Accounting Standards and Guidance

Examples – Debt instruments

1

A zero-coupon loan

For a zero-coupon loan, the holder's return is the difference between the nominal value of the loan and the issue price. The holder (lender) receives a fixed amount when the loan matures and the issuer (borrower) repays the loan. The return to the holder meets the condition in paragraph 11.9(a)(i).

2

A fixed interest rate loan with an initial tie-in period which reverts to the bank's standard variable interest rate after the tie-in period

The initial fixed rate is a return permitted by paragraph 11.9(a)(ii). A bank's standard variable interest rate is an observable interest rate and, in accordance with the definition of a variable rate, is a permissible link and so meets the condition in paragraph 11.9(a)(ii).

The variation of the interest rate after the tie-in period is non-contingent and, since the new rate (ie the bank's standard variable rate) meets the conditions in paragraph 11.9(a), the conditions in paragraph 11.9(aB)(i) are met.

3

A loan with interest payable at the bank's standard variable rate plus 1 per cent throughout the life of the loan

As discussed under Example 2 above, a bank's standard variable rate is a permitted variable rate in accordance with the definition of variable rate. The combination of a positive fixed rate (ie plus 1 per cent) and a positive variable rate is a permitted return under paragraph 11.9(a)(iv). The combination of a bank's standard variable rate plus a fixed interest rate of 1 per cent therefore meets the condition in paragraph 11.9(a)(iv).

3A

A loan with interest payable at the bank's standard variable rate plus 1 per cent throughout the life of the loan – the bank's standard variable rate is negative

As discussed in Example 3, the combination of a positive bank's standard variable rate plus a fixed interest rate of 1 per cent meets the condition in paragraph 11.9(a)(iv). However, the conditions in paragraph 11.9(a) do not explicitly address the case when the bank's standard variable rate is negative and such a rate may not meet the conditions.

The interest rate is consistent with the description in paragraph 11.9A provided the bank's standard variable rate reflects prevailing economic conditions and monetary policies. In this case the negative interest rate represents reasonable compensation for basic lending risks. ^{[AMD 297]}

4

A loan with interest payable at the bank's standard variable rate less 1 per cent throughout the life of the loan, with the condition that the interest rate can never fall below 2 per cent

Paragraph 11.9(aB)(i)(1) permits variation of a return to a holder (lender) that is contingent on a change of a contractual variable rate. In this example the contractual variable rate is the bank's standard variable rate. The variation of the return to the holder is between the bank's standard variable rate less 1 and 2 per cent, depending on the bank's standard variable rate. For example, if the bank's standard variable rate is less than 3 per cent, the return to the holder is fixed at 2 per cent; if the bank's standard variable rate is higher than 3 per cent, the return to the holder is the bank's standard variable rate less 1 per cent. The contractual variation meets the condition in paragraph 11.9(aB)(i)(1).

The holder is protected against the risk of losing the principal amount of the loan via the interest rate floor of 2 per cent. The condition in paragraph 11.9(b) is therefore also met.

4A

A loan with a condition that the interest rate is reset to a higher rate if a set number of payments is missed

In this case the change in interest rate is contingent on a set number of payments being missed. The missed payments are an indicator of credit deterioration of the issuer. The interest rate reset condition therefore meets the condition in paragraph 11.9(aB)(i)(2) (provided the new rate meets the conditions in paragraph 11.9(a)), and the interest rate reset condition would not result in the loan being measured at fair value in accordance with Section 12. ^{[AMD 298]}

5

Interest on a loan is referenced to 2 times the bank's standard variable rate

In accordance with the definition of a variable rate, the contractual interest rate payable can be linked to a single observable interest rate. A bank's standard variable rate is an observable rate and meets the definition of a variable rate, but the rate in this example is 2 times the bank's standard variable rate and therefore the link to the observable interest rate is leveraged. As a result of the leverage, the rate in this example is not a variable rate as described in paragraph 11.9(a).

A leveraged link to an observable interest rate is also inconsistent with the description in paragraph 11.9A because it increases the variability of cash flows so that they do not represent reasonable compensation for the time value of money, credit risk or other basic lending risks and costs. The instrument is measured at fair value in accordance with Section 12.

