2.1 Debt instruments

A debt instrument is normally measured at amortised cost if both of the following conditions are met: [IFRS 9.4.1.2]

1. the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows; and
2. the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

A debt instrument is normally measured at fair value through other comprehensive income if both of the following conditions are met: [IFRS 9.4.1.2A]

1. the asset is held within a business model in which assets are managed to achieve a particular objective by both collecting contractual cash flows and selling financial assets; and
2. the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

The application of these conditions (the ‘business model’ assessment and ‘contractual cash flow characteristics’ test) is covered in more detail at 5 and 6 below, respectively.

The above requirements should be applied to an entire financial asset, even if it contains an embedded derivative. [IFRS 9.4.3.2].

The application of these requirements to debt instruments means that, apart from the exceptions described in 6.4 below, only relatively simple ‘plain vanilla’ debt instruments qualify to be measured at amortised cost or at fair value through other comprehensive income. Debt instruments that are neither measured at amortised cost nor at fair value though other comprehensive income are measured at fair value through profit or loss. [IFRS 9.4.1.4]. As will be shown at 5.4 below, this includes instruments that are held for trading (see 4 below).

Notwithstanding the criteria for debt instruments to be classified at amortised cost or at fair value through other comprehensive income, as described above, an entity may irrevocably designate a debt instrument as measured at fair value through profit or loss at initial recognition. This is allowed if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’). Such mismatches would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases. [IFRS 9.4.1.5]. This is covered further at 7 below.

In its Basis for Conclusions, the IASB noted that the fair value through other comprehensive income measurement category is intended for debt instruments for which both amortised cost information and fair value information are relevant and useful. This will be the case if their performance is affected by both the collection of contractual cash flows and the realisation of fair values through sales. [IFRS 9.BC4.150].

The fair value through other comprehensive income measurement category may also help some insurers achieve consistency of measurement for assets held to back insurance liabilities under the IFRS 17 – Insurance Contracts – insurance contracts model. It should also help to address concerns raised by preparers who expect to sell financial assets in greater volume than would be consistent with a business model whose objective is to hold financial assets to collect contractual cash flows and would, without this category, have to record such assets at fair value through profit or loss.

It should be noted firstly that:

1. the fair value through other comprehensive income classification under IFRS 9 reflects a business model evidenced by facts and circumstances and is neither a residual classification nor an election;
2. debt instruments measured at fair value through other comprehensive income will be subject to the same impairment model as those measured at amortised cost. Accordingly, although the assets are recorded at fair value, the profit or loss treatment will be the same as for an amortised cost asset, with the difference between amortised cost, including impairment allowance, and fair value recorded in other comprehensive income; and
3. only relatively simple debt instruments will qualify for measurement at fair value through other comprehensive income as they will also need to pass the contractual cash flow characteristics test.

2.2 Equity instruments and derivatives

Equity instruments and derivatives are normally measured at fair value through profit or loss. [IFRS 9.5.7.1]. However, on initial recognition, an entity may make an irrevocable election (on an instrument-by-instrument basis) to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of IFRS 9. This option applies to instruments that are neither held for trading (see 4 below) nor contingent consideration recognised by an acquirer in a business combination to which IFRS 3 – Business Combinations – applies. [IFRS 9.5.7.1(b), 5.7.5]. For the purpose of this election, the term equity instrument uses the definition in IAS 32 – Financial Instruments: Presentation. The use of this election is covered further at 8 below.

Although most gains and losses on investments in equity instruments designated at fair value through other comprehensive income will be recognised in other comprehensive income, dividends will normally be recognised in profit or loss. [IFRS 9.5.7.6]. However, the IASB noted that dividends could sometimes represent a return of investment instead of a return on investment. Consequently, the IASB decided that dividends that clearly represent a recovery of part of the cost of the investment are not recognised in profit or loss. [IFRS 9.BC5.25(a)]. Meanwhile, gains or losses recognised in other comprehensive income are never reclassified from equity to profit or loss on derecognition of the asset, and consequently, there is no need to review such investments for possible impairment.

Determining when a dividend does or does not clearly represent a recovery of cost could prove somewhat judgemental in practice, especially as the standard contains no further explanatory guidance. Also, because it is an exception to a principle, it could open up the possibility of structuring transactions to convert fair value gains into dividends through the use of intermediate holding vehicles. However, in the IASB's view, those structuring opportunities would be limited because an entity with the ability to control or significantly influence the dividend policy of the investee would not account for those investments in accordance with IFRS 9. Furthermore, the IASB requires disclosures that would allow the user to compare the dividends recognised in profit or loss and other fair value changes easily. [IFRS 9.BC5.25(a)].

5.1 The level at which the business model assessment is applied

The business model assessment should be performed on the basis of the entity's business model as determined by the entity's key management personnel (as defined in IAS 24 – see Chapter 39 at 2.2.1.D). [IFRS 9.B4.1.1].

An entity's business model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. This does not need to be the reporting entity level. The entity's business model does not depend on management's intentions for an individual instrument. Accordingly, this condition is not an instrument-by-instrument approach to classification and should be determined on a higher level of aggregation. However, a single entity may have more than one business model for managing its financial instruments (for example, one portfolio that it manages in order to collect contractual cash flows and another portfolio that it manages in order to trade to realise fair value changes). [IFRS 9.B4.1.2].

