Challenging time ahead putting IFRS 9 into practice

First published in the November 2014 UK edition of Accounting and Business magazine.

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Putting the IFRS 9 requirements - which will affect all sectors, but mostly banks - into practice will be a challenge, says Graham Holt

In July 2014, the International Accounting Standards Board (IASB) completed its response to the financial crisis by issuing the final version of IFRS 9, Financial Instruments. IFRS 9 sets out:

• a model for classification and measurement
• an ‘expected loss’ impairment model
• a transformed approach to hedge accounting.

 The IASB had previously issued versions of IFRS 9 that introduced new classification and measurement requirements in 2009 and 2010 and a new hedge accounting model in 2013. 

The latest publication consolidates the previous versions of the standard, and replaces IAS 39, Financial Instruments: Recognition and Measurement.

It also changes some of the requirements of the previous publications. IFRS 9 is effective for annual periods beginning on or after 1 January 2018.

Classification determines how financial assets and financial liabilities are accounted for and measured in financial statements. The requirements for impairment and hedge accounting are based upon the instruments classification.

Classification and measurement

The standard introduces a principle-based system for the classification and measurement of financial assets, which depends upon the entity’s business model for managing the financial asset and the financial asset’s contractual cashflow characteristics.

IFRS 9 utilises a single classification approach for all types of financial assets, which includes those that contain embedded derivative features. Financial assets are now not subject to complicated bifurcation requirements.

The business model approach refers to how an entity manages its financial assets in order to generate cashflows either by: 

• collecting contractual cashflows
• selling financial assets 
• or both. 

Financial assets are measured at amortised cost, where the business model’s objective is to hold assets in order to collect contractual cashflows. The new standard clarifies the existing guidance on the collection of the assets’ contractual cashflows.

When determining the applicability of this business model, an entity should consider past and future sales information.

If an entity holds financial assets for sale, then it will fail the business model test for accounting for the financial assets at amortised cost. However, sales activity is not necessarily inconsistent with the business model if they are infrequent and insignificant in value but, where these sales are frequent and significant in value, an entity needs to assess whether such sales are consistent with an objective of collecting contractual cashflows.

The sales may be consistent with that objective if they ‘are made close to the maturity of the financial assets and the proceeds from the sales approximate the collection of the remaining contractual cashflows’.

For many entities, the assessment will be relatively straightforward, as their financial assets may be simply trade receivables and bank deposits for which the amortised cost criteria are likely to be met. For those entities with a broader range of financial assets such as investors in debt securities, and insurance companies, the motivations behind the disposal of the assets will have to be considered.

IFRS 9 includes a new measurement category whereby financial assets are measured at fair value through other comprehensive income (FVTOCI).

This category is used when financial assets are held in a business model whose objective is both collecting contractual cashflows and selling financial assets. Unlike the available-for-sale criteria in IAS 39, the criteria for measuring at FVTOCI are based on the financial asset’s cashflow characteristics and the entity’s business model.

This business model will involve a greater frequency and volume of sales with the possible objectives of managing liquidity or matching the duration of financial liabilities to the duration of the assets they are funding.

This category was introduced because of the concerns raised by preparers who sold financial assets in greater volume than was consistent with the previous business model and would, without this category, have to record such assets at fair value through profit or loss (FVTPL).

Financial assets may qualify for amortised cost or FVOCI only if they give rise to ‘solely payments of principal and interest’ (SPPI) under the contractual cashflows characteristics test. Many instruments have features that are not in line with the SPPI condition. IFRS 9 makes it clear that such features are disregarded if they are ‘non-genuine’ or ‘de minimis’.

IFRS 9 now provides more guidance on SPPI. For contractual cashflows to be SPPI, they must include returns that are consistent with the return on a basic lending arrangement to the holder, which generally includes: 

• consideration for the time value of money
• credit risk
• liquidity risk
• a profit margin
• consideration for costs associated with holding the financial asset over time, such as servicing costs. 

