SPPI Assessment, Staging of a Forborne Exposure and Fair Value Hierarchy
Vasudha Finance Ltd (VFL), an NBFC with a 31 March year-end, holds four financial assets at 31 March 20X5: (a) ₹90 crore of 6% bonds convertible at the holder's option into as many shares as ₹1,000 per bond will buy at the market price on conversion; (b) ₹60 crore of an 11% fixed-rate loan to a textile borrower repayable in 2028, with a borrower right to prepay at par plus accrued interest, no penalty; (c) ₹25 crore, the most subordinated tranche of an unrated securitisation SPV, which absorbs first losses on a ₹2,000 crore vehicle-loan pool and takes residual cash flows after senior tranches; there is no active market and it was bought at par 18 months ago; (d) ₹400 crore of term loans at amortised cost with an ECL allowance of ₹8 crore. In February 20X5, ₹70 crore due from a steel borrower was restructured after 90 days past due: the rating fell from A to BB, tenure was extended two years and the coupon cut 200 bps; no further deterioration is expected. VFL's business model is to collect contractual cash flows for (b) and (d), and to hold and sell for (a) and (c).
1. Classify and measure (a), (b) and (c) under Ind AS 109, explaining the SPPI test for each.
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(a) ₹90 crore convertible bonds - FVTPL. The conversion feature delivers a variable number of shares (₹1,000 ÷ market price), so the holder's return is exposed to equity price movements and the instrument is not fixed-for-fixed. Cash flows are not solely payments of principal and interest on the principal outstanding; they include a return linked to the issuer's equity. Financial assets are never split into host and embedded derivative, so the whole instrument fails SPPI and is measured at FVTPL. The 'hold and sell' business model is irrelevant once SPPI fails.
(b) ₹60 crore 11% loan - amortised cost. Interest is a fixed return on principal; the prepayment feature is at par plus accrued interest, i.e. it substantially represents unpaid principal and interest (Ind AS 109 para B4.1.12(b)), so SPPI is met even without a make-whole. The business model is hold to collect (cash flows from collection, not sale), so the loan is measured at amortised cost using the effective interest method; because the prepayment option is a contractual term, expected prepayments are reflected in estimating cash flows for the EIR. A modification or prepayment later is dealt with as a modification/derecognition, not as a reclassification.
(c) ₹25 crore first-loss tranche - FVTPL. The tranche absorbs the first credit losses on the pool and receives residual cash flows after the senior tranches are paid. Its cash flows are neither interest on principal nor a pass-through of P&I on the underlying pool - they are geared and include credit concentration and residual profit. SPPI fails, so FVTPL, notwithstanding the 'hold and sell' model; the absence of a market does not permit cost measurement.
2. How should the ₹70 crore steel exposure be treated at 31 March 20X5 - staging, measurement and interest recognition? Would a substantial modification change the answer?
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Staging. Three facts point to a significant increase in credit risk since initial recognition: a 90-day overdue position, a two-notch rating downgrade (A to BB) and a concession granted because of the borrower's financial difficulty. The 30-days-past-due backstop in Ind AS 109 is a rebuttable presumption of SICR; the 90-day point is a rebuttable presumption of default. Without evidence that credit risk has not increased materially, the exposure moves to Stage 2 - lifetime ECL, not 12-month ECL.
Is it credit-impaired? A distressed restructuring after 90 days past due is normally evidence of credit impairment. If the exposure is still in default at 31 March 20X5 (or the forbearance has not yet cured), it is Stage 3, interest revenue is computed on the net carrying amount (gross less loss allowance) and the ECL is the present value of cash shortfalls over the life of the exposure. If the restructuring has genuinely cured the default with a sustainable payment record, Stage 2 applies, with lifetime ECL and interest on the gross carrying amount. The judgement, and its basis, must be documented.
Modification. Compare the present value of the renegotiated cash flows (discounted at the original EIR) with the carrying amount. If the difference is not substantial (a 10% test as an accounting policy benchmark), do not derecognise - recognise a modification loss in profit or loss and continue to measure at the original EIR. If it is substantial, derecognise and recognise a new asset at fair value; if the new asset is credit-impaired at initial recognition it is POCI, with interest on the net amount and ECL movements recognised as a gain or loss.
Presentation. The ₹8 crore allowance must be increased for the additional lifetime ECL; the allowance continues to be shown as a deduction from the gross carrying amount, and the staging split is disclosed.
3. The tranche in (c) is carried at fair value. At which level of the Ind AS 113 hierarchy does it sit, and what drives the measurement?
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Level 3. The tranche is an unrated residual interest in an unrated SPV, with no quoted price in an active market and no identical instrument traded. A quoted price for the senior tranches or for the underlying vehicle loans is not a Level 1 input for this instrument - Level 1 requires a quoted price (unadjusted) in an active market for the identical asset. Observable pool-level data alone would not make it Level 2 either, because the significant inputs to the residual cash flows are unobservable.
Valuation approach. A discounted cash flow model of the tranche's residual cash flows, using: constant prepayment rate, probability of default and loss severity of the underlying vehicle loans, the expected loss allocation to the first-loss tranche, the discount rate (a market yield for a first-loss residual reflecting leverage and illiquidity), and the correlation between defaults.
Judgements an examiner will test:
- The purchase price 18 months ago is not fair value at 31 March 20X5 unless the market and the asset are unchanged (Ind AS 113 para 79 permits the transaction price as evidence only at initial recognition).
- A change in the entity's own credit spread is irrelevant to the fair value of an asset.
- Disclosures: valuation technique, significant unobservable inputs, quantitative sensitivity of the fair value to changes in unobservable inputs, and transfers between levels (Ind AS 113 paras 91–99).