All businesses hold financial instruments in some form, from cash and trade receivables at the simplest end of the scale to complex derivatives at the other. The IASB decided to replace IAS 39 in response to strong criticisms of that Standard in the aftermath of the global financial crisis of 2007/8. IFRS 9 fundamentally rewrites the accounting rules for financial instruments, particularly since it introduces a new approach for financial asset classification; a more forward-looking expected loss model; and major new requirements on hedge accounting. We have gained extensive insights into the challenges presented by the new Standard, and our guidance also addresses the classification of a financial instrument as liability or equity under IAS 32 ‘Financial Instruments: Presentation’, which is a critical issue for management when evaluating alternative options.
Classification and measurement of financial assets
Under IFRS 9 each financial asset is classified into one of three main classification categories:
- Amortised cost - Applies to debt assets for which:
- Contractual cash flows are solely principal and interest; and
- Business model is to hold to collect cashflows
- Fair value through other comprehensive income (FVOCI) - Applies to debt assets for which:
- Contractual cash flows are solely principal and interest; and
- Business model is to hold to collect cash flows and sell
- Fair value through profit or loss (FVTPL) - Applies to other financial assets that do not meet the conditions for amortised cost or FVTOCI (including derivatives and investments in equity assets).
The classification is determined by:
- The Business Model test – the entity’s business model for managing the financial asset; and
- The Cash flow characteristics test – the contractual cash flow characteristics of the financial asset.
The business model test
The Standard defines two such ‘business models’:
- Held to collect - a business model whose objective is to hold the financial asset in order to collect contractual cash flows.
- Hold to collect and sell – A business model in which assets are managed to achieve a particular objective by both collecting contractual cash flows and selling financial assets.
An entity’s business model is observable through particular activities that the entity undertakes to achieve the objectives of the business model and should be determined by considering all relevant and objective evidence.
The cash flow characteristics test
The second condition for classification in the amortised cost classification or FVTOCI category can be labelled the ‘solely payments of principal and interest’ (SPPI) test. The requirement is that the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
IFRS 9 permits a FVTOCI option for investments in equity instruments. An entity may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument that is not held for trading and is not contingent consideration of an acquirer in a business combination. However, in contrast to the FVTOCI category for debt instruments:
- Gains and losses recognised in OCI are not subsequently transferred to profit or loss (sometimes referred to as ‘recycling’); and
- Equity FVTOCI instruments are not subject to any impairment accounting.
Fair value option
IFRS 9 contains a modified version of IAS 39’s ‘fair value option’ – the option to designate a financial asset at fair value through profit or loss in some circumstances. At initial recognition, an entity may designate a financial asset as measured at fair value through profit or loss that would otherwise be measured subsequently at amortised cost or at fair value through other comprehensive income. Such a designation can only be made, however, if it eliminates or significantly reduces an ‘accounting mismatch’ that would otherwise arise.
IFRS 9 requires an entity to reclassify financial assets when, and only when, it changes its business model for managing its financial assets. Changes to an entity’s business model are expected to be very infrequent as they will only occur when an entity significantly changes the way it does business.
Classification and measurement of financial liabilities:
Most of IAS 39’s requirements were carried forward unchanged to IFRS 9. Changes were however made to address issues related to own credit risk where an entity takes the option to measure financial liabilities at fair value.
Own credit risk
Where an entity chooses to measure its own debt at fair value, IFRS 9 now requires the amount of the change in fair value due to changes in the entity’s own credit risk to be presented in other comprehensive income. The only exception to the new requirement is where the effects of changes in the liability’s credit risk would create or enlarge an accounting mismatch in profit or loss, in which case all gains or losses on that liability are to be presented in profit or loss.
IFRS 9 prohibits an entity from reclassifying any financial liability.
Derecognition of financial assets and financial liabilities
The IASB determined that IAS 39’s requirements in this area had performed reasonably during the financial crisis. IAS 39’s derecognition requirements have therefore been incorporated into IFRS 9 unchanged.
Expected credit losses
IAS 39’s ‘incurred loss’ model delayed the recognition of credit losses until objective evidence of a credit loss event had been identified. IFRS 9’s impairment requirements use more forward-looking information to recognise expected credit losses. Recognition of credit losses are no longer dependent on the entity first identifying a credit loss event. Instead an entity should consider a broader range of information when assessing credit risk and measuring expected credit losses.
In applying this more forward-looking approach, a distinction is made between:
- Financial instruments that have not deteriorated significantly in credit quality since initial recognition or that have low credit risk; and
- Financial instruments that have deteriorated significantly in credit quality since initial recognition and whose credit risk is not low.
‘12-month expected credit losses’ are recognised for the first of these two categories while ‘lifetime expected credit losses’ are recognised for the second category. An asset moves from 12-month expected credit losses to lifetime expected credit losses when there has been a significant deterioration in credit quality since initial recognition and the credit risk is more than ‘low’. There is also a third stage in the model. For assets for which there is objective evidence of impairment, interest is calculated based on the amortised cost net of the loss provision (this stage is essentially the same as the incurred loss model used in IAS 39).
Determining significant increases in credit risk
IFRS 9 requires an entity to assess at each reporting date whether the credit risk on a financial instrument has increased significantly since initial recognition. Where a financial instrument is determined to have low credit risk at the reporting date, it may assume that the credit risk on the instrument has not increased significantly since initial recognition. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.
Measurement of expected credit losses
Under IFRS 9, expected credit losses are a probability-weighted estimate of credit losses (i.e. the present value of all cash shortfalls) over the expected life of the financial instrument.
IFRS 9’s new requirements align hedge accounting more closely with entities’ risk management activities and should serve to reduce profit or loss volatility.