Similarly, in some circumstances, it may be appropriate to split a portfolio of financial assets into sub-portfolios to reflect how an entity manages them. [IFRS 9.B4.1.2]. Those portfolios would be split and treated as separate portfolios, provided the assets belonging to each sub-portfolio are defined. A sub-portfolio approach would not be appropriate in cases where an entity is not able to define which assets would be held to collect contractual cash flows and which assets would potentially be sold. It is clear that judgement will need to be applied when determining the level of aggregation to which the business model assessment should be applied. Splitting a portfolio into two sub-portfolios might allow an entity to achieve amortised cost accounting for most of the assets within the portfolio, even if it is required to sell a certain volume of assets. The entity could define the assets it intends (or is required) to sell as one sub-portfolio while it defines the assets it intends to keep as another.

5.2 Hold to collect contractual cash flows

A financial asset which is held within a business model whose objective is to hold assets in order to collect contractual cash flows is measured at amortised cost (provided the asset also meets the contractual cash flow characteristics test). [IFRS 9.4.1.2]. An entity manages such assets to realise cash flows by collecting contractual payments over the life of the instrument instead of managing the overall return on the portfolio by both holding and selling assets. [IFRS 9.B4.1.2C].

5.3 Hold to collect contractual cash flows and selling financial assets

The fair value through other comprehensive income measurement category is a mandatory category for portfolios of financial assets that are held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets (provided the asset also meets the contractual cash flow test). [IFRS 9.4.1.2A].

In this type of business model, the entity's key management personnel have made a decision that both collecting contractual cash flows and selling are fundamental to achieving the objective of the business model. There are various objectives that may be consistent with this type of business model. For example, the objective of the business model may be to manage everyday liquidity needs, to maintain a particular interest yield profile or to match the duration of the financial assets to the duration of the liabilities that those assets are funding. To achieve these objectives, the entity will both collect contractual cash flows and sell the financial assets. [IFRS 9.B4.1.4A].

Compared to the business model with an objective to hold financial assets to collect contractual cash flows, this business model will typically involve greater frequency and value of sales. This is because selling financial assets is integral to achieving the business model's objective rather than only incidental to it. There is no threshold for the frequency or value of sales that can or must occur in this business model. [IFRS 9.B4.1.4B].

As set out in the standard, the fair value through other comprehensive income is a defined category and is neither a residual classification nor an election. However, in practice, entities may identify those debt instruments which are held to collect contractual cash flows (see 5.2 above), those which are held for trading, those managed on a fair value basis (see 5.4 below) and those for which the entity applies the fair value option to avoid a measurement mismatch, (see 7.1 below), and then measure the remaining debt instruments at fair value through other comprehensive income. As a consequence, the fair value through other comprehensive income category might, in effect, be used as a residual, just because it is far easier to articulate business models that would be classified at amortised cost or at fair value through profit or loss.

5.4 Other business models

IFRS 9 requires financial assets to be measured at fair value through profit or loss if they are not held within either a business model whose objective is to hold assets to collect contractual cash flows or within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. A business model that results in measurement at fair value through profit or loss is where the financial assets are held for trading (see 4 above). Another is where the financial assets are managed on a fair value basis (see Example 48.14 below).

When the standard explains what it means by a portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis it refers to the requirements for designating financial liabilities as measured at fair value through profit or loss. [IFRS 9.B4.1.6]. In order to be considered to be managed on a fair value basis, the portfolio needs to be managed in accordance with a documented risk management or investment strategy and for information, prepared on a fair value basis, about the group of instruments to be provided internally to the entity's key management personnel (this is as defined in IAS 24 see Chapter 39 at 2.2.1.D), for example the entity's board of directors and chief executive officer. [IFRS 9.4.2.2(b)]. Further, it is explained that if an entity manages and evaluates the performance of a group of financial assets, measuring that group at fair value through profit or loss results in more relevant information. [IFRS 9.B4.1.33]. Documentation of the entity's strategy need not be extensive but should be sufficient to demonstrate that the classification at fair value through profit or loss is consistent with the entity's risk management or investment strategy. [IFRS 9.B4.1.36].

In each case, the entity manages the financial assets with the objective of realising cash flows through the sale of the assets. The entity makes decisions based on the assets' fair values and manages the assets to realise those fair values. As a consequence, the entity's objective will typically result in active buying and selling. Even though the entity will collect contractual cash flows while it holds financial assets in the fair value through profit or loss category, this is only incidental and not integral to achieving the business model's objective. [IFRS 9.B4.1.5, B4.1.6].

5.5 Consolidated and subsidiary accounts

A question that arises over the application of IFRS 9 concerns how to apply the business model test in the consolidated accounts to a subsidiary which is classified as held for sale in accordance with IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations. In particular, when the financial assets of a subsidiary are held with the objective of collecting contractual cash flows but the subsidiary itself is held for sale under IFRS 5, whether the financial assets of the subsidiary should be considered to be within a hold to collect or a hold to sell business model.

