Hold-to-Collect and SPPI: the new buzzwords

On the topic of the financial instruments standard – NZ IFRS 9, we will be looking in more detail at the requirements for classifying a financial instrument at amortised cost going forward.

As a reminder, NZ IFRS 9 is effective for Tier 1 and Tier 2 for-profit entities for annual periods beginning on or after 1 January 2018.

Under NZ IFRS 9, a financial asset will only be able to be classified as subsequently measured at amortised cost if it meets both of the following criteria:

“Hold-to-collect” business model test – The asset is held within a business model whose objective is to hold the financial asset in order to collect contractual cash flows; and
“SPPI” contractual cash flow characteristics test – The contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding on a specified date.

In this month’s article we look at these two criteria in more detail:

“Hold-to-collect” business model

A “hold-to-collect” business model is one in which the entity’s objective is to hold the financial asset to collect the contractual cash flows from the financial asset rather than with a view to selling the asset to realise a profit or loss.

For example, trade receivables held by a manufacturing entity are likely to fall within the “hold-to-collect” business model, as the manufacturing entity is likely to have the intention to collect the cash flows from those trade receivables. The “hold to collect” business model does not require that financial assets are always held until its maturity. An entity’s business model can still be to hold financial assets to collect contractual cash flows, even when sales of financial assets occur.

However, if more than an infrequent number of sales are made out of a portfolio, the entity should assess whether and how the sales are consistent with the “hold-to-collect” objective. This assessment should include the reason(s) for the sales, the expected frequency of sales, and whether the assets that are sold are held for an extended period of time relative to their contractual maturities.

Selling a financial asset to realise cash to deal with an unforeseen need for liquidity, selling a financial asset as a result of changes in tax laws, or selling a financial asset due to significant internal restructuring or business combinations or selling due to concerns about the collectability of the contractual cash flows (i.e. increase in credit risk) are considered to be consistent with the objective of a “hold-to-collect” business model.

Example 1 – “Hold-to-collect” business model

Entity A sold one of its diverse business operations and currently has $10 million of cash. It has not yet found another suitable investment opportunity to invest its funds so it buys short term (6 month maturity) high quality government bonds in order to generate interest income. It is not considered likely but, if a suitable investment opportunity arises before the maturity date, the entity will sell the bonds and use the proceeds for the acquisition of a business operation. Otherwise it will hold the bonds to their maturity date.

Question: Is the “hold-to-collect” business model test met?

Answer: Consideration of the facts and circumstances are required. It is likely that the government bonds would meet the “hold-to-collect” business model test, as the entity’s objective appears to be holding the government bonds and collecting the contractual cash flows which consist of the contractual interest payments and, on maturity, the principal amount. If the bond were to be sold prior to its maturity date, the fair value of the cash flows arising would be similar to those which would be collected by continuing to hold the bonds.

Key management personnel (KMP) determine whether a financial asset meets the business model test. The business model can be observed based on the facts and circumstances of the entity, how an entity is managed, and by the type of information that is provided to its management.

The business model test under NZ IFRS 9 is based on how the entity manages its business and not on an instrument-by-instrument basis (i.e. the test is applied on an “entity wide” basis and not on an individual asset basis).

However, it is also acknowledged that an entity might have more than one business model (for example, a bank might have a trading division and a retail division). Where an entity has a number of different objectives (or business models) for managing financial assets, KMP will have to make an assessment of at what level the business model is to be applied.

For example, an entity (such as a bank) may hold different portfolios of debt investments:

Some are managed in order to collect contractual cash flows
Some are managed for trading in order to realise changes in fair value.

The following would not be consistent with the “hold-to-collect” business model:

The objective for managing the debt investments is to realise cash flows through sale
The performance of the debt investment is evaluated on a fair value basis.

The ‘SPPI’ contractual cash flow characteristics test

The second condition for a financial asset to qualify for amortised cost classification is that the financial asset must meet the “solely payments of principal and interest” (SPPI) contractual cash flow characteristics test.

Contractual cash flows are considered to be SPPI if the contractual terms of the financial asset only give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding on specified dates i.e. the contractual cash flows are consistent with a basic lending arrangement.

Whilst the consideration for the time value of money and credit risk is typically the most significant element of “interest”, it can also contain other elements such as liquidity, profit margin and service or administrative costs.

However, if the contractual cash flows are linked to features such as changes in equity or commodity prices, they would not pass the SPPI test because they introduce exposure to risks or volatility that is unrelated to a basic lending arrangement.

The SPPI contractual cash flow test means that only debt instruments can qualify to be measured at amortised cost.

Example 2 – SPPI test for loan with zero interest and no fixed repayment terms

Parent A provides a loan to Subsidiary B. The loan has no interest and no fixed repayment terms. The loan is repayable on demand and is classified as a current liability in Subsidiary B’s books.

Question: Does the loan meet the “SPPI” contractual cash flows characteristic test?

Answer: Yes. The terms provide for the repayment of the principal amount on demand.

