IFRS 9

IFRS 9 Financial Instruments

 

Overview: The first version of IFRS 9 was issued in November 2009 and then it was amended in October 2010 and November 2013. Once it is fully finalized, it will replace standard IAS 39 in the future. IASB still works on several projects related to financial instruments and after these projects are completed, standard IFRS 9 will be further amended and expanded. IFRS 9 deals with recognition, classification, measurement and derecognition of financial instruments; as well as with the hedge accounting rules. The current version of IFRS 9 does NOT include mandatory effective date, but entities can adopt it voluntarily. IASB will add the mandatory effective date later when all phases are completed.

 

BACKGROUND

IFRS 9 introduces a single classification and measurement model for financial assets, dependent on both:

• The entity’s business model objective for managing financial assets
• The contractual cash flow characteristics of financial assets.

 

IFRS 9 removes the requirement to separate embedded derivatives from financial asset host contracts (it instead requires a hybrid contract to be classified in its entirety at either amortised cost or fair value.)

Separation of embedded derivatives has been retained for financial liabilities (subject to criteria being met).

 

INITIAL RECOGNITION AND MEASUREMENT (FINANCIAL ASSETS AND FINANCIAL LIABILITIES)

Initial Recognition:

When the entity becomes party to the contractual provisions of the instrument

Initial Measurement:

At fair value, plus for those financial assets and liabilities not classified at fair value through profit or loss, directly attributable transaction costs.

• Fair value - is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
• Directly attributable transaction costs - incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability.

 

FINANCIAL ASSETS - SUBSEQUENT CLASSIFICATION AND MEASUREMENT

Financial Assets are classified as either: (1) Amortised cost, (2) Fair value through profit or loss, (3) Fair Value through other comprehensive income

(1)          Amortised cost

Category classification criteria

Both of the below conditions must be met:

(i) Business model objective: financial assets held in order to collect contractual cash flows

(ii) Contractual cash flow characteristics: solely payments of principal and interest on the principal amount outstanding.

Subsequent measurement

 Amortised cost using the effective interest method.

(i)            Business model assessment

Based on the overall business, not instrument-by-instrument

Centres on whether financial assets are held to collect contractual cash flows:

• How the entity is run
• The objective of the business model as determined by key management personnel (KMP) (per IAS 24 Related Party Disclosures).

 

Financial assets do not have to be held to contractual maturity in order to be deemed to be held to collect contractual cash flows, but the overall approach must be consistent with ‘hold to collect’.

(ii) Contractual cash flow assessment

Based on an instrument-by-instrument basis

Financial assets with cash flows that are solely payments of principal and interest (SPPI) on the principal amount outstanding.

Interest is consideration for only the time-value of money and credit risk.

FOREX financial assets: assessment is made in the denomination currency (i.e. FX movements are not taken into account).

 

 

IFRS 9 contains various illustrative examples in the application of both the (i) Business Model Assessment and (ii) Contractual Cash Flow Characteristics.

 

(2)          Fair value through profit or loss

Category classification criteria

• Financial assets that do not meet the amortised cost criteria
• Financial assets designated at initial recognition. The option to designate is available:
• If doing so eliminates, or significantly reduces, a measurement or recognition inconsistency (i.e. ‘accounting mismatch’).

 

Note: the option to designate is irrevocable.

Subsequent measurement

• Fair value, with all gains and losses recognised in profit or loss

 

 

(3)          Fair value through other comprehensive income

Equity Instruments

Note: Designation at initial recognition is optional and irrevocable.

Category classification criteria

Available only for investments in equity instruments (within the scope of IFRS 9) that are not held for trading.

Subsequent measurement

• Fair value, with all gains and losses recognised in other comprehensive income
• Changes in fair value are not subsequently recycled to profit and loss
• Dividends are recognised in profit or loss.

 

Debt Instruments

Category classification criteria

• meets the SPPI contractual cash flow characteristics test (see box (1)(ii) above)
• Entity holds the instrument to collect contractual cash flows and to sell the financial assets

 

Subsequent measurement

• Fair value, with all gains and losses recognised in other comprehensive income
• Changes in fair value are not subsequently recycled to profit and loss.

