IFRS 9 Proper accounting for Related Company Loans

IFRS 9 Proper accounting for Related Company Loans – IFRS 9 Financial Instruments makes no distinction between unrelated third party and related party transactions. Entities that prepare stand-alone financial statements are required to apply the full provisions of the standard to all transactions within its scope.

This means related company loan receivables must be classified and measured in accordance with the requirements of IFRS 9, including where relevant, applying the Expected Credit Loss (ECL) model for impairment. IFRS 9 Proper accounting for Related Company Loans

Applying IFRS 9 to related company loans can present a number of application challenges as they are often advanced on terms that are not arms-length or sometimes advanced on an informal basis without any terms at all. IFRS 9 Proper accounting for Related Company Loans

In addition, they can contain features that expose the lender to risks that are not consistent with a basic lending arrangement. This is a summary of the key requirements of IFRS 9 (focusing on those that are likely to be most relevant to related company loans) and uses examples to illustrate how these requirements could be applied in practice.

The decisions in the tree

Is the related company loan in scope of IFRS?	→	NO	→	Apply IAS 27 Separate Financial Statements or IAS 28 Investments in Associates or Joint Ventures
↓	IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans
YES
↓
Does the loan meet the Solely Payments of Principal and Interest test?	→	NO	→	Classify at Fair Value Through Profit or Loss
↓	IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans
YES
↓
Is the loan in a ‘hold to collect’ business model?	NO →	Is the loan in a ‘hold to collect and sell’ business model	→
↓		↓	IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans
YES		YES
↓		↓
Classify at Amortised Cost & apply General ECL Approach1		Classify at Fair Value Through Other Comprehensive Income (for debt) & apply General ECL Approach2
↓		↓
Is the loan credit impaired?			→	Stage 3 = Lifetime ECL; interest on net basis
IFRS 9 Proper accounting for Related Company Loans	↓	NO	IFRS 9 Proper accounting for Related Company Loans
Has the loan suffered a Significant Increase In Credit Risk?			→	Stage 2 = Lifetime ECL; interest on gross basis
IFRS 9 Proper accounting for Related Company Loans	↓	NO	IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans IFRS 9 Proper accounting for Related Company Loans
Stage 1 = 12-month ECL; interest on gross basis

Other transactions within the scope of IFRS 9

This publication focuses on applying the requirements of IFRS 9 to certain types of related company loan receivables. However, entities should be aware that the requirements of IFRS 9 also apply to other types of related company transactions that can arise in the normal course of business, namely: IFRS 9 Proper accounting for Related Company Loans

• Trade receivables under IFRS 15 Revenue from Contracts with Customers are required to be classified and measured in accordance with IFRS 9 similar to any other financial asset; those that are not classified at Fair Value through Profit or Loss (FVPL) are within the scope of the ECL model (Simplified Approach is either permitted or, in some cases, required);
• Contract assets under IFRS 15 are within the scope of the ECL model (Simplified Approach is either permitted or, in some cases, required);
• Lease receivables under IFRS 16 Leases are within the scope of the ECL model (Simplified Approach permitted);
• Issued financial guarantee contracts (FGCs) that are not classified at FVPL (and not accounted for in accordance with IFRS 4 Insurance Contracts or IFRS 17 Insurance Contracts ) are within the scope of the ECL model (General Approach required); and IFRS 9 Proper accounting for Related Company Loans
• Issued loan commitments that are not classified at FVPL are within the scope of the ECL model (General Approach required).

In addition, other related party loan receivables, such as loans to an entity’s key management personnel must also be classified and measured in accordance with IFRS 9, including, where relevant applying the ECL model. IFRS 9 Proper accounting for Related Company Loans

Is the related company loan in scope of IFRS?

Before considering how to apply the requirements of IFRS 9 to related company loans, entities must first consider whether the loan is within the scope of IFRS 9 or another standard. This is because IFRS 9: 2.1(a) scopes out ‘interests in subsidiaries, associates and joint ventures’ that are accounted for in accordance with IAS 27 Separate Financial Statements or IAS 28 Investments in Associates and Joint Ventures i.e. at cost less impairment or using the equity method. IFRS 9 Proper accounting for Related Company Loans

In many cases, it will be clear that the loan is a debt instrument that falls within the scope of IFRS 9 but some scenarios may require a more detailed analysis.

