Examples of applying the business model test in practice
Scenario 1 – Switching investments within a portfolio (1)
An entity has debt investments worth €100m, comprising notes with maturities of 3 to 5 years. In practice, approximately €10m of the portfolio is sold and reinvested each year in assets with a similar maturity and risk but with a higher yield (a process known as ‘switching”). The remaining investments are typically held to near their maturity.
Analysis
In this situation the entity will first need to use judgment to determine whether it should apply the test to:
(a) two business models: (i) debt instruments to be held to near their maturity and (ii) debt instruments which are actively bought and sold. This will only be possible if these groups of assets can be separately identified; or
(b) one business model representing the overall portfolio of debt investments.
If conclusion (a) is considered more appropriate, portfolio (i) is likely to pass the business model test potentially resulting in the debt instruments being classified as amortised cost. However, it would probably need to classify the remaining debt instruments as measured at fair value through profit or loss.
Alternatively, if conclusion (b) is considered more appropriate, further judgment should be applied and the entity must determine whether the level of expected sales and repurchases is significant enough to require the whole portfolio to be measured at fair value through profit or loss. In this example, the sale and reinvestment of approximately 10% of the portfolio each year would potentially be considered ‘more than infrequent” (see 5.2 above) and/or more than ‘some” (see Scenario 1 in Example 47.2 above). However, the standard cites ‘more than infrequent” and/or more than ‘some” sales as indicators to use in assessing the business model test, not strict criteria. The overriding consideration is whether the business model remains to hold the financial assets to collect their contractual cash flows. The reason for the sales needs to be considered to assess whether it is consistent with a business model whose objective is to hold assets to collect their contractual cash flows.
Other factors to consider in making this judgment might include how the performance of the business is reported to and assessed by management. For example, if performance is measured on a fair value basis or if employees are rewarded using such measures, it is unlikely to be appropriate to account for the portfolio at amortised cost.
Although not finalised yet, it is relevant to note that in its project to improve IFRS 9 (see further details at 11 below), the IASB indicated that such a portfolio is not consistent with a business model whose objective is to hold assets to collect their contractual cash flows. Accordingly, entities are advised to follow the progress of this project in making any associated judgements.
Scenario 2 – Switching investments within a portfolio (2)
An entity has a portfolio of €100m of debt instruments. The employee responsible for managing the portfolio has been charged with optimising the long-term yield on the portfolio. Accordingly, she regularly sells the assets and reinvests the proceeds from the sales in new assets that have a similar maturity and risk profile, but generally with a higher yield.
Insignificant gains or losses are generated in the process of switching the assets in order to lock in a higher yield. This happens on a fairly regular basis and, over a period of six months, approximately 10% of the portfolio is turned over. Despite this, the overall size and composition of the portfolio remains relatively unchanged.
The employee is remunerated based on the overall yield of the portfolio (i.e. maximising the portfolio”s yield) and fair value gains/losses are not considered in her remuneration.
Management”s documented strategy and defined key performance indicators emphasise optimising long-term yield rather than generating fair value gains and accordingly, the entity”s management reporting system focuses on the yield rather than fair value of the debt instruments within the portfolio. At initial recognition, and upon subsequent sales (and reinvestment), the entity is not able to clearly identify the assets that would be switched.
Analysis
The key consideration is whether the underlying objective of the entity is to hold the assets to collect their contractual cash flows. Based on the factors mentioned above, it could be argued that the objective of the entity is not to realise fair value gains/losses because:
- insignificant gains/losses (relative to the interest earned from the portfolio) are earned/incurred in the switching process;
- the overall size and composition of the portfolio is relatively unchanged from the switching;
- the employee is remunerated based on the overall yield of the portfolio, and fair value gains/losses are not considered in her remuneration;
- management”s documented strategy and defined key performance indictors emphasise long-term yield rather than fair value gains; and
- management reporting is focused on yield rather than the fair value of the debt instruments within the portfolio.
However, in our view, the fact that it is not the entity”s objective to realise fair value gains/losses is not sufficient in itself to be able to conclude that measurement at amortised cost is appropriate. Such an objective is not necessarily the same as holding a portfolio of financial assets to collect their contractual cash flows. While the standard states that an infrequent number of sales and ‘some” sales would not contradict that objective, it does not provide any further guidance. Each entity will need to exercise its own judgment and consider other available information before concluding that amortised cost classification is consistent with the business model in these circumstances.
Whilst not finalised yet, it is relevant to note that the IASB in its project to improve IFRS 9 has indicated that such a portfolio would not be consistent with a business model whose objective is to hold assets to collect their contractual cash flows. Accordingly, entities are advised to follow the outcome of this project in making their own judgement.
Scenario 3 – Classification of originated loans to be partially sold or sub-participated
A bank originates loans, holds part of the portfolio to maturity and a portion is either sold in the near term or sub-participated to other banks.
Analysis
In applying IFRS 9, the bank first needs to assess whether it has one business model or two.