The IFRS Interpretations Committee were asked precisely this question in November 2016. They noted that, in its consolidated financial statements, an entity assesses the relevant requirements of IFRS 9 from the group perspective and will advise the IASB when it discusses the issue. However, until the IASB has concluded on this issue, it is unclear how the business model test would be applied in these circumstances.¹

5.6 Applying the business model test in practice

The application of the business model test is illustrated through a number of examples, in all the following examples in this section it is assumed that the instruments will meet the contractual cash flows characteristics test.

6.1 The meaning of ‘principal’

‘Principal’ is not a defined term in IFRS 9. However, the standard states that, for the purposes of applying the contractual cash flow characteristics test, the principal is ‘the fair value of the asset at initial recognition’ and that it may change over the life of the financial asset (for example, if there are repayments of principal). [IFRS 9.4.1.3(a), B4.1.7B].

The IASB believes that this usage reflects the economics of the financial asset from the perspective of the current holder; in other words, the entity would assess the contractual cash flow characteristics by comparing the contractual cash flows to the amount that it actually invested. [IFRS 9.BC4.182(a)].

For example: Entity A issued a bond with a contractually stated principal of CU1,000. The bond was originally issued at CU990. Because interest rates have risen sharply since the bond was originally issued, Entity B, the current holder of the bond, acquired the bond in the secondary market for CU975. From the perspective of entity B, the principal amount is CU975. The principal will increase over time as the discount of 25 amortises out until it reaches the contractual amount of CU1,000 at the bond's maturity.

The principal is, therefore, not necessarily the contractual par amount, nor (when the holder has acquired the asset subsequent to its origination) is it necessarily the amount that was advanced to the debtor when the instrument was originally issued.

The description of ‘principal’ as the fair value of an instrument on initial recognition avoids a concern that any financial asset acquired or issued at a substantial discount would be leveraged and hence would not have economic characteristics of interest.

A clear understanding of what the standard means by ‘principal’ is also necessary for the appropriate and consistent application of the contractual cash flow characteristics test to prepayable financial assets (see 6.4.4 below).

6.2 The meaning of ‘interest’

IFRS 9 states that the most significant elements of interest within a basic lending arrangement are typically the consideration for the time value of money and credit risk. In addition, interest may also include consideration for other basic lending risks (for example, liquidity risk) and costs (for example, administrative costs) associated with holding the financial asset for a particular period of time. Furthermore, interest may include a profit margin that is consistent with a basic lending arrangement.

In extreme economic circumstances, interest can be negative if, for example, the holder of a financial asset effectively pays a fee for the safekeeping of its money for a particular period of time and that fee exceeds the consideration the holder receives for the time value of money, credit risk and other basic lending risks and costs.

However, contractual terms that introduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement, such as exposure to changes in equity prices or commodity prices, do not give rise to contractual cash flows that are solely payments of principal and interest on the principal amount outstanding. An originated or a purchased financial asset can be a basic lending arrangement irrespective of whether it is a loan in its legal form. [IFRS 9.4.1.3(b), B4.1.7A].

The IASB notes that the assessment of interest focuses on what the entity is being compensated for (i.e. whether the entity is receiving consideration for basic lending risks, costs and a profit margin or is being compensated for something else), instead of how much the entity receives for a particular element. For example, the Board acknowledges that different entities may price the credit risk element differently. [IFRS 9.BC4.182(b)]. Although two entities may receive different amounts for the same element of interest, e.g. credit risk, they could both conclude that their consideration for credit risk is appropriate within a basic lending arrangement.

Time value of money is the element of interest that provides consideration for only the passage of time. That is, the time value of money element does not provide consideration for other risks or costs associated with holding the financial asset. To make this assessment, an entity applies judgement and considers relevant factors such as the currency in which the financial asset is denominated, and the period for which the interest rate is set. [IFRS 9.B4.1.9A].

The IASB also notes that, as a general proposition, the market in which the transaction occurs is relevant to the assessment of the time value of money element. For example, in Europe, it is common to reference interest rates to LIBOR and in the United States it is common to reference interest rates to the prime rate. However, a particular interest rate does not necessarily reflect consideration for only the time value of money merely because that rate is considered ‘normal’ in a particular market. For example, if an interest rate is reset every year but the reference rate is always a 15-year rate, it would be difficult for an entity to conclude that such a rate provides consideration for only the passage of time, even if such pricing is commonly used in that particular market. Accordingly, the IASB believes that an entity must apply judgement to conclude whether the stated time value of money element meets the objective of providing consideration for only the passage of time. [IFRS 9.BC4.178].

It could be argued that the standard is not entirely clear as to the status of benchmark rates such as LIBOR or its successor benchmark rates. For such rates, the consideration for credit risk is neither fixed, nor varies over time to reflect the specific credit risk of the obligor, but instead varies to reflect the credit risks associated with a class of borrowers. However, this seems to be a purist approach and given that LIBOR is widely used as a benchmark rate in capital markets at present and is cited in the standard as an example of a rate that would satisfy the criteria of the contractual cash flow characteristics test, it would seem that this is not an issue.

