Introduction
The International Financial Reporting Standard (IFRS) 9 Financial Instruments is a product of an incessant process commenced in November 2008. It replaced the International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement, which was introduced in March 2001. IFRS 9 applies to the classification and measurement of financial instruments, including financial assets, financial liabilities, and some business activities involving purchasing or selling non-financial items that a corporation should apply (IFRS, 2017). Table 1 below summarises the phases of the process involved in the development and enforcement of IFRS 9 along with the corresponding timelines.
Table 1. Phases in the introduction of IFRS 9
The July 2014 issue of the IFRS 9 was the final version of the standard that effectively came into force on or after 1 January 2018, with the IASB allowing for earlier adoption of the regulations. Since then, the IFRS 9 has, on different occasions, been amended through the introduction of new regulations on different reporting components (Loew et al., 2019). Even though there have been numerous amendments, table 2 below indicates the changes that have had a greater impact on the operation of IFRS 9.
Table 2. Amendments to IFRS 9
Key Changes Introduced by IFRS 9 Compared to IAS 39
On classification and measurement of financial assets, IFRS 9 upheld exact measurement bases for financial assets as IAS 39. However, it introduced fresh provisions for debt instruments requiring classification to be on the basis of the business model for which the asset is held. On impairment, IFRS 9 introduced fresh impairment provisions to contain the critique that for the period of the GFC, accounting for credit losses on financial assets was unexpected (ICAS, 2018). Therefore, IFRS 9 introduced a shift from the ‘incurred’ loss framework to the ‘expected’ loss model. The new approach provides greater information based on available data, historical losses, and ‘reasonable and supportable’ forward-looking information. IFRS 9 further introduced provisions requiring that the share of fair value changes depicted by shifts in own credit risk be accounted for in other comprehensive income (OCI) in place of profit or loss.
In addition, IFRS 9 introduced comprehensive changes in hedge accounting that is considered difficult in terms of understanding and application. The IASB established a model closely related to an entity’s own risk management method but defined a qualifying criterion on hedged items and hedging instruments. The new approach provides an improved strategy to representing underlying hedging actions (Ayariga, 2020). It also provides better disclosures to the users of the information on the impact of an entity’s risk management actions.
Classification of Financial Assets under IFRS 9
Financial assets entails contractual agreements in which interested parties agree to buy or sell an underlying asset contract and an invoice that will generate a cash flow. It involves both tangible and intangible items, production factors under the rule of supply and demand, along with an allowable level of risk in their value. The first publication of IFRS 9, in November 2009, the IASB was informed by the desire to eliminate the IAS 39 complicatedness in accounting for financial assets. The IASB introduces just two classifications of financial assets: under amortized cost and fair value. However, this development was sharply opposed as it failed to cater to the way a lot of financial entities organize their financial assets. This was amended by introducing a third category in the final version of IFRS 9 which was released in July 2014 (Spencer, n.d.). The three categories recognized by the regulations are amortized cost, fair value through other comprehensive income (FVTOCI), and fair value through profit or loss (FVTPL).
Business Model
Under IFRS 9, the categorization of financial assets is grounded on two main criteria: the business model test and the Solely Payments of Principal and Interest (SPPI) test. Therefore, it is important that an entity first establishes the business model within which a financial asset is attached so as to be able to specify the applicable classification under IFRS 9. A business model describes the mode of management of financial assets in an entity in order to yield cash flows. The IFRS 9 regulations establish three categories of business models: ‘hold to collect’, ‘hold to collect and sell’ and ‘other’. Characteristically, an entity is supposed to operate by just one business model, but it is practical to employ more than one (Ayariga, 2020). This depends on the objectives of each business model and the actions undertaken, along with the consideration of all applicable information.
Under the ‘hold to collect’ business model, an entity aims to hold financial assets mainly to benefit from their contractual cash flows rather than trading in the assets to generate cash flows. IFRS 9 does not require that an entity holds a financial asset until it matures. On the contrary, IAS 39 imposed penalties on entities that disposed of assets before maturity apart from sales in all but selected cases (Ayariga, 2020). In addition, IFRS 9 recognizes some sales that are deemed invariant to the ‘hold to collect’ business model, notwithstanding their regularity and prominence. Besides, IFRS 9 requires that it is just the financial assets that fulfill the SPPI test and are carried in a ‘hold to collect’ business model that can be classified at amortized cost.
Businesses that can be classified under the ‘hold to collect and sell’ business model aim to benefit from collecting contractual cash flows as well as selling financial asset. Since sales are part of the business, it attracts a higher frequency and number of sales. The IFRS 9 stipulates that financial assets under this business model must meet the SPPI test and can be estimated at fair value through other comprehensive income for debt.
