The entity’s business model for managing financial assets
B4.1 Paragraph 4.1(a) requires an entity to classify financial assets as subsequently measured at amortised cost or fair value on the basis of the entity’s business model for managing the financial assets. An entity assesses whether its financial assets meet this condition on the basis of the objective of the business model as determined by the entity’s key management personnel (as defined in AASB 124 Related Party Disclosures).
B4.2 The entity’s business model does not depend on management’s intentions for an individual instrument. Accordingly, this condition is not an instrument-by-instrument approach to classification and should be determined on a higher level of aggregation. However, a single entity may have more than one business model for managing its financial instruments. Therefore, classification need not be determined at the reporting entity level. For example, an entity may hold a portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to trade to realise fair value changes.
B4.3 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. For example, the entity may sell a financial asset if:
(a) the financial asset no longer meets the entity’s investment policy (e.g. the credit rating of the asset declines below that required by the entity’s investment policy);
(b) an insurer adjusts its investment portfolio to reflect a change in expected duration (i.e. the expected timing of payouts); or
(c) an entity needs to fund capital expenditures.
However, if more than an infrequent number of sales are made out of a portfolio, the entity needs to assess whether and how such sales are consistent with an objective of collecting contractual cash flows.
B4.4 The following are examples of when the objective of an entity’s business model may be to hold financial assets to collect the contractual cash flows. This list of examples is not exhaustive.
Example
Analysis
Example 1An entity holds investments to collect their contractual cash flows but would sell an investment in particular circumstances.
Although an entity may consider, among other information, the financial assets’ fair values from a liquidity perspective (i.e. the cash amount that would be realised if the entity needs to sell assets), the entity’s objective is to hold the financial assets and collect the contractual cash flows. Some sales would not contradict that objective.
Example 2An entity’s business model is to purchase portfolios of financial assets, such as loans. Those portfolios may or may not include financial assets with incurred credit losses. If payment on the loans is not made on a timely basis, the entity attempts to extract the contractual cash flows through various means – for example, by making contact with the debtor by mail, telephone or other methods.In some cases, the entity enters into interest rate swaps to change the interest rate on particular financial assets in a portfolio from a floating interest rate to a fixed interest rate.
The objective of the entity’s business model is to hold the financial assets and collect the contractual cash flows. The entity does not purchase the portfolio to make a profit by selling them.The same analysis would apply even if the entity does not expect to receive all of the contractual cash flows (e.g. some of the financial assets have incurred credit losses).Moreover, the fact that the entity has entered into derivatives to modify the cash flows of the portfolio does not in itself change the entity’s business model. If the portfolio is not managed on a fair value basis, the objective of the business model could be to hold the assets to collect the contractual cash flows.
Example 3An entity has a business model with the objective of originating loans to customers and subsequently to sell those loans to a securitisation vehicle. The securitisation vehicle issues instruments to investors.The originating entity controls the securitisation vehicle and thus consolidates it.The securitisation vehicle collects the contractual cash flows from the loans and passes them on to its investors.It is assumed for the purposes of this example that the loans continue to be recognised in the consolidated statement of financial position because they are not derecognised by the securitisation vehicle.
The consolidated group originated the loans with the objective of holding them to collect the contractual cash flows.However, the originating entity has an objective of realising cash flows on the loan portfolio by selling the loans to the securitisation vehicle, so for the purposes of its separate financial statements it would not be considered to be managing this portfolio in order to collect the contractual cash flows.
B4.5 One business model in which the objective is not to hold instruments to collect the contractual cash flows is if an entity manages the performance of a portfolio of financial assets with the objective of realising cash flows through the sale of the assets. For example, if an entity actively manages a portfolio of assets in order to realise fair value changes arising from changes in credit spreads and yield curves, its business model is not to hold those assets to collect the contractual cash flows. The entity’s objective results in active buying and selling and the entity is managing the instruments to realise fair value gains rather than to collect the contractual cash flows.
B4.6 A portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis (as described in paragraph 9(b)(ii) of AASB 139) is not held to collect contractual cash flows. Also, a portfolio of financial assets that meets the definition of held for trading is not held to collect contractual cash flows. Such portfolios of instruments must be measured at fair value through profit or loss.
Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding
B4.7 Paragraph 4.1 requires an entity (unless paragraph 4.5 applies) to classify a financial asset as subsequently measured at amortised cost or fair value on the basis of the contractual cash flow characteristics of the financial asset that is in a group of financial assets managed for the collection of the contractual cash flows.
