Parent A advances an unsecured loan for €1m to Subsidiary B on 1 January 2018 with the following terms:
- 0% interest (assume that a market rate of interest for a similar loan is estimated at 7%);
- €1m repayable in 5 years – December 2022.
Initial recognition of an interest-free term loan Interest-free term loan – No bank debt
IFRS 9 contains the same initial recognition requirements for financial assets as IAS 39. This means that, in contrast to demand loans, there are specific requirements which state that the initial fair value of an interest-free term loan is equal to the present value of future cash receipts discounted at an appropriate market rate of interest for a similar loan at that date. In this example, the present value of future cash receipts of €1m discounted for 5 years at the appropriate market rate of interest of 7% (the rate at which the subsidiary could have borrowed funds on equivalent terms from an unrelated third party), being the imputed effective interest rate (EIR), is equal to €713k. This amount which is initially recognised by Parent A accretes to €1m using the market rate of 7% over 5 years. It is important to note that difference between the transaction price of €1m and the initial fair value of €713k (i.e. €287k) does not constitute a Day 1 profit or loss. Instead, as a result of the parent subsidiary relationship, it is recognised as an addition to Parent A’s investment in Subsidiary B (and a capital contribution by Subsidiary B). This accounting treatment is specific to related company loans, and is different from the approach that is required to be followed for loans between unrelated parties.
Classification Interest-free term loan – No bank debt
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 on 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 amount of €1m which is equal to the principal (being the initial fair value of the loan of €713k) and interest (being €287k interest accrued using an EIR of 7%). 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) on Day 1 is 71% (€713k / €1m) because part of the loan has been added to Parent A’s the investment in Subsidiary B, the forecast LTV at date of repayment is expected to increase to 100%. However, by that point Subsidiary B is forecast to have built up €400k (i.e. €80k x 5 years) in rental income. In order to repay the loan to Parent A, Subsidiary B could:
- Refinance the loan from Parent A with a third party at a lower LTV; or Interest-free term loan – No bank debt
- Sell the property and use the proceeds to repay the loan from Parent A; Interest-free term loan – No bank debt
- The investment is made in accordance with Management’s investment policies which specify a number of key criteria including for example, whether expected rental yield is sufficient to allow for full 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 subsidiary which will in turn generate rental income for the group. Interest-free term loan – No bank debt
Based on the above, Parent A concludes that the loan to Subsidiary B is a basic lending arrangement that meets the SPPI test and would be classified at amortised cost because it is in a hold to collect business model.
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. Parent A therefore needs to 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 is required to consider all relevant reasonable and supportable historic, current and forward looking information that could affect 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 yield 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 term loans
Assessing which stage the loan is in and estimating the risk of a default occurring will be more complex for term loans than for demand loans. This is due to the longer maturity period over which the risk of a default needs to be estimated, in this example over the remaining life of 4 years to December 2022.
1. Staging Assessment Interest-free term loan – No bank debt
Assume that Management has the following accounting policies:
Default is defined as Subsidiary B having insufficient funds to repay the loan when due and monitors through a number of different indicators – including for example, the loss of a major tenant and LTVs falling below a minimum threshold. As a backstop indicator, a default is assumed if the loan is more than 90 days past due but given that the loan bears no interest throughout its life, it is not considered appropriate to solely rely on this indicator. Once a loan is in default, the loan is considered to be credit impaired.
Significant Increases in Credit Risk (SICR) is assessed on a qualitative basis by monitoring changes in actual and expected rental income and property values since initial recognition. This is because Management considers that changes in either of these measures have the greatest effect on the risk of a default occurring i.e. a decline in rental income would reduce cash flows available to repay the loan and a decline in property value would increase the LTV which could have a detrimental effect on refinancing options available to Subsidiary B. As a backstop indicator, a SICR is assumed if the loan is more than 30 days past due but given that the loan bears no interest throughout its life, it is not considered appropriate to solely rely on this indicator.
Based on the revised forecasts the rental income has fallen by 12.5% after 2019 (from €80k to €70k) and the property value has also fallen by 12.5% (from €1m to €875k). For the purposes of illustration assume that this is considered to constitute a SICR by Management. This means that the loan is in Stage 2 and Lifetime ECL is required to be recognised.
2. Estimating the risk of a default occurring Interest-free term loan – No bank debt
When estimating the risk of a default occurring, Management should consider internal and external information about past default rates on similar loans (to the extent available) as well as forward-looking information about factors that provide evidence about the risk of a default occurring such as expected property and rental market forecasts. Management is of the view that under the most likely scenario where property values and rental yields remain at or above current levels, no default is expected because Subsidiary B would be in a position to repay the loan when due using a combination of its accumulated rental income and refinancing with a third party at a lower LTV or through sale.
However, Management also considers an alternative scenario under which the property value will decline to €500k and annual rentals after 2019 will reduce to €40k. Under this scenario, Management considers that a default would arise as Subsidiary B would not be in a position to repay the loan through any means. The probability of this scenario arising is estimated at approximately 10% i.e. the risk of default is 10%.
3. ECL Measurement Interest-free term 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. In doing so, Management should consider that in some cases, they may be forced to pursue a strategy that does not maximise recoveries.
In this example, based on an analysis of relevant forward looking information relevant, Management is of the view that the property value is very unlikely to go below €500k and is instead expected to recover significantly. By 2025, Management estimates an annual rental income of €60k with a property valuation of €750k. This means that if Parent A was in a position to wait and allow the market to recover, this would be a viable recovery strategy.
For the purposes of illustration, assume that in this example, Management considers that waiting to receive rentals and making a sale at the end of 2025 would be the best recovery strategy (Scenario 1). However, under certain future market conditions, Parent A may not be in a position to wait and may instead need to force a sale of the underlying property at the loan maturity date – i.e. the end of 2022. In addition, while an orderly sale after a normal marketing period (Scenario 2) would maximise recoveries, the possibility of a fire sale (Scenario 3) cannot be ruled out (depending upon the cash flow position of Parent A).
Taking this information into account, Management estimates the following expected cash flows and their likelihood. In all scenarios, it is assumed that the rental income received can be used as part repayment of the loan.
|Total expected cash flows1|
|Rentals plus orderly sale in Q4 2025|
[(80,000 x 2yrs) + (40,000 x 5 yrs) + (60,000 x 1 yr]
Rentals plus orderly sale in Q4 2022
[80,000 x 2 yrs+ (40,000 x 3 yrs)]
Rentals plus orderly sale in Q4 2022 (15% discount)
[80,000 x 2 yrs + (40,000 x 3 yrs)]
The credit losses arising under these scenarios are illustrated below. These are then weighted accordingly and multiplied by the lifetime risk of default occurring of 10% to arrive at a lifetime ECL. Note:
- Because the effective interest rate (EIR) is 7% in this example, discounting future cash flows will have an effect – This means that even in Scenario 1 where full recovery is expected but payment will be later than the contractually due date, a credit loss will arise;
- To simplify the effect of discounting, it is assumed that Subsidiary B repays the total expected cash flows in one lump sum at the end of 2025 for Scenario 1 and at the end of 2022 for Scenario 2 and Scenario 3.
|Interest-free term loan – No bank debt|
Interest-free term loan – No bank debt
Weighted average credit loss
(discounted at 7%)
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 term loan – No bank debt
Risk of default Interest-free term loan – No bank debt
Lifetime expected credit losses Interest-free term loan – No bank debt