The beginning of the end for IAS 39 - Issue of IFRS 9 regarding Classification and Measurement of Financial Assets
Accounting Alert - November 2009 (Special update)
IFRS 9 Financial Instruments is the first phase of a complete rewrite of accounting standards on financial instruments. The current standards, particularly IAS 39 Financial Instruments: Recognition and Measurement, are considered by many to be overly complex and difficult to apply. The IASB’s project seeks to rectify these difficulties in a “fast-tracked” project. In addition to IFRS 9, the IASB has also recently released an exposure draft out of the second phase of the project covering amortised cost and impairment (refer below), and an exposure draft from the third phase of the project, hedge accounting, is expected by the end of the year.
IFRS 9 Financial Instruments introduces a new classification and measurement regime for financial assets within its scope. As a result of ongoing discussions about measurement of own credit risk when fair valuing financial liabilities, accounting for financial liabilities will continue to be performed under IAS 39 until further amendments are made by the IASB to IFRS 9.
In summary, IFRS 9 proposes that:
- debt instruments meeting both a ‘business model’ test and a ‘cash flow characteristics’ test are measured at amortised cost (the use of fair value is optional in some limited circumstances)
- investments in equity instruments can be designated as ‘fair value through other comprehensive income’ with only dividends being recognised in profit or loss
- all other instruments (including all derivatives) are measured at fair value with changes recognised in the profit or loss
- the concept of ‘embedded derivatives’ does not apply to financial assets within the scope of the Standard and the entire instrument must be classified and
measured in accordance with the above guidelines
- unquoted equity instruments can no longer be measured at cost less impairment (must be at fair value).
The table below provides a high-level summary of some of the key changes introduced by IFRS 9:
|Type of instrument||IAS 39||IFRS 9 impact|
|Investments in equity instruments||Often classified as ‘available for sale’ with gains and some losses deferred in other comprehensive income. Impairment losses recognised in profit or loss.||Measured at fair value with gains/losses recognised in profit or loss, unless designated at fair value through other comprehensive income in which case only dividends recognised in profit or loss|
|Available for sale debt instruments||Recognised at fair value with gains/losses deferred in other comprehensive income. Impairment losses and reversals recognised in profit and loss||May be measured on amortised cost basis if the ‘business model’ and ‘cash flow characteristics’ tests are met, otherwise measured at fair value through profit or loss|
|Convertible instruments||Embedded conversion option bifurcated and separately recognised at fair value, underlying debt instrument may be measured at amortised cost||Entire instrument must be classified and measured. Results in measurement at fair value with gains/losses in the profit or loss|
|Other hybrid debt instruments||Embedded derivatives bifurcated and separately recognised at fair value, underlying debt instrument may be measured at amortised cost||Entire instrument must be classified and measured, will generally result in measurement at fair value with gains/losses in the profit or loss|
|Other financial hosts with embedded derivatives||Bifurcation from underlying instrument in many cases, separately accounted for at fair value with gains/losses in profit or loss||No bifurcation, entire instrument classified and measured. Will often result in entire instrument being measured at fair value through profit or loss|
|Non financial hosts||Bifurcation from underlying instrument in many cases, separately accounted for at fair value with gains/losses in profit or loss||No change. Embedded derivatives must still be bifurcated|
|Listed debt securities||Measured at fair value (unless included in the held-to-maturity category)||Measured at amortised cost if ‘business model’ and ‘cash flow characteristics’ tests are satisfied otherwise measured at fair value through profit or loss|
|Held-to-maturity investments||Measured at amortised cost with a ‘tainting’ test||Must meet ‘business model’ and ‘cash flow characteristics’ tests to be measured at amortised cost, otherwise generally fair value through profit or loss|
|Limited recourse receivables||May be measured at amortised cost||‘Look through’ assessment may result in fair value measurement in some cases|
|Securitisation receivables||May be measured at amortised cost||‘Look through’ assessment may result in fair value measurement|
What are the ‘business model’ and ‘cash flow characteristics’ tests for amortised cost classification
IFRS 9 states that in determining the measurement attribute for a financial asset (i.e., amortised cost or fair value), an entity must use two classification criteria – a business model test and a cash flow characteristics test. If the financial asset satisfies the two classification criteria, the financial asset typically must be measured at amortised cost. An entity may irrevocably elect on initial recognition to designate a financial asset as fair value through profit or loss (FVTPL) if that designation eliminates or significantly reduces an accounting mismatch had the financial asset been measured at amortised cost. This is the so-called “fair value option.”
