Uncertainty in applying the new IFRS 9 standard weigh heavy on the financial industry. This post proposes a long-term solution to accommodate the IFRS 9 requirement to check, in order to classify, the contractual terms of a financial asset whether the cash flows are solely payments of principal and interest on the principal amount outstanding, also known as “SPPI Test” (IFRS 9, paragraphs 4.1.2 and 4.1.2A). An extensive assessment of the portfolio is needed to classify financial instruments according to chapter 4 of IFRS 9. In the short term, each reporting entity will be forced to analyze their bond indentures. In the long term, the bond indentures may already provide the SPPI Test result along with the usual bond information. The reporting entities should invest in static data depth and quality to meet increasing demands of regulation authorities.

Problem & impact

In applying the IFRS 9 standard for financial instruments, companies need to assess their portfolio in order to classify the financial instruments according to chapter 4 of IFRS. The burden for this assessment can be significantly lower if the company classifies all instruments at their fair value through profit or loss (FVPL). However, if a company wants to use other possible classifications, the SPPI Test implies extensive study of bond indentures and possibly significant adaptions in capturing and storing financial static data.

Therefore the costs for reporting entities to apply and maintain the IFRS standard will increase. Various financial data providers, i.e. Bloomberg, Reuters and others are now selling additional services in providing the SPPI test result (“passed” or “failed”) along with the corresponding reason. These services come at a considerable cost.

Possible solution

The issuers of bond indentures are mostly investment banks but also other issuing financial institutions. These companies are uniquely positioned to add the SPPI Test result to the bond/loan indentures among other information about the cash flows. They should know exactly to what extent the cash flows are solely payments of principal and interest on the principal amount outstanding. Thus, I propose to all institutions that write bond indentures to add the SPPI Test result at bond issuance.

Transition period short- to mid-term

Unfortunately there are many bonds outstanding without the proposed new SPPI Test result flag in the bond indenture. Therefore, during the implementation phase of IFRS 9, the reporting entities must either do the assessment or pay their data providers for the flag.

When facing the decision whether or not to implement an own SPPI Test logic, the reporting entity must assess its investment data depth and data quality. Since data quality and data depth are key to a functioning SPPI Test logic, a sufficient data management or data servicing is of utmost importance.

Nevertheless, if the issuing investment banks start to flag the bond indentures with the SPPI Test result now, the reporting entities will see lower costs in the longer term.

The longer term

The IFRS 9 SPPI Test result should be key information like the interest calculation method. If the described possible solution gets market acceptance, I expect that the business case for financial market data suppliers to provide the SPPI Test result for the industry will diminish (this might be the reason for their expensive fees).

I suggest the following to all entities that will report according to IFRS 9:

1. Analyze financial instruments static data depth and quality
2. Possibly invest in increasing static data depth and quality
3. Implement own SPPI Test logic

Conclusion

Reporting entities should invest in the analysis and improvement of static data depth and quality now to get confidence of applying the ever-increasing demands of regulation. A company that has sufficient data depth and quality in place has a clear advantage.

03.11.2017/ Roland Kurath, Merkpunkt GmbH