1 Loans for which settlement is neither planned nor likely

If an entity has minimal equity and is financed almost entirely through a loan, the nature of that loan may seem more akin to a capital contribution i.e. part of the interest in the subsidiary, associate or joint venture that is scoped out of IFRS 9. This is particularly the case if settlement of the loan is not planned or likely to occur for some time.

IAS 28 makes specific reference to items of this nature referring to them as long-term interests in an associate or joint venture. These are items for which settlement is neither planned nor likely to occur in the foreseeable future that in substance form part of the net investment in the associate or joint venture such as preference shares, long-term receivables or loans.

In October 2017, the IASB amended IAS 28 to clarify that IFRS 9 must be applied to long-term interests in an associate or joint venture to which the equity method is not applied. The equity method is applied to those instruments that give the holder a right to the share of net assets of the investee.

Although losses may be applied to long-term interests in certain circumstances (see IAS 28 38), this is not application of the equity method because it is an application of losses, and not of all changes in net assets. This means that an entity must first apply the requirements in IFRS 9 to that long-term interest (including, where relevant, the impairment requirements) and then apply both the loss allocation and impairment requirements in IAS 28.

This amendment has clarified that if the instrument meets the definition of a liability from the perspective of the issuer, and is not otherwise considered part of the interest the associate or joint venture that is accounted for in accordance with IAS 28º, it is within the scope of IFRS 9.

Similar loans advanced to subsidiaries While the IAS 28 amendment focused only on long-term interests in an associate or joint venture, the conclusions reached are likely to be equally applicable to instruments of a similar nature advanced to subsidiaries. Therefore, if the instrument meets the definition of a liability from the perspective of the issuer and is not otherwise considered part of the interest in the subsidiary that is accounted for in accordance with IAS 27º, it is within the scope of IFRS 9.

º In addition to equity instruments, instruments with potential voting rights that in substance currently give access to the returns associated with an ownership interest in an associate or a joint venture (or in a subsidiary) are specifically scoped out of IFRS 9 and are instead accounted for in accordance with IAS 28 (or IAS 27). See IAS 28 14 and IFRS 10 B91. Because such instruments are exposed to equity-like returns, even if they were within the scope of IFRS 9, they would be required to be classified at Fair Value through Profit or Loss.

2 Undocumented loans

Special consideration should be given to loans that are undocumented (i.e. loans that are advanced without any contractual terms such as a specified repayment date or interest rate). In these cases, entities must first determine whether the arrangement gives rise to a debt instrument or, in accordance with the laws and regulations in their jurisdiction, a capital contribution.

As noted in 1 Loans for which settlement is neither planned nor likely above, this is an important distinction because if the loan is considered to be a debt instrument it will fall within the scope of IFRS 9, whereas if it gives rise to a capital contribution and is considered part of the equity investment it will fall within the scope of IAS 27 or IAS 28.

If an entity provides funding without any contractual terms it is typically treated from a legal perspective as a repayable on demand loan and not a capital contribution. This means that under the applicable laws and regulations, the lender has a substantive right to demand repayment; the fact that the lender may choose not to demand repayment for some time does not negate this right. Consequently, this type of arrangement typically gives rise to a debt instrument within the scope of IFRS 9.

However, in some jurisdictions, it is possible that the effect of applicable laws and regulations means that an undocumented funding arrangement could be considered to be a capital contribution (i.e. part of the equity investment). In those cases, the entity would apply IAS 27 or IAS 28, and not IFRS 9.

This is not expected to be common and entities would be expected to provide detailed and robust evidence to support any such assertion, which may include appropriate legal advice. A careful analysis of undocumented funding arrangements will therefore be required. This could be particularly important for entities with multinational operations as their related company funding arrangements will be governed by multiple different legal jurisdictions.

