“Life is a series of natural and spontaneous changes. Don’t resist them – that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like.” Lao Tzu
IFRS 9, Financial Instruments
The final version of IFRS 9, Financial Instruments, was issued by the International Accounting Standards Board (IASB) in July 2014 which will replace IAS 39, Financial Instruments: Recognition and Measurement. The Standard includes requirements for recognition and measurement, impairment, derecognition and general hedge accounting. This latest version of the Standard supersedes all previous versions and is mandatory effective for periods beginning on or after 1 January 2018 with an option of early adoption permitted.
In this publication we tried to shed some light on major changes rather than full analysis on the Standard.
Classification and measurement
The Standard introduces a new single, principle based approach for determining the classification of financial assets, which is driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are complex and difficult to apply. The new model also results in a single impairment model being applied to all financial instruments removing a source of complexity associated with previous accounting requirements.
All financial instruments are initially measured at fair value, same as it was before.
For subsequent measurement IFRS 9 divides all financial assets that are currently in the scope of IAS 39 into two classifications – A) those measured at amortised cost and B) those measured at fair value (through profit and loss or through other comprehensive income).
The classification of a financial asset is made at the time it is initially recognized, namely when the entity becomes a party to the contractual provisions of the instrument.
The Standard introduces different models for debt instruments and equity instruments.
A debt instrument that meets the following two conditions must be measured at amortised cost (net of any write down for impairment) unless the asset is designated at fair value through profit and loss (FVTPL):
- Business model test (based on the overall business): The objective of the entity’s business model is to hold the financial asset to collect the contractual cash flows (rather than to sell the instrument prior to its contractual maturity to realise its fair value changes).
- Cash flow characteristics test (instrument-by-instrument analysis): The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.
A debt instrument that meets the following two conditions must be measured at fair value through other comprehensive income (FVTOCI) unless the asset is designated at FVTPL:
- Business model test (based on the overall business): The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.
- Cash flow characteristics test (instrument-by-instrument analysis): The contractual terms of the financial asset give rise on specified dates to cash flows that are SPPI on the principal amount outstanding.
The following debt instruments are classified as FVTPL:
- Financial assets that do not meet either the amortised cost criteria or the FVTOCI criteria;
- Financial assets designated as FVTPL at initial recognition. The option to designate is available if doing so eliminates, or significantly reduces, a measurement or recognition inconsistency (i.e. ‘accounting mismatch’). This election is irrevocable.
All equity investments in scope of IFRS 9 are to be measured at FVTPL, except for those equity investments for which the entity has elected to present value changes in ‘other comprehensive income’. If an equity investments is not held for trading, and entity can make an irrevocable election at initial recognition to measure it at FVTOCI with only dividend income recognized in profit and loss.
There is no ‘COST EXCEPTION’ for unquoted equities any more.
IFRS 9 doesn’t change the basic accounting model for financial liabilities under IAS 39.
Financial Liabilities are classified as either amortised cost or FVTPL.
Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are measured at amortised cost unless the fair value option is applied to designate a financial liability as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (i.e. ‘accounting mismatch’), or the liability is part or a group of financial liabilities or financial assets and financial liabilities that is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally to key management personnel.
For financial liabilities designated to be measured at fair value the Standard introduced further changes in respect of own credit risk, so that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognized in profit and loss and should be included into other comprehensive profits and loss.
In addition, the Standard introduces specific guidance for
- Financial guarantee contracts, and
- Commitments to provide a loan at a below market interest rate
For financial assets, reclassification is required between FVTPL, FVTOCI and amortised cost, if and only if the entity’s business model objective for its financial assets changes so its previous model assessment would no longer apply.
If reclassification is appropriate, it must be done prospectively from the reclassification date which is defined as the first day of the first reporting period following the change in business model. An entity does not restate any previously recognised gains, losses, or interest.
IFRS 9 does not allow reclassification:
- for equity investments measured at FVTOCI, or
- where the fair value option has been exercised in any circumstance for a financial assets or financial liability.
During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identifed as a weakness in existing accounting standards. As part of IFRS 9 the IASB has introduced a new single, forward-looking expected loss impairment model that will require more timely recognition of expected credit losses.
The impairment requirements are applied to:
- Financial assets measured at amortised cost (incl. trade receivables)
- Financial assets measured at fair value through OCI
- Loan commitments and financial guarantees contracts where losses are currently accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets
- Lease receivables
- Contract assets within the scope of IFRS 15 Revenues from Contracts with Customers.
In applying the IFRS 9 impairment requirements, an entity needs to follow one of the approaches below:
- The general approach
- The simplified approach
Under the general approach, at each reporting date, an entity recognises a loss allowance based on either 12-month expected credit losses (ECLs) or lifetime ECLs, depending on whether there has been a significant increase in credit risk on the financial instrument since initial recognition. The changes in the loss allowance balance are recognised in profit or loss as an impairment gain or loss.
An entity should make the following assessment at each reporting date:
- For credit exposures where there have not been significant increases in credit risk since initial recognition, an entity is required to provide for 12-month ECLs after the reporting date,
- For credit exposures where there have been significant increases in credit risk since initial recognition on an individual or collective basis, a loss allowance is required for lifetime ECLs, i.e., ECLs that result from all possible default events over the expected life of a financial instrument.
The simplified approach does not require an entity to track the changes in credit risk, but, instead, requires the entity to recognize a loss allowance based on lifetime ECLs at each reporting date, right from origination.
An entity is required to apply the simplified approach for trade receivables or contract assets that result from transactions within the scope of IFRS 15 and that do not contain a significant financing component (i.e. have a maturity of one year or less).
The Standard also specifies impairment approach for purchased or originated credit-impaired financial assets.
IFRS 9 retains the IAS 39 definition of an embedded derivative and most of the associated guidance on classification. The main change however, is that if the host contract is an asset in the scope of IFRS 9 then the embedded derivative is not separated but instead the whole contract in its entirety is accounted for as a single instrument.
IFRS 9 introduces a substantially-reformed model for hedge accounting with enhanced disclosures about risk management activity. The new model represents a substantial overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements. In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
The above article represents only a brief digest of the Standard.
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