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April 2019


By Zubin F. Billimoria
Chartered Accountant
Reading Time 18 mins


India Incorporated continues its journey
with the next phase of adoption of Ind As by Non-Banking Finance Companies
in two phases commencing from the accounting period beginning 1 April, 2018.
Whilst there are several implementation and transition challenges, assessment
of the business model is an important area which is likely to impact most


The initial plan of the MCA was to implement
Ind AS for the entire gamut of financial service entities covering NBFCs, banks
and insurance entities, which has been deferred by a year for banks and by two
years for insurance companies. Accordingly, the discussion in this article is
restricted only to NBFCs.


It may be pertinent to note that the RBI
had constituted a Working Group to deal with the various issues relating
to Ind AS Implementation by Banks which had submitted a detailed
report in
September, 2015 which may be equally important and
relevant to NBFCs since there is a fair degree of similarity in their business
models and the same would be also taken into account in the course of our
subsequent discussions.



Assessing the business model for holding
financial assets is the anchor on which the entire accounting for financial
assets rests. Before going into the assessment of the business model for
financial assets it is necessary to understand as to what constitutes a
financial asset, since for NBFCs it represents the single most important
component in the Balance Sheet and how its initial measurement is determined.


Meaning and Nature of Financial Assets Ind AS-32 defines a financial asset as any asset that is:

a)  Cash

b)  An equity instrument of another entity

c)  A contractual obligation to receive cash or
another financial asset from another entity or to exchange financial assets or
financial liabilities with another entity under conditions that are potentially
favourable to the entity.


As can be seen
above, an equity instrument needs to be evaluated from the perspective of an
and the same is defined in Ind AS-32 as any contract that
evidences a residual interest in the assets of an entity after deducting all
its liabilities.
Accordingly, from the point of view of the holder an
equity instrument is an asset / instrument in which the entity does not have a
right to receive a fixed contractual amount of principal or interest.


Accordingly, by
default any instrument which does not meet the definition of an equity
instrument from an issuer’s perspective would be regarded as a debt instrument
in which there is generally a contractual cash flow involved.


Initial Measurement of Financial Assets

As per Ind AS-109
an entity shall initially measure its financial assets at their
fair value plus or minus any transaction costs that are directly attributable
to the acquisition of the financial assets in case of those falling under the
FVTPL category (discussed later).


The best evidence of the fair value on initial
recognition is normally the transaction price.
However, if the NBFC determines that the fair
value based on quoted prices in an active market for identical items, or
based on observable and unobservable inputs like interest rates, yields, credit
spreads etc., is different, the same shall be recognised as a day one gain or
loss. The common areas where such adjustments are required are staff and
related party loans and refundable premises deposits which carry preferential
interest rates or no interest rates.


Classification of Financial Assets

Under Ind AS-109,
understanding the business model under which financial assets are held is the
key criterion for determining their classification and subsequent measurement
and accounting. Ind AS-109 requires that all financial assets are required to
be classified under the following three categories for subsequent measurement

a)  Amortised Cost

b)  Fair value through profit or loss (FVTPL)

c)  Fair value through other comprehensive income


The classification
depends upon the following two criteria and options elected by the entity:

a)  The entity’s business model for
managing the financial assets, and

b)  The contractual cash flow characteristics
of the financial assets.


Further, there are separate
classification requirements

a)  Equity Instruments

b)  Debt Instruments



Since equity instruments
do not involve the right to contractually receive fixed and determinable cash
flows whether through principal or interest, their classification is more dependent
upon the intention of whether it is “held for trading”
later). However, in situations in which the instruments are not held for
trading, the entity needs to exercise an irrevocable choice
as to whether
it wants to elect the FVTOCI option. A tabulation of the choices
available is depicted hereunder:




Accordingly, all
equity instruments which are “held for trading” are required to be mandatorily
classified as FVTPL, whereas for all other instruments, the entity can make an
irrevocable option to classify the same as FVTOCI or elect the FVTPL option
(discussed later). The following are some of the key points which are
relevant regarding the FVTOCI classification of equity instruments:

a)  Classification as FVTOCI is not mandatory
though it cannot be used for equity instruments “held for trading”.