6

Interest on a loan is charged at 10 per cent less 6-month LIBOR over the life of the loan

The effect of deducting a variable rate from a positive fixed rate is that the interest on the loan increases as and when the variable rate decreases and vice versa (so called inverse floating interest).

In accordance with paragraph 11.9(a)(iv) the combination of positive or negative fixed rate and positive variable rate is a permitted return. The variable rate (6-month LIBOR) meets the definition of a variable rate, as the rate is a quoted interest rate. However, since the variable rate is negative (minus 6-month LIBOR), the rate is in breach of the condition in paragraph 11.9(a)(iv).

The inverse floating interest rate is also inconsistent with the description in paragraph 11.9A because the interest charged increases when reasonable compensation for the time value of money, credit risk or other basic lending risks and costs would decrease, and vice versa. The instrument is measured at fair value in accordance with Section 12.

7

Interest on a GBP denominated mortgage is linked to the UK Land Registry House Price Index (HPI) plus 3 per cent

In accordance with paragraph 11.9(aA) the holder's return may be linked to an index of general price inflation of the currency of the debt instrument. The mortgage is denominated in GBP and a permitted inflation index would be an index that measures general price inflation of goods and services denominated in GBP.

As the HPI measures inflation for residential properties in the UK and is not a measure of general price inflation, the return to the holder breaches the condition in paragraph 11.9(aA).

The mortgage is also inconsistent with the description in paragraph 11.9A because the linkage to the HPI introduces exposure to a risk that is not consistent with a basic lending arrangement. The instrument is measured at fair value in accordance with Section 12.

8

Early repayment of a loan is not permitted during an initial two-year period, but is thereafter

The terms of a ten-year loan include that it may not be repaid within the initial two-year period, but thereafter it may be repaid at the issuer's option, subject only to the payment of reasonable compensation for early termination.

The early repayment condition is not contingent on future events, but automatically comes into effect with the passage of time, and therefore it meets the condition in paragraph 11.9(c) and would not result in the loan being measured at fair value in accordance with Section 12.

9

Early repayment on subordinated debt contingent on repayment of senior debt

Bank A lends CU10 million to Entity S. Entity S has an option to repay this loan at any time. Entity S's parent, Entity P, also lends it CU10 million. The loans have the same maturity date but the loan from Bank A is senior to the loan from Entity P. Entity S has the right to repay the loan to Entity P at par plus accrued interest at any time after the loan from Bank A has been repaid.

Early repayment terms that are within the control of the issuer are not contingent on future events. Therefore if early repayment of both loans is within Entity S's control then the prepayment option in the loan from Entity P is not considered to be contingent, does not breach the condition in paragraph 11.9(c) and does not therefore cause the loan from Entity P to be measured at fair value in accordance with Section 12.

If the terms were such that early repayment of the loan from Bank A was not within the control of Entity S, then the prepayment option in the loan from Entity P would be contingent on a future event other than those listed in paragraph 11.9(c). The nature of the contingent event may be an indicator when assessing whether a debt instrument is consistent with the description in paragraph 11.9A, but is not in itself a determinative factor. The restriction on the prepayment feature in the loan from Entity P would be consistent with the description in paragraph 11.9A because it exists simply to enforce its subordination relative to another debt instrument. The restriction on Entity S's ability to exercise the prepayment option in the loan from Entity P would not therefore cause the loan from Entity P to be measured at fair value in accordance with Section 12 by Entity S.

10

A loan with interest equal to a percentage of the profits of the issuer

The contractual return is neither a fixed rate or amount, nor a variable rate linked to a single observable interest rate or index of general price inflation. Therefore, the return breaches the conditions in paragraph 11.9(a).

In addition, the loan is inconsistent with the description in paragraph 11.9A because the linkage to the profits of the issuer introduces exposure to a risk that is not consistent with a basic lending arrangement.

The instrument is within the scope of Section 12 and will be measured at fair value by the holder. However, the issuer will need to consider whether measurement at fair value is permitted by the Small Companies Regulations, the Regulations, the Small LLP Regulations or the LLP Regulations (see paragraph A3.12A). These regulations prohibit the measurement of financial liabilities at fair value, except for those held as part of a trading portfolio, those that are derivatives and when permitted by IFRS as adopted in the EU. An example of the latter category is financial liabilities with embedded derivatives that meet certain conditions. However this would exclude instruments with 'a non-financial variable specific to a party to a contract'.