Amendments to related company funding arrangements Entities wishing to amend existing funding arrangements should carefully consider whether those changes alter the nature of the arrangement e.g. a debt instrument being converted to a capital contribution or the terms of a debt instrument being modified. Amendments that reflect the existing arrangement – Parent A has an undocumented funding arrangement with Subsidiary B that is currently accounted for as an interest-free demand loan, reflecting its nature and consistent with local law. If Parent A decides to formally document this arrangement as an interest-free demand loan such that there is no change to its nature, then no accounting consequences should arise. Amendments that alter the existing arrangement – Parent A has a funding arrangement with Subsidiary B that is currently accounted for as an interest-free demand loan, reflecting its nature and consistent with its contractually documented terms (or, if undocumented, consistent with local law). If Parent A amends this arrangement by removing the obligation to repay the amount advanced, there will be accounting consequences for both parties because the nature of the arrangement has changed – in this example, Parent A derecognises the loan receivable and recognises an addition to its investment in Subsidiary B and Subsidiary B extinguishes the loan payable and recognises a capital contribution. This might also have related tax effects and/or company law implications such as distributable profits. In contrast, if the new arrangement continues to contain a repayment obligation but the terms are now modified e.g. new interest rate or maturity date, the relevant modification requirements in IFRS 9 and associated accounting consequences should be considered by both parties.

Classification and Measurement Related Company Loans

Once it has been determined that the loan receivable is within the scope of IFRS 9, it must be classified into one of three categories:

1. Amortised cost; IFRS 9 Proper accounting for Related Company Loans
2. Fair Value through Profit or Loss (FVPL); or IFRS 9 Proper accounting for Related Company Loans
3. Fair Value through Other Comprehensive Income (FVOCI) for debt. IFRS 9 Proper accounting for Related Company Loans

The classification category determines the measurement requirements including whether the Expected Credit Loss (ECL) model applies. Classification is based on two key criteria³ (IFRS 9 4.1.5):

• The business model in which the loan is held (i.e. is it held in a ‘hold to collect’, ‘hold to collect and sell’ or ‘other’ business model); and
• The contractual cash flows of the loan (i.e. do they represent Solely Payments of Principal and Interest – commonly referred to as the ‘SPPI test’).

The table below illustrates the interaction between the business model and contractual cash flow criteria for loans:

Business model	Hold to collect	Hold to collect and sell	Other
Cash flow characteristic
SPPI	Amortised cost	FVOCI	FVPL
Other	FVPL	FVPL	FVPL

Related company loans that are classified at amortised cost or at FVOCI (for debt) are subject to the ECL model, whereas those classified at FVPL are not.

While many related company loans will meet the criteria to be classified at amortised cost i.e. in a ‘hold to collect’ business model with cash flows that meet the SPPI test, entities should not assume this to be the case. A number of potential issues require consideration, in particular in relation to the SPPI test.

Purchased or Originated Credit Impaired In addition to assessing the business model in which the loan is held and whether the loan meets the SPPI test, another relevant consideration is whether or not the loan is credit impaired at the point at which it was purchased or originated, i.e. at initial recognition (IAS 39 AG5 contained a similar requirement). If a loan meets the definition of a Purchased or Originated Credit Impaired (POCI) financial asset, it will be subject to special requirements for recognising interest income and for recognising ECL. Appendix A considers this requirement in the context of related company loans and contains a brief summary of the accounting requirements. Related company loans that meet the POCI definition are not expected to be particularly common and therefore the examples that follow assume that the loans are not POCI.

SPPI – Interest-free loans

Interest-free loans can be contractually repayable at a specific maturity date (term loans) or at any point in time (demand loans). Other loans may not have a contractually specified repayment date but are considered due on demand from a legal perspective (see undocumented loans). IFRS 9 Proper accounting for Related Company Loans

