A quick amendment to IFRS 9 is intended, among other things, to permit classification of an investment in ESG bonds based on the traditional and simple amortised cost model, instead of measurement at fair value through profit or loss, which triggers volatility of results. This amendment is expected to encourage investments in the said bonds and even to encourage banks to include ESG terms as part of loan agreements. Even though the proposed amendment is consistent with the global agenda regarding this matter, it creates a coherency problem with respect to the accounting treatment of the Standard. Accordingly, it would be wise to limit the amendment solely to cases where achieving the ESG target reduces the credit risk of the issuing entity.
At the present time, an investment in a debt instrument that includes adjustment of interest in respect of an ESG event could, in many cases, be required to be measured at fair value through profit or loss. This situation could discourage companies from making an investment in such bonds and could deter banks from including such terms as part of loan agreements. In light of these considerations, a proposal for amendment to IFRS 9 was recently published whereby an investment, as stated, may be considered an investment in a simple debt instrument that is measured based on the traditional amortised cost model. That is, the inclusion of an adjustment of interest in respect of an ESG event would not prevent the instrument from being measured at amortised cost.
Such an amendment would have significant impacts on the motivation of companies and particularly financial institutions, such as banks, to invest in ESG‑based bonds or to include ESG terms as part of loan agreements. It is difficult to ignore the fact that presently there are numerous distortions in the accounting standards that have not been addressed so quickly by the standards’ boards.
In order to understand the substance of the proposed amendment, it is important to first mention the accounting concept of IFRS 9 with respect to accounting for an investment in a debt instrument. In general, the starting point for measurement of financial instruments in the Standard is fair value, since fair value takes all the variables relevant to market participants into account, including the market interest rate at the reporting date. The exception to this rule is that, subject to the objective of the business model, an instrument that reflects a basic lending arrangement is to be measured at amortised cost. The main rationale for the exception is that the amortised cost model more relevantly reflects the business model of an investment in debt instruments that involve a basic lending arrangement and that are held in order to collect the principal and interest over the full life of the instrument (rather than sell it along the way). It is important to understand that the financial statements of banks worldwide are based precisely on this rationale, where their main assets – regular loans – are measured using the amortised cost model. This accounting treatment protects the banks against unwanted volatility in the results due to changes in market interest rates.
Clearly, it is necessary to underscore that the amortised cost model is subject to built‑in impairment rules and, therefore, it takes several significant variables into account – the forecast of collections, contractual changes in cash flows and credit losses. Nonetheless, full adjustment to fair value stemming from fluctuations in market interest rate is not made – and this is a tremendous difference. In addition, it must be borne in mind that in the annual financial statements there is a requirement to disclose the fair value of all the financial instruments measured at amortised cost, such that the accounting treatment based on amortised cost does not completely eliminate the need for measurement at fair value.
The key for determining whether a debt instrument satisfies the conditions of a basic lending arrangement is known as the SPPI (Solely Payments of Principal and Interest) test. The question is – are only payments of principal and interest involved? Accordingly, when the contractual terms include exposure to risk or volatility that do not relate to a basic lending arrangement, such as, for example, changes in the price of shares or commodities, the instrument does not meet the SPPI test.
Accordingly, IFRS 9 provides that a basic lending arrangement includes five characteristics: the time value of the money; credit risk; basic lending risks such as liquidity risk; costs relating to holding the financial asset; and a profit margin.
The proposed amendment
The proposed amendment includes several important clarifications and amendments with respect to the application of these principles. Before we address the difficulties apparently posed by the proposed amendment, a review will be made of the existing situation and the provisions of the present standard.
