In July 2014, the International Accounting Standards Board (IASB) issued the completed version of International Financial Reporting Standard (IFRS) 9, Financial Instruments.
In July 2014, the International Accounting Standards Board (IASB) issued the completed version of International Financial Reporting Standard (IFRS) 9, Financial Instruments. IFRS 9 sets out the principles for recognising and measuring financial instruments in order to provide relevant and useful information to users of financial statements. IFRS 9 is effective for annual periods beginning on or after 1 January 2018 with early application permitted.
IFRS 9 specifies that while determining the classification and measurement of financial assets, entities should consider the business model in which they are held and the contractual cash flow characteristics of the asset. Based on these two factors, entities may classify their financial assets as measured at Amortised cost, Fair Value through Other Comprehensive Income (FVOCI) or Fair Value through Profit or Loss (FVTPL).
For a financial asset to be eligible for classification and measurement at amortised cost or FVOCI, IFRS 9 requires its contractual cash flows to be ‘Solely Payments of Principal and Interest’ (SPPI).
Paragraph B4.1.10 read with paragraph B4.1.11(b) of IFRS 9 state that a prepayment option in a financial asset meets the SPPI criterion if the prepayment amount substantiallycrepresents unpaid amount of principal and interest, which may include reasonable additional compensation for early termination of the contract.
Reasonable additional compensation implies that the party choosing to exercise its option to terminate the contract compensates the other party.1
In 2016, the IASB set up a limited scope project on IFRS 9 for symmetric ‘make whole’ prepayment options. This project covered the classification and measurement requirements for a financial asset that included a prepayment option that allowed the borrower to prepay the financial asset at an amount that reflected the remaining contractual cash flows of the asset discounted at a market interest rate.
This prepayment option could result in the other party being forced to accept a negative compensation- e.g. the creditor would receive an amount lower than the unpaid amount of principal and interest if the debtor chose to prepay, when the market interest rate was higher than the effective interest rate of the asset.
Such an asset would not have cash flows that meet the SPPI criterion. Applying current IFRS 9 would result in the asset being classified and measured at FVTPL. The IASB believes this result would not be appropriate if amortised cost provides useful information.
Thus, the Interpretations Committee (IC) recommended and the IASB proposed a narrow exception to the requirement in IFRS 9 for the classification and measurement of financial assets. Accordingly, on 21 April 2017, the IASB issued an exposure draft on Prepayment Features with Negative Compensation (Proposed amendments to IFRS 9) (Exposure Draft).
The last date for comments on the exposure draft is 24 May 2017.
This issue of IFRS Notes provides an overview of the proposed amendments in the Exposure Draft.
Overview of Exposure Draft
The Exposure Draft proposes an exception to the classification and measurement requirements with respect to the SPPI criterion for financial assets that:
Such financial assets could be measured at amortised cost or at FVOCI based on the business model within which they are held.
The Exposure Draft also states that financial assets prepayable at current fair value would be classified as and measured at FVTPL. The same would apply if the prepayment amount includes the fair value cost to terminate a hedging instrument if the amount is inconsistent with the current IFRS 9 prepayment rules.1
Effective date and transition
The proposed amendment would be effective for annual periods beginning on or after 1 January 2018 - the effective date of IFRS 9 - and retrospective application would be required.
The EIR method allows for the possibility of reasonable compensation for the early termination of a contract. The Exposure Draft clarifies that the compensation need not be a single directional payment (i.e. the party exercising the option pays the other party for any unfavourable outcome due to the prepayment), but may also be in the nature of ‘negative’ compensation’.
This amendment may provide relief to entities that are party to contracts that include a prepayment feature with negative compensation. However, the amendment is narrow in its scope and would not extend to compensation based on fair value changes and break costs of related hedges at the time of prepayment. Given that IFRS 9 would be effective shortly (from 1 January 2018 onwards), companies should assess the impact of this proposed amendment on their implementation efforts and identify related adjustments, if any.
In India, this guidance would be applicable to companies that have transitioned or are transitioning to Indian Accounting Standards (Ind AS) only if a corresponding amendment is proposed and notified by the Ministry of Corporate Affairs (MCA) to Ind AS 109, Financial Instruments.
1Source: Prepayment features with negative compensation, KPMG IFRG Limited’s publication, April 2017
To access the text of the exposure draft on amendment to IFRS 9, please click here.
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