Are you looking for expert insights, timely updates, and valuable resources? Subscribe to our newsletter today!
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.
Under IFRS 9 each financial asset is classified into one of three main classification categories:
The classification is determined by:
The Standard defines two such ‘business models’:
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 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 on consideration of an acquirer in a business combination. However, in contrast to the FVTOCI category for debt instruments
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.
IFRS 9 prohibits an entity from reclassifying any financial liability.
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.
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.
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.
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:
‘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).
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.
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.
Get ready for IFRS 9 - Classifying and measuring financial instruments (PDF) >