B4.8 An entity shall assess whether contractual cash flows are solely payments of principal and interest on the principal amount outstanding for the currency in which the financial asset is denominated (see also paragraph B5.13).
B4.9 Leverage is a contractual cash flow characteristic of some financial assets. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Stand-alone option, forward and swap contracts are examples of financial assets that include leverage. Thus such contracts do not meet the condition in paragraph 4.2(b) and cannot be subsequently measured at amortised cost.
B4.10 Contractual provisions that permit the issuer (i.e. the debtor) to prepay a debt instrument (e.g. a loan or a bond) or permit the holder (i.e. the creditor) to put a debt instrument back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:
(a) the provision is not contingent on future events, other than to protect:
(i) the holder against the credit deterioration of the issuer (e.g. defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or
(ii) the holder or issuer against changes in relevant taxation or law; and
(b) the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the early termination of the contract.
B4.11 Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument (i.e. an extension option) result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:
(a) the provision is not contingent on future events, other than to protect:
(i) the holder against the credit deterioration of the issuer (e.g. defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or
(ii) the holder or issuer against changes in relevant taxation or law; and
(b) the terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding.
B4.12 A contractual term that changes the timing or amount of payments of principal or interest does not result in contractual cash flows that are solely principal and interest on the principal amount outstanding unless it:
(a) is a variable interest rate that is consideration for the time value of money and the credit risk (which may be determined at initial recognition only, and so may be fixed) associated with the principal amount outstanding; and
(b) if the contractual term is a prepayment option, meets the conditions in paragraph B4.10; or
(c) if the contractual term is an extension option, meets the conditions in paragraph B4.11.
B4.13 The following examples illustrate contractual cash flows that are solely payments of principal and interest on the principal amount outstanding. This list of examples is not exhaustive.
Instrument
Analysis
Instrument AInstrument A is a bond with a stated maturity date. Payments of principal and interest on the principal amount outstanding are linked to an inflation index of the currency in which the instrument is issued. The inflation link is not leveraged and the principal is protected.
The contractual cash flows are solely payments of principal and interest on the principal amount outstanding. Linking payments of principal and interest on the principal amount outstanding to an unleveraged inflation index resets the time value of money to a current level. In other words, the interest rate on the instrument reflects ‘real’ interest. Thus, the interest amounts are consideration for the time value of money on the principal amount outstanding.However, if the interest payments were indexed to another variable such as the debtor’s performance (e.g. the debtor’s net income) or an equity index, the contractual cash flows are not payments of principal and interest on the principal amount outstanding. That is because the interest payments are not consideration for the time value of money and for credit risk associated with the principal amount outstanding. There is variability in the contractual interest payments that is inconsistent with market interest rates.
Instrument BInstrument B is a variable interest rate instrument with a stated maturity date that permits the borrower to choose the market interest rate on an ongoing basis. For example, at each interest rate reset date, the borrower can choose to pay three-month LIBOR for a three-month term or one-month LIBOR for a one-month term.
The contractual cash flows are solely payments of principal and interest on the principal amount outstanding as long as the interest paid over the life of the instrument reflects consideration for the time value of money and for the credit risk associated with the instrument. The fact that the LIBOR interest rate is reset during the life of the instrument does not in itself disqualify the instrument.However, if the borrower is able to choose to receive one-month LIBOR for three months and that one-month LIBOR is not reset each month, the contractual cash flows are not payments of principal and interest.The same analysis would apply if the borrower is able to choose between the lender’s published one-month variable interest rate and the lender’s published three-month variable interest rate.However, if the instrument has a contractual interest rate that is based on a term that exceeds the instrument’s remaining life, its contractual cash flows are not payments of principal and interest on the principal amount outstanding. For example, a constant maturity bond with a five-year term that pays a variable rate that is reset periodically but always reflects a five-year maturity does not result in contractual cash flows that are payments of principal and interest on the principal amount outstanding. That is because the interest payable in each period is disconnected from the term of the instrument (except at origination).
Instrument CInstrument C is a bond with a stated maturity date and pays a variable market interest rate. That variable interest rate is capped.
