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Director, Accounting Consulting Services
The IASB has published the complete version of IFRS 9 Financial Instruments, which replaces IAS 39. The final version of the standard includes requirements on the classification and measurement of financial assets and liabilities and hedge accounting, and replaces the incurred loss impairment model with the expected credit loss model.
IFRS 9 is effective for annual periods beginning on or after 1 January 2018. Earlier application is permitted. However, IFRS 9 is still subject to the endorsement process in the EU.
These days there are all types of financial instruments (Figure 1) on balance sheets. This means that IFRS 9 can impact a broad range of entities.
The implications of the new standard depend on the industry and the type and scale of the financial instruments in question.
While the first two areas affect all entities and are mandatory for financial instruments, the hedge accounting section only affects entities intending to use this type of instrument.
The rules on recognition and derecognition remain basically unchanged. However, there are new rules on classification and measurement of financial assets and liabilities. Below we summarise the requirements with regard to financial assets.
Measurement of cash and cash equivalents, trade receivables and other short-term receivables remains unchanged; these are measured at amortised cost.
The classification and measurement of bonds and other receivables (or debt instruments overall) is driven by the entity’s business model for managing the financial assets and the complexity of the contractual cash flows.
If a debt instrument meets the cash flow requirements discussed below, its measurement depends on the objective of the business model (Figure 2).
The objective of the entity’s business model can be either to hold the financial asset to collect, or to hold it with the possibility of selling it. For both of these business models an assessment has to be made to determine whether the contractual cash flows meet the conditions of IFRS 9 for measurement at amortised cost or at fair value through other comprehensive income (FVOCI).
If the objective is to hold, and contractual cash flows are solely payments of principal and interest on the outstanding principal amount, subsequent measurements are made at amortised cost.
If the business model is to hold and possibly sell, and contractual cash flows are solely payments of principal and interest on the outstanding principal amount, subsequent measurements are made at FVOCI.
The above applies to all ‘regular’ bonds, but not to warrant or convertible bonds. This rule is designed to ensure that more complex instruments are always measured at fair value through profit or loss (FVPL).
Equity instruments do not generate contractual cash flows and are basically allocated to the FVPL category.
If an equity investment is not held for trading, an entity can make an irrevocable election at the time of the equity investment’s initial recognition to record changes in fair value through FVOCI instead of through profit or loss, with only dividend income recognised in profit or loss. All other changes in fair value and subsequent gains or losses on disposal are recognised directly in OCI.
The FVOCI category applies only to financial instruments that meet the definition of equity under IFRS; in practice these are primarily shares.
Derivatives with a positive market value continue to be measured at fair value and recognised as assets on the balance sheet, with changes in fair value recognised directly in profit or loss.
The following explanations relate to financial liabilities.
There are no changes for financial liabilities measured at amortised cost. This applies to the majority of financial liabilities recognised in the statement of financial position, for example issued bonds or trade payables.
Derivatives with a negative market value continue to be measured at fair value on the balance sheet, with changes in fair value recognised directly in profit or loss.
Under certain conditions, an entity can make an irrevocable election at the time of the financial liability's initial recognition to measure the liability at fair value in the balance sheet, with any future fair value changes recognised directly in profit or loss. In such cases the recognition of credit risks changes: under the existing rules the entity must present changes in credit risk only in the notes.
Since any deterioration in the entity’s credit risk should not lead to valuation gains in profit or loss, going forward changes in credit risk should be recognised in OCI (Figure 4).
|Financial liability||CHF||IAS 39||IFRS 9|
|Fair value 1 January 2014||100||Presented as liability of CHF 100|
|Fair value 31 December 2014||90||Presented as liability of CHF 90|
|Change in fair value in 2014|
|Because of deterioration in entity's credit risk||8||Recognised in profit or loss||Recognised in OCI|
|Because of change in interest rate levels||2||Recognised in profit or loss||Recognised in profit or loss|
IFRS 9 introduces a new impairment model - the expected loss impairment model - for the recognition of impairment losses of financial assets carried at amortised cost or FVOCI. This model is based on the premise that on day one of recognising a financial asset, an entity must determine and record what it expect its losses to be on the instrument. The model contains a three stage approach based on the change in credit quality of financial assets since initial recognition (Figure 5).
