IFRS IN PRACTICE

Applying IFRS 9 to related company loans

in the real estate sector
2022/2023
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Table of Contents

Introduction 3

Section 1 - Investment property group 4

Example 1.1 – Interest-free demand loan - No bank debt 5

Example 1.2 – Interest-free term loan - No bank debt 9

Example 1.3 – Interest free demand or term loan - Senior bank term debt 12

Example 1.4 - Refinancing of bank debt 14

Example 1.5 - Profit Participating Loan 16

Section 2 – Property Development group 17

Example 2.1 – Interest bearing term loan - Senior interest bearing bank term debt 18

Appendix A – IFRS 9: Key requirements 21

clickable
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1. Introduction

IFRS 9 makes no distinction between unrelated

third party and related party transactions. Entities
that prepare stand-alone financial statements are
required to apply the full provisions of the standard to
all transactions within its scope. This means related
company loan receivables must be classified and
measured in accordance with the requirements of IFRS
9, including where relevant, applying the Expected
Credit Loss (ECL) model for impairment.
The purpose of this publication is to illustrate the
application of IFRS 9 to a number of common
intragroup funding structures that a typical real estate
group might have in place.
In Section 1, we consider five common funding
structures for an investment property group.
In Section 2, we consider a typical funding structure for
a property development group, such as a house-builder.

Appendix A contains a high level summary of the

key requirements of IFRS 9. More detailed guidance
can be found in our BDO Global publication,
‘Applying IFRS 9 to related company loans’ which is
available on the BDO Global IFRS webpage.
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Section 1 - Investment property group

Parent A operates in the UK real estate sector. Its

subsidiaries undertake the purchase of investment Potential Funding Structures
properties for the purpose of generating rental income • Example 1.1 – Interest-free demand loan – No
and for capital appreciation. Management makes bank debt
each investment decision in line with the group’s
• Example 1.2 – Interest-free term loan– No bank
stated investment strategy and supporting policies.
debt
Each potential purchase proposal is supported by
a detailed business case which includes, for example, • Example 1.3 – Interest-free demand or term
a due diligence report and independent third party loan – Senior bank term debt
valuations. Management assesses each proposal in • Example 1.4 – Refinancing of bank debt
accordance with a number of key investment criteria,
including for example, the minimum yield required on • Example 1.5 – Profit participating loan
each investment and maximum loan to value (LTV)
accepted.
For each example we consider how the loan advanced
Once the proposal has been approved by Management, by Parent A should be classified under IFRS 9 and how
a new wholly owned subsidiary is set up for the purpose the ECL model should be applied (where relevant).
of undertaking the property purchase and appropriate Assume in all cases that the loans are in a hold-to-
financing is arranged. Typically, new subsidiaries are collect business model because Parent A intends to
thinly capitalised meaning that they are funded almost hold the loans in order to collect their contractual cash
entirely through debt with only minimal equity. In flows.
some cases, the subsidiary is financed entirely through
an unsecured loan from Parent A whereas in other
cases a third-party bank may provide a senior secured
loan with Parent A providing a junior unsecured loan.
Funds are received by the subsidiary from its debt
providers in advance of the property purchase and are
held on deposit with a bank or in some cases, with the
company’s lawyers for a short period until the property
purchase is complete.
At the end of 20x9, Parent A sets up a new subsidiary
(Subsidiary B) for the purposes of purchasing a new
investment property worth £1m which has been
approved by Management. An annual market rent
of £80k is expected (i.e. a rental yield of 8%) and a
tenant has already been secured at this rate for the
first 2 years. For the purposes of illustration, assume
that Management expects both the property value and
rental yield to remain stable year on year.
Parent A arranges debt financing for the transaction
to be put in place on 1 January 20x0 ahead of the
planned purchase date later that month. The following
examples illustrate different funding structures that
Management could choose to put in place at inception,
including a potential refinancing scenario that could
arise in a later accounting period.
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Example 1.1 – Interest-free demand loan - – rental income is expected to be sufficient to repay
no bank debt the loan in full by the end of year thirteen (i.e.
£80k x 13 yrs = £1.04m)
Parent A advances an unsecured loan for £1m to
Subsidiary B on 1 January 20x0 with the following – once Subsidiary B has accumulated sufficient
terms: rental income, the loan from Parent A could be
refinanced with a third party at a lower LTV;
• 0% interest;
– given the current valuation of the property, it
• £1m repayable on demand.
could be sold in order to repay the loan
• the investment is made in accordance with
BDO Comment: Initial recognition of an Management’s investment policies which specify
interest free demand loan a number of key criteria including for example, a
minimum LTV and rental income which supports
IFRS 9 contains the same initial recognition repayment of the loan. When Parent A provides
requirements for financial assets as IAS 39. This means funding to Subsidiary B, its aim is not to take
that at initial recognition the loan must be recognised property risk but to provide financing to its
at its fair value (which, for a demand loan, will be the subsidiaries for their ongoing business operations
transaction price) plus transaction costs (assumed to which will in turn generate rental income for the
be nil in this example). group.
Therefore, Parent A initially recognises the loan at Based on the above, Parent A concludes that the
its fair value being its transaction price of £1m. This loan to Subsidiary B is a basic lending arrangement
reflects the fact that repayment could be demanded that meets the SPPI test and would be classified
immediately which is in contrast to a related company at amortised cost because it is in a hold to collect
term loan. Owing to the demand feature and the business model.
contractual rate of interest of 0%, the EIR is 0%.
B. Impairment