The contractual cash flows of both:(a) an instrument that has a fixed interest rate; and(b) an instrument that has a variable interest rate;are payments of principal and interest on the principal amount outstanding as long as the interest reflects consideration for the time value of money and for the credit risk associated with the instrument during the term of the instrument.Therefore, an instrument that is a combination of (a) and (b) (e.g. a bond with an interest rate cap) can have cash flows that are solely payments of principal and interest on the principal amount outstanding. Such a feature may reduce cash flow variability by setting a limit on a variable interest rate (e.g. an interest rate cap or floor) or increase the cash flow variability because a fixed rate becomes variable.
Instrument DInstrument D is a full recourse loan and is secured by collateral.
The fact that a full recourse loan is collateralised does not in itself affect the analysis of whether the contractual cash flows are solely payments of principal and interest on the principal amount outstanding.
B4.14 The following examples illustrate contractual cash flows that are not payments of principal and interest on the principal amount outstanding. This list of examples is not exhaustive.
Instrument
Analysis
Instrument EInstrument E is a bond that is convertible into equity instruments of the issuer.
The holder would analyse the convertible bond in its entirety. The contractual cash flows are not payments of principal and interest on the principal amount outstanding because the interest rate does not reflect only consideration for the time value of money and the credit risk. The return is also linked to the value of the equity of the issuer.
Instrument FInstrument F is a loan that pays an inverse floating interest rate (i.e. the interest rate has an inverse relationship to market interest rates).
The contractual cash flows are not solely payments of principal and interest on the principal amount outstanding.The interest amounts are not consideration for the time value of money on the principal amount outstanding.
Instrument GInstrument G is a perpetual instrument but the issuer may call the instrument at any point and pay the holder the par amount plus accrued interest due.Instrument G pays a market interest rate but payment of interest cannot be made unless the issuer is able to remain solvent immediately afterwards.Deferred interest does not accrue additional interest.
The contractual cash flows are not payments of principal and interest on the principal amount outstanding. That is because the issuer may be required to defer interest payments and additional interest does not accrue on those deferred interest amounts. As a result, interest amounts are not consideration for the time value of money on the principal amount outstanding.If interest accrued on the deferred amounts, the contractual cash flows could be payments of principal and interest on the principal amount outstanding.…continued
The fact that Instrument G is perpetual does not in itself mean that the contractual cash flows are not payments of principal and interest on the principal amount outstanding. In effect, a perpetual instrument has continuous (multiple) extension options. Such options may result in contractual cash flows that are payments of principal and interest on the principal amount outstanding if interest payments are mandatory and must be paid in perpetuity.Also, the fact that Instrument G is callable does not mean that the contractual cash flows are not payments of principal and interest on the principal amount outstanding unless it is callable at an amount that does not substantially reflect payment of outstanding principal and interest on that principal. Even if the callable amount includes an amount that compensates the holder for the early termination of the instrument, the contractual cash flows could be payments of principal and interest on the principal amount outstanding.
B4.15 In some cases a financial asset may have contractual cash flows that are described as principal and interest but those cash flows do not represent the payment of principal and interest on the principal amount outstanding as described in paragraphs 4.2(b) and 4.3 of this Standard.
B4.16 This may be the case if the financial asset represents an investment in particular assets or cash flows and hence the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding. For example, the contractual cash flows may include payment for factors other than consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. As a result, the instrument would not satisfy the condition in paragraph 4.2(b). This could be the case when a creditor’s claim is limited to specified assets of the debtor or the cash flows from specified assets (for example, a ‘non-recourse’ financial asset).
B4.17 However, the fact that a financial asset is non-recourse does not in itself necessarily preclude the financial asset from meeting the condition in paragraph 4.2(b). In such situations, the creditor is required to assess (‘look through to’) the particular underlying assets or cash flows to determine whether the contractual cash flows of the financial asset being classified are payments of principal and interest on the principal amount outstanding. If the terms of the financial asset give rise to any other cash flows or limit the cash flows in a manner inconsistent with payments representing principal and interest, the financial asset does not meet the condition in paragraph 4.2(b). Whether the underlying assets are financial assets or non-financial assets does not in itself affect this assessment.
B4.18 If a contractual cash flow characteristic is not genuine, it does not affect the classification of a financial asset. A cash flow characteristic is not genuine if it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur.