Interest may include profit margin that is consistent with a basic lending arrangement. But elements that introduce exposure to risks or variability in the contractual cash flows that are unrelated to lending (such as exposure to equity or commodity price risk) are not consistent with a basic lending arrangement. The IASB also noted that the assessment of interest focusses on what the entity is being compensated for e.g. basic lending risk or something else, rather than how much the entity receives. [IFRS 9.BC4.182(b)].

6.3 Contractual features that normally pass the test

The most common instruments that normally pass the test are plain vanilla debt instruments which are acquired at par, have a fixed maturity and pay interest that is fixed at inception. Instruments that pay variable interest also normally pass the test, although further consideration is required in that case (see 6.4.4 below).

There are several features that are common in many financial assets and which would not usually cause the contractual cash flow characteristics test to be failed. This section describes some of those features and instruments that are normally unproblematic but also highlights cases that might result in an asset failing the contractual cash flow characteristics test. Features that are more complex and need more consideration are described in 6.4 below.

6.4 Contractual features that may affect the classification

Sometimes, contractual provisions may affect the cash flows of an instrument such that they do not give rise to only a straightforward repayment of principal and interest. An entity is required to carefully assess those features in order to conclude whether or not the instrument passes the contractual cash flow characteristics test. It is important to note that the standard grants an exception for all features that are non-genuine or have only a de minimis impact and can be disregarded when making the assessment (see 6.4.1 below).

Furthermore, the standard allows the time value of money element of interest to be what is referred to as ‘modified’ but only when the resulting cash flows could not be significantly different from an instrument that has an unmodified time value of money element (see 6.4.2 below). It also allows regulated interest rates as long as they provide consideration that is broadly consistent with the passage of time and do not introduce risks that are inconsistent with a basic lending arrangement (see 6.4.3 below).

An instrument may have other features that change the timing or amount of contractual cash flows which need to be assessed as to whether they represent payments of principal and interest on the principal outstanding. Examples of such features are variable interest rates, interest rates that step up, prepayment and extension options (see 6.4.4 below).

Lastly, there are features that most likely result in an instrument failing the contractual cash flow characteristics test because they introduce cash flow volatility caused by risks that are inconsistent with a basic lending arrangement (see 6.4.5 below).

6.5 Non-recourse assets

A financial asset may have contractual cash flows that are described as principal and interest but those cash flows do not, in economic substance, represent the payment of principal and interest on the principal amount outstanding. [IFRS 9.B4.1.15]. For example, under some contractual arrangements, a creditor's claim is limited to specified assets of the debtor or the cash flows from specified assets (described in the standard as a ‘non-recourse’ financial asset). Another example given in the standard is contractual terms stipulating that the financial asset's cash flows increase as more automobiles use a particular toll road. Those contractual cash flows are inconsistent with a basic lending arrangement. [IFRS 9.B4.1.16]. As a result, the instrument would not pass the contractual cash flow characteristics test unless such a feature is de minimis or non-genuine. [IFRS 9.B4.1.18].

However, the fact that a financial asset is non-recourse does not in itself necessarily preclude the financial asset from passing the contractual cash flow characteristics test (see also 6.3.2 above). Furthermore, conventional subordination features do not preclude an asset from passing the test (see 6.3.1 above).

The non-recourse provision in IFRS 9 is intended to prevent instruments that are linked to the performance of another asset from being classified as amortised cost or FVOCI. Where an asset is non-recourse the creditor is required to assess (‘look through to’) the particular underlying assets or cash flows to determine whether the contractual cash flows characteristics test is being met. [IFRS 9.B4.1.17]. When assessing a non-recourse asset, various factors could be considered, such as:

• nature of borrower and its business;
• adequacy of loss absorbing capital (particularly for SPEs);
• pricing of the loan (may indicate returns above a lending return);
• performance figures such as Loan to Value ratios (LTVs), Debt Service Coverage Ratios (DSCR) and Interest Coverage Ratios (ICR);
• expected source of repayment; or
• existence of other forms of economic recourse such as guarantees.

The following examples illustrate instruments which normally fail the contractual cash flow characteristics test because their cash flows are not solely payments of principal and interest on the principal amount outstanding.

1. Project finance loans

   Where a loan is given for the construction and maintenance of a toll road and the payments of cash flows to the lender are reduced or cancelled if less than a certain number of vehicles travel on that road, the loan is unlikely to pass the contractual cash flow characteristics test. Similarly, a loan with cash flows specifically referenced to the performance of an underlying business will not pass the test.

   In other cases, where there is no such reference and there is adequate equity in the project to absorb losses before affecting the ability to meet payments on the loan, it may well pass the contractual cash flow characteristics test. In these cases the adequacy of equity to absorb losses will be key.

2. Loans to a special purpose entity (SPE)

   Where a loan is provided to an SPE that funds the acquisition of other assets, whether that loan passes the contractual cash flow characteristics test will depend on the specific circumstances of the arrangement.