It is important to understand that many loan agreements include contractual conditions that increase or decrease the contractual interest paid to the lender upon the occurrence of market events or other debtor‑specific events that conform to the components mentioned above. Examples are a rise in the interest rate upon a decline in the borrower’s credit rating (compensation for credit risk) and an increase in the interest rate where there is an increase in the risk‑free rate or any benchmark interest rate (compensation for the time value of money). At the present time, the accepted interpretation of the term ‘solely payments of principal and interest’ (SPPI) is that if it is possible to demonstrate that the change stated in the contract indeed conforms to a permitted component of a basic lending arrangement, and also moves in the proper direction, the SPPI test is met and the debt instrument may be classified, depending on the business model, as measured at amortised cost. On the other hand, certain financial instruments include characteristics rising to the level of equity participations. These characteristics usually move inversely to a basic loan’s risks. For example, consider a bond of a CoCo type that was issued by a financial institution. Occasionally, there is a write-off (or postponement without interest) of the principal of such a bond upon a fall in the financial institution’s capital adequacy ratio. In this case, the write-off is not consistent with a basic lending arrangement, since when the credit risk rises, the compensation to the lender actually drops. In this case, as well as in other cases where the lender is entitled to a share in the debtor’s business results, the accepted practice is that the arrangement does not meet the SPPI test.
Regarding this aspect, in general it can be said that the first component of the proposed amendment conforms to the accepted practice and clarifies, for the avoidance of doubt, that a certain characteristic of a loan agreement does not meet the SPPI test if it is not consistent with the direction and magnitude of the loan risks or costs, regardless of whether they are common or customary in the market for loans or financial instruments of this type.
However, it appears that if the amendment that addresses classification of financial assets would have concluded solely with this section, it is certainly possible that investments in bonds that are subject to an interest reduction upon achievement of ESG targets would remain at fair value through profit or loss. This is since it is difficult to claim, for example, that achievement of a target of an equal number of men and women on the board of directors, or, possibly, the number of electric vehicles in the debtor’s fleet, indicates compensation for credit risk or other basic loan risks.
Hence, it seems that a serious effort was made to permit bonds of the ESG type to be accounted for at amortised cost. The Basis for Conclusions on the amendment notes that the list of the interest components is not exhaustive (without providing additional clear examples), and thus it appears that the amendment opens the door to the desired treatment, along with a certain measure of uncertainty.
It seems that in an attempt to minimize the impacts of the amendment, it was provided that in order for a change in the contractual cash flows of a certain loan to be considered consistent with a basic lending arrangement, it must be specific to the debtor and must not create exposure to the performance of specified assets or be tantamount to an investment in the debtor (similar to the equity investment as noted above). The example presented in the amendment includes an adjustment of interest that is contingent on achieving an ESG target involving greenhouse gas emissions – a target specific to the debtor. On the other hand, an example is presented involving payment of interest that is contingent on the price of a certain commodity or market index – targets that are not specific to the debtor.
Ultimately, it seems that in an attempt, on the one hand, to allow the accounting treatment and, on the other hand, to reduce the resulting impacts, the amendment is bound to contradict itself. For example, it is not clear how to resolve the new principle of debtor‑specific characteristics with other principles, such as adjustment of the contractual interest to the market interest (bonds and loans bearing floating interest rates). Similarly, where it is possible to clearly illustrate that a certain macro risk has a high correlation with the borrower’s credit risk, and that the loan agreement includes reasonable compensation in the correct direction and magnitude, it is not clear why this will not meet the SPPI test.
Ratio of the number of male employees to the number of female employees
It pays to point out that the illustration included in the amendment is also not clear since it notes that adjustment of interest for ESG characteristics meets the SPPI test without raising the question of the direction and magnitude of the adjustment. For example, is it reasonable to claim that a loan, which raises the interest rate by 10% depending on the number of women on the board of directors, is more basic than a loan for which the interest increases by 1% as a result of a rating decline of the borrower’s country below investment grade?
As mentioned above, ESG events derive from the contribution to environmental protection and the like, and in many cases do not relate to exposure to risk or fluctuations of a basic lending arrangement in accordance with the above‑mentioned characteristics.
It is noted that symmetry does not necessarily exist in the accounting treatment from the standpoint of the issuer of ESG‑based bonds or a loan recipient, since generally from their perspective the accounting treatment of the entire instrument will be based on the amortised cost model. This stems from the concept that there is no need in such cases to separate the embedded derivative as a result of not meeting the definition of a derivative where a non‑financial variable specific to a party to the contract is involved, as is true in the case of ESG.