A. Classification As the loan is classified at amortised cost, it is within

the scope of the ECL model and subject to the general
As the loan is in a ‘hold to collect’ business model, the approach. At the next reporting date following initial
key classification question is whether the loan meets recognition, Parent A must determine whether the
the Solely Payments of Principal and Interest (SPPI) loan is in stage 1, stage 2 or stage 3 and measure 12
test. month ECL or lifetime ECL accordingly. In performing
In considering whether the loan is likely to meet the this analysis, Parent A must consider all relevant
SPPI test, Parent A must take into consideration the reasonable and supportable historic, current and
fact that the loan is implicitly non-recourse in nature forward looking information that provides evidence
because Subsidiary B only holds one asset. This means about the risk that Subsidiary B will default on the loan
that Parent A must look-through to the cash flows and the amount of losses that would arise as a result
generated from this asset and determine whether of that default. Sources of this information can be
the non-recourse nature of the loan restricts the internal and external, including external providers to
contractual cash flows of the loan in a manner that is whom, a fee is payable.
inconsistent with a basic lending arrangement. Parent Assume that at 31 December 20x0, based on current
A notes the following: and forward looking information:
• the contractual terms of the loan specify a fixed • the property value has reduced to £875k and is
repayment of £1m which is equal to the principal forecast to remain at this level;
amount (being the initial fair value of the loan)
and interest (being nil as the EIR is 0%). These • the rental income after 20x1 is expected to reduce
repayments are consistent with a basic lending to £70k and is forecast to remain at this level; and
arrangement as they are not contractually linked to • the market rate rental yield is expected to remain at
changes in the property value; 8%.
• while the 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:
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of default is very low and the loan should be in Stage

BDO Comment: Estimating the risk of a 1) or it will not have sufficient liquid assets to repay
default occurring and the staging assessment the loan on demand (meaning that the risk of default
for demand loans is very high and the loan should be in Stage 3).
Estimating the risk of a default occurring • Under the second approach, the staging assessment
Because the expected life of a demand loan is limited takes into account Managements’ expectations of
to the contractual period of credit exposure i.e. ‘on the risk of a default occurring at initial recognition.
demand’, Management is required to assess the risk For example, if Management expected that the risk
of a default occurring at initial recognition and at the of default would be very high for the first number
reporting date assuming that repayment is demanded of years, then the fact that the risk of default is
immediately (irrespective of whether this is the close to 100% at the first reporting date should
intention). This is likely to be a very binary analysis not by itself cause the loan to move into Stage 2 or
because the borrower will either have sufficient liquid Stage 3. Under this approach, a demand loan would
assets to repay the loan immediately (meaning that only move from Stage 1 if there has been a change
the risk of default is very low, possibly close to 0%) or in initial expectations of credit risk taking into
it will not (meaning that the risk of default is very high, account actual and expected future performance of
possibly close to 100%). the underlying business together with actual and
expected economic conditions.
This means that typically, provided the funds are
not lent to an insolvent entity, the risk of a default It should be noted that only significant effect of
occurring at initial recognition is likely to be very low these two different staging approaches for interest-
because repayment was demanded immediately, the free demand loans with an EIR of 0% relates to the
subsidiary would be in a position to repay the amount associated IFRS 7 disclosures. It has no effect on
owed because it would not yet have used the funds. recognition and measurement. This is because the
In contrast, at subsequent reporting dates, assuming measurement of ECL will be identical due to the
the funds have been used by the subsidiary and it has fact that in both cases, Management is required to
no access to alternative sources of finance, the risk of assess the risk of a default occurring assuming that
default is likely to be very high because if repayment repayment is demanded immediately. Furthermore,
was demanded immediately, the subsidiary would not there is no effect on the recognition of interest income
be in a position to repay the amount owed. as the EIR is 0%. In this publication, the examples
which follow assume that the staging assessment
Staging assessment follows the first approach but the second approach
There are two possible approaches to the staging could equally be applied as a matter of accounting
assessment of demand loans. policy. A further discussion on this topic can be found
at the end of Section 5.3.1(b)(iii) of ‘Applying IFRS 9 to
• Under the first approach, similar to the estimation related company loans’ which is available on the BDO
of the risk of a default occurring, the staging Global IFRS webpage.
assessment is binary because at the reporting date,
the borrower will either have sufficient liquid assets
to repay the loan on demand (meaning that the risk
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(i) Staging Assessment Management also considers that there is

approximately a 10% probability that the property
Assume that Management defines default as Subsidiary
value will decline to £500k and that annual rental
B having insufficient funds to repay the loan when due
income will decline to £40k after 20x1. In this case,
(i.e. on demand) and considers that a loan is credit
Management considers that the best recovery
impaired once it meets the definition of a defaulted
strategy would be to force a sale of the underlying
loan. As a backstop indicator, a default is assumed if the
property at the end of 20x1 thus foregoing any future
loan is more than 90 days past due but given that the
rental income.2 While an orderly sale after a normal
loan is due on demand and bears no interest, it is not
marketing period (scenario 2) would maximise
considered appropriate to solely rely on this indicator.
recoveries, Management cannot rule out the possibility
At the reporting date, the loan is not past due but
of a fire sale (scenario 3) depending upon market
Management considers that Subsidiary B would have
conditions and the cash flow position of Parent A.
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.

(ii) Estimating the risk of a default occurring

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%.

(iii) ECL Measurement

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 Example 1.3.

Example 1.3

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 the loan
by the end of year fourteen at which point the property
could then be sold for £875k (scenario 1).1

1
Management is also likely to consider other options such as refinancing with
a third party (once sufficient rental income has been accumulated to allow
for refinancing with a lower LTV loan) or selling the property.
2
Other possible scenarios such as a subsequent recovery in market conditions
are also likely to be considered
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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 20x0 and 20x1
can be used as part repayment for the loan.