   If the assets of the SPE are all debt instruments which would themselves pass the contractual cash flow characteristics test, the loan to the SPE might well pass it too. Further, if, the SPE uses the loan from the entity to fund investments in assets which will not themselves pass the contractual cash flow characteristics test, such as equity securities or non-financial assets, but the SPE has sufficient equity to cover the losses on its investments, the loan may again pass the contractual cash flow characteristics test. However, if the loan is the only source of finance to the SPE so that it absorbs any losses from the equity securities, it would not pass the contractual cash flow characteristics test. Whether the loan is legally non-recourse does not matter in this scenario because the SPE has limited other assets to which the lender can have recourse. Therefore, the SPE must have adequate equity for the interest to represent compensation for basic lending risk.

3. Mortgages

   There are many different types of mortgage loans and some are structured so that in the event of default the lender has legal recourse only to the property provided as collateral and not to the borrower. This type of arrangement is common in some states of the USA. Other mortgages may, in substance, be non-recourse if the borrower has limited other assets.

   In general, we do not believe that IFRS 9 was intended to require all normal collateralised loans such as mortgages to be accounted for at fair value through profit or loss. Consequently, if a loan is granted at a rate of interest that compensates the lender for the time value of money and for the credit risk associated with the principal amount, it would in our view usually pass the contractual cash flow characteristics test, whether or not it is legally non-recourse.

   However, at inception, if the expected repayment of a loan is primarily driven by future movements in the value of the collateral so that the loan is, in substance, an investment in the real estate market, then measurement at amortised cost or fair value through other comprehensive income classification would most likely be inappropriate.

The contractual cash flow characteristics are assessed at initial recognition of the asset. If at initial recognition the asset is full recourse there is no need to reassess whether there is any change thereafter.

Other loans could also be considered to be in substance non-recourse if the borrower has limited resources with which to repay the loan. Under certain circumstances impaired loans backed by collateral could also be considered to be non-recourse in substance, such as if the lender could only recover the loan by realising the collateral. This would in substance be similar to the lender buying the collateral directly.

Where an SPE issues non-recourse notes and uses the funding to buy an asset which is pledged as collateral for the non-recourse notes, the question arises as to how to assess whether ‘a creditor's claim is limited to specified assets of the debtor or the cash flow from specified assets’ and whether ‘the terms of the financial asset give rise to any other cash flows or limit the cash flows in a manner inconsistent with payments representing principal and interest’. In these cases the question revolves around whether the SPE has adequate equity such that interest represents compensation for the basic lending risks rather than asset risks.

6.6 Contractually linked instruments

In some types of transactions, an entity may prioritise payments to the holders of financial assets using multiple contractually linked instruments that create concentrations of credit risk (known as tranches). Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche. In such situations, the holders of a tranche have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy higher ranking tranches. [IFRS 9.B4.1.20]. As this guidance should be applied to ‘multiple contractually linked instruments’ an investment in a single tranche securitisation would not be assessed under this test. Also the Basis for Conclusions refers to classic waterfall structures with different tranches, rather than a single tranche. [IFRS 9.BC4.26].

These types of arrangements can concentrate credit risk into certain tranches of a structure. Essentially such investments contained leveraged credit risk and accordingly, the IASB believes that measuring such investments at amortised cost or fair value through other comprehensive income may be inappropriate in certain circumstances. Where a structure has in issue only a single tranche, it may be more appropriate to view an investment in that tranche as a non-recourse loan (see 6.5 above) rather than a contractually linked instrument.

In some cases, where an entity transfers assets to a securitization vehicle while retaining all the junior tranche, the transferee may determine that it needs to consolidate the structure. In that case, the transferee will continue to recognise the transferred asset and will recognise a liability equivalent to the proceeds of the senior notes, but will not recognise the junior note separately. It could be argued therefore, if the securitization vehicle only had two tranches, that the consolidation of the structure results in only the senior tranche being accounted for and raises the question of whether the senior tranche is a non-recourse asset rather than a contractually linked instrument. This is not generally regarded as being the case as looking at the legal form of the arrangement, it is clear that contractually the structure contains two tranches and it is just the accounting treatment in the books of the transferee, while it consolidates the structure, which gives the appearance that the structure has a single tranche. As such this type of structure would still be regarded as issuing multiple contractually linked instruments rather than a single non-recourse instrument.

In multi-tranche transactions that concentrate credit risk in the way described above, a tranche is considered to have cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if the following three criteria are met: [IFRS 9.B4.1.21]

1. the contractual terms of the tranche being assessed for classification (without looking through to the underlying pool of financial instruments) give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (e.g. the interest rate on the tranche is not linked to a commodity index);
2. the underlying pool of financial instruments must contain one or more instruments that have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding (the primary instruments) and any other instruments in the underlying pool must either: [IFRS 9.B4.1.23‑25]
   1. reduce the cash flow variability of the primary instruments in the pool and, when combined with the primary instruments in the pool, result in cash flows that are solely payments of principal and interest on the principal amount outstanding; or
   2. align the cash flows of the tranches with the cash flows of the underlying primary instruments in the pool to address differences in and only in:
      • whether the interest rate is fixed or floating;
      • the currency in which the cash flows are denominated, including inflation in that currency; or
      • the timing of the cash flows.

