Feedback analysis—Assessment of contractual cash flows (Agenda Paper 16)

In March 2023, the IASB published the Exposure Draft Amendments to the Classification and Measurement of Financial Instruments (ED). This paper addressed the feedback received on Question 2 of the ED about contractual terms that are consistent with a basic lending arrangement. The paper asked the IASB for any comments or questions on the staff analysis but does not require the IASB to make any decisions.

One of the findings from the post-implementation review (PIR) of the classification and measurement requirements in IFRS 9 was concerns about growing diversity in practice of assessing whether the contractual cash flow of financial assets with ESG-linked features represent solely payments of principal and interest on the principal outstating (SPPI). The IASB concluded that, rather than create an exception for ESG-linked features, it would be better to provide clarifications to the application guidance for the SPPI assessment, including elements of interest that are consistent with a basic lending arrangement and contractual terms that change the timing and amount of contractual cash flows. Almost all respondents agreed with this approach, however concerns were raised that these clarifications could unintentionally disrupt existing practise. The staff believe this can be addressed by refining the clarifications. The staff highlighted that application guidance should be considered holistically. No specific paragraph or requirement takes precedence or can be applied in isolation.  

The ED also provided proposed examples to illustrate the application of SPPI requirements to financial assets with ESG-linked features. Feedback on these will be provided in a future meeting.

Concept of a basic lending arrangement

Respondents said that the ED mostly contains guidance on what is inconsistent with a basic lending arrangement and does not provide sufficient guidance to identify the types of features that would be consistent with a basic lending arrangement. The staff agree with the respondents and believe this guidance should be considered together with the requirements relating to contractual terms that change the timing or amount of the contractual cash flows.

Considering the size of changes in contractual cash flows

Many respondents observed a contradiction between the following two statements:

• The assessment of interest focuses on what an entity is being compensated for, rather than how much compensation an entity receives; and
• A change in contractual cash flows is inconsistent with a basic lending arrangement if it is not aligned with the direction and magnitude of the change in basic lending risks or costs

Most respondents agreed with first statement but do not support its inclusion, as they noted that IFRS 9 does require an entity to consider how much compensation it receives for a particular element of interest. Most respondents agreed with second statement with regards to the change in cash flows needing to be directionally consistent with a change in basic lending risk or costs, but many raised concerns with the term ‘magnitude’.

The staff acknowledged the concerns that the proposals do not provide sufficient clarity on when and to what extent a consideration of the size of changes in contractual cash flow is needed. In the staff’s view, in cases where it is not clear whether a contractual term that may change the timing or amount of contractual cash flows is consistent with a basic lending arrangement, a helpful consideration might be whether the fair value of a such contractual feature is insignificant.

Contractual terms that change the timing or amount of contractual cash flows (paragraph B4.1.10 of the ED)

Many respondents disagreed with the statement ‘a change in contractual cash flows due to a contingent event that is specific to the creditor or another party would be inconsistent with a basic lending arrangement’. In their view, this could be interpreted to include so-called ‘increased cost clauses’ in which the lender reserves the right to adjust the interest rate due to changes in tax laws or regulations which increase the cost of lending. In the staff’s view, it was not the IASB’s intention to disrupt current market practice.

Many respondents noted that the statement ‘the occurrence (or non-occurrence) of the contingent event must be specific to the debtor’, would preclude any instruments where the ESG-linked targets are set at a consolidated level or for a group entity other than the legal debtor.

Given the shortcomings of the proposal in B4.1.10, the staff believe it is worth considering a different approach to clarifying these principals.

Contingent events specific to the debtor

The staff acknowledged that whilst this can be a useful indicator that contractual cash flows are consistent with a basic lending arrangement, it does not provide sufficient guidance in all circumstances. The staff believe that the requirements in paragraph B4.1.10 of IFRS 9 can be supplemented by clarifying that if a financial asset, that would otherwise have cash flows that are SPPI, contains a contractual feature that would change the timing or amount of contractual cash flows based on the occurrence of a contingent event and the nature of this contingent event does not clearly indicate that the contractual cash flows over the life of the financial asset are SPPI, the instrument could nevertheless have SPPI cash flows if:

• The contractually specified changes in cash flows following the occurrence (or non-occurrence) of any contingent event would give rise to cash flows that are SPPI when considered in isolation; and
• The fair value of this contractual feature at initial recognition is insignificant.

Considering the fair value of the contractual feature could be a good indicator of whether an entity is being compensated for something other than basic lending risks and costs.

Investment in the debtor and performance of specific assets

The staff acknowledged concerns raised about the meaning of ‘investment in the debtor’ and ‘performance of specific assets’. Therefore, to resolve concerns, the wording will be amended to state that the resulting cash flows should not represent ‘an investment in particular assets of cash flows.’

IASB discussion

IASB members were pleased the feedback was supportive, and that the respondents provided helpful feedback. IASB members agreed with the staff’s work so far and believe the staff has addressed the issues in an objective way considering this is a narrow-scope amendment. IASB members made it clear that not all issues raised will be addressed and there will be circumstances in which preparers will have to apply judgement. An IASB member requested that any amendments should be checked to ensure that they do not result in any unintended consequences.

The suggestion made to replace ‘contingent events specific to a debtor’ with clarifications in IFRS 9:B4.1.10 was supported by IASB members as it complements existing guidance in IFRS 9. IASB members pointed out that if an ESG feature had a significant impact on the cash flows it would not meet the SPPI requirement. The staff confirmed that the word ‘insignificant’ is not defined in IFRS 9 but is used throughout the SPPI requirements in IFRS 9 and is therefore a familiar concept. An IASB member suggested to use the term ‘does not dominate the fair value’ in place of ‘insignificant’. However, the staff commented that this might result in unintended consequences, as the SPPI assessment is not about the amount but about the quality of what is received.

An IASB member asked if the clarifications suggested in IFRS 9:B4.1.10, i.e. to perform a comparison of the cash flows and to determine whether a contractual feature is insignificant, would require significant effort by preparers. The staff clarified that in some cases a qualitative assessment could be performed rather than a quantitative assessment. The IASB suggested that this is made clear in the Basis for Conclusions. Another IASB member pointed out that similar requirements are currently in place in IFRS 9 for prepayment features.  

An IASB member raised a concern that any amendments should not result in ‘greenwashing’. The staff clarified that the SPPI assessment is not assessing the economic rationale for entering into these transactions or stating that the ESG term is ingenuine or de-minimis. The assessment is about whether the term has an insignificant impact on the cash flows and that the measurement of these assets would not contribute or reduce any greenwashing. Disclosure of these assets would be important to ensure they have been clearly explained.

No decisions were made.