Total expected
Scenario Probability Recovery Strategy Rentals received Sale Proceeds
cash flows3
Scenario 1 90% Rentals plus orderly 1,000,000 875,000 1,000,000
sale in Q4 of year [(80k x 2yrs) + (70k
fourteen x12 yrs)]
Scenario 2 7% Rentals plus orderly 160,000 500,000 660,000
sale in Q4 20x1 [80k x 2 yrs]
Scenario 3 3% Rentals plus fire sale 160,000 425,000 585,000
in Q4 20x1 [80k x 2 yrs]
(15% discount)

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.

Weighted average
Credit loss Credit loss
Probability credit loss
(undiscounted) (discounted at 0%)
(discounted at 0%)
Scenario 1
Gross Carrying Amount 1,000,000 1,000,000
Expected cash flows 1,000,000 1,000,000
- - 90% -
Scenario 2
Gross Carrying Amount 1,000,000 1,000,000
Expected cash flows 660,000 660,000
340,000 340,000 7% 23,800
Scenario 3
Gross Carrying Amount 1,000,000 1,000,000
Expected cash flows 585,000 585,000
415,000 415,000 3% 12,450
Total Weighted Average Credit Loss 36,250
Risk of default 100%
Lifetime ECL 36,250

3
Total expected cash flows are capped at £1m – i.e. the contractual amount owed to Parent A. Any cash flows in excess of this amount represent a profit for Subsidiary B
and ultimately the wider group.
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Example 1.2 – Interest-free term loan - contractual cash flows on the loan in a manner that is
no bank debt inconsistent with a basic lending arrangement. Parent
A notes the following:
Parent A advances an unsecured loan for £1m to
Subsidiary B on 1 January 20x0 with the following • the contractual terms of the loan specify a fixed
terms: repayment amount of £1m which is equal to the
principal (being the initial fair value of the loan
• 0% interest (assume that a market rate of interest
of £713k) and interest (being £287k interest
for a similar loan is estimated at 7%)
accrued using an EIR of 7%). These repayments
• £1m repayable in 5 years – December 20x4 are consistent with a basic lending arrangement as
they are not contractually linked to changes in the
property value;
BDO Comment: initial recognition of an
interest free term loan • while the LTV on Day 1 is 71% (£713k/£1m) because
part of the loan has been added to Parent A’s
As noted earlier, IFRS 9 contains the same initial investment in Subsidiary B, the forecast LTV at date
recognition requirements for financial assets as IAS 39. of repayment is expected to increase to 100%.
This means that, in contrast to demand loans, there However, by that point Subsidiary B is forecast to
are specific requirements which state that the initial have built up £400k (i.e. £80k x 5 years) in rental
fair value of an interest free term loan is equal to the income. In order to repay the loan to Parent A,
present value of future cash receipts discounted at an Subsidiary B could:
appropriate market rate of interest for a similar loan at
that date. – refinance the loan from Parent A with a third
party at a lower LTV; or
In this example, the present value of future cash
receipts of £1m discounted for 5 years at the – sell the property and use the proceeds to repay
appropriate market rate of interest of 7% (the rate at the loan from Parent A
which the subsidiary could have borrowed funds on • the investment is made in accordance with
equivalent terms from an unrelated third party), being Management's investment policies which specify
the imputed EIR, is equal to £713k. This amount which a number of key criteria including for example,
is initially recognised by Parent A accretes to £1m whether expected rental yield is sufficient to allow
using the market rate of 7% over 5 years. for full repayment of the loan. When Parent A
It is important to note that difference between the provides funding to Subsidiary B, its aim is not to
transaction price of £1m and the initial fair value of take property risk but to provide financing to its
£713k (i.e. £287k) does not constitute a Day 1 profit subsidiary which will in turn generate rental income
or loss. Instead, as a result of the parent subsidiary for the group.
relationship, it is recognised as an addition to Based on the above, Parent A concludes that the
Parent A’s investment in Subsidiary B (and a capital loan to Subsidiary B is a basic lending arrangement
contribution by Subsidiary B). This accounting that it meets the SPPI test and would be classified
treatment is specific to related company loans, and at amortised cost because it is in a hold to collect
is different from the approach that is required to be business model.
followed for loans between unrelated parties.
B. Impairment