Therefore, if the issuer concludes that the issuer's profits are 'a non-financial variable specific to a party to a contract' and that the instrument could not otherwise be measured at fair value under IFRS as adopted in the EU, then it must measure the instrument at amortised cost, rather than at fair value, in accordance with paragraph 12.8(c). ^{[AMD 299]}

Examples – Debt instruments

1

A zero-coupon loan

For a zero-coupon loan, the holder's return is the difference between the nominal value of the loan and the issue price. The holder (lender) receives a fixed amount when the loan matures and the issuer (borrower) repays the loan. The return to the holder meets the condition of paragraph 11.9(a)(i).

2

A fixed interest rate loan with an initial tie-in period which reverts to the bank's standard variable interest rate after the tie-in period

The initial fixed rate is a return permitted by paragraph 11.9(a)(ii). A bank's standard variable interest rate is an observable interest rate and, in accordance with the definition of a variable rate, is a permissible link. In accordance with paragraph 11.9(a)(ii) the variable rate should be a positive rate.

The variation of the interest rate after the tie-in period is non-contingent and since the new rate (ie the bank's standard variable rate) meets the condition of paragraph 11.9(a), paragraph 11.9(aB)(i) is met.

3

A loan with interest payable at the bank's standard variable rate plus 1 per cent throughout the life of the loan

As discussed under Example 2 above, a bank's standard variable rate is a permitted variable rate in accordance with the definition of variable rate. The combination of a positive fixed rate (ie plus 1 per cent) and a positive variable rate is a permitted return under paragraph 11.9(a)(iv). The combination of a bank's standard variable rate plus a fixed interest rate of 1 per cent therefore meets the condition in paragraph 11.9(a)(iv).

4

A loan with interest payable at the bank's standard variable rate less 1 per cent throughout the life of the loan, with the condition that the interest rate can never fall below 2 per cent

Paragraph 11.9(aB)(i)(a) permits variation of a return to a holder (lender) that is contingent on a change of a contractual variable rate. In this example the contractual variable rate is the bank's standard variable rate. The variation of the return to the holder is between the bank's standard variable rate less 1 per cent and 2 per cent, depending on the bank's standard variable rate. For example, if the bank's standard variable rate is less than 3 per cent, the return to the holder is fixed at 2 per cent; if the bank's standard variable rate is higher than 3 per cent, the return to the holder is the bank's standard variable rate less 1 per cent. The contractual variation meets the condition of paragraph 11.9(aB)(i)(1).

The holder is protected against the risk of losing the principal amount of the loan via the interest rate floor of 2 per cent. The requirement of paragraph 11.9(b) is therefore also met.

5

Interest on a loan is referenced to 2 times the bank's standard variable rate.

In accordance with the definition of a variable rate, the contractual interest rate payable can be linked to a single observable interest rate. A bank's standard variable rate is an observable rate and meets the definition of a variable rate, but the rate in this example is 2 times the bank's standard variable rate and the link to the observable interest rate is leveraged. Therefore, the rate in this example is not a variable rate as described in paragraph 11.9(a). The instrument is measured at fair value in accordance with Section 12.

6

Interest on a loan is charged at 10 per cent less 6-month LIBOR over the life of the loan.

The effect of combining a negative variable rate with a positive fixed rate is that the interest on the loan increases as and when the variable rate decreases and vice versa (so called inverse floating interest).

Under paragraph 11.9(a)(iv) the combination of positive or negative fixed rate and positive variable rate is a permitted return. The variable rate (6-month LIBOR) meets the definition of a variable rate, as the rate is a quoted interest rate. However, since the variable rate is negative (minus 6-month LIBOR), the rate is in breach of paragraph 11.9(a)(iv). The instrument is measured at fair value in accordance with Section 12.

7

Interest on a GBP denominated mortgage is linked to the UK Land Registry House Price Index (HPI) plus 3 per cent.

In accordance with paragraph 11.9(aA) the holder's return may be linked to an index of general price inflation of the currency of the debt instrument. The mortgage is denominated in GBP and a permitted inflation index would be an index that measures general price inflation of goods and services denominated in GBP.

The HPI measures inflation for residential properties in the UK and is not a measure of general price inflation. The return to the holder therefore fails to meet the condition in paragraph 11.9(aA). The instrument is measured at fair value in accordance with Section 12.