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

In March 2023, the IASB published the exposure draft Amendments to the Classification and Measurement of Financial Instruments (ED). In October 2023, the staff presented a paper addressing the feedback received on Question 2 of the ED about contractual terms that are consistent with a basic lending arrangement. This paper continues that analysis and asks for the IASB’s approval of the staff recommendations.

In October 2023, the staff noted that almost all respondents agreed with the IASB’s intention to clarify the requirements for assessing whether the contractual cash flows of financial assets are solely payments of principal and interest (SPPI), specifically in the case of financial assets with ESG-linked features. However, the main concerns raised were:

• How the concept of a basic lending arrangement applies in the case of ESG-linked features
• When and how to consider the size of changes in contractual cash flows
• The scope and application of the proposals in paragraph B4.1.10A of the ED, in particular the requirement for a contingent event to be specific to the debtor
• The intention with the reference to ‘neither an investment in the debtor nor an exposure to the performance of specified assets’

In October 2023, in response to the feedback, the staff suggested building on application guidance on the basic lending arrangement, remove reference to the word ‘magnitude’ and instead specifying that the fair value of the contractual term at initial recognition is insignificant, replace the term ‘investment in the debtor’ and ‘performance of specified assets’ with the term ‘investment in particular assets or cash flows.’ The IASB was generally supportive of the staff’s refinements. However, IASB members questioned how the refinements are intended to interact with other requirements in IFRS 9 and had concerns about requiring an entity to assess whether the fair value of the contractual term is insignificant at initial recognition.

Staff recommendation

The staff recommended finalising the proposed amendments to paragraph B4.1.8A of the ED, subject to drafting improvements to clarify that although SPPI focuses on what an entity is compensated for rather than how much compensation the entity receives, the amount of compensation may be an indicator that the lender is being compensated for something other than basic lending risks or costs.

The staff also recommended amending the proposed amendments in paragraph B4.1.10A of the ED to require that, when the nature of the contingent event is not directly related to a change in basic lending risks or costs, a financial asset have contractual cash flows that are SPPI if:

• irrespective of the probability of the contingent event occurring (except where the event is not genuine), the cash flows before and after any contingent event(s), when considered in isolation, are SPPI; and
• the contractual cash flows arising from a contingent event is not significantly different from the cash flows on a similar financial asset without such a contingent event and do not represent an investment in the debtor or in particular assets or cash flows.

The staff further recommended updating the proposed examples in paragraph B4.1.13 and B4.1.14 of the ED based on the above recommendations.

IASB discussion

The majority of the IASB members agreed with the direction the staff had taken in this project. An IASB member highlighted that the model requires judgement in order to assess whether the cash flows are significantly different before and after a contingent event, which he did noy object to. However, he considered that more clarity could be provided around the assessment required if there are multiple contingent events. The staff confirmed that if the contingent events are mutually exclusive, each contingent event would need to be assessed separately whereas if they are not mutually exclusive, they would need to be looked at in aggregate and individually. Even if the probability of the event occurring is small, it would still need to be assessed.

One IASB member asked whether the IASB should explain the term ‘investment in debtor’ as it may cause confusion. The staff confirmed they will consider alternative wording, but the intention is to make it clear that if there is a link to sales targets, or share of profit/revenue, then the instrument would fail SPPI.

One IASB member disagreed with the staff recommendation. In his view, there is a concept of de minimis in IFRS 9 and this amendment would widen this concept. If the difference in cash flows before and after is insignificant, then ESG features have no economic consequence. However, ESG features should have an impact in a broader sense. The staff disagreed and said that the de minimis concept is a very low threshold. They noted that the words used are ‘not significant’ rather than ‘insignificant’ and whilst subtle they sit at different ends of a spectrum. The staff noted that SPPI does not look at whether a term has an economic effect. Instead, it looks at whether the cash flows will change significantly. If they change significantly, then amortised cost as a measurement basis would not provide useful information. Currently, in the majority of contracts, ESG features are not significant. However, if the ESG feature did alter cash flows significantly, then the instrument would fail SPPI and would have to be measured at fair value.