Example – Interest-free term loan Parent A obtains external bank financing at competitive market rates and then lends to its subsidiaries on an interest-free basis. On 1 January 2018, Parent A advanced a loan of CU1 million to Subsidiary B with the following terms: CU1 million repayable in three years – December 2020; 0% interest. The purpose of the loan is to fund Subsidiary B’s ongoing business operations and, based on current cash flow projections, Subsidiary B is expected to be in a position to fund the repayment of the loan by December 2020. Assume that: The market rate of interest for a loan with similar terms is 15%; and The loan not considered POCI. Question: Does the loan meet the SPPI test? Analysis In order to meet the SPPI test, the contractual cash flow of CU1 million in three years must represent payments of principal (being the initial fair value) and interest (being interest accrued using the EIR method). The initial fair value will be the amount recognised in accordance with IFRS 9 at initial recognition that is generally equal to the transaction price. However, in the case of long-term interest-free loans, the standard contains guidance that is more specific. In such scenarios, the initial fair value is measured as the present value of future cash receipts discounted at an appropriate market rate of interest for a similar loan at the date of initial recognition (IFRS 9 5.1.1 and IFRS 9 B5.1.1). In this example, the present value CU1 million in three years discounted by the market rate of interest of 15% is CU658,000. This amount will accrete back to CU1 million over the 3-year life of the loan using the EIR method at a rate of 15%. In this way, the contractual cash flow of CU1 million due in 2020 represents payments of principal (being the initial fair value of CU658,000) and interest (being the accretions of CU342,000). The loan therefore meets the SPPI test. The difference between the initial fair value of CU658,000 and the amount of cash advanced of CU1 million (i.e. CU342,000) will be considered a capital contribution and an addition to Parent A’s investment in the Subsidiary B. This amount will not be within the scope of IFRS 9. Instead, it will be accounted for in accordance with IAS 27 and subject to impairment testing in accordance with the requirements of that standard (i.e. IAS 36 Impairment of Assets).

Note: Prepayment options IFRS 9 Proper accounting for Related Company Loans

If, in Example 1 above, Subsidiary B had an option to repay the loan at par at any time, entities would need to consider whether that prepayment option was consistent with the SPPI test. The general rule set out in IFRS 9 B4.1.11.(b) is that a prepayment option is only consistent with the SPPI test as long as the prepayment amount represents substantially all the unpaid amounts of principal and interest on the principal amount outstanding (which may include additional reasonable compensation). IFRS 9 Proper accounting for Related Company Loans

Applying these requirements to the example above would result in the loan failing the SPPI test because the prepayment amount of par would be greater than the principal (i.e. the fair value at initial recognition) and interest outstanding (i.e. interest accrual using the EIR method). IFRS 9 Proper accounting for Related Company Loans

However, IFRS 9 B4.1.12 contains an exception to this requirement for loans that are originated (or purchased) at a discount (or premium) that would otherwise meet the SPPI test. In those cases, if the prepayment amount is equal to the contractual par amount plus the contractual (accrued but unpaid) interest amount (which may include additional reasonable compensation) and if the fair value of the prepayment option at initial recognition is insignificant, then the loan can still meet the SPPI test.

In the context of the example above, this exception is likely to apply because:  IFRS 9 Proper accounting for Related Company Loans

1. The loan is originated at a discount; IFRS 9 Proper accounting for Related Company Loans
   
2. The prepayment option is at par; and IFRS 9 Proper accounting for Related Company Loans
   
3. The fair value of the prepayment option at initial recognition would be insignificant (because Subsidiary B would be unlikely to repay given the preferential interest rate of 0%).

Example – Interest-free demand loan Parent A provides a loan of CU5 million to Subsidiary C to fund its ongoing business operations. The loan has the following terms: 0% interest; CU5 million repayable on demand of Parent A. Assume that: Parent A does not intend to demand repayment of the loan for several years; and The loan is not considered POCI. Question: Does the loan meet the SPPI test? Analysis Similar to the previous example, in order to meet the SPPI test, the contractual cash flow of CU5 million repayable on demand must represent payments of principal (being the initial fair value) and interest (being interest accrued using the EIR method). The initial fair value will be the amount recognised in accordance with IFRS 9 at initial recognition which, in contrast to the previous example, is equal to the transaction price i.e. the amount of cash advanced of CU5 million. The fair value amount reflects the fact that Parent A has the contractual right to demand repayment immediately after the loan was advanced. In addition, unlike interest-free term loans, there is specific guidance in IFRS 9 which requires financial assets and liabilities to be measured on initial recognition at the transaction price (unless there is a difference between the transaction price and fair value, and the fair value is evidenced by a quoted price in an active market or is based on a valuation technique that uses only data from observable markets) (See IFRS 9 5.1.1, IFRS 9 5.1.1A, IFRS 9 B5.1.1, and IFRS 9 B5.1.2A. Subsidiary C would also be required to recognise the corresponding demand liability at the transaction price in accordance with IFRS 13 47). As the loan is due on demand and no interest in charged, the EIR is 0%. In this way the repayment of CU5 million represents the repayment of the principal amount (being the initial fair value) and interest (being nil as there are no interest accretions). The loan therefore meets the SPPI test. As there is no difference between the initial fair value and the amount of cash advanced, no adjustment to Parent A’s investment in Subsidiary C is required.