 

Scope

The impairment requirements are applied to:

• Financial assets measured at amortised cost (incl. trade receivables)
• Financial assets measured at fair value through OCI
• Loan commitments and financial guarantees contracts where losses are currently accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• Lease receivables.

 

The impairment model follows a three-stage approach based on changes in expected credit losses of a financial instrument that determine

• the recognition of impairment, and
• the recognition of interest revenue.

 

THREE-STAGE APPROACH

Stage 1 –

12 month expected credit losses (gross interest)

• Applicable when no significant increase in credit risk
• Entities continue to recognise 12 month expected losses that are updated at each reporting date
• Presentation of interest on gross basis

 

Stage 2 –

Lifetime expected credit losses (gross interest)

• Applicable in case of significant increase in credit risk
• Recognition of lifetime expected losses
• Presentation of interest on gross basis

 

Stage 3 –

Lifetime expected credit losses (net interest)

• Applicable in case of credit impairment
• Recognition of lifetime expected losses
• Presentation of interest on a net basis

 

PRACTICAL EXPEDIENTS

30 days past due rebuttable presumption

• Rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due
• When payments are 30 days past due, a financial asset is considered to be in stage 2 and lifetime expected credit losses would be recognised
• An entity can rebut this presumption when it has reasonable and supportable information available that demonstrates that even if payments are 30 days or more past due, it does not represent a significant increase in the credit risk of a financial instrument.

 

Low credit risk instruments

• Instruments that have a low risk of default and the counterparties have a strong capacity to repay (e.g. financial instruments that are of investment grade)
• Instruments would remain in stage 1, and only 12 month expected credit losses would be provided.

 

SIMPLIFIED APPROACH

 

Short term trade receivables

• Recognition of only ‘lifetime expected credit losses’ (i.e. stage 2)
• Expected credit losses on trade receivables can be calculated using provision matrix (e.g. geographical region, product type, customer rating, collateral or trade credit insurance, or type of customer)
• Entities will need to adjust the historical provision rates to reflect relevant information about current conditions and reasonable and supportable forecasts about future expectations.

 

Long term trade receivables and lease receivables

Entities have a choice to either apply:

• the three-stage expected credit loss model; or
• the ‘simplified approach’ where only lifetime expected credit losses are recognised.

 

 

LOAN COMMITMENTS AND FINANCIAL GUARANTEES

• The three-stage expected credit loss model also applies to these off balance sheet financial commitments
• An entity considers the expected portion of a loan commitment that will be drawn down within the next 12 months when estimating 12 month expected credit losses (stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life the loan commitment (stage 2)
• For loan commitments that are managed on a collective basis an entity estimates expected credit losses over the period until the entity has the practical ability to withdraw the loan commitment.

 

 

FINANCIAL LIABILTIES - SUBSEQUENT CLASSIFICATION AND MEASUREMENT

 

Financial Liabilities are classified as either: (1) Amortised Cost, (2) Fair value through profit or loss.

In addition, specific guidance exists for:

(i) Financial guarantee contracts, and (ii) Commitments to provide a loan at a below market interest rate

(iii) Financial Liabilities that arise when the transfer of a financial asset either does not qualify for derecognition or where there is continuing involvement.

 

 

(1) Amortised cost

Category classification criteria

All financial liabilities, except those that meet the criteria of (2), (i), and (ii).

Subsequent measurement

• Amortised cost using the effective interest method.

 

(2) Fair value through profit or loss

Category classification criteria

• Financial liabilities held for trading
• Derivative financial liabilities
• Financial liabilities designated at initial recognition The option to designate is available:
• If doing so eliminates, or significantly reduces, a measurement or recognition inconsistency (i.e. ‘accounting mismatch’), or
• If a group of financial liabilities (or financial assets and financial liabilities) is managed, and evaluated, on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally to KMP.

 

Subsequent measurement

• Fair value with all gains and losses being recognised in profit or loss

 

(i) Financial guarantee contracts

(ii) Commitments to provide a loan at a below market interest rate

Subsequent measurement (the higher of either)

(i) The amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets

 

(ii) The amount initially recognised, less (when appropriate) cumulative amortisation recognised in accordance with IAS 18 Revenue.