B4.19 In almost every lending transaction the creditor’s instrument is ranked relative to the instruments of the debtor’s other creditors. An instrument that is subordinated to other instruments may have contractual cash flows that are payments of principal and interest on the principal amount outstanding if the debtor’s non-payment is a breach of contract and the holder has a contractual right to unpaid amounts of principal and interest on the principal amount outstanding even in the event of the debtor’s bankruptcy. For example, a trade receivable that ranks its creditor as a general creditor would qualify as having payments of principal and interest on the principal amount outstanding. This is the case even if the debtor issued loans that are collateralised, which in the event of bankruptcy would give that loan holder priority over the claims of the general creditor in respect of the collateral but does not affect the contractual right of the general creditor to unpaid principal and other amounts due.
Contractually linked instruments
B4.20 In some types of transactions, an entity may prioritise payments to the holders of financial assets using multiple contractually linked instruments that create concentrations of credit risk (tranches). Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche. In such situations, the holders of a tranche have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy higher-ranking tranches.
B4.21 In such transactions, a tranche has cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if:
(a) the contractual terms of the tranche being assessed for classification (without looking through to the underlying pool of financial instruments) give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (e.g. the interest rate on the tranche is not linked to a commodity index);
(b) the underlying pool of financial instruments has the cash flow characteristics set out in paragraphs B4.23 and B4.24; and
(c) the exposure to credit risk in the underlying pool of financial instruments inherent in the tranche is equal to or lower than the exposure to credit risk of the underlying pool of financial instruments (for example, this condition would be met if the underlying pool of instruments were to lose 50 per cent as a result of credit losses and under all circumstances the tranche would lose 50 per cent or less).
B4.22 An entity must look through until it can identify the underlying pool of instruments that are creating (rather than passing through) the cash flows. This is the underlying pool of financial instruments.
B4.23 The underlying pool must contain one or more instruments that have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.
B4.24 The underlying pool of instruments may also include instruments that:
(a) reduce the cash flow variability of the instruments in paragraph B4.23 and, when combined with the instruments in paragraph B4.23, result in cash flows that are solely payments of principal and interest on the principal amount outstanding (e.g. an interest rate cap or floor or a contract that reduces the credit risk on some or all of the instruments in paragraph B4.23); or
(b) align the cash flows of the tranches with the cash flows of the pool of underlying instruments in paragraph B4.23 to address differences in and only in:
(i) whether the interest rate is fixed or floating;
(ii) the currency in which the cash flows are denominated, including inflation in that currency; or
(iii) the timing of the cash flows.
B4.25 If any instrument in the pool does not meet the conditions in either paragraph B4.23 or paragraph B4.24, the condition in paragraph B4.21(b) is not met.
B4.26 If the holder cannot assess the conditions in paragraph B4.21 at initial recognition, the tranche must be measured at fair value. If the underlying pool of instruments can change after initial recognition in such a way that the pool may not meet the conditions in paragraphs B4.23 and B4.24, the tranche does not meet the conditions in paragraph B4.21 and must be measured at fair value.
Measurement
Initial measurement of financial assets
B5.1 The fair value of a financial asset at initial recognition is normally the transaction price (i.e. the fair value of the consideration given, see also AASB 13 and paragraph AG76 of AASB 139). However, if part of the consideration given is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument. For example, the fair value of a long-term loan or receivable that carries no interest can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.
B5.2 If an entity originates a loan that bears an off-market interest rate (e.g. 5 per cent when the market rate for similar loans is 8 per cent), and receives an upfront fee as compensation, the entity recognises the loan at its fair value, i.e. net of the fee it receives.
Subsequent measurement of financial assets
B5.3 If a financial instrument that was previously recognised as a financial asset is measured at fair value and its fair value decreases below zero, it is a financial liability measured in accordance with AASB 139. However, hybrid contracts with financial asset hosts are always measured in accordance with AASB 9.
B5.4 The following example illustrates the accounting for transaction costs on the initial and subsequent measurement of a financial asset measured at fair value with changes through other comprehensive income in accordance with paragraph 5.4.4. An entity acquires an asset for CU100[1] plus a purchase commission of CU2. Initially, the entity recognises the asset at CU102. The reporting period ends one day later, when the quoted market price of the asset is CU100. If the asset were sold, a commission of CU3 would be paid. On that date, the entity measures the asset at CU100 (without regard to the possible commission on sale) and recognises a loss of CU2 in other comprehensive income.