Subsequent measurement of interest-free loans classified at amortised cost (that are not POCI)

In Example – Interest-free term loan, because an EIR of 15% is imputed for the interest-free term loan at initial recognition, the subsequent application of the EIR method results in the recognition of: IFRS 9 Proper accounting for Related Company Loans

• Interest income in profit or loss in accordance with IFRS 9 5.4.1; and IFRS 9 Proper accounting for Related Company Loans
• Additional gains or losses in profit or loss which could arise as a result of applying, (where relevant) IFRS 9 B 5.4.6. For example, if the contractual cash flows are re-estimated as a result of changes in expectations of a prepayment or extension option being exercised. IFRS 9 Proper accounting for Related Company Loans

In contrast, in Example – Interest-free demand loan, because the EIR on the interest-free demand loan is 0%, the subsequent application of the EIR method will not give rise to interest income or other gains or losses in profit or loss as a result of applying IFRS 9 5.4.1 or IFRS 9 B5.4.6 respectively. IFRS 9 Proper accounting for Related Company Loans

Loans linked to underlying asset or borrower performance

Loans may also contain contingent features that give rise to cash flows that are inconsistent with the SPPI test. IFRS 9 Proper accounting for Related Company Loans

Example – Loan linked to underlying asset performance Parent A provides a loan of CU3 million to Subsidiary D, a real estate investment company. Subsidiary D uses the loan to part fund a property worth CU3.5 million. Subsidiary D intends to generate cash flows though rental income. The loan has the following terms: CU3 million repayable in three years; 5% annual interest; 30% of the annual appreciation in the property value. Question: Does the loan meet the SPPI test? Analysis Despite the fact that the loan has contractual payments of principal and interest, the additional contingent payment linked to the appreciation in the property value must be considered in order to determine whether the loan meets the SPPI test. This because IFRS 9 requires the loan to be assessed in its entirety i.e. as one unit of account and specifies that contractual terms can only be ignored if the potential impact on the contractual cash flows is considered ‘de minimis’ or if the feature is ‘non-genuine’. When determining whether a contingent feature is ‘de minimus’ entities must consider the ‘possible effect’ that the feature could have on the contractual cash flows in each reporting period (and cumulatively). ‘Non-genuine’ contingent features are those that are only triggered upon the occurrence of a rare or highly abnormal event and are therefore not expected to be common (IFRS 9 B4.1.18). In this example, there is no reason to suggest that the contractual provision is non-genuine because a possible increase in property value above its purchase price would not be a rare or highly abnormal event. In addition, the contingent payment could have a more than de minimis effect on the contractual cash flows of the loan. For example, even an increase in value of 10% i.e. CU350,000 would give rise to an additional payment of CU105,000 (being CU350,000 x 30%) in the first year. The contingent feature therefore introduces property price risk, which is inconsistent with a basic lending arrangement (IFRS 9 B4.1.15. – B4.1.16). The loan fails the SPPI test and would be classified at FVPL (Similarly, a contingent payment linked to the profits of Subsidiary D would also fail the SPPI test as it introduces an equity-like risk).

De minimis features that are genuine IFRS 9 Proper accounting for Related Company Loans

Because the de minimis analysis requires an entity to consider the ‘possible effect’ that the contingent feature could have on the contractual cash flows, the likelihood of the feature being triggered is not relevant. IFRS 9 Proper accounting for Related Company Loans

While de minimis is not defined IFRS 9, an example might be a contingent feature that, if triggered, could only ever have an immaterial effect on the contractual cash flows.