The last business model, ‘other’, encompasses all financial assets that do not satisfy the ‘hold to collect’ or ‘hold to collect and sell’ measures. Examples include business models aimed at realizing cash flows through sales whereby contractual cash flows are incidentally realized. It also covers business models where financial assets are operated and performance is assessed on a fair value basis (Spencer, n.d.). All non-equity financial assets falling into ‘other’ business models must be classified at fair value through profit or loss, irrespective of whether the SPPI test is passed.
Initial Recognition
The IFRS 9 indicates that the initial recognition of a financial asset entails its fair value plus transaction fees. This applies if it is not recognized FVTPL, in which case the transaction fees are forthwith expensed. However, this rule does not apply in the case of trade receivables with no notable financing element (Lin et al., 2019). They should be initially recognized at the transaction cost. The regulation further dictates that when deciding how a financial asset should be measured after initial recognition, an entity must first establish whether the possession is an equity or non-equity instrument.
Subsequent Measurement
In the case a financial asset is categorized as an equity instrument, IFRS 9 states that it be recognized using the FVTPL. If the equity instrument is not held for trading and an irrevocable decision is made at initial obtainment, it is measured at FVTOCI. If a financial asset is defined as a non-equity instrument, such as a debt in the instrument is measured at amortized cost or FVTOCI. The amortized cost measurement applies if the asset meets the contractual cash flow characteristics test along with the ‘hold to collect’ business model test (Lin et al., 2019). The FVTOCI applies for an asset that satisfies the contractual cash flow characteristics test along with the ‘hold to collect and sell’ business model test. Finally, the FVTPL measure applies to assets not covered under amortized cost and FVTOCI.
Classification of Financial Liabilities
Business Model
Even as IFRS 9 introduced notable changes to IAS 39 in the accounting for financial assets, it did not significantly vary the accounting of financial liabilities. The two classifications of financial liabilities under IAS 39 were upheld, that is amortized cost and FVTPL (Loew et al., 2019). If a financial liability is not classified under amortized cost, then it has to be captured under FVTPL.
Initial Recognition and Subsequent Measurement
Financial liabilities at amortized cost are initially recognized at fair value minus the transaction fees and are subsequently carried at amortized cost utilizing the effective interest method. On the other hand, financial liabilities at FVTPL are initially recognized at fair value and are subsequently carried at fair value (IFRS, 2017). This is summarized in table 3 below.
Table 3. Initial Recognition and Subsequent Measurement of Financial Liabilities
Practical Illustration
Consider that company A holds bonds issued by third parties bearing interest at a fixed coupon. The bonds are accounted for at FVTPL since they are regulated on a fair-value basis. Company A has also issued bonds in the same currency as the bonds held and also pays interest at a fixed coupon. The bonds issued by the company are not held for trading and would generally be recognized at amortized cost. The company directors contemplate the bonds issued to procure a natural hedge of the entity’s exposure to shifts in the fair value of the bonds held. Then company A may elect to account for the issued bonds as at FVTPL so as to minimize the accounting mismatch that would contrarily arise if different measurement bases of the bonds are used.
Hedge Accounting According to IFRS 9
Hedge accounting depicts the effect of a firm’s risk management actions that employ financial instruments to control possible vulnerabilities due to certain obstacles that could impact the profit/loss or other comprehensive income (Lin et al., 2017). The lack of defined regulations for hedge accounting can derail the operation of many risk management strategies causing accounting mismatches. This is because varied accounting rules may apply to assets or liabilities that form a hedging connection, such as inventory items assessed at cost and derivatives evaluated at fair value.
IFRS 9 introduced improvements to the IAS 39 to enhance the decision-usefulness of financial statements. This involved introducing key changes by withdrawing or modifying some of the main prohibitions and regulations within IAS 39. IFRS 9 places more power on an entity’s risk management strategies, thus improving hedge accounting. The regulations create room for more flexibility, such that corporations introduce hedge accounting to areas not previously covered (Ayariga, 2020). It also introduced a window for company treasurers and committees to assess their existing hedging strategies and accounting, and to condor on their effectiveness in the contemporary accounting framework. IFRS 9 upheld the three main categories of hedge accounting as previously defined under IAS 39.
Fair Value Hedge
A fair value hedge seeks to protect an entity against the risk of variations in the fair value of a key asset or liability or of a disregarded firm obligation attributable to some risk. According to Spencer (n.d.) IFRS 9 introduced a slight change to IAS 39 requiring that fair value hedges of an equity instrument accounted for at FVOCI; any realized gain or loss is not indicated in the profit and loss statement but rather it is acknowledged under the OCI.
