IFRS 9 Financial Instruments

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IFRS 9 Financial Instruments – The rules on financial instruments are set out in three accounting standards: IFRS 9 Financial Instruments, IAS 32 and IAS 7
IFRS 9 Financial Instruments

Overview

IFRS 9 Financial Instruments – The rules on financial instruments are set out in three accounting standards: IFRS 9 Financial Instruments, IAS 32 Financial instruments: Presentation, IFRS 7 Financial instruments: Disclosure. IFRS 9 applies to all financial assets and liabilities except for those specifically scoped out of the standard. These IFRS 9 summary notes are prepared by mindmaplab team and covering, IFRS 9 revised amendment, the key definitions, full standard with illustrative examples, the sppi test, IFRS 9 impairment, expected credit loss (ecl) IFRS 9, lifetime ecl, hedge accounting, expected credit loss, impairment of financial assets, poci IFRS 9, financial assets at amortized cost, sicr IFRS 9, compound financial instruments IFRS 9 with IFRS 9 disclosure requirements. This IFRS 9 is a guide for dummies as well as for professionals. This is the IFRS 9 full text guide; we have also prepared IFRS 9 pdf version download.

Introduction to Financial Instruments

The rules on financial instruments are set out in three accounting standards:

  1. IFRS 9 Financial Instruments
  2. IAS 32 Financial instruments: Presentation
  3. IFRS 7 Financial instruments: Disclosure

IFRS 9 applies to all financial assets and liabilities except for those specifically scoped out of the standard.

Examples of scope exclusions are:

  • investment in a subsidiary
  • lease receivables
  • entity’s own equity
  • Financial guarantees are accounted for (as a financial liability) under IFRS 9 unless the entity has “previously asserted explicitly” that it regards such contracts as insurance contracts. In this case the entity can elect to apply IFRS 4: Insurance Contracts or IFRS 9 on a contract by contract basis.
  • Contracts to buy or sell non-financial items are not financial assets or liabilities.

* If the contract can be net settled it is within the scope of the standard.

IFRS 9 defines net settlement very widely with the result that many derivatives on non-financial items are within the scope of the standard. Thus IFRS 9 says that a contract is net settled in either of the following circumstances:

  1. when the ability to net settle is not explicit in the terms of the contract, but the entity has a practice of net settling similar contracts;
  2. when an entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin.
  3. when the terms of the contract permit either party to settle it net; or
  4. when the non-financial item that is the subject of the contract is readily convertible to cash.

Definitions

Financial Instrument – A financial instrument is a contract that gives rise to both:

  • a financial asset in one entity, and
  • a financial liability or equity instrument in another entity.

Financial Asset – A financial asset is any asset that is:

  • cash;
  • an equity instrument of another entity;
  • a contractual right – to receive cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity.

Financial Liability – A financial liability is any liability that is a contractual obligation:

  • to deliver cash or another financial asset to another entity; or
  • to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.

Amortised cost – The amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount and, for financial assets, adjusted for any loss allowance.

Credit loss – The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate.

Lifetime expected credit losses – The expected credit losses that result from all possible default events over the expected life of a financial instrument.

12-month expected credit losses – The portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.

Derivatives

A derivative is a financial instrument with all three of the following characteristics:

  1. Its value changes in response to a specified underlying (interest rate, commodity price, exchange rate etc.); and
  2. It requires no or little initial investment; and
  3. It is settled at a future date.

Categories of derivatives

Derivatives can be classified into two broad categories:

  1. Forward arrangements (commit parties to a course of action)
    • Forward contracts
    • Futures
    • Swaps
  2. Options (Gives the option buyer a choice over whether or not to exercise his rights under the contract).

Forward arrangements

Forward contracts

A forward contract is a contract to buy or sell a specified amount of a specified item (commodity or financial item) on a specified date at a specified price. it has zero fair value at the date it is entered into. Over the life of the contract its fair value will depend on the spot exchange rates and the time to the end of the contract.

Futures

They can be traded. A company can enter into a futures contract and then may make a gain or a loss on the market just like any other traded item. If a company holds futures, they might be an asset or a liability at any particular date.

Swaps

A swap is an agreement between parties to exchange cash flows related to an underlying obligation. The most common type of swap is an interest rate swap. A swap might be recorded as an asset or liability at any particular date.

Options

The holder of the option has entered into a contract that gives it the right but not the obligation to buy (call option) or sell (put option) a specified amount of a specified commodity at a specified price.

Holding an option is therefore similar to an insurance policy: it is exercised if the market price moves adversely.

