Parent A advances an unsecured loan for €1m to Subsidiary B on 1 January 2018 with the following terms:
- 0% interest;
- €1m repayable on demand.
Initial recognition of an interest-free demand loan
IFRS 9 contains the same initial recognition requirements for financial assets as IAS 39. This means that at initial recognition the loan must be recognised at its fair value (which, for a demand loan, will be the transaction price) plus transaction costs (assumed to be nil in this example). Therefore, Parent A initially recognises the loan at its fair value being its transaction price of €1m. This reflects the fact that repayment could be demanded immediately which is in contrast to a related company term loan. Owing to the demand feature and the contractual rate of interest of 0%, the effective interest rate (EIR) is 0%.
As the loan is in a ‘hold to collect’ business model, the key classification question is whether the loan meets the Solely Payments of Principal and Interest test (the SPPI test).
In considering whether the loan is likely to meet the SPPI test, Parent A must take into consideration the fact that the loan is implicitly non-recourse in nature because Subsidiary B only holds one asset. This means that Parent A must look-through to the cash flows generated from this asset and determine whether the non-recourse nature of the loan restricts the contractual cash flows of the loan in a manner that is inconsistent with a basic lending arrangement. Parent A notes the following:
- The contractual terms of the loan specify a fixed repayment of €1m which is equal to the principal amount (being the initial fair value of the loan) and interest (being nil as the EIR is 0%). These repayments are consistent with a basic lending arrangement as they are not contractually linked to changes in the property value;
- While the loan to value (LTV) is 100% at initial recognition, Parent A notes that it could choose immediately to demand repayment and receive back cash flows equal to principal (€1m) plus interest (nil). In addition:
- Rental income is expected to be sufficient to repay the loan in full by 2030 (i.e. €80k x 13 yrs = €1.04m);
- Once Subsidiary B has accumulated sufficient rental income, the loan from Parent A could be refinanced with a third party at a lower LTV;
- Given the current valuation of the property, it could be sold in order to repay the loan;
- The investment is made in accordance with Management’s investment policies which specify a number of key criteria including, for example, a minimum loan LTV and rental income which supports repayment of the loan. When Parent A provides funding to Subsidiary B, its aim is not to take property risk but to provide financing to its subsidiaries for their ongoing business operations which will, in turn, generate rental income for the group.
Based on the above, Parent A concludes that the loan to Subsidiary B is a basic lending arrangement that meets the SPPI test and should be classified at amortised cost because it is in a hold to collect business model.
Impairment Interest-free demand loan – No bank debt
As the loan is classified at amortised cost, it is within the scope of the expected credit losses (ECL) model and subject to the general approach. At the next reporting date following initial recognition, Parent A must determine whether the loan is in Stage 1, Stage 2 or Stage 3 and measure 12 month ECL or lifetime ECL accordingly. In performing this analysis, Parent A must consider all relevant reasonable and supportable historic, current and forward-looking information that provides evidence about the risk that Subsidiary B will default on the loan and the amount of losses that would arise as a result of that default. Sources of this information can be internal and external, including external providers to whom, a fee is payable.
Assume that at 31 December 2018, based on current and forward-looking information:
- The property value has reduced to €875k and is forecast to remain at this level;
- The rental income after 2019 is expected to reduce to €70k and is forecast to remain at this level; and
- The market rate rental yield is expected to remain at 8%.
Staging assessment and estimating the risk of a default occurring for demand loans Interest-free demand loan – No bank debt
Assessing which stage the loan is in and estimating the risk of a default occurring should be relatively straightforward for demand loans. This is because Management must determine the risk of a default occurring based on the assumption that repayment is demanded immediately (irrespective of whether this is the intention). This is likely to be a binary analysis as the subsidiary will either:
- Have sufficient cash or other liquid assets to repay the loan immediately (meaning that the risk of default is very low, possibly close to 0% and the loan is in Stage 1); or
- Not have sufficient cash or other liquid assets to repay the loan immediately (meaning that the risk of default is very high, possibly close to 100% and the loan is in Stage 3).
This means that typically, provided the funds are not lent to an insolvent entity, the risk of a default occurring at initial recognition is likely to be very low. This is on the basis that repayment could be demanded immediately and because the subsidiary would not yet have used the funds, the full amount would almost certainly be recovered.
1. Staging Assessment Interest-free demand loan – No bank debt
Assume that Management defines default as Subsidiary B having insufficient funds to repay the loan when due (i.e. on demand) and considers that a loan is credit impaired once it meets the definition of a defaulted loan. As a backstop indicator, a default is assumed if the loan is more than 90 days past due but given that the loan is due on demand and bears no interest, it is not considered appropriate to solely rely on this indicator. At the reporting date, the loan is not past due but Management considers that Subsidiary B would have insufficient funds to repay the loan if demanded (as the full amount has been used to purchase the property). This means that the loan is in default and considered credit impaired. The loan is therefore in Stage 3 and Lifetime ECL is required to be recognised.
2. Estimating the risk of a default occurring Interest-free demand loan – No bank debt
Due to the fact that Subsidiary B would default if repayment was demanded immediately, Management concludes the risk of default can be assumed to be 100%.
3. ECL Measurement Interest-free demand loan – No bank debt
Management must then consider the possible credit losses that would arise upon a default taking into account different possible recovery strategies and expected cash flows using historic, current and forward looking information. In doing so, Management should consider that in some cases, they may be forced to pursue a strategy that does not maximise recoveries for example, depending upon Parent A’s cash flow position at that time. The analysis may also be affected by the extent to which Parent A has unrelated third party funding in place, and the recovery strategy that the third party lender might adopt. This is explained further in ‘Interest-free demand or term loan – Senior bank term debt‘.
Assume that Management has determined that there is approximately a 90% probability that the property value and rental yield will remain at or above current levels. In this case, Management considers that the best recovery strategy is to wait for Subsidiary B to accumulate sufficient rental income to repay of the loan by 2031 at which point the property could then be sold for €875k (Scenario 1)1.
Management also considers that there is approximately a 10% probability that the property value will decline to €500k and that annual rental income will decline to €40k after 2019. In this case, Management considers that the best recovery strategy would be to force a sale of the underlying property at the end of 2019 thus foregoing any future rental income2. While an orderly sale after a normal marketing period (Scenario 2) would maximise recoveries, Management cannot rule out the possibility of a fire sale (Scenario 3) depending upon market conditions and the cash flow position of Parent A.
Taking this information into account, Management estimates the following expected cash flow scenarios and their likelihood. Note that for Scenario 2 and Scenario 3, it is assumed that the rental income received in 2018 and 2019 can be used as part repayment for the loan.
|Total expected cash flows3|
|Rentals plus orderly sale in Q4 2031|
[(80,000 x 2yrs) + (70,000 x 12 yrs)]
Rentals plus orderly sale in Q4 2019
[80,000 x 2 yrs]
Rentals plus orderly sale in Q4 2019 (15% discount)
[80,000 x 2 yrs]
The credit losses arising under these scenarios are then weighted accordingly and multiplied by the lifetime risk of default occurring of 100% to arrive at a lifetime ECL. Note that because the EIR is 0% in this example, discounting credit losses has no effect.
|Interest-free demand loan – No bank debt|
Interest-free demand loan – No bank debt
Weighted average credit loss
(discounted at 0%)
Gross carrying amount
Expected cash flow
Gross carrying amount
Expected cash flow
Gross carrying amount
Expected cash flow
Total weighted average expected credit loss Interest-free demand loan – No bank debt
Risk of default Interest-free demand loan – No bank debt
Lifetime expected credit losses Interest-free demand loan – No bank debt