IFRS 9 Business model Examples- solely (or not solely) payments of principal and interest

Few examples to illustrate contractual cash flows that are solely payments of principal and interest on the principal amount outstanding:-

Example 1

Instrument A is a bond with an established maturity date. The principal and interest payments on the outstanding principal amount are linked to an inflation index of the currency in which the instrument is issued. Inflation bond is unlevered and principal is protected

Analysis

Contractual cash flows are only principal and interest payments on the outstanding principal amount. Linking principal and interest payments on the outstanding principal amount with an unlevered inflation index restores the time value of money to a current level. In other words, the interest rate on the instrument reflects "real" interest. Therefore, the interest amounts are considered at the time value of money over the outstanding principal amount. However, if the interest payments were indexed to another variable, such as the debtor's return (for example, the debtor's net income) or an equity index, the contractual cash flows are not payments of the principal and interest on the amount of outstanding principal (unless indexation to Debtor's performance results in an adjustment that only compensates the holder for changes in the instrument's credit risk, so that contractual cash flows are only principal and interest payments) . This is because contractual cash flows reflect performance inconsistent with a basic loan agreement.

 

Example 2

Instrument E is issued by a regulated bank and has an established expiration date. The instrument pays a fixed interest rate and all contractual cash flows are not discretionary. However, the issuer is subject to legislation that allows or requires a national resolution authority to impose losses on holders of particular instruments, including Instrument E, in particular circumstances. For example, the national resolution authority has the power to enter the nominal amount of Instrument E or convert it to a fixed number of issuer's ordinary shares if the national resolution authority determines that the issuer is having severe financial difficulties, needs additional capital regulation or is 'failing'.

 

Analysis

The holder would analyze the contractual terms of the financial instrument to determine if they give rise to cash flows that are only payments of the principal and interest on the amount of the outstanding principal and, therefore, are consistent with a basic loan agreement. That analysis would not consider payments that arise only as a result of the power of the national resolution authority to impose losses on holders of Instrument E. This is because that power, and the resulting payments, are not contractual terms of the financial instrument. Conversely, contractual cash flows would not be solely payments of principal and interest on the amount of outstanding principal if the contractual terms of the financial instrument allow or require the issuer or other entity to impose losses on the holder (for example, writing the par amount or by converting the instrument into a fixed number of the issuer's ordinary shares) as long as those contractual terms are genuine, even if the probability is remote that such loss will be imposed.

 

Examples illustrate contractual cash flows that are not solely payments of principal and interest on the principal amount outstanding:-

 

Example 3

Instrument F is a bond convertible into a fixed number of the issuer's equity instruments.

 

Analysis

The holder would analyze the convertible bond in its entirety. Contractual cash flows are not principal and interest payments on the outstanding principal amount because they reflect performance that is inconsistent with a basic loan agreement; that is, the return is linked to the value of the issuer's equity.

 

Example 4

Instrument H is a perpetual instrument, but the issuer can call the instrument at any time and pay the holder the nominal amount plus accrued interest due. Instrument H pays a market interest rate, but the payment of interest cannot be made unless the issuer can remain solvent immediately thereafter. Deferred interest does not generate additional interest.

 

Analysis

Contractual cash flows are not payments of principal and interest on the amount of outstanding principal. This is because the issuer may be required to defer interest payments and no additional interest accrues on those deferred interest amounts. As a result, interest amounts are not considered at the time value of money on the outstanding principal amount. If interest accrues on the deferred amounts, the contractual cash flows may be payments of the principal and interest on the amount of the outstanding principal. The fact that Instrument H is perpetual does not in itself mean that contractual cash flows are not payments of principal and interest on the amount of outstanding principal. Indeed, a perpetual instrument has continuous (multiple) extension options. Such options may result in contractual cash flows that are payments of principal and interest on the outstanding principal amount if interest payments are mandatory and must be paid in perpetuity. Furthermore, the fact that Instrument H is due does not mean that contractual cash flows are not payments of principal and interest on the outstanding amount of principal unless it is due at an amount that does not substantially reflect the payment of the outstanding principal and interest on that principal Outstanding amount. Even if the callable amount includes an amount that reasonably compensates the holder for the early termination of the instrument, the contractual cash flows could be payments of the principal and interest on the amount of the outstanding principal.

 

Refer following for more detail on business model and IFRS 9:-

IFRS 9 Business Model and SPPI Testing

IFRS 9