Question: In paragraph B4.1.11(b) of IFRS 9, one of the examples provided of instruments whose cash flows are ‘solely payments of principal and interest’ or ‘SPPI’, is an instrument with a contractual term that permits the issuer (that is, the debtor) to prepay or permits the holder (that is, the creditor) to put the instrument back to the issuer before maturity. The prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable compensation for the early termination of the contract.
What is reasonable compensation?
The IASB issued an amendment to IFRS 9 in October 2017 addressing prepayment features with negative compensation. The amendment is mandatory for annual periods beginning on or after 1 January 2019, though earlier application is permitted where applicable. However, the amendment added paragraphs to the Basis for Conclusions on what is reasonable compensation and these are also considered relevant in interpreting ‘reasonable additional compensation’ in the pre-amendment version of IFRS 9 issued in July 2014. The guidance set out below, which incorporates the additional guidance contained in the amendment, is therefore considered relevant to both annual periods beginning on or after 1 January 2019 and earlier periods to which IFRS 9 is applied.
Solution: IFRS 9 does not provide detailed guidance on what is considered ‘reasonable compensation’. An entity therefore needs to apply judgement in developing its own accounting policy and in determining whether specific compensation clauses provide for only reasonable compensation. That policy should be consistently applied. In making this judgement, the following factors are relevant.
In order to assess whether or not a compensation clause provides for only reasonable compensation, the first step is to understand the economic rationale of the clause, what it is designed to achieve and in what circumstances it may in practice be exercised. The assessment of whether a clause contains ‘reasonable compensation’ is complicated by the fact that a wide variety of clauses exist in practice, and their meaning and application can be unclear. For this reason an entity may consider it appropriate in some circumstances to seek legal advice in order to assess the enforceability of a clause and its contractual effect. A clause should not automatically be considered to result in ‘reasonable compensation’ just because it occurs more commonly or is a ‘market standard’ clause, so analysis of the specific details will still be needed where this is the case.
In some situations the compensation for early termination may not affect whether the instrument meets the SPPI criterion. This will be the case where:
- The reasonable compensation could only ever be de minimis (both in a single reporting period and cumulatively) or is non-genuine (that is, it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur) as stated in paragraph B4.1.18 of IFRS 9. However, such cases are expected to be rare, and it should be questioned why the compensation clause has been included in the contract if it appears it may be either de minimis or non-genuine; or
- The compensation feature arises solely as a matter of law rather than contract.
- Further analysis will be necessary where the above do not apply.
Paragraph B4.1.7A of IFRS 9 states that the following elements of interest are consistent with a basic lending arrangement that is SPPI:
- Time value of money;
- Credit risk associated with the principal amount outstanding;
- Other basic lending risks (for example, liquidity risk);
- Costs (for example, administrative costs) associated with holding the financial asset for a particular period of time; and
- A profit margin.
Therefore, where the additional compensation for early termination compensates only for some or all of these elements, the additional compensation may be considered reasonable on a qualitative basis, subject to the other considerations discussed below. Where additional compensation includes compensation for other factors it would not be considered reasonable on a qualitative basis. For example, a loan whose prepayment amount varies with the proceeds received on IPO by the borrower would introduce equity price risk into the loan, which is inconsistent with a basic lending arrangement and would fail SPPI.
Particular judgement may be required when a financial instrument is prepayable at its current fair value or at an amount that includes the fair value cost to terminate an associated hedging instrument (which may or may not be designated in an accounting hedge of the prepayable instrument). Paragraph BC4.232 of IFRS 9 states that whilst there may be some circumstances in which such contractual prepayment features meet SPPI as the compensation is reasonable for the early termination of the contract, that will not always be the case.
In the case of prepayment that includes the fair value cost to terminate an associated hedging instrument, paragraph BC4.232 includes an example where compensation may be considered reasonable. This is when the calculation of the prepayment amount is intended to approximate unpaid amounts of principal and interest plus or minus an amount that reflects the effect of the change in the relevant benchmark interest rate. The cost to terminate a collateralised fixed/floating interest rate swap hedge whose critical terms (such as currency, maturity) match those of the instrument, would generally be expected to reflect the effect of the change in the relevant benchmark interest rate over the remaining term and so be consistent with SPPI. Conversely, a EUR denominated instrument prepayable at an amount that includes the lenders’ cost to terminate an associated EUR/USD cross-currency swap hedging instrument would introduce EUR/USD currency risk into the EUR denominated loan, which would not be consistent with a basic lending arrangement and would fail SPPI.
In contrast to compensation that reflects the effect of changes in the benchmark interest rate, IFRS 9 contains no explicit guidance regarding circumstances in which the terms of a financial instrument provide for prepayment at the instrument’s current fair value. This will therefore be a particularly judgemental area. It can be argued that prepayment at fair value compensates the holder for all of the components of SPPI and so can be considered reasonable compensation. Furthermore if the instrument contained no prepayment clause, fair value is the amount at which the two parties would often be expected to agree to terminate. However, if there is a high likelihood of prepayment at fair value it could be questioned whether amortised cost is the most appropriate measurement basis. The considerations in this paragraph would also apply where, rather than being prepaid at current fair value, prepayment is instead at a formulaic amount designed to approximate current fair value.
IFRS 9 does not contain guidance on how to quantitatively assess what is reasonable and therefore this aspect of the assessment may be particularly judgemental. However, relevant factors to consider in making this assessment include:
- The mechanics of the compensation calculation - a formula used to determine compensation for lost interest that references a time period longer than the period remaining from prepayment up to contractual maturity, for example double that period with the result that the compensation paid is twice the present value of lost interest, would not be reasonable.
- Whether the clause is common in the relevant market - if the compensation to be paid is significantly more than the ‘market standard’ amount payable by other similar instruments that would call into question whether the compensation was reasonable. It would then be necessary to understand the specific facts and circumstances of the instrument, the customer etc. before concluding. Conversely, a compensation clause that is ‘market standard’ may indicate that the resulting compensation is reasonable, however as noted above, a clause should not automatically be considered to result in ‘reasonable compensation’ just because it is a ‘market standard’ amount.
Where judgements as to whether compensation features provide only for reasonable compensation have a significant effect, the disclosures on significant accounting judgements required by paragraph 122 of IAS 1 should be provided.