Investments in equity instruments and contracts on those investments
B5.5 All investments in equity instruments and contracts on those instruments must be measured at fair value. However, in limited circumstances, cost may be an appropriate estimate of fair value. That may be the case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range.
B5.6 Indicators that cost might not be representative of fair value include:
(a) a significant change in the performance of the investee compared with budgets, plans or milestones.
(b) changes in expectation that the investee’s technical product milestones will be achieved.
(c) a significant change in the market for the investee’s equity or its products or potential products.
(d) a significant change in the global economy or the economic environment in which the investee operates.
(e) a significant change in the performance of comparable entities, or in the valuations implied by the overall market.
(f) internal matters of the investee such as fraud, commercial disputes, litigation, changes in management or strategy.
(g) evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties.
B5.7 The list in paragraph B5.6 is not exhaustive. An entity shall use all information about the performance and operations of the investee that becomes available after the date of initial recognition. To the extent that any such relevant factors exist, they may indicate that cost might not be representative of fair value. In such cases, the entity must measure fair value.
B5.8 Cost is never the best estimate of fair value for investments in quoted equity instruments (or contracts on quoted equity instruments).
Reclassification
B5.9 Paragraph 4.9 requires an entity to reclassify financial assets if the objective of the entity’s business model for managing those financial assets changes. Such changes are expected to be very infrequent. Such changes must be determined by the entity’s senior management as a result of external or internal changes and must be significant to the entity’s operations and demonstrable to external parties. Examples of a change in business model include the following:
(a) An entity has a portfolio of commercial loans that it holds to sell in the short term. The entity acquires a company that manages commercial loans and has a business model that holds the loans in order to collect the contractual cash flows. The portfolio of commercial loans is no longer for sale, and the portfolio is now managed together with the acquired commercial loans and all are held to collect the contractual cash flows.
(b) A financial services firm decides to shut down its retail mortgage business. That business no longer accepts new business and the financial services firm is actively marketing its mortgage loan portfolio for sale.
B5.10 A change in the objective of the entity’s business model must be effected before the reclassification date. For example, if a financial services firm decides on 15 February to shut down its retail mortgage business and hence must reclassify all affected financial assets on 1 April (i.e. the first day of the entity’s next reporting period), the entity must not accept new retail mortgage business or otherwise engage in activities consistent with its former business model after 15 February.
B5.11 The following are not changes in business model:
(a) a change in intention related to particular financial assets (even in circumstances of significant changes in market conditions).
(b) a temporary disappearance of a particular market for financial assets.
(c) a transfer of financial assets between parts of the entity with different business models.
Gains and losses
B5.12 Paragraph 5.4.4 permits an entity to make an irrevocable election to present in other comprehensive income changes in the fair value of an investment in an equity instrument that is not held for trading. This election is made on an instrument-by-instrument (i.e. share-by-share) basis. Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss. However, the entity may transfer the cumulative gain or loss within equity. Dividends on such investments are recognised in profit or loss in accordance with paragraph 5.4.5 unless the dividend clearly represents a recovery of part of the cost of the investment.
B5.13 An entity applies AASB 121 The Effects of Changes in Foreign Exchange Rates to financial assets that are monetary items in accordance with AASB 121 and denominated in a foreign currency. AASB 121 requires any foreign exchange gains and losses on monetary assets to be recognised in profit or loss. An exception is a monetary item that is designated as a hedging instrument in either a cash flow hedge (see paragraphs 95-101 of AASB 139) or a hedge of a net investment (see paragraph 102 of AASB 139).
B5.14 Paragraph 5.4.4 permits an entity to make an irrevocable election to present in other comprehensive income changes in the fair value of an investment in an equity instrument that is not held for trading. Such an investment is not a monetary item. Accordingly, the gain or loss that is presented in other comprehensive income in accordance with paragraph 5.4.4 includes any related foreign exchange component.
B5.15 If there is a hedging relationship between a non-derivative monetary asset and a non-derivative monetary liability, changes in the foreign currency component of those financial instruments are presented in profit or loss.
Transition
Financial assets held for trading
B8.1 At the date of initial application of this Standard, an entity must determine whether the objective of the entity’s business model for managing any of its financial assets meets the condition in paragraph 4.2(a) or if a financial asset is eligible for the election in paragraph 5.4.4. For that purpose, an entity shall determine whether financial assets meet the definition of held for trading as if the entity had acquired the assets at the date of initial application.