IFRS 9 The Business Model Test is a necessary condition (see IFRS 9 Classification and Measurement of Financial Instruments) for classifying a loan or receivable at Amortized Cost or FVOCI. The test is about whether the asset is part of a group or portfolio that is being managed within a business model whose objective is to collect contractual cash flows from the non-equity financial asset (Amortized Cost), or to both collect contractual cash flows from the non-equity financial asset and sell the non-equity financial asset (FVOCI). Otherwise, the asset is measured at FVPL. The key elements of this test are listed below.
Observe: IFRS 9 recommends applying the Business Model test before applying the SPPI test because this may eliminate the need to apply the more detailed SPPI test, which is applied at a more granular level. However, the ordering of the tests will not change the outcome.
IFRS 9 lists the following examples for relevant and objective evidence:
- how the performance of the business model (and the financial assets held within that business model) are evaluated and reported to the entity’s key management personnel;
- the risks that affect the performance of the business model (and the financial assets held within that business model) and the way those risks are managed; and
- how managers of the business are compensated – e.g. whether the compensation is based on the fair value of the assets managed or the contractual cash flows collected. [IFRS 9 B4.1.2B]
In addition, an entity considers the frequency, volume and timing of sales in prior periods, the reasons for such sales, and its expectations about future sales activity. However, information about sales activity is not considered in isolation, but as part of an holistic assessment of how the entity’s stated objective for managing the financial assets is achieved and how cash flows are realised. Therefore, an entity considers information about past sales in the context of the reasons for those sales, and the conditions that existed at that time as compared to current conditions. [IFRS 9 B4.1.2C]
Judgement needed for business model assessment
Although IFRS 9 states that an entity’s business model for managing financial assets is a matter of fact, it also acknowledges that judgement is needed to assess the business model for managing particular financial assets.
For example, the standard does not include ’bright lines’ for assessing the impact of sales activity, but instead requires an entity to consider:
- the significance and frequency of sales activity; and
- whether sales activity and the collection of contractual cash flows are each integral or incidental to the business model. [IFRS 9 B4.1.2B]
Examples of portfolios where judgement is likely to be required include:
- portfolios of instruments that are held for liquidity management; and
- those supporting a business model objective of providing insurance or pension
In preparing to apply IFRS 9, entities will have to identify and assess their business models for managing financial assets and document their conclusions. To do this, they may also need to: IFRS 9 The Business Model Test
- enhance their documentation of the relevant business objectives and operating policies; and
- establish processes and controls over gathering and assessing relevant and objective evidence, to support their assessments on an ongoing basis – g. reviewing actual and expected levels of sales activity.
Applying the Business Model test involves four basic steps: IFRS 9 The Business Model Test
- Subdividing as necessary loans and receivables into separate groups or portfolios according to the way they are managed.
- Identifying the objectives the entity is using in the course of its business to manage each grouping or portfolio.
- Based on those objectives, classifying each group or portfolio as being “held to collect”, “held to collect and to sell”, or “other”.
- For assets classified as being held to collect, evaluating the appropriateness of the classification by back-testing against past activities.
The following table summarizes the key factors and other guidance in IFRS 9 for classifying assets as held for collection, held for collection and sale, and other.
|IFRS 9 The Business Model Test|
Holding to collect contractual cash flows
Holding to collect contractual cash flows and sell
Collecting cash flows is integral, sales are incidental
Collecting cash flows and selling assets are both integral
Sales are integral, collecting cash flows is incidental
|Examples of why sales happen in each category|
Sales are made in response to increase in asset’s credit risk or to manage credit concentration risk
Sales are made as part of managing everyday liquidity needs, maintaining a particular interest yield profile or matching the duration of financial assets and liabilities
Sales are made within a program of active buying and selling to realize fair values
|Illustrative examples in IFRS 9|
Classifying business models
IFRS 9 states that identifying business models is a matter of fact that is typically observable through an entity’s activities, not merely an assertion. Relevant evidences that entities should consider include: IFRS 9 The Business Model Test
- How information about financial assets and their performance is evaluated by the entity’s key management personnel.
- The risks that affect the performance of the group and the way which those risks are managed. IFRS 9 The Business Model Test
- How managers are compensated (e.g., whether the compensation is based on the fair value of the assets or the contractual cash flows that are collected).
Consideration of historical sales
In considering whether an entity’s business model is holding to collect contractual cash flows, IFRS 9 requires entities to consider the frequency, value and timing of any sales in prior periods, the reasons for them and the conditions under which they are made. The purpose is to establish whether sales continue to be only an incidental part of the entity’s business model, and thus that Amortized Cost classification continues to be appropriate.
Nevertheless, such sales must be considered in assessing the business model for new instruments. IFRS 9 The Business Model Test
Factoring and securitization of trade receivables
Many entities realize contractual cash flows from trade receivables through factoring or securitization programs. The classification of the related assets under the Business Model test may depend on whether the factoring or securitization will be accounted for as a sale or a financing. If the former, classification as other than holding for collection, or holding for collection and sale, would likely be appropriate. IFRS 9 The Business Model Test
Data needed for business model assessment
Under IAS 39, an entity did not need to consider the business model for managing financial assets in a way that is similar to the new standard. IAS 39 required an assessment of whether a financial asset is held for trading or whether the entity intends to hold a particular financial asset to maturity, but otherwise did not generally require an assessment of past levels of sales. IFRS 9 The Business Model Test
Accordingly, entities may not have readily available historic data on the frequency and significance of sales, and collecting it may require effort.
Purpose of the business model assessment
It appears that, in making the business model assessment, an entity should consider the stated objective of IFRS 9, which is to provide relevant and useful information to users of the financial statements for their assessment of the amounts, timing and uncertainty of the entity’s future cash flows.
The more that a business model envisages holding financial assets for an extended period or until maturity to collect contractual cash flows, the more relevant and useful amortised cost information is. Conversely, the more that a business model envisages making sales of assets significantly before maturity, the more relevant and useful fair value information is. [IFRS 9 1.1, IFRS 9 BCE.53–56]
See also: The IFRS Foundation