In May 2024, the International Accounting Standards Board (IASB) released amending guidance1 to its accounting standards for financial instruments, IFRS 9. The amendments centres on the ‘Solely Payments of Principal and Interest’ (SPPI) test, which plays a significant role in the classification and measurement of bonds and other debt instruments.
Addressing Industry Concerns and Market Evolution
As the IASB was performing its post-implementation review of IFRS 9, many within the industry became concerned about IFRS 9’s requirements for assessing contractual cash flow characteristics on fixed income assets, particularly as they pertained to debt instruments with features linked to sustainability or environmental, social, and governance (ESG) issues. IFRS 9 was initially finalized in 2014 and went live for IFRS filers in 2018. However, because of the IASB’s recent project to revamp the accounting for insurance contracts (IFRS 17), most IFRS insurers were given a reprieve from adopting IFRS 9 until 2023, which lined up with IFRS 17’s effective date. This was done to allow for a more harmonious implementation and to lessen the effects of any asset-liability mismatches. In the APAC region, 28 out of the 35 jurisdictions have adopted IFRS accounting standards. Japan permits, rather than require, the use of IFRS. Taiwan plan to adopt IFRS in 2026. Unsurprisingly, during this lengthy delay in implementation, a natural evolution of markets followed, and over the last decade, there has been significant growth in sustainable debt issuance.
SPPI Test and Classification Rules
The IFRS 9 classification rules stipulate that, for a bond to be held at either amortised cost (AC) or fair value through OCI (FVOCI), it must pass the SPPI test. This is important because bonds held at AC or FVOCI are able to shield market volatility from an insurer’s earnings.
When analysing a bond for SPPI purposes, the rules emphasize that its cash flows must be consistent with a basic lending agreement. Specific to the interest component, the assessment focuses on what an investor is being compensated for, rather than how much compensation the investor receives (though the amount of compensation may indicate that the investor is being compensated for something other than basic lending risks and costs). Contractual cash flows are considered to be inconsistent with a basic lending arrangement if they include compensation tied to variable or market factors that are not typically considered to be basic lending risks or costs. Typical basic lending risks includes the consideration of credit risk or liquidity risk. Interest rate risk is another common consideration – which can be addressed through the issuance of floating or variable rate instruments with coupons tied to commonly used benchmark reference rates such as SONIA, ESTR, SOFR, etc.
Contingent Events and ESG Metrics
Furthermore, if there are terms that could change the timing or amount of contractual cash flows, the investor needs to assess the nature of any contingent event or trigger, and its effect on the instrument’s cash flows. For a change in contractual cash flows to be consistent with a basic lending arrangement, the contingent event must not result in cash flows that are significantly different from the expected cash flows absent of any contingent event. The analysis of cash flows can be performed qualitatively, but depending on the complexity of the contingent feature, may need to be performed quantitatively.
The sustainable debt market has seen rapid growth in recent years, with some instruments having its coupons tied to a specific ESG metric (e.g. carbon emissions) and an issuer may have its interest rate increased or decreased depending on its ability to meet an emissions target (the contingent event). For that instrument to pass the SPPI test, the instrument must have SPPI cash flows before and after the contingent event. Additionally, because contingent features linked to ESG targets like carbon emissions are not typical basic lending risks, the effects of the emissions target cannot result in cash flows that are significantly different from those that would exist if the contingent event did not occur.
If the instrument was, for example, designed to where its interest rate can be adjusted based on a market-determined variable, such as a carbon price index, (as opposed to a contingent event tied to the issuer), this type of metric would result in the instrument failing the SPPI test because the instrument’s cash flows are linked to a variable that is not a basic lending risk or cost.
Clarity for Sustainable Bond Investors
With the IASB amending its guidance2 on matters affecting of sustainability / ESG-linked instruments, the hope is that this will provide clarity for bond investors, particularly for companies sensitive to the accounting treatment of their bond portfolios. This should also lessen concerns for investors and issuers of sustainable debt, as global regulators push to meet its climate policy goal for a more sustainable economy.
1 IFRS 9 Financial Instruments: new paragraphs B4.1.8A and B4.1.10A; amended paragraphs B4.1.10, B4.1.13, B4.1.14
2 The amended paragraphs in IFRS 9 become effective for annual reporting periods beginning on or after January 1st 2026. Early adoption is also permitted.