What Is the SPPI Test for Financial Asset Classification?

Financial asset classification dictates how a company reports its investments on financial statements. The value and income from these assets, which range from simple loans to complex securities, must be measured according to specific rules. These evaluations determine the appropriate accounting treatment, which in turn affects a company’s reported earnings and financial position.

Purpose of the SPPI Test in Financial Asset Classification

The requirement for classifying financial assets stems from accounting standards like International Financial Reporting Standard 9 (IFRS 9) and U.S. Accounting Standards Codification (ASC) Topic 326. Classification is determined by two criteria: the entity’s business model for managing the assets and the contractual cash flow characteristics of the asset. The Solely Payments of Principal and Interest (SPPI) test is the specific mechanism used to assess the second criterion.

The purpose of the SPPI test is to determine if a financial instrument has cash flows consistent with a basic lending arrangement. It acts as a filter, separating simpler debt instruments from those with more complex features that introduce risks beyond typical lending. The test identifies assets whose cash flows are payments of the principal amount and interest on that principal. This assessment must be performed on an instrument-by-instrument basis.

If an asset’s contractual terms introduce exposure to risks or volatility unrelated to a basic loan, such as linking payments to equity prices or commodity markets, it will fail the SPPI test. This failure signals that the asset contains features more akin to an equity investment or a derivative, requiring a different accounting approach.

Core Components of the SPPI Criteria

The SPPI test is built on the definitions of its two core components: principal and interest. The criteria are designed to be specific, ensuring that only instruments with straightforward lending characteristics can pass.

Principal is defined as the fair value of the financial asset at its initial recognition. This represents the amount invested or loaned at the beginning of the contract. The outstanding principal will change over the life of the instrument as repayments are made.

Interest is defined more narrowly than its common usage and consists of compensation for several specific elements. Any contractual feature that creates cash flows based on factors outside of these specific elements would not be considered interest under the SPPI criteria. Acceptable components of interest include compensation for:

• The time value of money
• Credit risk, which is the compensation for the risk that the borrower will default on their payments
• Other basic lending risks, such as liquidity risk
• Costs associated with holding the financial asset, such as administrative costs
• A profit margin for the lender

Analyzing Contractual Features

The analysis of contractual features involves examining a financial asset’s terms to see if they align with the SPPI criteria. This assessment focuses on the economic substance of the cash flows and whether the contract exposes the holder to risks inconsistent with a basic lending relationship.

Certain financial instruments clearly pass the test. For example, a standard corporate bond with a fixed 5% annual coupon has contractual cash flows that are solely payments of principal and interest. Similarly, a variable-rate loan where the interest rate is tied to a common benchmark, such as the Secured Overnight Financing Rate (SOFR), plus a fixed margin for credit risk, would also pass. In this case, the benchmark rate reflects the time value of money, and the margin covers other basic lending risks and profit, fitting squarely within the definition of interest.

Conversely, many financial instruments contain features that cause them to fail the SPPI test. A common example is a convertible bond, which allows the holder to convert the debt into a specified number of the issuer’s equity shares. This feature fails the test because the value of the conversion option, and therefore the potential cash flows, is linked to the performance of the issuer’s stock, which is an equity risk, not a lending risk.

Other failing features include those that introduce leverage or are tied to non-lending variables. An instrument whose interest payments are calculated as a multiple of an interest rate index, such as three times SOFR, would fail because the leveraged feature magnifies the volatility of cash flows beyond what is typical for interest. Likewise, a note where the principal repayment is linked to the price of a commodity, like oil, or the performance of an equity index, like the S&P 500, would fail. These terms introduce commodity or equity market risks, which are unrelated to a basic lending arrangement.

Classification Outcomes Based on the SPPI Test

The outcome of the SPPI test determines the potential accounting classifications for a financial asset. The consequences of passing or failing have a significant impact on how the asset is reported on the financial statements.

If a financial asset passes the SPPI test, it becomes eligible for measurement at either Amortized Cost or Fair Value through Other Comprehensive Income (FVOCI). The final classification depends on the entity’s business model for managing the asset. If the company’s objective is to hold the asset to collect its contractual cash flows, it is measured at Amortized Cost. If the business model involves both collecting cash flows and potentially selling the asset, it is measured at FVOCI.

If a financial asset fails the SPPI test, it must be classified and measured at Fair Value through Profit or Loss (FVTPL). This is required regardless of the company’s business model. Under FVTPL, the asset is reported at its current market value at each reporting date, and all changes in value are reported directly on the income statement, which can lead to greater volatility in reported earnings.