A. Classification As the loan is classified at amortised cost, it is within

the scope of the ECL model and subject to the general
As the loan is in a ‘hold to collect’ business model, the approach. Parent A therefore needs to determine
key classification question is whether the loan meets whether the loan is in stage 1, stage 2 or stage 3 and
the Solely Payments of Principal and Interest (SPPI) measure 12 month ECL or Lifetime ECL accordingly.
test. In performing this analysis, Parent A is required to
In considering whether the loan is likely to meet the consider all relevant reasonable and supportable
SPPI test, Parent A must take into consideration the historic, current and forward looking information that
fact that the loan is implicitly non-recourse in nature could affect the risk that Subsidiary B will default on
because Subsidiary B only holds one asset. This means the loan and the amount of losses that would arise as
that Parent A must look-through to the cash flows a result of that default. Sources of this information can
generated from this asset and determine whether be internal and external, including external providers
the non-recourse nature of the loan restricts the to whom, a fee is payable.
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Assume that at 31 December 20x0, based on current information about factors that provide evidence
and forward looking information: about the risk of a default occurring such as expected
property and rental market forecasts. Management
• the property value has reduced to £875k and is
is of the view that under the most likely scenario
forecast to remain at this level;
where property values and rental yields remain at or
• the rental yield after 20x1 is expected to reduce to above current levels, no default is expected because
£70k and is forecast to remain at this level; and Subsidiary B would be in a position to repay the loan
• the market rate rental yield is expected to remain at when due using a combination of its accumulated
8%. rental income and refinancing with a third party at a
lower LTV or through sale.
(i) Staging Assessment However, Management also considers an alternative
Assume that Management has the following scenario under which the property value will decline
accounting policies: to £500k and annual rentals after 20x1 will reduce
to £40k. Under this scenario, Management considers
• Default is defined as Subsidiary B having insufficient that a default would arise as Subsidiary B would not
funds to repay the loan when due and monitors be in a position to repay the loan through any means.
through a number of different indicators – including The probability of this scenario arising is estimated at
for example, the loss of a major tenant and LTVs approximately 10% i.e. the risk of default is 10%.
falling below a minimum threshold. As a backstop
indicator, a default is assumed if the loan is more (iii) ECL Measurement
than 90 days past due but given that the loan bears
no interest throughout its life, it is not considered Management must then consider the possible credit
appropriate to solely rely on this indicator. Once a losses that would arise upon a default taking into
loan is in default, the loan is considered to be credit account different possible recovery strategies and
impaired. expected cash flows. In doing so, Management should
consider that in some cases, they may be forced to
• Significant Increases in Credit Risk (SICR) is pursue a strategy that does not maximise recoveries.
assessed on a qualitative basis by monitoring
changes in actual and expected rental income and In this example, based on an analysis of relevant
property values since initial recognition. This is forward looking information relevant, Management
because Management considers that changes in is of the view that the property value is very unlikely
either of these measures have the greatest effect to go below £500k and is instead expected to recover
on the risk of a default occurring i.e. a decline in significantly. By 20x5, Management estimates
rental income would reduce cash flows available to an annual rental income of £60k with a property
repay the loan and a decline in property value would valuation of £750k. This means that if Parent A was in
increase the LTV which could have a detrimental a position to wait and allow the market to recover, this
effect on refinancing options available to Subsidiary would be a viable recovery strategy.
B. As a backstop indicator, a SICR is assumed if the For the purposes of illustration, assume that in this
loan is more than 30 days past due but given that example, Management considers that waiting to
the loan bears no interest throughout its life, it is receive rentals and making a sale at the end of 20x7
not considered appropriate to solely rely on this would be the best recovery strategy (scenario 1).
indicator. However, under current and potential future market
Based on the revised forecasts the rental income has conditions, Parent A may not be in a position to wait
fallen by 12.5% after 20x1 (from £80k to £70k) and and may instead need to force a sale of the underlying
the property value has also fallen by 12.5% (from £1m property. In addition, while an orderly sale after a
to £875k). For the purposes of illustration assume that normal marketing period (scenario 2) would maximise
this is considered to constitute a SICR by Management. recoveries, the possibility of a fire sale (scenario 3)
This means that the loan is in Stage 2 and Lifetime ECL cannot be ruled out (depending upon the cash flow
is required to be recognised. position of Parent A).
Taking this information into account, Management
(ii) Estimating the risk of a default occurring estimates the following expected cash flows and their
When estimating the risk of a default occurring, likelihood. In all scenarios, it is assumed that the rental
Management should consider internal and external income received can be used as part repayment of the
information about past default rates on similar loans loan.
(to the extent available) as well as forward looking
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Total expected
Scenario Probability Recovery Strategy Rentals received Sale Proceeds
cash flows4
Scenario 1 70% Rentals plus orderly 420,000 750,000 1,000,000
sale in Q4 20x7 [(80k x 2 yrs) + (40k x
5 yrs) + (60k x 1yrs)]
Scenario 2 20% Rentals plus orderly 280,000 500,000 780,000
sale in Q4 20x4 [(80k x 2 yrs) + (40k
x 3 yrs)]
Scenario 3 10% Rentals plus fire sale 280,000 425,000 705,000
in Q4 20x4 [(80k x 2yrs) + (40k x
(15% discount) 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 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 20x7 for scenario 1 and at the end of 20x4 for scenario 2 and scenario 3.

Weighted average
Credit loss Credit loss
Probability credit loss
(undiscounted) (discounted @ 7%)
(discounted)
Scenario 1 1,000,000 762,895
Gross Carrying Amount 1,000,000 622,750
Expected cash flows
- 140,145 70% 98,102
Scenario 2 1,000,000 762,895
Gross Carrying Amount 780,000 595,058
Expected cash flows
220,000 167,837 20% 33,567
Scenario 3 1,000,000 1,000,000
Gross Carrying Amount 705,000 537,841
Expected cash flows
295,000 225,054 10% 22,505
Total Weighted Average Credit Loss 154,175
Risk of default 10%
Lifetime ECL 15,418