Example 3 – SPPI test for a loan with interest rate cap

Entity B lends Entity C $5 million for 5 years at the prevailing variable market interest rate. In addition, the variable interest rate is capped at 8%.

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 would also meet the contractual cash flow characteristics test.

Example 4 – SPPI test for loan with profit linked element

Entity D lends Entity E $500 million for 5 years at an interest rates 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 this 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 reflect only the time value of money and credit risk. Therefore, the loan will fail the requirements for amortised cost classification and Entity D will account for the loan at fair value through profit or loss.

Prepayment and extension terms

Debt instruments often contain prepayment and extension option terms. These do not necessarily violate the SPPI contractual cash flow characteristics test.

A debt instrument with a prepayment option can still meet the SPPI contractual cash flow characteristics test if the prepayment amount represents substantially all the unpaid amounts of principal and interest outstanding (the prepayment amount may include reasonable additional compensation for early repayment) and the prepayment is not contingent on any future events other than to protect:

The holder against the credit deterioration of the issuer (e.g. defaults, credit downgrades or loan covenant violations), or a change in control of the issuer, or
The holder or issuer against changes in relevant taxation or law.

Similarly, a debt instrument with an extension option would still meet the contractual cash flow characteristics test if the terms in the extension period result in contractual cash flows that also meet the contractual cash flow characteristics test and the extension provision is not contingent on future events other than the criteria set out in subparagraphs a) and b) above.

Example 5 – SPPI test for loan with prepayment option

Entity D lends Entity E $5 million at a fixed interest rate. The loan is repayable in 5 years. Entity E has the option to repay the loan at any time at $5 million plus any accrued interest plus a prepayment penalty fee of 3%.

Question: Does the loan meet the ‘SPPI’ contractual cash flows characteristic test?

Answer: Yes. The prepayment option is not contingent on any future event. The prepayment penalty of 3% is considered to be reasonable additional compensation for early contract termination.

Other provisions that change the timing or amount of cash flows

Other contractual provisions that change the timing or amount of cash flows can still meet the SPPI test if their effect is consistent with the return of a basic lending arrangement.

For example, an instrument with an interest rate that is reset to a higher rate if the debtor misses a particular number of payments can still meet the SPPI test as the resulting change in the contractual terms is likely to represent consideration for the increase in credit risk of the instrument.

Other instruments where the interest payment is linked to net debt/earnings before interest tax, depreciation and amortisation (EBITDA) ratio (where the ratio is intended to be a proxy reflecting the borrower’s credit risk) are unlikely to meet the SPPI test, except in rare cases when a genuine link can be made between the linkage feature and the required SPPI features.

However, a financial instrument with an interest rate that resets to a higher rate if a specified equity index reaches a particular level (e.g. NZX 50 reaching 8,000 points) will not meet the SPPI test, because there is no relationship between the change in equity index and credit risk.

A non-recourse provision does not in itself preclude a financial asset from meeting the contractual cash flow characteristics test. A non-recourse provision has the effect that, if the borrower defaults, the lender would only be able to recover its claim through the asset that has been pledged as security over the loan. The borrower has no further obligation beyond the asset that has been pledged. When there is a non-recourse provision, a lender needs to ‘look through’ to the underlying assets or cash flows to determine whether the contractual cash flows of the financial assets are solely payments of principal and interest on the principal amount outstanding. If the terms of the financial asset (including the effect of the non-recourse provision) give rise to any other cash flows or limit the cash flows in a manner that is inconsistent with SPPI, then the loan does not meet the contractual cash flow characteristics test.

Example 6 – SPPI test for loan with interest rate reset

Company I lends Company J $5 million at a fixed interest rate of 8%. The loan is repayable in five years. If Company J misses two interest payments, the interest rate is reset to 15%.

Question: Does the loan meet the ‘SPPI’ contractual cash flows characteristic test?

Answer: Yes, because there is a relation between the missed payment and an increase in credit risk.

Example 11 – SPPI test for convertible note

Question: Does an investment in a convertible note that converts into equity instruments of the issuer meet the ‘SPPI’ contractual cash flows characteristic test?

Answer: No. NZ IFRS 9 requires analysis of the terms of the convertible bond in its entirety. The interest rate in a convertible note typically does not reflect the consideration for the time value of money and the credit risk. The interest rate is usually set lower than the market interest rate. The overall return is also linked to the value of the equity of the issuer such that the conversion feature would potentially enhance the overall return.

What to focus on

All Tier 1 and Tier 2 for-profit entities will need to carefully assess their business models in relation to financial instruments to determine whether the “hold-to-collect’ model test is met.

In addition, an assessment of all financial instruments that are currently classified as “Loans and Receivables” and “Held-to-Maturity” under NZ IAS 39 Financial Instruments: Recognition and Measurement will need to be carried out to determine whether the ‘SPPI’ contractual cash flow characteristics test will be met.

If these tests are not met, entities will no longer be able to measure financial instruments at amortised cost and instead will have to carry the financial instruments at fair value

For more on the above, please contact your local BDO representative.