   For these purposes, when identifying the underlying pool of financial instruments, the holder should ‘look through’ the structure until it can identify an underlying pool of instruments that are creating (rather than passing through) the cash flows; [IFRS 9.B4.1.22]

3. the exposure to credit risk in the underlying pool of financial instruments inherent in the tranche is equal to, or lower than, the exposure to credit risk of all of the underlying pool of instruments (for example, the credit rating of the tranche is equal to or higher than the credit rating that would apply to a single borrowing that funded the underlying pool).

If the instrument in the pool does not meet the conditions in (b) above then the instrument fails the contractual cash flow test. In making this assessment, a detailed instrument-by-instrument analysis of the pool may not be necessary, however an entity must use judgement and perform sufficient analysis to determine whether the instruments in the pool meet the conditions in (b) above. [IFRS 9.B4.1.25].

If the holder cannot assess whether a financial asset meets criteria (a) to (c) above at initial recognition, the tranche must be measured at fair value through profit or loss. [IFRS 9.B4.1.26].

IFRS 9 implies that the underlying pool should consist of financial instruments. [IFRS 9.B4.1.21(b)]. Contractually linked instruments referencing a pool of non-financial instruments do not meet the contractual cash flow characteristics test and cannot be classified at amortised cost. However, a non-recourse financial asset could pass the contractual cash flow test depending on whether the underlying assets or cash-flows meet the contractual cash flow criteria. This is the case whether the underlying assets are financial assets or non-financial assets. [IFRS 9.B4.1.17]. This highlights a difference in the treatment of contractually linked and non-recourse instruments. The question therefore arises as to whether the guidance concerning non-recourse requirements (see 6.5 above) can be applied to contractually linked instruments.

Some structures contain liquidity facilities which provide short term funding to enable interest to be paid on notes when cashflows from the underlying assets are delayed, for instance a facility which provides liquidity to cover the cashflows needed for the SPE to operate and to pay interest to the noteholders for a short period. These facilities usually have a seniority above all other notes in the structure and a failure to pay on the facility would be considered a default of the SPE. Normally these liquidity features would not be considered to be a tranche of the structure and are seen as being an instrument in the pool rather than a tranche. This is because they are short term and designed to align the cash flows in the structure in a similar way to plain vanilla derivative instruments in (b) above, rather than to absorb risks by the holder and thereby create concentrations of credit risk.

The standard requires the guidance for contractually linked instruments to apply to all contractually linked instruments without exception. The scope of contractually linked instruments is based on the nature of the instruments issued not on the nature of the pool of assets underlying the instrument. As such it is not possible for a structure which contains contractually linked instruments to also contain non-recourse assets as well, if a structure issues multiple contractually linked instruments then the contractually linked instrument requirements will apply. Furthermore, in a structure where an SPE issues contractually linked notes referenced to a non-recourse note issued by another SPE referencing a pool of non-financial assets, IFRS guidance would require the entity holding the instrument to look through all contractually linked instruments.

Because of the way the standard is written the outcome of the contractual cash flow characteristics assessment will depend on the form of the arrangement. Arrangements which involve using multiple contractually linked instruments should be assessed under the contractually linked instruments requirements while arrangements with non-recourse features but without multiple tranches should be assessed under the non-recourse requirements. Therefore, the accounting outcome can vary depending on the structure employed, for instance, a non-recourse financial asset whose cash flows depend on vehicles using a toll road would be required to be assessed under the non-recourse requirement if structured as a single instrument but, if structured into tranches, would be assessed differently under the contractually linked instrument criteria.

In practice it may be difficult for the holder to perform the look-through test because the underlying reference assets of a collateralised debt obligation (CDO) may not all have been acquired at the time of investment. In such circumstances, the holder will need to consider, amongst other things, the intended objectives of the CDO as well as the manager's investment mandate before determining whether the investment qualifies for measurement at amortised cost or fair value through other comprehensive income. If after this consideration the holder is able to conclude that all the underlying reference assets of the CDO will always have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding, the interest in the CDO can qualify for measurement at amortised cost or fair value through other comprehensive income. Otherwise, the investment in the CDO must be accounted for at fair value through profit or loss because it fails the contractual cash flow characteristics test, unless the effect is de minimis.

If the underlying pool of instruments can change after initial recognition in a way that does not meet conditions (a) and (b) above, the tranche must be measured at fair value through profit or loss. However, if the underlying pool includes instruments that are collateralised by assets that do not meet the conditions above (as will often be the case), the ability to take possession of such assets is disregarded for the purposes of applying this paragraph, unless (which will be rare) the entity acquired the tranche with the intention of controlling the collateral. [IFRS 9.B4.1.26].

The IASB noted that a key principle underlying the contractual cash flow provisions for contractually linked instruments was that an entity should not be disadvantaged simply by holding an asset indirectly if the underlying asset has cash flows that are solely principal and interest, and the holding is not subject to more-than-insignificant leverage or a concentration of credit risk relative to the underlying assets.

Accordingly, the IASB clarified that a tranche may have contractual cash flows that are solely payments of principal and interest even if the tranche is prepayable in the event that the underlying pool of financial instruments is prepaid. The Board noted that because the underlying pool of assets must have contractual cash flows that are solely payments of principal and interest, then, by extension, any prepayment features in those underlying financial assets are also required to be solely payments of principal and interest. [IFRS 9.BC4.206(a)].