It is possible that the activities of lending to hold and lending to sell or sub-participate could be considered two separate business models, requiring different skills and processes. Whilst the financial assets resulting from the former would typically qualify for amortised cost measurement, those from the latter would need to be measured at fair value through profit or loss.
If it is assessed that a loan will in part be sold or sub-participated, this raises the additional issue of whether a single financial asset can be considered to fall within two separate business models. It is already common under IAS 39 – Financial Instruments: Recognition and Measurement – for loans to be classified in part as held for trading and in part as loans and receivables (measured at amortised cost) in similar circumstances and it is likely that this practice will continue under IFRS 9.
If the bank fails to achieve an intended disposal or sub-participation, having previously classified a portion of a loan at fair value through profit or loss because of its intention to sell, that portion of the loan will continue to be classified as measured at fair value through profit or loss.
Scenario 4 – Sale of securities held for liquidity purposes
A bank holds a liquidity ‘buffer” portfolio of high grade plain vanilla securities. These are assets that are held by the bank to fund unexpected cash outflows arising from stressed scenarios. The bank”s strategy is to always hold such a buffer, hence the overall portfolio size remains stable within pre-defined credit, currency and maturity bands.
The performance of the bank”s employees who are responsible for managing the portfolio is assessed based on the yield achieved. The fair value performance of the portfolio is not considered in determining the employees” remuneration. The employees are aware of the portfolio”s fair value such that they know how much cash can be raised if the assets ever need to be sold, but the portfolio is not managed to maximise fair value.
However, the employees churn the portfolio, regularly buying and selling, for the following reasons:
- the regulators require regular sales to prove that the assets are liquid; and
- the bank wants to maintain a presence in the market so that, in the event of liquidity difficulties, it would not be obvious that they have been forced to sell.
The churn rate is about 10% per month. The duration of the portfolio is roughly three years and it is anticipated that the gains or losses earned or incurred as the portfolio is churned could be significant.
Analysis
Even though the bank”s strategy, and the basis for the employees” performance assessment, is non-trading in nature, a portion of the portfolio is sold frequently and substantial fair value gains or losses are expected to be earned or incurred in churning the portfolio.
We would expect that if a portfolio of financial assets is to qualify for amortised cost classification, the bank should not expect to report significant fair value gains or losses from sales. In this scenario, the fair value gains and losses were already anticipated at inception, hence the assessment of the business model of being to hold the assets to collect their contractual cash flows may be inappropriate.
In addition, the churn rate of 10% per month would mean that only a small proportion of the original portfolio would still be held after eleven months, which would seem inconsistent with an objective to hold the assets to collect the contractual cash flows. Hence, the sale of 10% of the portfolio every month may be considered more than an ‘infrequent number” and/or ‘some” sales and the business model may not qualify for amortised cost classification.
The debate around liquidity portfolios and whether they meet the IFRS 9 business model test is one of those areas where no consensus has yet emerged. In addition, facts and circumstances differ from one bank to another, hence, it is a challenge to draw parallels and, as a result, diversity of application is likely to arise.
Overall, the assessment will need to make use of appropriate judgment, considering the facts and circumstances specific to the entity, in order to determine whether amortised cost represents the most appropriate method of accounting for a particular business model.
Although not finalised yet, it is relevant to note that in its project to improve IFRS 9 (see further details at 11 below), the IASB has indicated that such a portfolio would not be consistent with a business model whose objective is to hold assets to collect their contractual cash flows. Accordingly, entities are advised to follow the progress of this project in making any associated judgements.
Scenario 5 – Sale of assets in response to infrequent event
An entity sells a large proportion of financial assets that are classified as measured at amortised cost in response to a major loss, unexpected capital expenditure or a business acquisition.
Analysis
The entity needs to consider, amongst other facts and circumstances, the factors described in Scenario 1 above and, in particular, the purpose for which the assets were originally acquired.
If a business model is initially assessed as qualifying for amortised cost measurement and if assets are subsequently sold infrequently for reasons that were not previously anticipated, we believe that the business model may possibly still qualify for amortised cost accounting.
However, if assets are held to fund capital expenditure or an acquisition that is expected to take place, it would normally be necessary for the maturities of the financial assets to reflect the expected holding period if they are to be recorded at amortised cost. For example, if an acquisition is expected to take place in six months time, then the assets that will be used to fund the acquisition should normally have a maturity of approximately six months or less, not several years, if they are to be accounted for at amortised cost.
Scenario 6 – Change in the way a portfolio is managed
An entity determines that the objective for a portfolio meets the business model test to be classified at amortised cost. Subsequently, the entity changes the way it manages the assets so that more than an infrequent number of sales is made.
Analysis
Although more than an infrequent number of sales is now occurring, it is unlikely to be a significant enough change in the entity”s business model to trigger reclassification of the portfolio. This is because IFRS 9 requires assets to be reclassified only if there is a change in the business model that is significant to the entity”s operations (see 9 below). In other words, there are no tainting provisions similar to that of the held to maturity measurement category under IAS 39.