b)  The classification needs to be made on initial
recognition and is irrevocable.

c)  The election can be made on an instrument by
instrument basis and is not an accounting policy choice.

d)  If the entity elects this option then all fair
value changes on the particular instrument, excluding dividends, are recognised
through OCI and no recycling is permitted to Profit and Loss even on disposal,
though the cumulative gain or loss at the time of disposal may be transferred
within equity to retained earnings.

e)  There are no separate impairment requirements.

f)   Ind AS-101 gives the entity a choice to
designate the equity instruments on the basis of facts and circumstances that
exist on the date of transition to Ind AS.


Debt Instruments

The classification of debt instruments is dependent upon the business
model which refers to how an entity manages its financial assets so as to
generate cash flows i.e. whether the entity will collect the cash flows
by holding the financial asset till maturity or sell those assets or both.

A tabulation of the choices available is depicted hereunder:



The following are some of the key points which are relevant regarding
the FVTOCI classification of debt instruments:

a)  For debt instruments meeting
the above prescribed criteria, FVTOCI classification is mandatory, unless
FVTPL option is exercised as discussed below

b)  For such debt instruments, interest income,
impairment and foreign exchange changes are recognised in profit and loss
whereas all other changes are recognised directly in OCI.

c)  On derecognition, cumulative
gains and losses previously recognised in OCI are reclassified from equity to
profit and loss.

d)  Ind
AS-101 gives the entity a choice to designate the debt instruments on the basis
of facts and circumstances that exist on the date of transition to Ind AS.


Option to Designate Financial Assets at FVTPL

Irrespective of the satisfaction of any of the above conditions for
amortised cost or FVTOCL designation, Ind AS-109 provides an option to
irrevocably designate a financial asset as measured at FVTPL if doing so eliminates
or significantly reduces a measurement mismatch, which is also referred to as
an ‘accounting mismatch’,
which would otherwise arise if a different basis
is followed.
Though this is an accounting policy choice, it is not required to be applied
consistently for all similar transactions. Ind AS-109 provides the following
guiding principles to designate financial assets as measured at FVTPL:


a)  When the financial asset is
part of a hedging relationship.

b)  When the financial assets,
financial liabilities or both share a common risk such as interest rate risk
that gives rise to offsetting changes as part of the entity’s ALM policy.

c)  When a group of financial
assets is managed and performance is evaluated on a fair value basis such as
investment management, venture capital companies or stock broking companies.


Held for

Apart from the option to designate financial assets at FVTPL as
discussed above, another important consideration for FVTPL designation is
whether the financial assets are “held for trading” for which Ind AS-109 has
provided certain guiding principles which are briefly discussed hereunder:


a)  The financial assets are
acquired ‘principally’ for the purpose of selling in the near term e.g. stock
in trade held by a stock broker.

b)  The financial asset is part of a portfolio of
financial instruments that are managed together and for which there is evidence
of a recent actual pattern of short-term profit taking.

c)  ‘Trading’ generally reflects active and
frequent buying/selling with the objective of generating a profit from
short-term fluctuations in the price. However, churning of portfolio for risk
management purposes is not necessarily ‘trading’ activity.  


Business Model Assessment


The following are some of the guiding principles laid down in Ind AS-109
which need to be considered whilst assessing and determining the business model
for managing financial assets, in the context of debt instruments, some of
which have also been reiterated in the RBI Working Group Report, referred to
in the context of Banks which may also be pertinent to NBFCs:


a)  Assessing the entity’s business model for
managing financial assets is a matter of fact and not merely an assertion. It
has to be based on relevant and objective evidence including but not limited to
how the performance of the business model and the financial assets held within
the same are evaluated by the entity’s key management personnel, their risks and
how the personnel are compensated.

b)  The assessment is based on how groups of
financial assets are managed to achieve a particular business objective and is not
an instrument by instrument analysis, though at another level it is also not an
entity level assessment.

c)  A few exceptions against the stated portfolio
objectives may not necessitate a change in the business model e.g. a few sales
out of a portfolio which is on the “hold to collect” business model. In such
situations what needs to be considered are factors like the frequency, timing
and reasons for the sales and expectations of the future sales activity.

d)  Business model assessment is done based on
scenarios reasonably expected to occur and not on exceptional or extreme
situations such as ‘worst case scenario’ or ‘stress case scenario’.