The Board's clarification that a prepayment feature in the underlying pool of assets does not necessarily prevent a tranche from meeting the contractual cash flow characteristics test is helpful. But, unless the underlying pool can only be acquired at origination, it may be very difficult to ‘look through’ to the underlying pool to determine if its prepayment features would themselves be solely payments of principal and interest. This is because the information will often not be available to determine whether the assets were acquired at a premium or discount, and whether the fair value of any prepayment feature was insignificant on acquisition (see 6.4.4 above).

While some contractually linked instruments may pass the contractual cash flow characteristics test and consequently may be measured at amortised cost or fair value through other comprehensive income, the contractual cash flows of the individual tranches are normally based on a pre-defined waterfall structure (i.e. principal and interest are first paid on the most senior tranche and then successively paid on more junior tranches). Accordingly, one could argue that more junior tranches could never suffer a credit loss because the contractually defined cash flows under the waterfall structure are always equal to the cash flows that an entity expects to receive, and so would never be regarded as impaired. This is, because Appendix A of IFRS 9 defines ‘credit loss’ as ‘the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive, discounted at the original effective interest rate’.

However, consistent with treating these assets as having passed the contractual cash flow characteristics test, we believe that the impairment requirements of IFRS 9 (see Chapter 51) apply to such tranches if they are measured at amortised cost or fair value through other comprehensive income. Instead of the cash flows determined under the waterfall structure, an entity needs to consider deemed principal and interest payments as contractual cash flows when calculating expected credit losses. In many cases, when a bank sets up an SPE to securitise assets and issue notes, the bank will also provide a liquidity facility to the SPE to ensure that interest and principle on the notes can be paid on time regardless of the timing of the cash flows of the underlying assets. In these cases the liquidity facility is not considered to be a tranche of the contractually linked instrument even if it is included in the liquidity waterfall structure of the arrangement e.g. it is given a place in the subordination ranking of the tranches. The characteristics of the liquidity facility are sufficiently different from the notes. If the liquidity facility does not have features that would fail the contractual cash flow characteristics test then it would be treated as a short term loan.

7.1 Designation eliminates or significantly reduces a measurement or recognition inconsistency (accounting mismatch) that would otherwise arise

The notion of an accounting mismatch necessarily involves two propositions. First, that an entity has particular assets and liabilities that are measured, or on which gains and losses are recognised, on different bases; and second, that there is a perceived economic relationship between those assets and liabilities. [IFRS 9.BCZ4.61].

For example, absent any designation, a financial asset might be classified as subsequently measured at fair value and a liability the entity considers related would be subsequently measured at amortised cost (with changes in fair value not recognised). In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were measured as at fair value through profit or loss. [IFRS 9.B4.1.29].

IFRS 9 gives the following examples of situations in which designation of a financial asset or financial liability as measured at fair value through profit or loss might eliminate or significantly reduce an accounting mismatch and produce more relevant information: [IFRS 9.B4.1.30]

1. an entity has liabilities under insurance contracts whose measurement incorporates current information (as permitted by IFRS 4 – Insurance Contracts), and financial assets it considers related that would otherwise be measured at fair value through other comprehensive income or amortised cost;
2. an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, that gives rise to changes in fair value that tend to offset each other. However, only some of the instruments would be measured at fair value through profit or loss (e.g. derivatives or those classified as held for trading). It may also be the case that the requirements for hedge accounting are not met, for example because the requirements for hedge effectiveness are not met;
3. an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, that gives rise to changes in fair value that tend to offset each other and the entity does not use hedge accounting. This could be for different reasons, for example, because items giving rise to the accounting mismatch would not qualify for hedge accounting or because the entity does not want to use hedge accounting because of operational complexity. Furthermore, in the absence of hedge accounting there is a significant inconsistency in the recognition of gains and losses. For example, the entity has financed a specified group of loans by issuing traded bonds, the changes in the fair value of which tend to offset each other. If, in addition, the entity regularly buys and sells the bonds but rarely, if ever, buys and sells the loans, reporting both the loans and the bonds at fair value through profit or loss eliminates the inconsistency in the timing of recognition of gains and losses that would otherwise result from measuring them both at amortised cost and recognising a gain or loss each time a bond is repurchased.

For practical purposes, an entity need not acquire all the assets and incur all the liabilities giving rise to the measurement or recognition inconsistency at exactly the same time. A reasonable delay is permitted provided that each transaction is designated as at fair value through profit or loss at its initial recognition and, at that time, any remaining transactions are expected to occur. [IFRS 9.B4.1.31].

It would not be acceptable to designate only some of the financial assets giving rise to the inconsistency as at fair value through profit or loss if to do so would not eliminate or significantly reduce the inconsistency and would therefore not result in more relevant information. However, it would be acceptable to designate only some of a number of similar financial assets if doing so does achieve a significant reduction (and possibly a greater reduction than other allowable designations) in the inconsistency. [IFRS 9.B4.1.32].