Non-recourse loans

In most cases, loans are advanced on a full recourse basis, which means that if the borrower defaults, the lender has a general claim against the borrower for the full amount of the loan. For additional security, such loans are often collateralised which means that upon default, in addition to a general claim against the borrower, the lender has a first ranking charge over a specific asset or assets. The fact that a full recourse loan is collateralised should not generally affect the SPPI test.

However, in other cases, loans are advanced on a non-recourse basis which means that the lenders claim is limited to specified assets (or cash flows from specified assets) of the borrower. Non-recourse features will generally be part of the explicit contractual terms of the loan agreement but it is also possible for a loan to be implicitly non-recourse. For example, a full recourse loan, which may or may not be collateralised, that is advanced to a borrower that holds a single asset or limited assets, is in substance more akin to a non-recourse loan.

Non-recourse features do not, by themselves, preclude a financial asset from meeting the SPPI test but additional analysis is required in order to determine whether the loan is:

• A lending exposure for which the lender receives payments of principal and interest (being compensation for credit risk and the time value of money) that meets the SPPI test; or
• An indirect investment in the underlying assets of the entity for which the lender will receive payments dependent upon the performance of specific assets that fails the SPPI test.

When a non-recourse feature is present, the lender is required to look-through to the underlying assets (which can be financial or non-financial in nature) or cash flows and determine whether the contractual terms of the loan give rise to cash flows that are inconsistent with SPPI or limit the cash flows in a manner that is inconsistent with SPPI (IFRS 9 B4.1.16 – B4.1.17).

Example – Non-recourse loan – Scenario 1 Parent A set up Subsidiary E in January 2017 for the purposes of purchasing a single investment property worth CU2 million with the aim of generating rental income. Subsidiary E was funded via CU200,000 of equity from Parent A and a loan at 90% loan-to-value (LTV) from Bank X with the following terms: CU1.8 million repayable on 31 December 2018, annual interest rate of 10%; Secured by first charge over the property. At 31 December 2018, the market valuation of the property has declined to CU1.5 million, resulting in a LTV of 120% (CU1.8 million/CU1.5 million). Bank X is unwilling to refinance at this LTV and as a result, Subsidiary E repays the bank loan and obtains financing from Parent A with the following terms: CU1.8 million repayable on 31 December 2020, annual interest rate of 20%; Secured by first charge over the property. Assume that: Subsidiary E continues to earn rental income sufficient to cover interest payments but has no other assets or sources of income; and 20% is considered to be a market rate of interest for a loan with similar terms (loans with similar terms are available through specialist property lenders. Such lenders are willing to advance loans at greater than 100% LTV based on the potential for property prices to increase to a level that would result in full recovery of the loan). Question: Does the loan from Parent A to Subsidiary E meet the SPPI test? Analysis Irrespective of whether the loan is structured on a full recourse basis, the substance is that of a non-recourse loan because Subsidiary E only holds one asset that can be used to repay the loan. Subsidiary E is expected to be in a position to meet its interest payment obligations using its rental income. However, at an LTV of 120%, the principal repayment is limited in a manner that appears inconsistent with a basic lending arrangement, as the value of the property to which it has recourse is not sufficient to repay the loan. The property price risk that Parent A is exposed to would seem to imply that the loan is more in the nature of an indirect investment in the underlying property rather than an exposure to basic lending risks i.e. the time value of money and credit risk. On this basis, the loan would fail the SPPI test and would be classified at FVPL.

Example – Non-recourse loan – Scenario 2 Same facts as Example 4(a) except that on 31 December 2018, the market valuation of the property has increased by CU200,000 to CU2.2 million resulting in a LTV of 82% (CU1.8 / CU2.2). Bank X is prepared to refinance the loan at market rates but Subsidiary E chooses to repay the bank loan and obtain funding from Parent A on the following terms: CU1.8 million repayable on 31 December 2020; Interest rate of 7%. Assume that 7% is considered to be a market rate of interest for a loan with similar terms. Question: Does the loan meet the SPPI test? Analysis Similar to the previous example, the substance of the loan is limited recourse because Subsidiary E only holds one asset that can be used to repay the loan. However, in contrast to the previous example, based on the current LTV of 82% the principal repayment would not seem to be limited in a manner that is inconsistent with a basic lending arrangement because the value of the property is more than sufficient to generate cash flows to repay the loan. The loan is likely to meet the SPPI test.