4
Total expected cash flows are capped at £1m – i.e. the contractual amount owed to Parent A. Any cash flows in excess of this amount represent a profit for Subsidiary B
and ultimately the wider group.
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Example 1.3 – Interest free demand or term • Recovery Strategies: Parent A will need to take into
loan - senior bank term debt account not only its own position but that of Bank X.
For example, Bank X could wish to enforce security
Parent A advances a £200k unsecured loan to
in accordance with the terms of the loan agreement
Subsidiary B on 1 January 20x0 with the following
at a point that maximised its own recoveries but not
terms:
those of Parent A. This could in turn lead to Parent
• 0% interest and repayable on demand; or A being forced to refinance the bank loan itself (see
• 0% interest and repayable in 5 years (assume 5 year Example 1.4).
market rate of interest = 7%)
At or around the same time, Bank X advances a £800k
senior secured loan to Subsidiary B with the following Example 1.4
terms:
• market rate of interest of 5% i.e. £40k per annum; A. Classification
• repayable at par in 5 years and at any time at par Similar to Examples 1.1 and 1.2, the loans are in a
plus accrued interest. hold to collect business model and therefore the key
This means that the LTV for the combined funding is classification issue is the SPPI test. In this example,
100% (i.e. £1m / £1m). However, from the perspective the contractual terms of both the demand loan and
of Bank X the LTV is 80% because it is secured over a term loan only specify payments of principal and
property worth £1m (i.e. £800k/£1m). The loan from interest and are not linked to changes in the property
Bank X must be repaid in full before the loan from value but Parent A is required to consider whether the
Parent A.5 non-recourse nature of the loan results in the SPPI test
not being met.
Similar to the previous examples, Parent A’s intention
BDO Comment: Funding involving senior is to provide financing to its subsidiaries for the
ranking interest bearing bank debt – purposes of their ongoing business activities which
additional considerations will in turn generate rental income for the group. In
Determining how the loan from Parent A should be addition, Subsidiary B is expected to earn sufficient
classified and how the impairment model should be rental income to service the bank debt and will have
applied requires a similar approach to that outlined accumulated an additional £200k (i.e. net rental
in Example 1.1 and Example 1.2. However, the income of £40k x 5 years) by the time that the bank
introduction of a senior ranking interest bearing bank loan is due to be repaid. At this point, assuming (i)
term loan does give rise to additional considerations, the property value remains stable at £1m and (ii) the
including for example: additional £200k can be used to part repay the bank
debt, a number of scenarios could arise, including:
• Estimation of expected cash flows: Subsidiary B is
expected to earn £80k annual rental income but will • Subsidiary B could refinance both the bank loan and
be required to pay annual interest of £40k (i.e. 5% x the loan from Parent A with a new third party loan
£800k) to Bank X which reduces cash flows available for £800k i.e. at an LTV of 80%;
to meet the principal and interest payments on the • Parent A may wish to continue funding Subsidiary B,
loan from Parent A; meaning that only £600k of new debt at an LTV of
• Refinancing Risk: as the loan from Bank X has 60% would be required;6
a 5 year term, this gives rise to refinancing risk at • Subsidiary B could choose to sell the property in
the end of year 5 which needs to be considered order to fund the repayment of both loans in full.
irrespective of whether the loan from Parent A is
repayable on demand or repayable in 5 years; In all of the above scenarios, Parent A is likely to
conclude that both the demand loan and the term loan
• SICR: a breach of covenant or late payment under are basic lending arrangements that meet the SPPI
the bank loan may be indicators of a SICR on the test and would therefore be classified at amortised cost
loan from Parent A; because they are in a hold to collect business model.
• Default: events of default under the bank loan may
trigger a default under the loan from Parent A;

5
This means that if Parent A advanced a demand loan, it would need to require Subsidiary B to repay the bank loan prior to demanding repayment.
6
Note that in the context of a demand loan, Parent A could simply choose not to demand repayment whereas with a term loan, Parent A would need to either modify
the existing term loan or advance a new loan term which could give rise to a profit or loss effect (note that this profit or loss effect is separate, and in addition to, any
impairment charge).
 13

B. Impairment
Once it has been determined that the loan is
classified at amortised cost, it is within the scope of
the ECL model and subject to the general approach.
Applying the ECL model follows a similar approach
to that set out in Examples 1.1 and 1.2 but as with
the classification decision, a number of additional
considerations arise.

(i) Staging Assessment & estimating the risk of a default

occurring
In the case of a demand loan, on the basis that
Subsidiary B would not have sufficient funds to repay
the loan on demand, the risk of default is likely to be
close to 100%. As explained in Example 1.1, this means
that the loan will be in stage 3 and Lifetime ECL will be
recognised.7
The staging assessment for a term loan follows a
similar approach to that set out in Example 1.2 with
some additional considerations for Parent A including:
• monitoring actual or expected breaches of covenant
and/ or late payments on the bank loan as indicators
of an increased risk of default / SICR on Parent A’s
loan to Subsidiary B;
• incorporating interest payable to Bank X which
reduces available cash flows of Subsidiary B which
is in turn likely to increase the risk of a default
occurring.

(ii) Measuring ECL

A similar approach to that set out in Example 1.1 and
1.2 should be followed. However, the expected cash
flow scenarios that would arise upon a default and
related credit losses will need to take into account the
cash flows required to service and repay the bank debt
in full, prior to repaying the loan from Parent A.
In addition, Parent A will need to factor in the possible
recovery strategies of Bank X that may influence
its own actions. For example, Bank X could wish to
enforce security in accordance with the terms of the
loan agreement at a point that maximised its own
recoveries but not those of Parent A. In this case,
Parent A might consider refinancing the bank loan
itself as illustrated in Example 1.4.

7
However, as explained in Example 1.1, there are different possible approaches to
the staging assessment of demand loans
 14