For example, assume an entity has a number of similar financial assets totalling €100 and a number of similar financial liabilities totalling €50, but these are measured on a different basis. The entity may significantly reduce the measurement inconsistency by designating at initial recognition all of the liabilities but only some of the assets (for example, individual assets with a combined total of €45) as at fair value through profit or loss. However, because designation as at fair value through profit or loss can be applied only to the whole of a financial instrument, the entity in this example must designate one or more assets in their entirety. It could not designate either a component of an asset (e.g. changes in value attributable to only one risk, such as changes in a benchmark interest rate) or a proportion (i.e. percentage) of an asset. [IFRS 9.B4.1.32].

7.2 A group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis

The second situation in which the fair value option may be used (for financial liabilities) is where a group of financial liabilities or financial assets and financial liabilities is managed, and its performance evaluated, on a fair value basis. In order to meet this condition, it is necessary for the group of instruments to be managed in accordance with a documented risk management or investment strategy and for information, prepared on a fair value basis, about the group of instruments to be provided internally to the entity's key management personnel (as defined in IAS 24 – see Chapter 39 at 2.2.1.D), for example the entity's board of directors and chief executive officer. [IFRS 9.4.2.2(b)].

If an entity manages and evaluates the performance of a group of financial liabilities or financial assets and financial liabilities in such a way, measuring that group at fair value through profit or loss results in more relevant information. The focus in this instance is on the way the entity manages and evaluates performance, rather than on the nature of its financial instruments. [IFRS 9.B4.1.33]. Accordingly, subject to the requirement of designation at initial recognition, an entity that designates financial instruments as at fair value through profit or loss on the basis of this condition should so designate all eligible financial instruments that are managed and evaluated together. [IFRS 9.B4.1.35].

An entity may designate financial liabilities as at fair value through profit or loss if it has financial assets and financial liabilities that share one or more risks and those risks are managed and evaluated on a fair value basis in accordance with a documented policy of asset and liability management. For example, the entity may issue ‘structured products’ containing multiple embedded derivatives and manage the resulting risks on a fair value basis using a mix of derivative and non-derivative financial instruments. [IFRS 9.B4.1.34].

An entity's documentation of its strategy need not be extensive (e.g. it need not be at the level of detail required for hedge accounting) but should be sufficient to demonstrate that using the fair value option is consistent with the entity's risk management or investment strategy. Such documentation is not required for each individual item, but may be on a portfolio basis. The IASB notes that in many cases, the entity's existing documentation, as approved by its key management personnel, should be sufficient for this purpose. For example, if the performance management system for a department (as approved by the entity's key management personnel) clearly demonstrates that its performance is evaluated on a total return basis, no further documentation is required. [IFRS 9.B4.1.36].

The IASB made it clear in its basis for conclusions that in looking to an entity's documented risk management or investment strategy, it makes no judgement on what an entity's strategy should be. However, the IASB believes that users, in making economic decisions, would find useful a description both of the chosen strategy and of how designation at fair value through profit or loss is consistent with that strategy. Accordingly, IFRS 7 – Financial Instruments: Disclosures – requires these to be disclosed (see Chapter 54 at 4.1). [IFRS 9.BCZ4.66].

7.3 Hybrid contracts with a host that is not a financial asset within the scope of IFRS 9

If a contract contains one or more embedded derivatives, and the host is not a financial asset within the scope of IFRS 9, an entity may designate the entire hybrid contract as at fair value through profit or loss unless:

1. the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract; or
2. it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost. [IFRS 9.4.3.5].

As discussed in Chapter 46 at 4 to 6, when an entity becomes a party to a hybrid financial instrument that contains one or more embedded derivatives and the host is not a financial asset within the scope of IFRS 9, the entity is required to identify any such embedded derivative, assess whether it is required to be separated from the host contract and, if so, measure it at fair value at initial recognition and subsequently. These requirements can be more complex, or result in less reliable measures, than measuring the entire instrument at fair value through profit or loss. For that reason, the entire instrument is normally permitted to be designated as at fair value through profit or loss. [IFRS 9.B4.3.9].

Such designation may be used whether the entity is required to, or prohibited from, separating the embedded derivative from the host contract, except for those situations in (a) or (b) above – this is because doing so would not reduce complexity or increase reliability. [IFRS 9.B4.3.10].

Little further guidance is given on what instruments might fall within (a) and (b) above. The basis for conclusions explains that, at one extreme, the terms of a prepayment option in an ordinary residential mortgage is likely to mean that the fair value option is unavailable to such a mortgage (unless it met one of the conditions in 7.1 and 7.2 above). At the other, it is likely to be available for ‘structured products’ that contain several embedded derivatives which are typically hedged with derivatives that offset all (or nearly all) of the risks they contain irrespective of the accounting treatment applied to the embedded derivatives. [IFRS 9.BCZ4.68‑70].

Essentially, the IASB explains, the standard seeks to strike a balance between reducing the costs of complying with the embedded derivatives provisions and the need to respond to concerns expressed regarding possible inappropriate use of the fair value option. Allowing the fair value option to be used for any instrument with an embedded derivative would make other restrictions on the use of the option ineffective, because many financial instruments include an embedded derivative. In contrast, limiting the use of the fair value option to situations in which the embedded derivative must otherwise be separated would not significantly reduce the costs of compliance and could result in less reliable measures being included in the financial statements. [IFRS 9.BCZ4.70].