Thus if the contractual arrangement includes a return for equity price risk, then this would be inconsistent with SPPI.

IFRS 9 introduces guidance on how the contractual cashflows characteristics assessment applies to debt instruments that may contain a modified time value element; for example, those instruments that may contain a variable interest rate.

These characteristics will result in an instrument failing the contractual cashflow characteristics test if the resulting undiscounted contractual cashflows could be ‘significantly different’ from the undiscounted cashflows of a benchmark instrument that does not have such features.

Interest rates set by a government or a regulatory authority are accepted as a proxy for the consideration for the time value of money if those rates provide consideration that is ‘broadly consistent with consideration for the passage of time’. Such cashflows are considered SPPI as long as they do not introduce risk or volatility, which is inconsistent with a basic lending arrangement.

Any financial assets not held in one of the two business models above are measured at FVTPL, which is essentially a residual category. Also included in this category are financial assets that are held for trading and those managed on a fair-value basis. Financial assets are reclassified when the entity’s business model for managing them changes. This is not expected to occur frequently and it ensures that users of financial statements are provided with information on the realisation of cashflows.

IAS 39 was felt to work well as regards the accounting for financial liabilities; therefore the IASB felt there was little need for change. Thus most financial liabilities will continue to be measured at amortised cost. IAS 39 also permitted entities to elect to measure financial liabilities at fair value through profit or loss (fair-value option).

The changes introduced by IFRS 9 are restricted to those liabilities designated at FVTPL using the fair-value option. Fair-value changes of these financial liabilities are presented in other comprehensive income to the extent that they are attributable to the change in the entity’s own credit risk. If this would cause an accounting mismatch, then the total fair-value change is presented in profit or loss.

This change is designed to eliminate volatility in profit or loss caused by changes in the credit risk of financial liabilities that an entity has elected to measure at fair value.

Impairment

IFRS 9 introduces an impairment model for financial assets that is based on expected losses rather than incurred losses. It applies to amortised-cost financial assets and those categorised as FVTOCI. It also applies to certain: 

• loan commitments
• financial guarantees
• lease receivables
• contract assets. 

An entity recognises expected credit losses at all times and updates the assessment at each reporting date to reflect any changes in the credit risk. It is no longer necessary for there to be a trigger event for credit losses to be recognised and the same impairment model is used for all financial instruments that are impairment tested.

Other than purchased or originated credit-impaired financial assets, IFRS 9 requires entities to measure expected credit losses by recognising a loss allowance equal to either:

• 12-month expected credit losses. This measurement is required if the credit risk is low at the reporting date or the credit risk has not increased significantly since initial recognition.
• Full lifetime expected credit losses. This measurement is required if the credit risk has risen significantly since recognition and the resulting credit quality is not considered to be low credit risk. Entities can elect for an accounting policy of always recognising full lifetime expected losses for contract assets, trade receivables, and lease receivables. When measuring expected credit losses, an entity should consider the probability-weighted outcome, the time value of money and information that is available without undue cost or effort.

Hedge accounting

IFRS 9 introduces a reformed model for hedge accounting with enhanced disclosures about risk management activity. Under IFRS 9, a hedging relationship qualifies for hedge accounting only if all of these criteria are met:

• the hedging relationship consists only of eligible hedging instruments and eligible hedged items
• at its inception there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge
• the relationship meets all of the hedge effectiveness requirements. The hedge relationship must meet the effectiveness criteria at the beginning of each hedged period to qualify for hedge accounting
• there is an economic relationship between the hedged item and the hedging instrument
• the effect of credit risk does not dominate the value changes that result from that relationship
• the hedge ratio of the hedging relationship is the same as that used in the economic hedge.

IFRS 9 will affect all sectors through the introduction of an expected loss model for loan loss provisioning, but will impact mostly on banks. It should give investors better insight into the credit quality of all financial assets.

Putting the new requirements into practice by the effective date, however, will be quite a challenge.

Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School