Example 1.4 - Refinancing of bank debt A. Classification

(i) Loan from Subsidiary C to Subsidiary B (novated

Following on from Example 1.3 above, assume Parent A
interest bearing bank term loan)
advances a £200k unsecured loan to Subsidiary B on 1
January 20x0. The loan is interest free and is repayable The loan from Subsidiary C is non-recourse in nature
in 5 years. At the same time, Bank X advances a £800k due to the fact that Subsidiary B only holds one asset
secured loan to Subsidiary B. The loan carries market being the investment property. Subsidiary C must
rate of interest of 5% and is repayable in 5 years. therefore look through to the underlying asset (being
the investment property) and determine whether this
At initial recognition Parent A concluded that the
feature results in the SPPI test being failed.
loan to Subsidiary B met the criteria to be classified at
amortised cost and applied the ECL model accordingly. In considering the SPPI test, Subsidiary C notes that if
the loan was considered a basic lending arrangement
Rental yields for the first 2 years were locked in at
which met the SPPI test, it would also meet the
£80k and this allowed Subsidiary B to service the
definition of a ‘Purchased or Originated Credit
external debt (i.e. 5% x £800k = £40k per annum)
Impaired’ loan because the discount of £300k would
leaving residual cash of £40k each year. However, in
represent incurred credit losses. This means that a
20x2, yields have reduced to £40k, leaving no residual
credit adjusted EIR taking into account those incurred
cash flow for the remainder of the loan maturity. In
losses would be calculated. At initial recognition
addition, the market valuation of the property has
therefore:
declined to £500k which has in turn breached an
LTV covenant in the bank loan agreement resulting • fair value = £500k
in an event of default. At this point, Bank X could • credit adjusted EIR = 8% (i.e. the interest rate which
seek recourse to any remaining liquid assets held by discounts future cash flows of £40k in 20x3 and
Subsidiary B and enforce security over the property. £540k 20x4 back to the initial carrying amount of
However, following a negotiation, Parent A agrees to £500k)
acquire the outstanding loan amount of £800k from Under this method of accounting, any subsequent
Bank X through a newly set up intermediate subsidiary, changes (gains or losses) in lifetime ECL of £300k
Subsidiary C, for an amount equal to the market would be taken as an impairment gain or loss in future
valuation of the property i.e. £500k. Bank X accepts periods and would be entirely dependent upon the
this offer because it avoids a potentially lengthy sales value of the property. This is not consistent with a
process during which time it could be exposed to basic lending arrangement and implies that the loan
further declines in property prices. Bank X considers is more in the nature of an indirect investment in the
that this would be inconsistent with the nature of its underlying property than the provision of finance.
business as a lender. In contrast, given the nature of
Parent A’s real estate business, it is willing to accept Based on the above analysis, Subsidiary C concludes
this level of property risk for the benefit of the wider that the loan fails the SPPI test and would be classified
group and wait for the market to recover over time. at FVPL. On an ongoing basis, the loan would be
The following steps are taken: measured at fair value in accordance with IFRS 13 Fair
Value Measurement with all movements in fair value
• Parent A lends £500k to Subsidiary C – the loan is going through profit or loss.
repayable on demand and interest free
• Subsidiary C uses the £500k to purchase the
outstanding bank loan i.e. remaining 2 year
maturity, 5% rate of interest and a notional of
£800k
Assume for the purpose of illustration that Parent A’s
original loan to Subsidiary B for £200k has been fully
impaired.
 15

(ii) Loan from Parent A to Subsidiary C (interest free

demand loan)
The loan from Parent A is also non-recourse in nature
due to the fact that Subsidiary C only holds one asset
being the non-recourse loan to Subsidiary B. Parent A
must therefore look through to that underlying asset
and determine whether this feature results in the SPPI
test being failed.
In contrast to the novated interest bearing bank term
loan which has a contractual par amount of £800k, the
demand loan has been advanced on an interest free
basis with a contractual par amount of £500k. This
means that unlike Subsidiary C, Parent A will never be
entitled to an amount in excess of £500k as a result of
an increase in the property valuation.
Determining whether the loan from Parent A meets
the SPPI test will require judgment and will depend
upon a detailed consideration of the individual facts
and circumstances, including Parent A’s views on the
property market. In this particular example, the fact
that Parent A does not expect the property to decline
in value below £500k means that it should receive
back the full amount of £500k which may seem to
suggest that the non-recourse feature will not result
in the SPPI test being failed. However, consideration
should also be given to the fact that even a slight
decline in property prices could result in Parent A not
recovering the amount advanced because the rental
income and property valuation is only just sufficient to
cover the principal and interest on the novated bank
loan. This may imply that the nature of the loan is
more akin to an investment in the underlying property
than the provision of financing which would result in
similar accounting to that of Subsidiary C.
 16

Example 1.5 - Profit Participating Loan When determining whether a feature is de minimis
entities must consider the ‘possible effect’ that the
Parent A advances £1m to Subsidiary B on 1 January feature could have on the contractual cash flows in
20x0 with the following terms: each reporting period (and cumulatively). Non-genuine
features are those that are only triggered upon the
• 5% interest occurrence of a rare or highly abnormal event (that is,
• 30% of the annual appreciation in the property the potential for the event to occur is at or very close
value to zero) and are therefore not expected to be common.
In this example, the contingent feature is clearly
• £1m repayable in 5 years – December 20x4 genuine and in addition, it could have a substantially
more than de minimis effect on the contractual cash
A. Classification
flows of the loan. This feature therefore introduces
As the loan is in a ‘hold to collect’ business model, the property price risk, which is inconsistent with a basic
key classification question is whether the loan meets lending arrangement.
the Solely Payments of Principal and Interest (SPPI)
Based on the above analysis, Parent A concludes that
test.
the loan fails the SPPI test and would be classified
Despite the fact that the loan has contractual at FVPL. On an ongoing basis, the loan would be
payments of principal and interest, the additional measured at fair value in accordance with IFRS 13 Fair
contingent payment linked to the appreciation in Value Measurement with all movements in fair value
the property value must be considered in order to going through profit or loss.
determine whether the loan meets the SPPI test. This
because IFRS 9 requires the loan to be assessed in its
entirety i.e. as one unit of account and specifies that
contractual terms can only be ignored if the potential
impact on the contractual cash flows is considered ‘de
minimis’ or if the feature is ‘non-genuine’.
 17