Cash Flow Hedge
A cash flow hedge seeks to protect an entity against the risk of variations in the cash flows of a key asset or liability or of a future transaction that is exposed to a particular risk, which can affect the firm’s profit or loss (ICAS, 2018). IFRS 9 improved on the provisions under IAS 39 by abolishing and adding new regulations on forecasted transactions, net positions, and offsetting risk.
Net Investment Hedge
The net investment hedge seeks to protect an entity against the risk of fluctuations in the value of its net investment in foreign activities that could be caused by shifts in foreign exchange rates between an investor’s currency and a foreign currency (ICAS, 2018). Overseas operations may be in the form of joint ventures, subsidiaries, branches, or associates. IFRS 9 did not introduce any changes to this type of hedging.
Qualifying Criteria
IFRS 9 places the goal of hedge accounting to be at the core of an entity’s risk management strategy. Nonetheless, hedge accounting is not regarded as an integral part of the typical accounting rules. In light of this, IFRS 9 has imposed a few conditions that help to define whether or not a designated hedging connection qualifies for accounting (Loew et al., 2019). Consequently, only a firm that meets the prescribed qualifying criteria, as indicated in table 4 below, is permitted to apply hedge accounting.
Table 4. IFRS 9 Hedge Accounting Qualifying Criteria
Impairment of Financial Assets According to IFRS 9
Impairment of losses under IFRS 9 is carried out on a forward-looking basis. This implies that impairment loss is accounted for ahead of the adventure of any credit event. Such an occurrence is defined under IFRS 9 as expected credit loss (ECL). As a general, the ECL approach under IFRS 9 applies to assets measured at FVOCI with recycling, assets measured at amortized cost, lease receivables, loan commitments (not at FVTPL), and contract assets (IFRS, 2017). Furthermore, the IFRS 9 sets out three main techniques for impairment, that is the general method, the specific technique for acquired or originated credit-impaired financial assets, and the simplified technique or credit-adjusted approach for specific trade receivables, lease receivables, and contract assets.
The general approach involves three main stages, hence the name three-stage model. Under this approach, IFRS 9 requires that the entity accounts for all expected credit losses regardless of whether they are lifetime ECL or 12-month ECL, relying on whether there was a considerable rise in credit risk. IFRS 9 introduced the simplified approach to cater to entities having less complicated credit risk management procedures. The entities are not required to track changes in the credit risk of financial assets, but they have to account for lifetime ECL from the period of initial recognition of a financial asset (Lin et al., 2017). Lastly, under the credit-adjusted approach, IFRS 9 requires that an establishment must recognize just the incremental changes in lifetime ECL from the initial recognition of such a possession.
Expected Credit Loss According to IFRS 9
Credit loss is defined by the variation between all contractual cash flows that are unpaid to an entity according to the agreement and all the cash flows that the corporation anticipates obtaining, which are discounted at the credit-adjusted effective interest rate (EIR) or the original EIR (Ayariga, 2020). The following considerations are factored in when estimating cash flows for ECL measurement.
- Collateral held.
- Contractual terms of the financial instrument, such as call, extension, prepayment, and similar alternatives.
- The expected life of a financial instrument.
- Additional credit enhancements are essential to the contractual terms.
Conclusion
The 2008 GFC uncovered a lot of difficulties financial entities had been battling in reporting on financial instruments under IAS 39. In recognizing these concerns, the IASB immediately commenced the process of containing the challenges by improving IAS 39. The project was undertaken in phases commencing in 2009, leading to a final release of the IFRS 9 in November 2014 with an effective application date of 1 January 2018. The new standard introduced changes touching on the classification and measurement of financial assets and financial liabilities. IFRS 9 also introduced new provisions on impairment and hedge accounting with the aim of enhancing reporting.
References
Ayariga, C. (2020). IAS 39 and IFRS 9: Effects of changing accounting standards for financial instruments on the financial asset management of commercial banks in the Sekondi-Takoradi metropolis of Ghana. International Journal of Accounting and Financial Reporting, 10(1), 58.
IFRS. (2017). Ifrs.org.
IFRS 9 explained – the classification of financial assets. (n.d.). Www.bdo.co.uk.
ICAS (2018). How will IFRS 9 change accounting for financial instruments? ICAS.com.
Loew, E., Schmidt, L. E., & Thiel, L. F. (2019). Accounting for financial instruments under IFRS 9 – First-time application effects on European banks’ balance sheets. SSRN Electronic Journal.
Lin, S. W. J., & Wang, C. (John). (2017). Relative effects of IFRS adoption and IFRS convergence on financial statement comparability. SSRN Electronic Journal.
Spencer, M. (n.d.). IFRS 9 Financial instruments. www.bdo.co.uk.