Often debts include clauses in which either borrower or an issuer can prepay the debt amount earlier than its contractually agreed period or extension of term can be requested. As per the classification of Assets rules defined under as per Ind-As 109 – Financial Instruments which states that after the initial recognition of such financial Assets i.e. on Fair value, its subsequent classification would be based on Business Modal for managing such financial asset & contractual cash flow characteristic associated with these Financial Assets.
Para -4.1.2 –A financial asset shall be measured at amortised cost if both of the following conditions are met:
(a) the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows and
(b) 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.
In order to classify an Financial Asset at “Amortised Cost” the entity should have a business modal which could state that the asset will be held for collecting Cash-flows and these cash flows would be solely for the payment of Interest & Principal only. The payment for Interest and Principal includes credit risk and time value of money.
There is a commonly asked question in which debt is being prepaid either at the option of holder or issuer and it carries some penalty clauses together with a requirement to payback all outstanding amount or in other case where extension of the debt is being done by paying some additional amount, hence should it satisfy the SOLELY PAYMENT for PRINCIPAL & INTEREST?
Lets’ have a look at the requirement and guidance given in the standard itself –
Ind-As 109 – Financial Instruments – Appendix B
(b) a contractual term that permits the issuer (ie the debtor) to prepay a debt instrument or permits the holder (ie the creditor) to put a debt instrument back to the issuer before maturity and the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the early termination of the contract; and
(c) a contractual term that permits the issuer or the holder to extend the contractual term of a debt instrument (ie an extension option) and the terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the extension of the contract.
Let’s take an example to understand the same –
Entity A lends INR 1 million to entity B at an agreed rate for a period of 5 years with the following conditions –
1- B could prepay the loan before 5 years however a penalty of INR 100,000 needs to be paid along with the outstanding interest and principal payments, or
2- Either A or B could request for term extension in which some additional processing fees of INR 10,000 would need to pay to the lender,
Standard states that a “reasonable compensation” which has not been defined properly and hence one needs to apply its own judgment while using these clauses.
1- INR 100,000 could be “reasonable compensation” for such prepayment of debt and hence the debt could still meet the characteristic of solely payment for Principal & Interest (SPPI test),
2- INR 10,000 would be considered “reasonable compensation” and hence in the presence of such clauses, the debt could still meet SPPI test if the business modal of Entity A would suggest that such debt are holding to collect contractual cash flow then it may be considered for amortized cost accounting.
There are many more different areas pertaining to SPPI test which would be covered in future articles to provide an approach while dealing with such cases. Correct categorization is a key to avoid any confusion at inception and any consequences while having external reviews (Auditor or regulatory authorities)
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries . He can be reached via email at [email protected] or Whatsapp +91-9634706933)