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IASB publishes final version of IFRS 9: Financial Instruments

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Accounting AlertBackground

The International Accounting Standards Board (IASB) has published the final version of IFRS 9: Financial Instruments (IFRS 9) bringing together the classification and measurement, impairment and hedge accounting phases of the IASB's project to replace IAS 39: Financial Instruments: Recognition and Measurement (IAS 39). This version adds a new expected loss impairment model and limited amendments to classification and measurement for financial assets. The Standard supersedes all previous versions of IFRS 9 and is effective for periods beginning on or after 1 January 2018.

Summary of key requirements

Expected loss impairment model

The impairment model in IFRS 9 is based on the concept of providing for expected losses at inception of a contract, except in the case of purchased or originated credit-impaired financial assets, where expected credit losses are incorporated into the effective interest rate.

Scope

The impairment requirements of IFRS 9 apply to a variety of financial instruments, including financial assets measured at amortised cost, financial assets mandatorily measured at fair value through other comprehensive income (FVTOCI), certain loan commitments and financial guarantee contracts, lease receivables and contract assets within the scope of IFRS 15 Revenue from Contracts with Customers.

General Approach

With the exception of purchased or originated credit impaired financial assets (see below), expected credit losses are required to be measured through a loss allowance at an amount equal to:

  • the 12-month expected credit losses (expected credit losses that result from those default events on the financial instrument that are possible within 12 months after the reporting date); or
  • full lifetime expected credit losses (expected credit losses that result from all possible default events over the life of the financial instrument).

A loss allowance for full lifetime expected credit losses is required for a financial instrument if the credit risk of that financial instrument has increased significantly since initial recognition, as well as to contract assets or trade receivables that do not constitute a financing transaction in accordance with IFRS 15.

Additionally, entities can elect an accounting policy to recognise full lifetime expected losses for all contract assets and/or all trade receivables that do constitute a financing transaction in accordance with IFRS 15. The same election is also separately permitted for lease receivables.

For all other financial instruments, expected credit losses are measured at an amount equal to the 12-month expected credit losses.

Significant increase in credit risk

The assessment of whether there has been a significant increase in credit risk is based on an increase in the probability of a default occurring since initial recognition. Where the credit risk of the financial instrument is low (e.g. investment grade) at the reporting date it can be assumed that credit risk on the financial instrument has not increased significantly since initial recognition.

The requirements also contain a rebuttable presumption that the credit risk has increased significantly when contractual payments are more than 30 days past due. Where the increase in credit risk has reversed by a subsequent reporting period then the expected credit losses on the financial instrument revert to being measured based on an amount equal to the 12-month expected credit losses.

Purchased or originated credit-impaired financial assets

Purchased or originated credit-impaired financial assets are treated differently because the asset is credit-impaired at initial recognition. For these assets, the estimated cash flows used to calculate the credit-adjusted effective interest rate at initial recognition incorporate lifetime expected credit losses. Subsequently, any changes in expected losses are recognised as a loss allowance with a corresponding gain or loss recognised in profit or loss.

Credit-impaired financial asset

Under IFRS 9 a financial asset is credit-impaired when one or more events have occurred that have a significant impact on the expected future cash flows of the financial asset. It includes observable data that has come to the attention of the holder of a financial asset such as significant financial difficulty of the issuer or borrower or a breach of contract, such as a default or past-due event.

Basis for estimating expected credit losses

Any measurement of expected credit losses under IFRS 9 shall reflect an unbiased and probability-weighted amount that is determined by evaluating the range of possible outcomes as well as incorporating the time value of money. Also, the entity should consider reasonable and supportable information about past events, current conditions and reasonable and supportable forecasts of future economic conditions when measuring expected credit losses.

To reflect time value, expected losses should be discounted to the reporting date using the effective interest rate of the asset (or an approximation thereof) that was determined at initial recognition. A “credit-adjusted effective interest” rate should be used for expected credit losses of purchased or originated credit-impaired financial assets.  In contrast to the “effective interest rate” (calculated using expected cash flows that ignore expected credit losses), the credit-adjusted effective interest rate reflects expected credit losses of the financial asset.

Presentation

Whilst interest revenue is always required to be presented as a separate line item, it is calculated differently according to the status of the asset with regard to credit impairment. In the case of a financial asset that is not a purchased or originated credit-impaired financial asset and for which there is no objective evidence of impairment at the reporting date, interest revenue is calculated by applying the effective interest rate method to the gross carrying amount.

In the case of a financial asset that is not a purchased or originated credit-impaired financial asset but subsequently has become credit-impaired, interest revenue is calculated by applying the effective interest rate to the amortised cost balance, which comprises the gross carrying amount adjusted for any loss allowance.

In the case of purchased or originated credit-impaired financial assets, interest revenue is always recognised by applying the credit-adjusted effective interest rate to the amortised cost carrying amount.

Limited amendments to classification and measurement of financial assets

Fair value through other comprehensive income (FVTOCI) category

The final version of IFRS 9 introduces a new classification and measurement category of FVTOCI for debt instruments that meet the following two conditions:

  • Business model test: The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.
  • Cash flow characteristics test: 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.

When an asset meets both of these conditions it is required to be measured at FVTOCI unless, on initial recognition, it is designated at fair value through profit or loss to address an accounting mismatch.

For such assets, interest revenue, foreign exchange gains and losses and impairment gains and losses are recognised in profit or loss with other gains or losses (i.e., the difference between those items and the total change in fair value) recognised in other comprehensive income (OCI). Any cumulative gain or loss recorded in OCI would be reclassified to profit or loss on derecognition or dealt with in accordance with specific guidance in the case of reclassifications.

Interest income and impairment gains and losses are recognised and measured in the same manner as for assets measured at amortised cost such that the amount in OCI represents the difference between the amortised cost value and fair value. This results in the same information in profit or loss as if the asset was measured at amortised cost, yet the statement of financial position reflects the instrument’s fair value.

Additional guidance

The final Standard includes additional guidance to assist entities with the classification of financial assets.

 

Effective date

The Standard has a mandatory effective date for annual periods beginning on or after 1 January 2018, with earlier application permitted. The Standard is applied retrospectively with some exceptions (for example most of the hedge accounting requirements apply prospectively) but entities need not restate prior periods in relation to classification and measurement (including impairment).

The final version of IFRS 9 supersedes all previous versions of the Standard. However, for annual periods beginning before 1 January 2018, an entity may elect to apply those earlier versions of IFRS 9 if the entity’s relevant date of initial application is before 1 February 2015.

The New Zealand Accounting Standards Board has yet to consider the final version of the standard for release in New Zealand.

Additional information

IASB website


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