Amortised Cost –
Business Model Test

Some of the key
features for assessing the business model test of holding on to a financial
asset for amortised cost determination areas are as under:

a)  To evaluate the entity’s business model to
hold financial assets to collect contractual cash flows, the frequency,
value and timing of sales in prior periods and the reasons for such sales have
to be analysed.
Also, future expectations about such sales is required
to be analysed. It is important to bear in mind that higher or lower sales than
the previous expectations is not a prior period error.

b)  In real time business it is not always
practical to hold all the financial assets until their maturity, regardless of
the business model. Hence, some amount of selling/buying or so called ‘churning
of portfolio’ is expected and permitted. However, if more than infrequent
number of sales are made out of a portfolio or those sales are more than
insignificant in value
, then there will be a need to assess and
validate how such sales are consistent with the business model whose objective
is to collect contractual cash flows.  


It would be useful
at this stage to analyse certain common situations where the business model
test of holding would not fail or fail from a practical perspective, before
getting into the assessment of the subsequent criteria of the contractual cash
flow test:


Circumstances when the business model test would not
necessarily fail

Circumstances when the business model test may generally fail

Infrequent  sales to meet unforeseen funding needs.

financial assets to meet everyday liquidity needs.

of loan portfolio instead of originating loan portfolio, which may include
credit impaired loans.

originated with an intention to sell in the near future.

due to increase in credit risk of the financial assets which can be
demonstrated either with entity’s credit risk management policy or in some
other way. This could also include sales to manage credit concentration risk
regardless of the increase in credit risk.

of financial assets that meet the definition of ‘held for trading’ as
discussed above even if they are held for a long period.

effected closer to maturity where the proceeds approximately equal the
remaining contractual cash flows.



Amortised Cost –
Cash Flow Characteristics Test

Another equally
important test or criterion to be met for classification of financial assets as
subsequently measured at amortised cost is the characteristics of the cash
flows arising from the financial asset. Ind AS-109 provides that for this
purpose, the contractual terms of the financial asset should give rise on
specified dates to cash flows that are solely payment of principal and the
interest on the principal outstanding (SPPI).


Ind AS-109 defines
, for the purpose of the above assessment, as consideration for the


a)  the time value of money.

b)  credit risk associated with the principal
amount outstanding during a particular period of time.

c)  other basic lending risks (such
as liquidity risk) and costs (such as administration for holding
the financial asset).

d)  profit margin.


Ind AS-109 defines
, for the purpose of the above assessment, as fair value of
the financial asset at the date of initial recognition. This initial amount may
change subsequently if there are repayments of the principal amount.   


For the purposes of
the above assessment, principal and interest payments should be in the currency
in which the financial asset is denominated. The following are some of the practical
considerations which are relevant for assessing the SPPI test:


a)  Modified (or imperfect) Time Value of Money
This kind of situation arises when the financial asset’s interest
rate is reset periodically and the tenor of rate (benchmark rate) does not
match the tenor of interest period e.g. interest rate for a term loan is reset
monthly but rate is reset to one year rate. In such cases, entity will have to
assess whether the cash flows represent SPPI. This has to be demonstrated as

  • Compute (undiscounted) cash
    flows as if benchmark rate tenor matches interest period and compare it with
    cash flows (undiscounted) as per contractual terms (i.e. tenors do not match).

  • Above computation has to be
    done for entire period of the financial asset and hence consideration of facts
    that affect future interest rates and estimation would be required.
  • If the cash flows under
    above two scenarios are significantly different then the modified time value of
    money element does not represent SPPI.

b)  Rates set by Regulators: These shall be
considered as proxy for time value of money element, provided it is set by
broadly considering the passage of time element and does not introduce exposure
to risks and volatility inconsistent with basic lending arrangement.

c)  Pre-payment or extension options pass
the SPPI test, provided that the repayment amount substantially represents
unpaid principal and interest accrued as well as reasonable compensation for
early payment or extension of payment period.

d)  Floating or Variable Rates: Provisions
that change the timing or amount of payments of principal and interest fail the
SPPI test unless it is a variable interest rate that is a consideration for the
time value of money and credit risk and other basic lending risk associated
with the principal outstanding and the profit margin.


