Applying some of the concepts of IFRS 9 in related party situations
You’ll recall that under the model in IFRS 9, a financial asset is measured at amortized cost only when it’s held within a business model with the objective of holding financial assets in order to collect contractual cash flows, and the asset’s contractual terms give rise on specified dates to cash flows that are solely payments of principal and of interest on the principal amount outstanding. The application guidance to the standard provides numerous examples to illustrate where the lines are drawn on this.
CPA Canada’s IFRS Discussion Group recently discussed how these concepts apply in classifying and measuring related party financial assets. As the meeting report observes, IFRS 9 doesn’t set out any different requirements for such assets. It notes: “Related party loans are typically advanced on terms that are not at arms-length or on an informal basis with unspecified terms. They can also have features that expose the lender to risks that are not consistent with a basic lending arrangement. Applying IFRS 9 to related party loans can be complex.”
Against that backdrop, the group considered the following scenario:
- Parent Entity A provides a loan of CU5 million to Subsidiary C to fund its ongoing business operations. The loan bears zero per cent and CU5 million is repayable on demand of Parent Entity A. Parent Entity A does not intend to demand repayment of the loan for several years and the loan is not considered purchased or originated credit-impaired.
- Subsidiary C has the ability to repay the loan if demanded by Parent A.
You might think that if there’s no specified repayment date, and no interest, then the instrument can’t be judged as “giving rise on specified dates to cash flows that are solely payments of principal and of interest.” But the broader point perhaps is that it doesn’t give rise to anything that isn’t a payment of principal or interest. IFRS 9 doesn’t say that the interest charged has to be a reasonable amount of compensation, so a zero rate fits the standard as well as any other amount. And the on-demand nature of the loan constitutes a specified date for a repayment of principal, regardless that the lender isn’t being held to it.
The following fact pattern is a bit more complex:
- Parent Entity A provides a loan of CU3 million to Subsidiary D, a real estate investment company.
- Subsidiary D uses the loan to partly fund the purchase of a property worth CU3.5 million. It intends to generate cash flows through rental income.
- The loan is repayable in three years with 5 per cent annual interest. The loan also has a contingent payment clause, which is 30 per cent of the annual appreciation in the property value.
In this case the group agreed that the contingent payment clause introduces a form of return and related risk that goes beyond the concept of interest. The clause could be disregarded if it “could have only a de minimis effect on the contractual cash flows” or if it would affect those cash flows “only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur.” In this case, there’s no reason to think that’s the case, and therefore the loan doesn’t meet the criteria to be measured at amortized cost. It’s clear though that there’s some arbitrariness to this analysis. As the parent has control over the subsidiary, it could presumably equally have settled for extending finance through a more straightforward instrument, knowing that it can always put mechanisms in place later for channelling money up through the structure. This is just an example of how the distinction between form and substance can become fuzzy in a related party situation.
On the other hand, the group provided some illustrations of how economic substance may affect the analysis. Consider a loan from a parent to a subsidiary in which the only asset is an income-generating rental property. If the fair value of the property is significantly below the amount of the loan at the time the loan is made, then it’s evident that (regardless of what’s specified in the terms of the instrument) the parent lender is entering the arrangement in awareness of a broader risk and return calculation: as the meeting report puts it, the loan is more “like an indirect investment in the underlying property.” But this opens up additional complexities that the group didn’t fully explore. Maybe for instance the economic discrepancy indicates that the arrangement in effect contains an equity contribution from the parent to the subsidiary, which should be quantified and recognized separately. In this case, the balance of the arrangement would be recognized at amortized cost, but at a greater inherent interest rate than the contractual rate. This kind of thinking makes a lot of sense to me, but as the group addressed it only in passing, it’s likely that practice will continue to differ…
The opinions expressed are solely those of the author