From now until its mandatory effective date of 1 January 2018, we are going to consider a different element of IFRS 9 Financial Instruments on a regular basis. This month we take a look at the different Business Models which IFRS 9 identifies and how this impacts the classification of financial assets.
Why is the Business Model assessment important?
As explained in the June edition of Business Edge, the classification decision for non-equity financial assets under IFRS 9 is dependent on two key criteria:
- the business model within which the asset is held (the business model test); and
- the contractual cash flows of the asset (the Solely Payments of Principal and Interest (SPPI) test)
Consequently, determining the business model within which the financial asset is held is necessary in order to determine the appropriate classification category under IFRS 9.
What is a Business Model?
A business model refers to how an entity manages its financial assets in order to generate cash flows. It is determined at a level that reflects how groups of financial assets are managed rather than at an instrument level. IFRS 9 identifies three types of business models: ‘hold to collect’, ‘hold to collect and sell’ and ‘other’. Many entities may only have one business model but it is possible to have more than one.
In order to determine which type of business model(s) an entity has, it is necessary to understand the objectives of each business model and the activities undertaken. In doing so, an entity would need to consider all relevant information including, for example, how business performance is reported to the entity’s key management personnel and how managers of the business are compensated.
Hold to collect
The objective of the ‘hold to collect’ business model is to hold financial assets to collect their contractual cash flows, rather than with a view to selling the assets to generate cash flows. However, there is no requirement that financial assets are always held until their maturity, and IFRS 9 identifies some sales that are considered consistent with the ‘hold to collect’ business model irrespective of their frequency and significance. This is in contrast to the held to maturity category under IAS 39 which penalised entities for sales in all but exceptional circumstances (commonly known as ‘tainting rules’). Nevertheless, it is expected that sales would be incidental to this business model and consequently an entity will need to assess the nature, frequency and significance of any sales occurring.
Only financial assets that meet the SPPI test and are held in a ‘hold to collect’ business model can be classified at amortised cost. A typical example would be trade receivables or intercompany loans where the entity intends to collect the contractual cash flows and has no intention of selling those financial assets.
Hold to collect and sell
Under the 'hold to collect and sell’ business model, the objective is to both collect the contractual cash flows and sell the financial asset. In contrast to the ‘hold to collect’ business model, sales are integral rather than incidental, and consequently this business model typically involves a greater frequency and volume of sales.
Only financial assets that meet the SPPI test and are held in a ‘hold to collect and sell’ business model can be classified at fair value through other comprehensive income for debt. One example would be government or corporate bonds that are held with the dual objective of holding those bonds to earn interest and selling those bonds before their maturity in order to generate cash for investment or liquidity purposes.
It is worth noting that this business model could also apply to trade receivables in cases where an entity has a practice of factoring subsequent to initial recognition. In these cases, further analysis would be required in order to determine whether the factoring arrangement constitutes a sale and if so whether a ‘hold to collect and sell’ business model or indeed one of the ‘other’ business models is more appropriate.
Other business models are all those that do not meet the ‘hold to collect’ or ‘hold to collect and sell’ qualifying criteria. Some examples are:
- business models for which the primary objective is realising cash flows through sale (i.e. collecting contractual cash flows is incidental)
- business models which are managed and performance evaluated on a fair value basis
- held for trading business models
All non-equity financial assets falling into ‘other’ business models must be classified at fair value through profit or loss, irrespective of whether the SPPI test is passed.
Can the Business Model change?
Changes to the business model are possible but are expected to be very infrequent. Such changes should be determined by the entity’s senior management and must be both significant to the entity’s operations and evident to external parties, for example, terminating a particular business line. If an entity re-assesses the business model for a particular group of financial assets, then this would result in those assets being reclassified prospectively. In contrast to IAS 39, a change to the business model is the only instance which results in the reclassification of a financial asset under IFRS 9.
For help and advice on IFRS 9 please get in touch with your usual BDO contact or Dan Taylor.
Read more on IFRS9:
IFRS 9 Explained – the new expected credit loss model
IFRS 9 explained - modifications of financial liabilities
IFRS 9 explained – the classification of financial assets
IFRS 9 explained – Hedge effectiveness thresholds
IFRS 9 explained - Impairment and the simplified approach
IFRS 9 Explained – Available For Sale Financial Assets
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