An IASB member noted that it is important to ensure to provide context of how the IASB have reached their conclusions to give stakeholders the best possible chance to understand its intentions.

IASB decision

13 out of 14 IASB members voted in favour of the staff recommendations.

Feedback analysis— Financial assets with non-recourse features and contractually linked instruments (Agenda Paper 16B)

This paper focused on Q3 and Q4 of the ED which asked for feedback on the proposed requirements regarding the classification and measurement of financial assets with non-recourse features and contractually linked instruments (CLIs).

For financial assets with non-recourse features, the ED proposed clarifying the term ‘non-recourse’ and providing factors that an entity may need to consider when assessing the contractual cash flow characteristics of financial assets with those features.

For CLIs, the ED proposed clarifying the description of transactions containing CLIs, specifying the characteristics of particular secured lending arrangements that are not subject to the CLI requirements and clarifying that the reference to instruments in the underlying pool include financial instruments that are not within the scope of the classification requirements of IFRS 9.

Most respondents supported clarifying the term ‘non-recourse’, however some respondents expressed concerns that the proposed description of non-recourse features is narrower than how this term is commonly interpreted in practice. The staff considers that the amendment proposed in the ED is in line with the IASB’s intention, however the staff will make some clarifications to the wording to minimise the risk of unintended consequences.

The ED included some factors an entity may need to consider when performing the ‘look through’ assessment (looking through to the particular underlying assets or cash flows to determine whether financial assets with non-recourse features have cash flows that are SPPI). Most respondents supported the inclusion of factors, however some asked for additional guidance or illustrative examples. Although the IASB’s intention was not to provide comprehensive examples, the staff recommends refining the amendments to better explain that purpose of the look through assessment is to understand the link between the underlying assets and the contractual cash flows of the financial assets.  This is needed because contractually, the entity is absorbing the asset-specific risk and does not benefit from any protection provided by general creditor ranking or any loss-absorption potential of the debtor’s equity.

Almost all respondents agreed with the IASB’s approach to clarify the scope of instruments to which CLI requirements are applied. Some respondents made suggestions to further enhance the clarity of the scope. The staff agreed that the scope could be refined to avoid any unintended consequence.

Some respondents raised concerns over the lending arrangements that are not CLIs, noting that there could be potential structuring opportunities to avoid the application of CLI requirements. This could be the case for example, if at initial recognition the junior debt instrument is held by the ‘sponsoring entity’ but is sold to a third party subsequently. As the CLI requirements, similar to the general SPPI requirements are assessed by the lender (the reporting entity) only at initial recognition, the sale of the junior instrument would not trigger a reassessment and could result the CLI requirements are not being applied to a transaction that really is a CLI. The staff considered that this could be resolved by requiring the junior debt to be held by the sponsoring entity throughout the life of the transaction.

Almost all respondents agreed with the IASB’s decision relating to eligible financial instruments in the underlying pool for the purpose of the assessment required in B4.1.23 if IFRS 9. However, some requested more clarity to promote consistent application. The staff considered that the concerns can be addressed by refining the wording of the proposals.

Staff recommendation

The staff recommended finalising the proposed amendments to the requirements for financial assets with non-recourse features (paragraphs B4.1.16A, B4.1.17 and B4.1.17A of the ED) and CLIs (paragraphs B4.1.20, B4.1.20A, B4.1.21 and B4.1.23 of the ED), subject to requiring in paragraph B4.1.20A of the ED that the junior debt instrument is held by the debtor (the sponsoring entity) throughout the life of the transaction, and minor drafting suggestions to further clarify the proposed amendments.

IASB discussion

IASB members agreed with the staff recommendation. IASB members highlighted that many good clarifications have been included in the papers and they should also be included in the Basis for Conclusions.

One point was raised around requiring the junior debt to be held by the debtor throughout the life of the transaction. In practice, there may be extreme situations in which an entity could sell or replace the debt. The staff agreed and will clarify that the junior debt instrument cannot be sold without affecting the repayment of the loan. 

IASB decision

All IASB members voted in favour of staff recommendations.