Business Model Test
The business model test requires an entity to assess whether its business objective for financial assets is to collect the contractual cash flows of the assets rather than realise their fair value change from sale before their contractual maturity. This determination is made at a business unit level and not an individual financial instrument level and therefore is not based on management’s intent for individual instruments.
IFRS 9 acknowledges that an entity may have different business units that are managed differently. For example, an entity may have a retail banking business whose objective is to collect contractual cash flows of loan assets and an investment banking business whose objective is to realise fair value changes through the sale of loan assets before their maturity. Therefore, financial instruments held in the retail banking business that give rise to cash flows that are payments of principal and interest (see Cash Flow Characteristics Test below) may qualify for amortised cost measurement even if similar financial instruments in the investment banking business do not. Note that all instruments that meet the existing held-for-trading definition in IAS 39 will continue to be classified as FVTPL because they are not held to collect the contractual cash flows of the instrument.
Because the assessment under the business model test is performed at the portfolio level and not the financial instrument level, an entity’s business model can be to hold financial assets to collect contractual cash flows even when there are some sales of financial assets. For example, an entity’s conclusion that it holds investments to collect their contractual cash flows is still valid even if the entity sells some of the investments to fund capital expenditures.
Cash Flow Characteristics Test
IFRS 9 requires an entity to assess the contractual cash flow characteristics of a financial asset. The concept is that only instruments with contractual cash flows of principal and interest on principal could qualify for amortised cost measurement. IFRS 9 describes interest as consideration for the time value of money and credit risk associated with the principal outstanding during a specific period. Therefore, an investment in a convertible debt instrument would not qualify because of the inclusion of the conversion option, which is not deemed to represent payments of principal and interest.
The cash flow characteristics criterion is met when the cash flows on a loan are entirely fixed (e.g., a fixed interest rate loan or zero coupon bond), when interest is floating (e.g., when interest is contractually linked to BKBM), or when interest is a combination of fixed and floating (e.g., BKBM plus a fixed spread).
Financial assets that do not meet the above criteria are required to be measured at fair value, including all equity investments, all derivative assets, all trading assets, and those loans, receivables, and debt securities that do not meet the two criteria described above.
Applicable date and transition
IFRS 9 is applicable to annual reporting periods beginning on or after 1 January 2013, but can be early adopted from December 2009 year ends. IFRS 9 is applied on a modified retrospective basis, including permitting certain instruments to be reclassified based on conditions at the date of application. Exemptions from the requirement to restate comparative information are also available for early adopters.
Should I early adopt the Standard?
The impacts of early adoption will depend upon the nature of the financial assets held by the entity and those that might be expected to be held in the period to mandatory adoption in 2013.
Some companies will find the new ‘fair value through other comprehensive income’ category for equity investments quite attractive as it potentially removes some volatility in reported profits by eliminating the requirement to recycle losses to profit or loss where there is a significant or prolonged decline in fair value below cost i.e. fair value gains and losses will always be recognised in other comprehensive income but dividends will continue to be recognised in profit or loss.
Financial institutions and other entities with complex financial asset holdings may find early adoption less attractive due to such requirements for ‘look through’ assessments of certain instruments (e.g. securitisations and limited recourse debt arrangements), the removal of separate accounting for embedded derivatives and so on.
The impact on companies without significant financial assets is likely to be small and early adoption may not offer much improvement on current requirements.
IFRS 9 will continue to be amended as the IASB finalises its proposals on accounting for financial liabilities, hedging, impairment and derecognition. Changes to the existing classification and measurement requirements are likely as a result of the United States Financial Accounting Standards Board concurrent project on financial instruments. Whilst the IASB has tentatively agreed that early adopters of the existing IFRS 9 will not be required to early adopt later additions to IFRS 9, careful consideration of the impacts of early adoption is recommended.
The New Zealand equivalent to IFRS 9 (NZ IFRS 9) has been approved by the FRSB and is expected to be approved by the ASRB shortly. When approved it will be available on the ASRB Recent Approvals page on the NZICA website.
Further information can be found in the Deloitte IAS Plus Newsletter: IFRS 9 Financial Instruments