Section 2 – Property Development group

Parent C operates in the UK real estate sector and Sales of completed units are generally made prior to
purchases land for development into residential units or during the development phase rather than after the
for public sale. Each potential development proposal is development is completed. Typically, the bank debt
supported by a detailed business case which includes must be repaid as and when units are sold/ proceeds
a due diligence report in respect of the expected Gross are received during the development but there is also a
Development Costs (GDC) as well as an independent backstop or maturity date at which point any remaining
third party valuation of the Gross Development unsold units would either need to be sold by Subsidiary
Value (GDV) of the completed site both of which D in order to repay the bank debt or seized by the bank.
are undertaken in order to secure bank financing.
Owing to the nature of the investment, there is
Management assesses each proposal in accordance
no immediate source of income until the property
with a number of key investment criteria, including
development is completed and units are sold. This
for example, the minimum yield required on each
means that any interest due on either the loan from
development.
Parent C or the external provider will be rolled up and
Once the proposal has been approved by Management, paid as and when the principal is repaid.
a new subsidiary is set up for the purpose of
In the example below, a new property development
undertaking the development and appropriate financing
project has been approved by Management. Subsidiary
is arranged. Similar to the Investment Property Group,
D has been set up for this new project and will be
the subsidiaries are generally financed almost entirely
funded by a combination of bank debt and a loan from
through debt. Typically, new subsidiaries are funded as
Parent C. The example illustrates how IFRS 9 should be
follows:
applied to the loan from Parent C. Assume that Parent
• Parent C provides an unsecured loan to finance the C holds the loan in a hold to collect business model.
purchase of vacant land; and
• a third-party bank provides a senior secured loan
commitment used to finance the development
spend based on a maximum loan to GDV ratio.8
The loan commitment provided covers the expected
GDC plus a small contingency amount and is drawn
down over the course of the development period based
on construction certifications obtained for costs of
work completed. Typically, different elements of the
development are sub-contracted at an agreed price
prior to the development commencing which reduces
the risk of the contingency being required.

8
Alternatively, the parent company may jointly fund the development spend with the bank. In either case, any costs arising in excess the stated contingency amount
would be funded by the parent company.
 18

Example 2.1 – Interest bearing term loan -

senior interest bearing bank term debt
At the end of 20x0, Parent C sets up a new subsidiary
(Subsidiary D) for the purposes of purchasing a vacant
plot of land and developing four residential units for
sale over a 2 year period. The cost of the land is £200k
and the maximum GDC is £840k (i.e. expected GDC
of £800k plus a 5% contingency amount of £40k).
The four individual units are expected to be sold for
£350k (after selling costs) each which results in a total
expected GDV of £1.4m.

Project Details GBP

Land Cost £200k
Gross Development Cost (GDC) – £800k
excluding contingency
Total Development Cost £1m

Unit Value (£350k x 4) £1.4m

Gross Development Value (GDV) £1.4m

On 1 January 20x1, Subsidiary D enters into the

following funding arrangements:
• £200k unsecured loan from Parent C at a market rate
of interest of 10%. Both the principal and interest
amount is repayable in 2 years following the sale of
all completed units and repayment of bank debt.
The funds are used to acquire land worth £200k; and
• £840k senior secured loan commitment from Bank
X. Once drawn, the loan attracts a market rate of
interest of 5%. Similar to the loan from Parent C
both the principal and interest amount is repayable
in two years following the sale of all completed units.
The funds are used to finance the development of the
land into 4 houses which is expected to cost £800k.
Assume the following:9
• no other fees are charged in respect of the bank loan
and the EIR is 5%;
• £800k is drawn down on the bank loan on Day 1 and
not repaid until the maturity date of December 20x2
resulting in an interest charge of 5% on £800k for
2 years.

Principal Interest roll-up Total repayment

Parent C loan £200k £42k (10% for 2 years) £242k
Bank loan facility £800k £82k (5% for 2 years) £882k
Total £1m £124k £1.12m

9
These facts have been assumed in order to simplify the example. In practice, additional fees are likely for example commitment and exit fees. In addition, the facility is
likely to be drawn down in stages and the loan will be repaid over the life of the development as and when the residential units are sold.
 19

Pre Interest Post Interest

Total loan to GDV ratio 71% (£1m/ £1.4m) 80% (£1.12m/ £1.4m)
Expected Profit £400k (£1.4m - £1m) £280k (£1.4m - £1.12m)

In this example, as the loan bears a market rate of interest, the fair value at initial recognition is equal to the
transaction price of £200k.

A. Classification • while the loan advanced by Parent C provided

financing for 100% of the cost of the land, the total
As the loan is in a ‘hold to collect’ business model, the
loan (i.e. Parent C loan plus bank loan) to GDV (post
key classification question is whether the loan meets
interest) is 80% which suggests that there are more
the Solely Payments of Principal and Interest (SPPI)
than sufficient cash flows expected to be generated
test.
to repay the amounts of principal and interest
In considering whether the loan is likely to meet the outstanding on both loans, with a residual equity
SPPI test, Parent C must take into consideration the margin;
fact that the loan is implicitly non-recourse in nature
• the investment is made in accordance with
because Subsidiary B only holds only one single
Management’s investment policies which specify
property development project. This means that Parent
a number of key criteria including for example,
C must look-through to the cash flows expected to be
minimum yield and loan to GDV accepted. When
generated from this project and determine whether
Parent C provides funding to Subsidiary D, its aim is
the non-recourse nature of the loan restricts the
not to take construction risk but to provide financing
contractual cash flows on the loan in a manner that
for the development which will in turn generate
is inconsistent with the SPPI test. Parent C notes the
profits on sales of developed units for the group.
following:
Based on the above, Parent A concludes that the
• the contractual terms of the loan specifies a fixed
loan to Subsidiary B is a basic lending arrangement
repayment of £200k which is equal to the principal
that meets the SPPI test and would be classified
(being the fair value at initial recognition) and
at amortised cost because it is in a hold to collect
interest of £42k (being 10% interest compounded
business model.
for 2 years). The contractual cash flows of the loan
are not linked to changes in the property value;
 20

B. Impairment (iii) ECL Measurement

As the loan is classified at amortised cost, it is within Once the risk of a default occurring has been
the scope of the ECL model and subject to the general estimated, Management must estimate possible
approach. Parent A therefore needs to determine credit losses that could arise. Similar to the previous
whether the loan is in stage 1, stage 2 or stage 3 and examples, it should consider different possible
measure 12 month ECL or Lifetime ECL accordingly. recovery strategies, for example:
Parent C should follow a similar approach to that set
• allowing more time for Subsidiary D to execute sales
out in Example 1.2 which illustrated a term loan being
resulting in late payment;
advanced to an investment property company (taking
into account that the loan advanced by Parent C is • being forced to sell the underlying units at a discount
interest bearing). It should also take into account the in cases where the bank is unwilling to wait;
additional considerations that are required as a result • selling the development prior to completion.
of the interest bearing senior bank debt set out in
Example 1.3.
In addition, the nature of Subsidiary D’s business
as a property developer (rather than an investment
property company) means that different factors are
likely to be relevant to the analysis. Some possible
examples are noted below.