The option holder is required to pay a sum of money (a premium) to the option seller. This premium is paid when the option is arranged, and non-refundable if the holder later decides not to exercise his rights under the option.

From the point of view of the holder the option will only ever be recorded as an asset. At initial recognition this would be the amount of the premium.

Using derivatives

A company can enter into a transaction involving a derivative for one of two reasons:

  1. to speculate, and hope to make a profit from favourable movements in rates or prices; or
  2. to hedge (protect) against exposure to a particular risk.

*Speculating in derivatives may expose entities to huge risks, if expectations do not come true and the price of the underlying item moves the ‘wrong way’.

Initial recognition and measurement of financial instruments

A financial instrument should initially be measured at fair value. This is usually the transaction price. If the transaction price differs from the fair value a gain or loss would be recognised on initial recognition.

Transaction costs – Incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. The accounting treatment for transaction costs depends on how the instrument is subsequently measured.

IFRS 9 accounting treatment for transaction costs

Financial instruments measurement methods

The two measurement methods required by IFRS 9 are:

  1. Amortised cost
  2. Fair value

Amortised cost method

Amortised cost is a measurement technique that can be applied to both financial assets and financial liabilities.

IFRS 9 specifies that interest (to be recognised in profit and loss each year) should be calculated using the effective rate, which is calculated on initial recognition. Therefore, the amortised cost as calculated at each period end is always the present value of the future cash flows discounted at the effective rate.

Amortisation table of a financial liability (from the borrower’s viewpoint):

IFRS 9 Amortisation table of a financial liability (from the borrower viewpoint)

Amortisation table of a financial asset (from the lender’s viewpoint):

IFRS 9 Amortisation table of a financial asset (from the lender’s viewpoint)

*The only difference is the naming of the balances (amortised cost for financial liabilities and gross carrying amount for financial assets).

The final carrying amount for a financial asset carried at amortised cost is in fact made up of two balances being the gross carrying amount of the financial asset less the loss allowance.

The lender would show the following amounts in its financial statements at each year end (where figures for a loss allowance have been made up):

IFRS 9 loss allowance

* The recognition of a loss allowance results in a lower value in the books of the lender to that in the books of the borrower for the same instrument.

Amortised cost and credit-impaired assets

An entity might purchase or issue a credit-impaired financial asset. A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred.

Such financial assets might need to be carried at amortised cost.

Fair value

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 (i.e. it is an exit price).

IFRS 13 defines an active market as a market in which transactions for the asset (liability) take place with sufficient frequency and volume to provide pricing information on an on-going basis.

Valuation techniques

IFRS 13 requires that one of three valuation techniques must be used:

  1. market approach
  2. cost approach
  3. income approach

*Quoted price in an active market provides the most reliable evidence of fair value and must be used to measure fair value whenever available.

Classification and measurement of financial assets

Financial assets must be classified into one of three categories on initial recognition. This classification of a financial asset drives its subsequent measurement. The three categories are:

  1. financial assets at amortised cost;
  2. financial assets at fair value with gains and losses recognised in other comprehensive income (described as fair value through OCI or FVOCI); or
  3. financial assets at fair value with gains and losses recognised in profit or loss (described as fair value through P&L or FVPL).

The classification is based on an assessment of the business model followed for holding the financial asset and the cash flow characteristics of the asset.

Reclassification

Reclassification of financial assets after initial recognition is required when an entity changes its model for managing financial assets. It is not allowed in any other circumstance.

Financial assets at amortised cost

A financial asset is measured at amortised cost if both of the following conditions are met:

  1. the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows; and
  2. 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.

Financial assets at fair value through OCI (FVOCI)

A financial asset is measured at fair value through OCI if both of the following conditions are met:

  1. the asset is held within a business model whose objective is achieved by both holding and collecting contractual cash flows and selling the financial assets; and
  2. 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.

Disposal of financial assets measured at fair value through OCI

A financial asset in this category might be sold. When this occurs, the accumulated gain or loss previously recognised in OCI in respect of the asset is reclassified to P&L.

(Note that this only applies to financial assets that are debt instruments. It does not apply to those investments in equity in respect of which an entity has made an irrevocable decision to measure at fair value through OCI).

Financial assets at fair value through P&L (FVPL)

All other financial assets must be measured at fair value through P&L.

Subsequent measurement of financial assets at fair value through other comprehensive income

  • Only the fair value movement is recognised in other comprehensive income. Interest income, foreign exchange gains and losses and impairment are recognised in profit or loss.
  • The fair value adjustment in OCI will always be the accumulated difference between the fair value and the amortised cost of the bond at the year end.

