- 20 Marks
Question
Ariba Bank Plc. (the Bank) is a Tier 1 Bank in Nigeria with branch network across all the six geo-political zones of the country. Its credit portfolio is spread among many industries with a special focus on the oil and gas industry and real estate.
One of its major customers with a very good credit standing is Dunga Property Development Company (DPDC).
The management of DPDC recently approved a plan to build four shopping malls in major cities across the country. A special purpose entity was registered as a limited liability company, Dunga Malls Limited (DML), dedicated to the development and management of the malls. The project will be solely financed by a loan to be obtained from Ariba Bank. There will be no equity contribution from DPDC other than the minimum required by law to establish a company.
Ariba Bank has approved a loan of N80 billion at a fixed interest rate of 15% per annum payable annually in arrears. The loan has a maturity of 10 years with a moratorium of 3 years. There was no transaction cost and therefore the contractual rate is the same as the effective rate. The loan was granted directly to DML on 1 January, 2018.
The Financial Controller of Ariba Bank Plc. is concerned about the accounting treatment of the loan as IFRS 9 Financial Instrument was adopted by the bank during the year. He noted that the majority of the bank loans are classified at amortized cost in the statement of financial position, but the loans must pass certain tests before such classification.
The Chief Risk Officer noted in his memo that the arrangement is substantially the same as the other borrowing arrangements of the bank except that a borrowing entity would normally have equity or other assets that could be called upon by the bank in a case of default other than the asset being financed.
Required:
a. Discuss how financial assets are classified in accordance with the requirements of IFRS 9. (8 Marks)
b. Advise the Bank on how the loan granted to DML should be classified in the statement of financial position. (6 Marks)
c. Discuss, with supporting calculations, how the loan will be accounted for in the financial statement of the bank for the year ended 31 December, 2018. (6 Marks)
Answer
(a) Classification of Financial Assets under IFRS 9
According to IFRS 9, the classification of a financial asset at initial recognition depends on whether it is a debt instrument or an equity instrument.
- Debt Instrument:
A debt instrument is classified into one of three categories:
- Amortized Cost
- Fair Value Through Other Comprehensive Income (FVOCI)
- Fair Value Through Profit or Loss (FVTPL)
- Equity Instrument:
Equity instruments cannot be measured at amortized cost and are either classified at FVOCI or FVTPL.
Tests for Debt Instrument Classification:
- Business Model Test:
The business model must aim to hold the asset to collect contractual cash flows. - SPPI Test (Solely Payments of Principal and Interest):
The contractual terms must give rise to cash flows that are solely payments of principal and interest on specified dates.
Classification Categories:
- Amortized Cost:
A debt instrument is measured at amortized cost if:- It passes both the Business Model Test and the SPPI Test.
- The objective is to hold the financial asset to collect contractual cash flows.
- FVOCI:
A debt instrument is measured at FVOCI if:- It passes the SPPI Test.
- The business model includes both collecting contractual cash flows and selling financial assets.
- FVTPL:
A debt instrument that does not meet the criteria for amortized cost or FVOCI is classified at FVTPL.
The classification is applied to the entire financial asset, even if it contains an embedded derivative.
(b) Classification of the Loan to DML
The loan of ₦80 billion to DML is assessed as follows:
- Business Model Test:
Ariba Bank’s primary objective is to hold the loan to collect contractual cash flows, meeting the business model test. - SPPI Test:
- The loan terms involve compensation for the time value of money and credit risk but do not include compensation for risks of the underlying asset.
- Although DML is solely financed by the loan, and the bank bears the risk of default, the loan is guaranteed by DPDC, which has a good credit standing.
Based on these assessments, the loan passes both the Business Model Test and the SPPI Test.
Conclusion:
The loan should be classified at amortized cost in the statement of financial position.
(c) Accounting for the Loan as at 31 December 2018
Debt instruments classified at amortized cost are initially measured at fair value plus transaction costs.
- Initial Recognition:
- Face value of the loan: ₦80 billion.
- No transaction cost; therefore, the fair value equals ₦80 billion.
- Subsequent Measurement:
The amortized cost is calculated using the Effective Interest Rate (EIR) method:Calculation of Amortized Cost at 31 December 2018 ₦ ‘Million Initial recognition (1 January 2018): 78,000 Finance income @ EIR of 16% (₦78,000 × 16%): 12,480 Less: Interest received @ contractual rate (₦80,000 × 15%): (12,000) Amortized cost at 31 December 2018: 78,480 - Financial Reporting Impact:
- Statement of Financial Position:
The loan will be reported as a financial asset with a carrying amount of ₦78.48 billion. - Statement of Profit or Loss:
Finance income of ₦12.48 billion will be recognized as revenue. - Impairment Loss:
An impairment loss based on expected credit loss (ECL) must also be recognized, though its calculation is not provided here.
- Statement of Financial Position:
Summary:
The loan is classified and measured at amortized cost with a carrying value of ₦78.48 billion at year-end. Finance income of ₦12.48 billion is recognized in profit or loss.
- Tags: Amortized Cost, Business Model Test, Effective Interest Rate, Financial Assets, IFRS 9, SPPI Test
- Level: Level 3
- Topic: IAS 39)
- Uploader: Kofi