IFRS 9 – Financial Instruments
Another forthcoming reporting standard we want briefly present to you is IFRS 9
Financial Instruments. This is the replacement for IAS 39
Financial Instruments: Recognition and Measurement.
The new standard is effective for accounting periods beginning on or after 1 January 2018.
IFRS 9 is relevant to many different companies but will have the greatest effect on financial institutions.
The scope of the standard is similar to that of IAS 39, however, there are some changes:
- it is now made clearer that the exclusion for forward contracts for business combinations applies only to such combinations which are within the scope of IFRS 3 Business Combinations;
- loan commitments now fall within the scope of the impairment requirements; and
- entities may now, at inception, irrevocably designate a contract to buy or sell a non-financial item that would normally be excluded from the scope if this eliminates or reduces a recognition inconsistency (or accounting mismatch).
Recognition and De-recognition
IFRS 9 does not make substantive changes to the IAS 39 requirements in respect of recognition and de-recognition of financial assets or liabilities, instead more disclosures are required by IFRS 7 on
de-recognition.
Classification of Financial Assets
The four categories of financial asset set out in IAS 39 do not survive into IFRS 9. Instead there are three categories:
- at amortised cost;
- at fair value through other comprehensive income; and
- at fair value through profit or loss.
All financial assets which do not fall into the first two categories must be stated at fair value through profit or loss. There is an exception to this general rule. An item which would normally be stated at amortised cost may be designated as to be measured at fair value through profit or loss if doing so would eliminate or significantly reduce a measurement or recognition inconsistency (or “accounting mismatch”) that would otherwise arise.
It should also be noted that under IFRS 9 all equity investments must be stated at fair value.
In deciding into which category a financial asset falls, the entity must take account of:
- the entity’s business model for managing the financial assets; and
- the contractual cash flow characteristics of the financial asset.
The business model is a complex concept. In broad terms, it represents the general approach that an entity takes to its portfolio of “debt” instruments. The assessment of which business model is being applied needs to be based on observable data, such as business plans, remuneration arrangements, risk management practices, and amount and frequency of disposals, including in some cases the business rationale for those disposal.
Entities may have more than one business model, although in this case there would have to be a clear observable distinction between the relevant portfolios.
Classification of Financial Liabilities
The requirements in respect of classification of financial liabilities of IAS 39 have, largely, been carried
forward without change into IFRS 9.
However, the standard does change the treatment of derivative liabilities that are linked to, and must be settled by delivery of, unquoted equity instruments. Under IAS 39, such instruments were potentially subject to an exemption on fair value measurement. That exemption does not survive.
The exceptions related to financial guarantee contracts and below-market loan commitments survive, with the only change being that no reference is made to the amount that would be determined under IAS 37
Provisions, Contingent Liabilities and Contingent Assets. Instead, these are subject to the impairment, or loss allowance, requirements set out in IFRS 9.
Entities will still have the option to designate liabilities that would otherwise have been stated at amortised cost, as at fair value through profit or loss. The conditions that must be satisfied to do this are substantively unchanged from those in IAS 39.
Reclassification of Financial Assets and Financial Liabilities
Reclassification of financial assets is allowed if, and only if, the entity changes its business model for managing financial assets, or specific portfolios of financial assets.
Financial liabilities cannot be reclassified.
Embedded Derivatives
IFRS 9 has, with some rewording, basically taken the definition of an embedded derivative from IAS 39 without substantive change. It does, however, change the accounting consequences of identifying embedded derivatives, quite substantially in some cases.
Gains and Losses
All gains or losses on assets and liabilities held at fair value are recognised in profit or loss, other
than:
- gains and losses on items in a hedge relationship, where the hedge accounting rules require them
to be recognised outside of profit or loss;
- gains and losses (other than dividends) on equity investments where the entity has made the irrevocable election to present in other comprehensive income subsequent changes in fair value;
- the amount of changes in the fair value of a liability measured at fair value which are attributable to changes in that liability’s credit risk (which are shown within other comprehensive income); and
- in respect of assets carried at fair value through other comprehensive income, any changes in fair value that are not attributable to impairment, foreign exchange movements or the use of the effective interest method.
Where a financial asset is stated at amortised cost (and is not part of a hedging relationship) then gains or losses are recognised in profit or loss:
- on de-recognition;
- when the asset is impaired;
- if the asset is reclassified in accordance with the requirements set out above; or
- through the amortisation process.
If settlement date accounting is used then any value changes between trade date and settlement date are ignored, if the asset is measured at amortised cost. They are taken to profit or loss or other comprehensive income (in accordance with the normal rules) if the asset is measured at fair value.
Where a financial liability is stated at amortised cost (and is not part of a hedging relationship) then gains or losses are recognised in profit or loss:
- on de-recognition; and
- through the amortisation process.
Where a financial asset is treated at fair value through other comprehensive income then gains or losses are split between profit or loss and other comprehensive income, as set out above, during the life of the asset. On de-recognition, the cumulative gains or losses previously recognised in other comprehensive income are reclassified from equity to profit or loss.