Distinguishing between credit risk and asset performance risk

Determining whether a non-recourse loan meets the SPPI test can be a very judgmental area because the distinction between an entity’s credit risk and asset performance risk is not always clear. This is particularly true in cases where an entity is funded almost entirely by debt and has a single or very limited number of assets. A careful assessment of all relevant facts and circumstances will therefore be required. Examples of factors that that would indicate an exposure to credit risk (i.e. meeting the SPPI test) rather than asset performance risk include:

• A loan to value ratio which demonstrates that the fair value of the underlying asset(s) to which the borrower has recourse (whether these are only specified assets or all assets of the borrower) are more than sufficient to support the contractual repayment of amounts of principal and interest on the loan;
• The nature of the borrower being that of an operating entity with commercial substance that may be able to source alternative funding;
• Sufficient levels of equity in the borrower entity to cover any expected losses; and
• The loan being managed by the lender as an exposure to credit risk.

One of the areas where this assessment may prove particularly challenging is in cases where the borrower is not only thinly capitalised but is also engaged in early stage high-risk projects such as R&D or mining exploration. Despite typically being supported by a robust business plan, the high risk nature of such projects often means that there is no viable alternative source of finance other than through related companies.

While such cases will require increased levels of scrutiny and judgment, it is important to note that the fact that the borrower’s business is high risk does not, in and of itself, mean that the loan will automatically fail the SPPI test. If that were the case, then all Purchased or Originated Credit Impaired (POCI) loans would fail the SPPI test and would therefore be measured at FVPL rendering the POCI requirements redundant. Furthermore the fact that a loan has high credit risk at origination does not mean that it meets the definition of a POCI loan.

In these situations, as explained in Non-recourse loans above, entities will need to exercise their judgment in order to determine whether the loan is:

• A credit exposure i.e. the provision of funding for which the lender receives payments of principal and interest; or
• An exposure to the underlying assets – i.e. an indirect investment in the underlying assets of the borrower.

For example, consider a parent company advancing a loan to a subsidiary which has commercial substance and is using its resources to actively manage and develop an underlying project. In this scenario, assuming the subsidiary is not insolvent at the date the loan is advanced, it is likely that the parent company will be managing that loan as an exposure to credit risk rather than an exposure to the underlying assets of the subsidiary.

General Approach Impairment

Under the General Approach, at each reporting date, entities are required to determine whether there has been a Significant Increase in Credit Risk (SICR) since initial recognition and whether the loan is credit impaired12. This determines whether the loan is in Stage 1, Stage 2 or Stage 3, which in turn determines both:

• The amount of ECL to be recognised: 12-month ECL or Lifetime ECL; and IFRS 9 Proper accounting for Related Company Loans
• The amount of interest income to be recognised in future reporting periods: EIR based on gross carrying amount of the loan which excludes ECL or the net carrying amount (i.e. the amortised cost) which includes ECL. IFRS 9 Proper accounting for Related Company Loans

Lifetime ECL are the ECL that result from all possible default events over the expected life of the loan whereas 12-month ECL are a portion of Lifetime ECL that represent the ECL that result from default events that are possible within 12 months of the reporting date. For loans with an expected life in excess of 12 months, Lifetime ECL will typically be greater than 12-month ECL because entities will need to factor in all possible default event rather than only those possible within 12 months.

It is important to note that the ECL model is symmetrical in nature, which means that a loan can move between the various stages. For example, a previous SICR can reverse such that a loan transfers from Stage 2 back to Stage 1. IFRS 9 Proper accounting for Related Company Loans

The interaction between the different stages and the amount of ECL and interest income to be recognised is set out in the table below:

IFRS 9 Proper accounting for Related Company Loans	Stage 1 No Significant Increase in Credit Risk	Stage 2 Significant Increase in Credit Risk	Stage 3 Credit Impaired
Recognition of Expected Credit Losses (ECL)	12-month ECL	Lifetime ECL
Recognition of interest	EIR on gross carrying amount (excluding ECL)		EIR on net carrying amount (including ECL)

IFRS 9 Proper accounting for Related Company Loans