Can loans issued with ESG-linked features be classified and measured at amortised cost?
In order for a financial asset to be classified and measured at amortised cost, it must be held within a business model whose objective is to hold financial assets in order to collect contractual cash flows (hold to collect business model) and the contractual cash flows are solely payments of principal and interest on the principal amount outstanding (SPPI). If the contractual cash flows comprise payments other than for principal and interest (i.e., SPPI test fails), then the financial asset must be measured at fair value through profit or loss (FVTPL).
With the global push to ‘net zero’ emissions, many financial institutions and other financiers/investors are inserting sustainability (‘ESG’) clauses into agreements, such that cash flows on the financial asset may vary, depending on various ESG targets being met. So, the question arises:
‘Do these ‘ESG-linked’ features require the financial asset to be measured at FVTPL rather than amortised cost because the contractual cash flows fail the SPPI test?’
This article summarises proposed amendments to IFRS 9 Financial Instruments, which aim to clarify two key features of the SPPI test, namely:
- Elements of interest in a ‘basic lending arrangement’
- Contractual terms that change the timing or amount of contractual cash flows (including contingent events).
These amendments are designed to help entities assess whether any ‘ESG clauses’ in financial asset agreements will meet the SPPI test for classification at amortised cost.
Basic lending arrangements
Contractual cash flows are considered to meet the SPPI test if they are consistent with a basic lending arrangement. This usually means that consideration for the time value of money and credit risk are the most significant elements of interest, but interest can also include consideration for other lending risks such as:
- Administrative costs
- A profit margin
Example – ESG-linked features
Entity A purchases green bonds of Entity B. The bonds carry a coupon of 4% per annum. If Entity B fails to meet its target of reduction in greenhouse gas emissions in a reporting period, the coupon is increased to 5% per annum.
In this example, it is challenging to determine whether changing the interest rate from 4% to 5% is consistent with a basic lending arrangement, i.e., whether it relates to credit risk, profit margin or some other factor.
Proposed additional guidance for SPPI test and basic lending arrangements
To help entities determine whether ESG-linked features that vary contractual cash flows are consistent with a basic lending arrangement, and therefore meet the SPPI test, the International Accounting Standards Board (IASB) is proposing amendments to IFRS 9 to clarify that:
- The assessment of interest should focus on what an entity is being compensated for, rather than how much compensation it receives
- Contractual cash flows are inconsistent with a basic lending arrangement if they include compensation for risks or market factors that are not typically considered to be basic lending risks or costs (for example – a share of a debtor’s revenue or profit). This applies even if such contractual terms are common in the market in which the entity operates
- 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. For example, if the interest rate decreases when the credit risk of the borrower has increased, the changes in the contractual cash flows is inconsistent with a basic lending arrangement.
Contractual terms change the timing and/or amount of contractual cash flows (including contingent events)
When a financial asset contains a contractual term that could change the timing and/or amount of contractual cash flows over the life of the instrument (such as illustrated in our ESG example above), the entity must determine if these cash flows meet the SPPI test by assessing the contractual cash flows that could arise before and after the change in contractual cash flows.
The entity may need to assess the nature of this contingent event (i.e., the trigger) that would change the timing and/or amount of the contractual cash flows. IFRS 9 currently notes that a contingent event by itself does not determine whether the contractual cash flows meet the SPPI test, but it could be an indicator. IFRS 9 contrasts the following examples where a financial instrument resets to a higher interest rate:
- The debtor misses a particular number of payments
- A specified equity index reaches a particular level.
Where the rate resets because a debtor has missed a particular number of payments, IFRS 9 notes that it is more likely that the contractual cash flows over the life of the instrument will meet the SPPI test because of the relationship between missed payments and an increase in credit risk associated with the loan.
Some entities may infer from these examples that for cash flows to be SPPI, the nature of the contingent event must be associated with one of the elements of interest as noted above. However, the IASB clarified in the Basis for Conclusions which accompany these proposed amendments to IFRS 9 that:
- Variability cannot be assumed to be consistent with a basic lending arrangement simply because it arises from one of the elements of interest mentioned above, and
- Variability in cash flows need not relate to one of the elements of interest mentioned above.
Proposed additional guidance for assessing contractual cash flows over the life of the financial asset
In order to clarify how entities should assess contractual cash flows over the life of the financial asset, the IASB is proposing that:
- Entities must assess whether contractually specified changes in cash flows meet the SPPI test, irrespective of the probability of the contingent event occurring (such as the ESG clause being triggered)
- For a change in contractual cash flows to be consistent with a basic lending arrangement, the occurrence or non-occurrence of the contingent event (such as the triggering of an ESG clause) must be specific to the debtor. In our Example above, the contingent event is specific to Entity B because it is based upon Entity B failing to meet its own reduction targets in greenhouse gas emissions in a reporting period
- The resulting contractual cash flows must represent neither an investment in the debtor nor an exposure to the performance of the specified assets.
The Exposure Draft includes two examples to illustrate the above proposals:
|Loan A has an interest rate that is periodically adjusted by a specified number of basis points if the debtor achieves a contractually specified reduction in greenhouse gas emissions during the preceding reporting period.
The occurrence of the contingent event, i.e., achieving a contractually specified reduction in greenhouse gas emissions, is specific to the debtor.
The contractual cash flows arising from the occurrence (or non-occurrence) of the contingent event are in all circumstances solely SPPI on the principal outstanding amount.
The contractual cash flows represent neither an investment in the debtor nor an exposure to the performance of specified assets.
|Loan B has an interest rate that is periodically adjusted when a market-determined carbon price index reaches a contractually defined threshold.
The occurrence of the contingent event, i.e., when a market-determined carbon price reaches a contractually defined threshold, is not specific to the debtor.
The contractual cash flows change in response to a market factor (the carbon price index), which is not a basic lending risk or cost and is therefore inconsistent with a basic lending arrangement.
The contractual cash flows therefore fail the SPPI test.
Proposed additional disclosures
In order to provide users with an understanding of the contractual terms that could change the timing and/or amount of contractual cash flows, as well as the potential magnitude of changes in future contractual cash flows based on the occurrence or non-occurrence of a contingent event that is specific to a debtor, the IASB is also proposing the following additional disclosures in IFRS 7 Financial Instrument: Disclosures:
- A qualitative description of the nature of the contingent event
- Quantitative information about the range of changes to contractual cash flows that could result from the contractual terms
- The gross carrying amount of financial assets and the amortised cost of financial liabilities subject to those contractual restrictions.
It should be noted that these proposed new disclosures are not limited to financial assets with ESG-linked features. They would apply to all financial assets, and all financial liabilities whose contractual terms could result in the timing and/or amount of future cash flows changing as a result of the occurrence or non-occurrence of a contingent event.
Please refer to our IFR Bulletin for more information on these proposed amendments to IFRS 9.
Please contact our IFRS Advisory team if you require assistance in this regard, or wish to provide comments on these proposals.
For more on the above, please contact your local BDO representative.