It is likely that the entity will now be considered to have two business models, the first representing the assets held when the business model changed and the second being any new assets acquired. Financial assets in the first portfolio will remain classified as measured at amortised cost and new financial assets acquired will be classified as measured at fair value through profit or loss.
Scenario 7 – Portfolio of assets held to match the duration of a bank”s liabilities
A bank allocates investments into maturity bands to match the expected duration of its time deposit accounts. The invested assets have a similar maturity profile and amount to the corresponding deposits. The ratio of assets to deposits for each maturity band has pre-determined minimum and maximum levels. For example, if the ratio exceeds the maximum level because of an unexpected withdrawal of deposits, the bank will sell some assets to reduce the ratio. The choice of assets to be sold would be based on those that would generate the highest profit or incur the lowest loss.
Meanwhile, new assets will be acquired when necessary (i.e. when the ratio of assets to deposits falls below the pre-determined minimum level). The expected repayment profile of the deposits would be updated on a quarterly basis, based on changes in customer behaviour. Under IAS 39, these assets were classified as available-for-sale and there has been no history of active trading.
Analysis
The question here is whether adjusting the asset/deposit ratio by selling assets to correspond with a change in the expected repayment profile of the deposits would mean that the business model is inconsistent with the objective of holding assets to collect the contractual cash flows.
In these circumstances, an analogy can be drawn to paragraph B4.1.3(b) of IFRS 9 (see 5.2 above) which states that an insurer may adjust its investment portfolio by selling a financial asset to reflect a change in the expected duration (i.e. expected timing of payouts) of its liabilities. However, the guidance clarifies that if more than an infrequent number of sales are made out of the portfolio, the entity would need to assess how such sales are consistent with an objective of holding assets to collect the contractual cash flows.
If the bank had a good track record of forecasting its deposit repayments, we would expect such sales to be infrequent. If numerous sales happen every year, it might be difficult to rationalise such practice with an objective of holding to collect the contractual cash flows. Due consideration will also need to be given to the magnitude of sales, the reasons for the sales and whether or not significant fair value gains and losses are anticipated at inception before an appropriate conclusion could be reached.
Scenario 8 – Loans reclassified from trading under IAS 39
At the date of initial application of IFRS 9, a bank holds a portfolio of loans that it intends to sell as soon as possible, but is currently unable to do so due to illiquidity in the market. The bank had taken advantage of the October 2008 amendments to IAS 39 and because it had the intention and ability to hold the assets for the foreseeable future had reclassified this portfolio from trading to loans and receivables.
Analysis
An entity applying IFRS 9 for the first time should apply the business model test at the date of initial application (see 10.2.2 below).
Given management”s intention to sell the assets as soon as possible, the presumption would be that the portfolio should be classified as at fair value through profit or loss. It does not matter that the bank may have to hold the portfolio for the foreseeable future due to the market”s illiquidity. The standard is clear that the entity”s objective should be to hold the assets to collect the contractual cash flows to qualify for amortised cost classification.
Scenario 9 – Loans held within a business intended for disposal
An international bank has a variety of businesses each of which is managed separately. Before the date of initial application of IFRS 9, the bank makes a strategic decision to dispose of its auto finance business, which originates loans to collect their contractual cash flows. The bank intends to dispose of the entire business, including personnel, IT systems and buildings, and not merely a portfolio of loans.
Analysis
There is no ‘right” answer in respect of these facts and circumstances. Arguments can be articulated to support either classification of the loans at amortised cost or at fair value through profit or loss.
Proponents of amortised cost classification would argue that at the date of initial application, even though the bank intends to sell the business at some point in the future, the loans are still held within a business model whose objective is to hold them to collect their contractual cash flows. That objective continues regardless of whether the bank intends or is able to sell the business. In addition, some of the loans may be fully collected even before the business is sold. Therefore, based on facts and circumstances at the date of initial application, the loans are considered to be held within a business model whose objective is to hold them to collect their contractual cash flows.
On the other hand, proponents of fair value through profit or loss classification would argue that on the date of initial application, the expectation is that the bank will dispose the loans rather than hold them to collect their contractual cash flows. Therefore, from the bank”s perspective, the loans are no longer held within a business model whose objective is to hold assets to collect their contractual cash flows.
Due to the mixed views and the fact that this is a prevailing issue in the marketplace as a result of regulator and government initiatives to require banks to dispose of non-core business activities or selected businesses due to concerns around the lack of competition, this is an area where further guidance from the IASB or Interpretations Committee would be welcome.
When applying IFRS 9 for the first time, in our opinion the two views set out above are acceptable. If the decision to dispose the business is made subsequent to the adoption of IFRS 9, it is unlikely that the financial assets would need to be reclassified from amortised cost to fair value through profit or loss because of the high threshold in IFRS 9 for triggering reclassification (see 9 below).