(i) Staging Assessment

When determining which stage the loan is in,
Management will need to develop appropriate
accounting policies including how default is
defined and what constitutes a SICR. In this regard,
Management may consider:
• different indicators of default e.g. the loan to GDV
ratio falling below a minimum threshold, costs
in excess of a maximum threshold, the loss of a
potential purchaser, events of default under the
bank loan;
• different indicators of SICR e.g. increases in actual
and expected development costs (i.e. GDC) or
decreases in sales values (i.e. GDV) since initial
recognition, actual or expected covenant breaches
under the bank loan.

(ii) Estimating the risk of a default occurring

When estimating the risk of a default occurring,
Management should consider forward-looking
information about various factors that could affect
the risk of a default occurring. For example, cost
inflation (in cases where costs are not agreed with
subcontractors upfront), expected sales values and
market sentiment.
As noted previously, even if the most likely scenario
is that no default will arise, the possibility of a default
must be considered. In this example, this could include
a scenario where the expected GDV reduces and/ or
cost inflation increases to a level which would not only
eliminate profits but also result in the subsidiary being
unable to repay the loan.
 21

Appendix A – IFRS 9: Key requirements

Classification & Measurement

Once it has been determined that a loan receivable is within the scope of IFRS 9, it must be classified into one of
three categories:
a) Amortised cost;
b) Fair Value through Profit or Loss (FVPL); or
c) Fair Value through Other Comprehensive Income (FVOCI) for debt
The classification decision is based on (i) the business model within which the loan is held and (ii) whether its
contractual cash flows meet the ‘solely payments of principal and interest’ (SPPI) test, as illustrated below:

BUSINESS MODEL Hold to collect Hold to collect and sell Other

CASH SPPI Amortised cost FVOCI FVPL
FLOW TYPE Other FVPL FVPL FVPL

All related company loan receivables that are classified at amortised cost or at FVOCI are subject to the ECL
model which means that impairment losses are recognised in profit or loss. Loans that are classified at FVPL are
not subject to the ECL model because all fair value changes must be recognised in profit or loss. Fair values must
be determined in accordance with the requirements in IFRS 13 Fair Value Measurement.

Impairment – ECL model

There are a number of approaches to applying the ECL model; however all related company loan receivables
within its scope (i.e. loans at amortised cost or FVOCI) are subject to the General Approach.
Under this approach, an entity must determine at each reporting date whether the loan has suffered a significant
increase in credit risk (SICR) or whether the loan is credit impaired. This then determines which stage the loan is in
which drives both the basis of ECL recognition and interest income recognition as illustrated below:

Stage 1 Stage 2 Stage 3

No SICR SICR Credit Impaired

Recognition of ECL 12 month ECL Lifetime ECL

EIR on net carrying

Recognition of interest EIR on gross carrying amount (excluding ECL)
amount (including ECL)

When measuring ECL, entities are required, at a minimum, to consider the possibility of a credit loss and the
possibility of no credit loss. However, in some cases, in order to calculate a probability weighted measure of credit
losses entities will need to consider a range of different future scenarios. This is because additional credit losses
that arise in a downside scenario will often be greater than the reduced losses in the equivalent upside scenario.
 22

BDO Comment: Reasonable and supportable

information
When applying the ECL model, IFRS 9 requires
the incorporation of reasonable and supportable
information (sources of which may be external or
internal) that is available without undue cost or effort.
It is important to note that this does not mean no cost
or effort and therefore may involve external providers,
to whom a fee is payable.
 23

Contact

For further information about how BDO can assist you and your organisation, please get in touch with one of our key
contacts listed below.
Alternatively, please visit www.bdo.global where you can find full lists of regional and country contacts.

EUROPE

Anne Catherine Farlay France [email protected]

Jens Freiberg Germany [email protected]
Ehud Greenberg Israel [email protected]
Stefano Bianchi Italy [email protected]
Roald Beumer Netherlands [email protected]
Reidar Jensen Norway [email protected]
David Cabaleiro Spain [email protected]
René Füglister Switzerland [email protected]
Moses Serfaty United Kingdom [email protected]

ASIA PACIFIC

Aletta Boshoff Australia [email protected]

Hu Jian Fei China [email protected]
Fanny Hsiang Hong Kong [email protected]
Pradeep Suresh India [email protected]
Khoon Yeow Tan Malaysia [email protected]
Ng Kian Hui Singapore [email protected]

LATIN AMERICA

Marcello Canetti Argentina [email protected]

Victor Ramirez Colombia [email protected]
Ernesto Bartesaghi Uruguay [email protected]

NORTH AMERICA & CARIBBEAN

Armand Capisciolto Canada [email protected]

Wendy Hambleton USA [email protected]

MIDDLE EAST

Ayez Qureshi Bahrain [email protected]

Antoine Gholam Lebanon [email protected]

SUB SAHARAN AFRICA

Theunis Schoeman South Africa [email protected]

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