IFRS 9 Business Model and SPPI Testing
What’s the business model test and SPPI testing and why it’s important to understand?
According
to IFRS 9, When an entity first
recognizes a financial asset, it classifies based on the entity’s business
model for managing the asset and the asset’s contractual cash
flow (SPPI test) characteristics, as further described below.
A financial asset is measured at amortised cost if both of the following
conditions are met, otherwise considered at Fair
value through other comprehensive income (FVOCI) or Fair value through PL
(FVTPL) as advised in IFRS 9:
1. Business
model test- the asset is held within a business model whose objective is
to hold assets in order to collect contractual cash flows;
and
2. SPPI
test- the contractual terms of the financial asset give rise
on specified dates to cash flows that are solely
payments of principal and interest(SPPI) on the principal
amount outstanding.
Business model test
In
business model test an entity does classification of financial assets to
determine the level, that reflects how groups of financial assets are managed
together to achieve a particular business objective. The entity’s business
model neither depends on management’s intentions for an individual instrument
nor on an instrument-by instrument approach, it should be determined at a
higher level of financial asset aggregation. Thus, an entity may have more than
one business model for managing its financial assets.
The
‘Business Model test’ involves four basic steps:
• Grouping of
all loans and receivables into separate portfolio according to the way they are
managed.
• Analyze
the objective of entity to manage the each portfolio/group
• Determine
the nature of each portfolio in order to generate cash flows,
whether its for ‘held to collect’ or ‘available for sale’.
• For
assets classified as being held to collect, evaluating the appropriateness of
the classification by back-testing against past activities.
Classification of Business models:- An
entity’s business model for managing financial assets is a matter of fact and
not merely an assertion. It is typically observable through the activities that
the entity undertakes to achieve the objective of the business model. An entity
will need to use judgement when it assesses its business model for managing
financial assets and that assessment is not determined by a single factor or
activity. Instead, the entity must consider all relevant evidence that is
available at the date of the assessment. Such relevant evidence includes, but
is not limited to:
(a) how
the performance of the business model and the financial assets held within that
business model are evaluated and reported to the entity’s key management
personnel;
(b) the
risks that affect the performance of the business model (and the financial
assets held within that business model) and, in particular, the way in which
those risks are managed; and
(c) how
managers of the business are compensated (for example, whether the compensation
is based on the fair value of the assets managed or on the contractual cash
flows collected).
Following business models whose objective is also considered to
hold assets in order to collect contractual cash flows:
Ø Insignificant
sale- Although the objective of an entity’s business model may be to
hold financial assets in order to collect contractual cash flows, the entity
need not hold all of those instruments until maturity. Thus an entity’s
business model can be to hold financial assets to collect contractual cash
flows even when sales of financial assets occur or are expected to occur in the
future majorly result of following issues:
- When
there is an increase in the assets credit risk. To determine
increase in credit risk, the entity considers reasonable and supportable
information, including forward looking information. Irrespective of their
frequency and value, sales due to an increase in the assets’ credit risk are
not inconsistent with a business model whose objective is to hold financial
assets to collect contractual cash flows because the credit quality of
financial assets is relevant to the entity’s ability to collect contractual
cash flows.
- Sales that occur for other reasons, such as sales made to manage credit concentration risk. Such sales should be infrequent (even if significant in value) or insignificant in value both individually and in aggregate (even if frequent) otherwise reassessment of portfolio is required.
Ø Factoring and securitization of trade receivables- Many entities realize contractual cash flows from trade
receivables through factoring or securitization programs. The classification of
the related assets under the Business Model test may depend on whether the factoring
or securitization will be accounted for as a sale or a financing. If the
former, classification as other than holding for collection, or holding for
collection and sale, would likely be appropriate.
Note- Refer ''IFRS 9 Business model Examples- To collect the contractual cash flows''.
Business model whose objective is both collecting
contractual cash flows and selling financial assets:
An entity may hold
financial assets in a business model whose objective is achieved by collecting
contractual cash flows and selling financial assets. In this type of business
model, the entity's key management personnel have made the decision that both
the collection of contractual cash flows and the sale of financial assets are
essential to achieve the objective of the business model.
This business model
will generally involve a higher frequency and value of sales compared to the
contractual cash flow model (see the "Insignificant Sales"
paragraph). This is because the sale of financial assets is integral to
achieving the objective of the business model instead of being only incidental.
Note- Refer ''IFRS 9 Business model Examples- For both collecting contractual cash flows and selling financial assets''.