 

(iii) Financial liabilities resulting from the transfer of a financial asset

(That does not qualify for derecognition)

(Where there is continuing involvement

Financial liability for the consideration received is recognised.

Subsequent measurement

The net carrying amount of the transferred asset and associated liability is measured as either:

• Amortised cost of the rights and obligations retained (if the transferred asset is measured at amortised cost)
• The fair value of the rights and obligations retained by the entity when measured on a stand-alone basis (if the transferred asset is measured at fair value).

 

EMBEDDED DERIVATIVES

Definition and description

Embedded derivatives are components of a hybrid contract (i.e. a contract that also includes a non-derivative host), that causes some (or all) of the contractual cash flows to be modified according to a specified variable (e.g. interest rate, commodity price, foreign exchange rate, index, etc.)

 

Exclusions and exemptions (i.e. not embedded derivatives)

• Non-financial variables that are specific to a party to the contract.
• A derivative, attached to a financial instrument that is contractually transferable independently of that instrument, or, has a different counterparty from that instrument.
• Instead, this is a separate financial instrument.

 

Embedded derivatives are accounted for differently depending on whether they are within a host contract that is a financial asset or a financial liability

 

Embedded derivatives within a financial asset host contract

The embedded derivative is not separated from the host contract

Instead, the whole contract in its entirety is accounted for as a single instrument in accordance with the requirements of IFRS 9.

 

Embedded derivatives within a host contract that is a financial liability

Subject to meeting the adjacent criteria, the embedded derivative is:

• Separated from the host contract

 

• Accounted for as a derivative in accordance with IFRS 9 (i.e. at fair value through profit or loss).

 

Criteria: to separate an embedded derivative

1) Economic characteristics of the embedded derivative and host are not closely related

 

2) An identical instrument (with the same terms) would meet the definition of a derivative, and

 

3) The entire (hybrid) contract is not measured at fair value through profit or loss

 

Host contract (once embedded derivative is separated)

The (non-financial asset) host contract is accounted for in accordance with the appropriate IFRS.

 

TRANSITION

Retrospective application in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, subject to certain exemptions and reliefs (refer section 7.2 of IFRS 9).

 

CRITERIA TO APPLY HEDGE ACCOUNTING (ALL CRITERIA MUST BE MET)

 

(i) Hedging Relationship

Must consist of:

• Eligible hedging instruments
• Eligible hedged items

 

(ii) Designation and Documentation

Must be formalised at the inception of the hedging relationship:

• The hedging relationship
• Risk management strategy and objective for undertaking the hedge
• The hedged item and hedging instrument
• How hedge effectiveness will be assessed.

 

(iii) All three hedge effectiveness requirements met

(a) An economic relationship exists between the hedged item and hedging instrument

(b) Credit risk does not dominate changes in value

(c) The hedge ratio is the is the same for both the:

• Hedging relationship
• Quantity of the hedged item actually hedged, and the quantity of the hedging instrument used to hedge it.

 

ELIGIBLE HEDGING INSTRUMENTS

Only those with from contracts with EXTERNAL parties of the entity (or group), that are:

Derivatives measured at fair value through profit or loss (FVTPL).

Note: this excludes written options unless they are designated as an offset to a purchased option.

Non-derivatives measured at fair value through profit or loss (FVTPL).

Note: this excludes FVTPL financial liabilities where fair value changes resulting from changes in own credit risk are recognised in other comprehensive income (OCI).

Designation: An entity must designate a hedging instrument in full, except for:

• A proportion (e.g. 50%) of the nominal amount an entire hedging instrument (but not part of the fair value change resulting from a portion of the time period that the hedging instrument is outstanding)
• Option contracts: separating the intrinsic value and time value, and designating only the change in intrinsic value
• Forward contract: separating the forward element and spot element, and designating only the change in the spot element.

 

 

ELIGIBLE HEDGED ITEMS

Eligible hedged items are reliably measurable: assets; liabilities; unrecognised firm commitment; highly probable forecast transactions; net investment in a foreign operation. May be a single item, or a group of items (subject to additional criteria - below).