asset resulting in variability in both the timing and amount of cash flows and the return on the instrument. However, variability in cash flows is not necessarily inconsistent with the notion of solely principal and interest and therefore prepayment and extension options do not automatically preclude an instrument from being measured at other than FVTPL.

For prepayment options, if the prepayment amount represents the outstanding amount of principal and interest then that would represent cash flows that are solely principal and interest. However, if the financial asset can be prepaid at an amount other than the outstanding principal and interest, then that would result in cash flows that are not solely principal and interest. If the financial asset has been acquired at a significant premium or discount and can be prepaid at par, then this would not represent cash flows that are solely principal and interest. The staff highlighted that both IFRS 9 and the FASB's tentative model contain guidance on prepayment options. IFRS 9 provides that prepayment options are cash flows representing principal and interest if 'the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding'. The FASB's model states that a debt instrument must be measured at FVTPL if the instrument can 'contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its initial investment, other than through its own choice'.

Extension options are the inverse of prepayment options and therefore also do not preclude an instrument from being measured at other than FVTPL if the cash flows during the extension period are solely principal and interest. The staff highlighted that under IFRS 9 the interest rate does not need to be reset at the beginning of the reset period for the cash flows to represent solely principal and interest while the FASB model the interest rate must be reset upon the exercise of the extension option to the current market rate for a hybrid financial asset to qualify in its entirety for a measurement category other than FVTPL. The staff also highlighted that prepayment and extension options often are embedded in contingencies, for example, an instrument is prepayable upon a change in control of the entity. The staff noted that contingent prepayment and extension options could be eligible for measurement at other than FVTPL if the resulting cash flows are solely principal and interest and the nature of the contingency is related to the time value of money and the associated credit risk.

The FASB Chair noted that the inclusion of the phrase 'through its own choice' in the FASB model was crucial as it had been included to resolve a practice issue and wanted assurance that it would be carried forward. An IASB member questioned whether the IASB planned to include the 'through its own choice' language in their guidance suggesting they do so.

The Boards tentatively decided that a prepayment or extension option, including those whose exercise are based on contingencies, would not preclude a financial asset from being eligible for a measurement category other than FVTPL as long as these features are consistent with the notions of solely principal and interest. No changes to IFRS 9 would need to be made based on this tentative decision but for the FASB the guidance will be included as part of the contractual cash flow characteristics assessment.

Business model assessment education session

The Boards also held an education session to discuss the business model assessment under IFRS 9 and the FASB's classification and measurement model. No decisions were made at this education session.