Under the three-stage approach, essentially all financial assets are assigned to Stage 1 at the time of the initial recognition. For these financial assets a 12-month expected credit loss (ECL) is recognised. The 12-month ECL is calculated as the ECL that results from those default events of the financial instrument that are possible within 12 months after the reporting date. Interest revenue is calculated by applying the effective interest rate method to the gross carrying amount.
In the event of a significant increase in credit risk since initial recognition, the financial instrument is assigned to Stage 2. Here the entity has to recognise impairment amounting to so-called lifetime ECL (expected credit losses over the expected life of the financial instrument) in profit and loss.
If there is objective evidence of impairment at the reporting date, the financial asset is assigned to Stage 3. For Stage 3 assets, impairment is recognised analogously to the existing impairment model on the net carrying amount.
The information required for an entity to apply the expected loss model is different than for the current model. Implementing the model entails considerable effort and resources, and can include comprehensive system modifications.
Under certain circumstances IFRS 9 provides the option of a simplified approach for areas such as trade receivables whereby impairment is recognised utilising the lifetime ECL regardless of credit risk.
Figure 6 summarises the main differences between IAS 39 and IFRS 9 in terms of measuring common financial assets.
|Financial assets||IAS 39 measurement||IFRS 9 measurement||IFRS 9 impairment|
|Cash||Amortised cost||Amortised cost||Not applicable|
|Receivables||Amortised cost||Amortised cost||Simplified model|
|Bonds||Amortised cost||Amortised cost||Expected loss model|
|FVOCI||FVOCI||Expected loss model|
|Investment fund units||FVOCI||FVPL||Not applicable|
One of the major changes concerns equity instruments in the FVOCI category. Under IFRS 9, realised gains or losses are recognised directly in equity. This means the ‘available for sale’ category chosen until now by many IFRS users for equities will cease to exist in its present form. It also means that impairment rules no longer exist for equity instruments carried under the FVOCI category, as all changes in fair value are recognised in OCI, with no reclassification to profit or loss.
The new FVOCI for debt instruments largely corresponds to the current ‘available for sale’ category: when derecognised from OCI, realised gains or losses are reclassified to profit or loss. However, this procedure means that the new impairment model has to be applied.
Under IFRS 9 it is not permissible to measure investment fund units at FVOCI because they do not meet the definition of equity. On the other hand the debt instrument classification does not generally apply as investment fund units do not have contractual cash flows. For this reason, units must be measured at fair value with changes recognised in profit or loss.
The biggest challenge when it comes to implementing IFRS 9 arises when the impairment model is applied to large bond portfolios, as a result of the requirement to apply the new expected loss model.
The IFRS 9 rules on hedge accounting were completed back in November 2013 and adopted unchanged in the final standard.
The IFRS 9 rules on hedge accounting are designed to align accounting for hedging instruments more closely with risk management activities. They can thus reduce economic distortions in the profit and loss statement. However, entities must continue to document their hedging activities and provide evidence of their effectiveness.
The IFRS 9 general hedge accounting rules offer simplified approaches and new hedging options. For instance, with regard to the frequent practice among industrial companies of entering into hedging transactions in goods and commodities against price changes, under the old standard it was not permitted to divide commodity supply contracts into individual components for hedge accounting purposes. This meant that entities could either shoulder the high costs of acquiring a derivative specially tailored to the contract or accept an ineffective solution and the volatility in profit and loss. Under the new rules, in certain circumstances, the hedging of individual components is allowed, taking better account of the economic reality.
The implementation of IFRS 9 is a good opportunity for companies to reconsider their current hedging strategies, even those entities that currently do not follow hedge accounting.
You will find more details in the article in the June 2014 issue of Disclose, Hedge Accounting unter IFRS 9: Was der neue Standard bringt (German and French only).
The implications of IFRS 9 can be summarised as follows: