Two Key Tests Drive Classification of Financial Assets Under PBE IPSAS 41
In the February 2021 edition of Accounting Alert we noted that public benefit entities face substantial changes to accounting for financial instruments, due to PBE IPSAS 41 Financial Instruments (“PBE IPSAS 41”) replacing PBE IPSAS 29 Financial Instruments: Recognition and Measurement (“PBE IPSAS 29”) for financial reporting periods beginning on or after 1 January 2022.
In the March 2021 edition of Accounting Alert we examined the classification of financial assets under PBE IPSAS 41. In that article, we noted that, under PBE IPSAS 41, where a financial asset is a non-equity instrument such as a debt instrument, the default measurement approach is fair value through profit or loss, but measurement at amortised cost or at fair value through other comprehensive income will occur if specified criteria are met:
|If the instrument is:
||It may be measured at:
|A non-equity instrument (for example, a debt instrument)
||It meets both (1) the contractual cash flow characteristics test and (2) the hold to collect management model test
||Fair value through other comprehensive revenue and expense
||It meets both (1) the contractual cash flow characteristics test and (2) the hold to collect and sell management model test
The following flow chart shows how non-equity financial assets are classified under PBE IPSAS 41:
As shown in the table and decision tree above, the classification of a financial asset that is a debt instrument is based on whether that financial asset will pass the contractual cash flow characteristics test and a management model test.
The remainder of this article examines the contractual cash flow characteristics and management model tests in greater depth.
Contractual cash flow characteristics test
The aim of this test is to identify financial assets with contractual cash flows that are consistent with a basic lending arrangement (i.e. contractual cash flows that consist solely of payments of principal and interest on the principal outstanding, with the key components of interest being the time value of money and credit risk). Interest can also include consideration for other basic lending risks (for example, liquidity risk) and costs (for example, administrative costs) associated with holding the financial asset for a particular period of time. Contractual terms that introduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement (such as exposure to changes in equity or commodity prices, a specific profitability or income threshold being reached by the borrower or lender, or the achievement of specific financial or other ratios), do not give rise to contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.
Any debt instruments that do not meet the contractual cash flow characteristics test must be classified at fair value through profit or loss, irrespective of the management model under which they are held. Note that this test must be carried out on an individual asset basis.
||Is the contractual cash flow characteristics test met?
|A bond that matures in three years and pays a variable market interest rate
Contractual cash flows of an instrument that has a variable interest rate are consistent with a basic lending arrangement if the interest reflects consideration for the time value of money and credit risk.
|A bond that matures in three years and pays a fixed market interest rate of 5%
Contractual cash flows of an instrument that has a fixed interest rate are considered to be consistent with a basic lending arrangement if the interest rate is based on the market fixed rate at initial recognition.
|A bond that matures in three years and pays a variable market interest rate that is capped at 8%
Contractual cash flows of both an instrument that has a fixed interest rate and an instrument that has a variable interest rate are payments of principal and interest (provided the interest reflects consideration for the time value of money and credit risk). Therefore, an instrument with both a fixed and a variable interest rate is considered to be consistent with a basic lending arrangement if the interest rates are at market rates at initial recognition.
|A bond with contractual interest payments linked to the earnings before interest, tax, depreciation and amortisation (EBITDA) of the issuer.
The interest rate reflects the performance of the issuer.
|Entity A provides a loan to its controlled entity, Entity B. The loan has no interest and no fixed repayment terms, is repayable on demand, and is classified as a current liability in Entity B’s books
It is possible for loans with such terms to be considered consistent with a basic lending arrangement and hence meet the cash flow characteristics test. However, in some situations (for example, where the loan is a non-recourse loan or where the controlled entity only has one asset) further analysis may be required to determine whether the controlled entity is able to generate sufficient cash flows to enable the controlling entity to recover the principal amount lent.
|Entity C provides a loan to Entity D. The loan is for $50,000 at a fixed market interest rate and is repayable in five years’ time, but Entity D has the option to repay the loan at any time at $50,000, plus any accrued interest, plus a prepayment penalty of 3%
||Yes (if the prepayment penalty of 3% is deemed reasonable additional compensation for early contract termination).
Contractual provisions that permit the issuer to prepay a debt instrument before maturity can meet the cash flow characteristics test if the prepayment amount substantially represents unpaid amounts of principal and interest, which may include reasonable additional compensation for the early termination of the contract.
|Entity E provides a loan to Entity F. The loan is for $100,000 at a fixed market interest rate and is repayable in five years’ time. Entity F has the right to extend the term for another three years and, if it does so, a variable market interest rate will be charged from years 6 to 8
Extension options meet the contractual cash flow characteristics test if the terms result in contractual cash flows during the extension period that are considered to be solely payments of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the extension of the contract.
Management model tests
The management model test looks at how the financial asset is managed.
Hold to collect
A financial asset is managed on a hold to collect basis where the entity’s management objective is to hold the financial asset in order to collect its contractual cash flows. The hold to collect management model test does not require that financial assets are always held until their maturity - the test will likely still be met if there are only infrequent sales, and those sales occur for reasons such as to realise cash to deal with an unforeseen need for liquidity, or concerns about the collectability of the contractual cash flows.
Hold to collect and sell
A financial asset is managed on a hold to collect and sell basis where the entity’s management objective is to both hold the financial asset in order to collect its contractual cash flows and sell the financial asset. The hold to collect and sell management model results in a greater frequency and volume of sales than the hold to collect management model, because selling financial assets is an integral part of achieving the entity’s management objective for the financial asset.
The examples below illustrate these two management models:
|If an entity has invested in an instrument, such as a government or a corporate bond, that matures in:
||And the entity is likely to need the funds in:
||The management model for the financial asset is likely to be:
||Hold to collect and sell (because the funds will be required before the maturity date of the investment and selling the instrument would therefore be an integral part of the investment)
||Hold to collect (because the investment will mature before the funds are required)
||Hold to collect
||Hold to collect and sell
Under PBE IPSAS 41, the characteristics of a financial asset that is a debt instrument are central to the manner in which it will be measured subsequent to initial recognition. As public benefit entities prepare for their adoption of PBE IPSAS 41, they will need to understand the cash flow characteristics of each of their financial assets that are debt instruments and identify the management model under which those financial assets are held.
For more information on the above, please contact your local BDO representative.
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