Measurement
With one main exception, financial assets and liabilities are initially recorded at their fair value (at trade date, if relevant). In the case of items which will not be carried at fair value through profit or loss, this is then adjusted for directly attributable acquisition costs.
The main exception is trade receivables which do not contain a significant financing component, which are initially recorded at transaction price.
There is another, minor, exception where the transaction price does not equal the fair value (so called “day one” gains or losses). Where the fair value is evidenced by a level 1 input (refer to IFRS 13) then it should be used for initial recording, giving rise to an immediate gain or loss. In all other cases, the difference is deferred, which means that in practice it is the transaction price that is used. This difference is then only recognised to the extent it arises from a change in a factor, including time, that a market participant would take into account in pricing the item.
After recognition, financial assets are carried at a value measured in accordance with their classification, as set out above. Impairment requirements also need to be reflected for items at amortised cost or at fair value through other comprehensive income.
Similarly, financial liabilities are measured in accordance with their classification.
The general rule is that the effective interest method is applied to the gross carrying amount of financial assets (i.e. ignoring impairment) but this does not apply to:
- purchased or originated credit-impaired assets; or
- assets that have become credit-impaired since recognition (unless and until there is objective evidence that the credit-impairment has reversed).
Impairment
IFRS 9 moves to an expected loss model of accounting for impairments compared with IAS 39 incurred loss model.
Under the new model, expected credit losses are recognised from the point at which a financial asset is initially recognised. This applies to financial assets measured at amortised cost, lease receivables, contract assets, loan commitments, financial guarantee contracts and financial assets measured at fair value through other comprehensive income. The difference is that, in the final case, the loss allowance is recognised in other comprehensive income and is not reflected directly in the balance sheet as it is incorporated in the fair value of the asset.
For the purposes of dealing with expected credit losses, financial assets fall into three categories:
- trade receivables, contract assets and lease receivables (although this involves a policy choice for longer term trade receivables and contract assets, and for all lease receivables);
- purchased or originated credit-impaired assets; and
- all other financial assets (including trade, contract and lease receivables where the entity has decided not to apply the simplified approach) as well as financial guarantee contracts and loan commitments.
When dealing with impairment the standard deals with two bases for determining losses. The first is lifetime expected credit losses. This is, in effect, a reasonable estimate of the losses that might be expected to arise on an instrument, or a portfolio of instruments, over its whole life.
The second is 12-month expected credit losses, that is a portion of the lifetime expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.
For trade receivables and contract assets that do not contain a significant financing component, entities are always required to measure their allowance account as lifetime expected credit losses.
The same applies to trade receivables and contract assets that do contain a significant financing element, and to lease receivables, although in these cases that is a policy choice. (The choice can be made separately for each class, and indeed separately for operating and finance lease receivables.)
For all other financial assets, as well as financial guarantee contracts and loan commitments apart from those which were credit impaired at origination or acquisition, the approach depends on whether the credit risk has increased significantly since original recognition or not. If it has, then the entity must measure the allowance account based on lifetime expected credit losses. If it has not, then the entity must measure the allowance account based on 12-month expected credit losses.
For financial assets which were credit impaired at origination or acquisition, the allowance account must always be based on lifetime expected credit losses. This applies even if there is an improvement such that the asset is no longer considered to be credit-impaired.
Deciding whether there has been a significant increase in credit risk, is not always going to be an easy exercise and requires judgement.
Regardless of the period covered by the allowance account, credit losses should be measured by reference to:
- an unbiased and probability-weighted amount determined by evaluating a range of possible outcomes;
- the time value of money; and
- reasonable and supportable information available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions.
Hedge Accounting
IFRS 9 contains hedge accounting conditions that are more liberal than those of IAS 39. Whilst hedge accounting remains optional, the simplicity that IFRS 9 introduces is likely to extend its use.
However, entities have an option, they could apply IFRS 9 hedge accounting requirements or continue to apply existing IAS 39 hedge accounting requirements as the project on macro hedge accounting has not been completed.
IFRS 9 allows an entity to apply hedge accounting where it designates a hedging relationship between a hedging instrument and a hedged item that meets all the qualifying criteria.
Transitional Provisions
While IFRS 9 is a fairly straightforward standard, its transitional provisions are complex.
The basic requirement is that IFRS 9 is to be applied retrospectively, but there is a very wide range of exceptions to this general principle. In particular, there is no requirement to restate prior periods. Indeed, prior periods may only be restated where it is possible to do so without the use of hindsight. Where this cannot be done, or an entity has chosen not to do it, the retrospective effect is reflected by adjustment to opening retained earnings, or other category of equity as appropriate.
The date of initial application is now defined as the beginning of the first reporting period in which the entity adopts this IFRS. There is no longer an option to adopt the standard from a date which is not the beginning of an accounting period.
Entities must also apply the rules on change of counterparty included in IFRS 9.
There are also various transitional provisions to deal with those entities which have already adopted previous versions of IFRS 9.
IFRS 9 also makes changes to various other standards. Some of the changes are minor, but there are more significant ones.
The range of helpful materials on IFRS 9 available on
website of International Accounting Standards Board.