Moreover, the starting point of the Standard for measurement of debt instruments that are not considered to be basic is, as noted, fair value, since in many cases it is more relevant to measure such instruments at fair value (particularly when they have a quoted market price). Regarding this aspect, it is not clear from the amendment’s Basis for Conclusions what role the users of the financial statements played in respect of the necessity of the amendment regarding an investment in bonds linked to ESG indices. The wish to allow measurement of ESG‑linked bonds at amortised cost, rather than at fair value, stands out so much more against the background of the crisis presently plaguing the banks in the United States. Many banks, such as SVB, did not recognise losses and impairments in their financial statements stemming from the rising interest rates, in such a manner that harmed the relevancy of their financial statements.
It is difficult to ignore the theoretical problems of the proposed amendment. The purported purpose of the proposed amendment is indeed not to provide an exception only for the ESG issue. However, the general exception that is apparently proposed does not align with the general accounting logic, as stated.
In this context, to illustrate the distortion in the proposed amendment, which as noted is drafted in a general manner and not only for ESG, even if there is a specific target, such as opening of stores or a certain sales’ turnover amount, it might meet the SPPI test due to the amendment even if it is not clearly correlated with credit risk. It is also not clear what exactly ESG targets are. For example, can it be said that a loan bearing an interest rate that is contingent on the total number of an entity’s employees does not meet the SPPI test, while a loan bearing an interest rate that is contingent on the ratio of the number of male employees to the number of female employees does meet the said test, simply because it is specific to the debtor?
It could be possible to explain the amendment as stemming from the fact that the entry of ESG events into loan agreements is becoming standard worldwide, i.e., this is the widespread basic lending arrangement. Nonetheless, it is important to emphasize that in the Standard itself the criterion that was ultimately adopted is the SPPI, as stated, and not necessarily standardization. As mentioned above, it is sufficient to note that a condition that relates to the capital adequacy ratio (such as Basel or solvency capital requirements) could also be considered widespread but it is not considered to meet the SPPI test and, therefore, the debt instrument should be measured at fair value. Similarly, an investment in catastrophe bonds is also measured at fair value.
The bottom line is, beyond the attention the ESG matter receives in the accounting standards and the Boards’ willingness to contribute to this matter, it is important to resolve the theoretical problem arising as a result of the proposed amendment. It is important to understand that the function the parent institution of the IFRS is undertaking in establishment of the ISSB, as was visible last week upon publication of the first two reporting standards on ESG (IFRS S1 and IFRS S2), has considerable importance with respect to the creation of standardization for investors and coherency with the information in the financial statements. However, at the same time, it is important that these goals do not have a harmful impact on the coherency and propriety of the purposes of the accounting standards themselves.
Clarification – not an amendment
A possible solution is to adopt a general principle that the ESG targets, as well as other targets that are specific to the reporting entity, and maybe even targets that are not specific to the reporting entity, meet the SPPI test only if it can be assumed that achieving the target will decrease or increase the credit risk of the issuing entity or another component such as liquidity risk, subject to the requirement that the magnitude of the change, as well as its direction, are consistent with the substance of the target. In our view, the provision whereby the list of permitted characteristics of a basic lending arrangement is not exhaustive, could create uncertainty. For example, it could be determined that where it can be assumed that achieving the ESG target results in a decline in the business risk of the reporting entity, and the adjustment for the decline will be nominal, the SPPI test will be met. In contrast, for an inverse direction, for an unclear relationship between the target and credit risk or where the said decline is too significant, the SPPI test will not be met. This will also be the case where a growth target of revenue is involved that was set for the issuing company. Pursuant to the Standard’s concept, as well as the amendment itself, the direction of the adjustment is critically important – since if it is set inversely to an increase in the interest rate where the positive targets are achieved, whether an ESG or a revenue target, the result is essentially the same as an equity participation and therefore does not meet the SPPI test.
It is important to emphasize that this possible solution does not require an amendment to the Standard and its guiding principle but, rather, no more than a clarification of the matter, or several examples, in order to ensure uniformity of application, since this appears to be the presently existing interpretive situation.