Other
business models
•
Financial assets are measured at fair value through profit or loss (FVTPL) if they
are not maintained within a business model whose objective is to maintain
assets to collect contractual cash flows or within a business model whose
objective is achieved through collection of contractual cash flows and sale of
financial assets
• A portfolio
of financial assets that meets the definition of holding to trade is not held
to collect contractual cash flows or to collect contractual cash flows and to
sell financial assets. For such portfolios, the collection of contractual cash
flows is only incidental to achieving the business model objective and such
assets are measured in FVTPL.
SPPI
test
In SPPI
tests, an entity assesses contractual cash flows on a specified date that are
only principal and interest payments on the outstanding principal amount. It is
a necessary condition to classify loans and accounts receivable at amortized
cost or FVOCI.
What is
the principal?
Principal
is the fair value of a financial asset at initial recognition, which may change
during the life of a financial instrument (for example, if there are repayments
of the principal).
What is
interest?
Interest
is the consideration for the time value of money, for the credit risk
associated with the amount of principal outstanding during a particular period
of time, and for other basic loan risks (for example, liquidity risks) and
costs (for example , administrative costs), also as profit margin.
Note:
Leverage is a contractual cash flow characteristic of some financial assets.
Leverage increases the variability of contractual cash flows with the result
that they do not have the economic characteristics of interest. Independent,
forward and swap option contracts are examples of financial assets that include
such leverage. Therefore, such contracts cannot subsequently be measured at
amortized cost or fair value through other comprehensive income.
Consideration
of the time value of money
The
value of money over time is the element of interest that only considers the
passage of time and does not consider other risks and costs. The element of the
passage of time will be determined based on judgment and consideration of other
factors.
If the
interest rate on a financial asset is periodically reset or contains a modified
time value term of the monetary element, then the entity should evaluate the
change to determine whether the contractual cash flows represent only principal
and interest payments on the amount of the main pending.
If the
contractual cash flow or interest rate is based on the rates established by the
government or any regulatory authority, then that interest rate will be
considered a representation of the time value element of money to satisfy the
purpose of the contractual cash flow.
Ø Contractual
terms that change the timing or amount of contractual cash
flows
· If a financial
asset contains a contractual term that could change the time or amount of
contractual cash flows, the entity must determine whether the contractual cash
flows that could arise during the life of the instrument due to that contractual
term are only payments of principal and interest on the amount of the
outstanding principal evaluating the cash flow that could arise before and
after the change and also evaluating contingent events, if any.
Illustration:
Compare a financial instrument with an interest rate that is reset to a higher
rate if the debtor misses a particular number of payments to a financial
instrument with an interest rate that is reset to a higher rate if a principal
index specific reaches a particular level. In the first case, contractual cash
flows over the life of the instrument are more likely to be solely principal
and interest payments on the outstanding principal amount due to the
relationship between late payments and an increase in credit risk. .
• If a
financial asset meets the contractual cash flow condition but does not do so
only as a result of a contractual term that allows (or requires) the issuer to
prepay a debt instrument before maturity is eligible to be measured at
amortized cost (or FVOCI as the case may be) if:
(a) the
entity acquires or originates the financial asset with a premium or discount on
the contractual nominal amount;
(b) the
prepayment amount substantially represents the nominal contractual amount and
the accrued (but not paid) contractual interest, which may include reasonable
compensation for early termination of the contract; and
(c) when the
entity initially recognizes the financial asset, the fair value of the prepaid
characteristic is insignificant.
• A
contractual cash flow characteristic does not affect the classification of the
financial asset if it could only have a de minimis effect on the contractual
cash flows of the financial asset. In making this determination, an entity must
consider the potential effect of the contractual cash flow characteristic at
each reporting period and cumulatively over the life of the financial
instrument.
• A cash
flow characteristic is not genuine if it affects the instrument's contractual
cash flows only when an event occurs that is extremely rare, highly abnormal, and
highly unlikely.
Ø Contractually
linked instruments
In some
types of transactions, an issuer may prioritize payments to holders of
financial assets using multiple contractually linked instruments that create
concentrations of credit risk (tranches). Each tranche has a subordination
classification that specifies the order in which the cash flows generated by
the issuer are assigned to the tranche. In such situations, holders of a
tranche are entitled to principal and interest payments on the outstanding
principal amount only if the issuer generates sufficient cash flows to satisfy
higher-rated tranches. An entity should look until it can identify the
underlying set of instruments that are creating the cash flows.
Note- Refer ''IFRS 9 Business model Examples- solely (or not solely) payments of principal and interest''.
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