Implementation and Transition Challenges

The current requirements for classification and accounting for
investments by NBFCs were quite simple and hence shifting over to an Ind AS
regime is expected to present a fair share of challenges both in initial
transition and on-going implementation. Further, though all Ind AS requirements
are required to be applied retrospectively on the date of transition, Ind
AS-101 provides certain exceptions thereto, one of them being that the entity
should assess the business model criteria on the basis
of facts and circumstances on the date of transition. Finally, the measurement
basis for all financial assets on initial recognition would henceforth be at
the fair value for which also Ind AS-101 provides for prospective application
on or after the date of transition to Ind AS. In spite of the aforesaid
exemptions from retrospective application, NBFCs are likely to face certain
transition and on-going implementation challenges, which are briefly discussed


a)  Treatment of existing
investments classified as current:
As per the existing AS-13, all
investments that by their nature are readily realisable and are intended to be
held for not more than one year from the date on which they were made, are
regarded as current investments. Under Ind AS, all such investments may not
automatically meet the held for trading criteria especially in respect of
equity instruments, and especially if these are continuing for periods in
excess of one year on the date of transition. Accordingly, a fresh evaluation
of the purpose, nature and intention of such investments would need to be
undertaken to categorise them under the appropriate bucket. Also,
investments in mutual funds would generally fall under the
category based on the “look through” test since there are no defined
contractual cash flows even in case of fixed maturity plans.

b)  Documentation and business
model assessment:
– The classification requirements based on the criteria
discussed above may not be straitjacketed in all cases and would need to be
documented in a fair degree of detail based on the activity level and type of
business of the NBFC. The existing risk management and ALM policies especially
in case of smaller and unlisted entities would need to be recalibrated to
capture the various scenarios under Ind AS.

c)  Fair value determination:
The initial measurement of all financial assets at fair value would be a game
changer for many NBFCs. Whilst initially the transaction price would be the
fair value in many cases, this would need to be carefully evaluated in the case
of transactions with related parties, transactions not on an arm’s length basis
or transactions under duress, since in such cases the fair value at which other
market participants enter into the transactions would need to be considered which
would represent a day one gain or loss. Finally, the on-going assessment of the
fair value especially in case of financial assets which are not readily
tradeable or quoted on an active market would present challenges especially in
cases where there are not many observable inputs to determine the fair value,
since it could be based on significant judgements which more often than not
could be biased. This would make it inherently difficult for a comparison
between entities and also involve significant costs and efforts which may not
be always commensurate with the benefits.

d)  Link with liquidity crisis:
The current liquidity crisis which has engulfed many NBFCs may necessitate
selling of portfolios of financial assets the impact of which on the continued
assessment of the business portfolio would need a closer assessment requiring a
reclassification of debt instruments and loans from amortised cost to FVTOCI
for subsequent measurement.

e)  Judgements: Finally, the
assessment of the business model involves significant judgements and
assumptions which need to be constantly evaluated by the key management
personnel on several matters like determining the frequency and volume of sales
so as to rebut the business model of held to sale, whether interest rates reset
is on time value and the other criteria discussed earlier, the manner of
determining the pricing for financial assets and the inputs involved therein
since all of this would ultimately impact the business model assessment and the
consequential classification and measurement of financial assets. It may be
noted that the RBI working group has recommended the fixing of certain
thresholds to determine as to when the volume of sales could be considered frequent
so as to rebut the business model of “held to sale” criteria.



The above
evaluation is just the tip of the iceberg on a subject for which there may not
always be straitjacketed answers. However, the business model assessment is
here to stay and it would impact the way the financial statements are evaluated
and also impact the auditors and prove to be a bonanza for specialists to
develop fair values, who could laugh all the way to the bank!



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