Irrevocable designations

On initial recognition of a financial asset that would otherwise be measured at amortised cost or at fair value through OCI a company can make an irrevocable decision to designate them as at fair value through P&L.

Investments in equity instruments are measured at fair value through P&L.

Overview of classification of financial assets

IFRS 9 classification of financial assets

Interaction of IFRS 9 and IAS 21

Debt instruments are monetary items.

IAS 21 requires the retranslation of foreign currency monetary items to the closing rate at each reporting date. Any exchange difference arising is recognised in the statement of profit or loss.

Classification and measurement of financial liabilities

All financial liabilities are classified (on initial recognition) as subsequently measured at amortised cost with specific exceptions including:

  • Derivatives that are liabilities at the reporting date; and
  • Financial liabilities that might arise when a financial asset is transferred but this transfer does not satisfy the derecognition criteria.

Reclassification of a financial liability after initial recognition is not allowed.

Irrevocable designation

A company is allowed to designate a financial liability as measured at fair value through profit or loss. This designation is irrevocable and can only be made if:

  • it eliminates or significantly reduces a measurement or recognition inconsistency; or
  • this would allow the company to reflect a documented risk management strategy.

Where this designation is used, the part of the change in fair value due to a change in the entity’s own credit risk must be recognised in other comprehensive income.

Financial guarantee contracts

A financial guarantee within the scope of IFRS 9 is a financial liability. It is initially measured at its fair value. At subsequent reporting dates it is measured at the higher of:

  1. the amount of the loss allowance; or
  2. the amount initially recognised (amortised to recognise income in accordance with IFRS 15: Revenue from Contracts with Customers if appropriate).

Impairment of financial assets

Impairment of most non-current assets is covered by IAS 36. IAS 36 operates an incurred loss model.

Impairment of financial instruments is dealt with by IFRS 9. IFRS 9 contains an expected loss model.

  • The expected loss model applies to all debt instruments (loans, receivables etc.) recorded at amortised cost or at fair value through OCI. It also applies to lease receivables (IFRS 16) and contract assets (IFRS 15).
  • The aim of the expected loss model is that financial statements should reflect the deterioration or improvement in the credit quality of financial assets held by an entity. This is achieved by recognising amounts for the expected credit loss associated with financial assets.

General approach

This approach must be applied to financial assets measured at amortised cost and financial assets measured at fair value through OCI. Any impairment losses on financial assets measured at fair value through profit and loss are automatically recognised in profit or loss.

For those financial assets to which the general approach applies, a loss allowance measured as the 12-month expected credit losses is recognised at initial recognition.

The expected credit loss associated with the financial asset is then reviewed at each subsequent reporting date and remeasured as necessary.

  • If there is no significant increase in credit risk the loss allowance for that asset is remeasured to the 12-month expected credit loss as at that date.
  • If there is a significant increase in credit risk the loss allowance for that asset is remeasured to the lifetime expected credit losses as at that date. This does not mean that the financial asset is impaired. The entity still hopes to collect amounts due but the possibility of a loss event has increased.
  • If there is credit impairment, the financial asset is written down to its estimated recoverable amount. The entity accepts that not all contractual cash flows will be collected and the asset is impaired.

Basis for estimating credit losses

Credit loss is measured as the present value of the difference between:

  • the contractual cash flows that are due to an entity under the contract; and
  • the cash flows that the entity expects to receive.

Expected credit losses are a probability-weighted estimate of credit losses (i.e. the present value of all cash shortfalls) over the expected life of the financial instrument.

A cash shortfall is the difference between the cash flows that are due in accordance with a contract and the cash flows that an entity expects to receive.

Credit loss can arise even if the entity expects to be paid in full later than when contractually due.

Determining significant increases in credit risk

At each reporting date, an assessment is needed about whether the credit risk on a financial instrument has increased significantly since initial recognition.

This assessment compares the risk of a default occurring as at the reporting date with the risk of a default occurring as at the date of initial recognition.

Accounting for the loss allowance: financial assets at amortised cost

The movement on the loss allowance is recognised in profit or loss.

The loss allowance balance is netted against the financial asset to which it relates on the face of the statement of financial position.

The loss allowance does not affect the recognition of interest revenue. Interest revenue is calculated on the gross carrying amount (i.e. without adjustment for credit losses).

Accounting for the loss allowance: financial assets at FVOCI

There is no separate loss allowance account for financial assets at fair value through OCI. Any impairment on these assets is automatically recognised in OCI as part of the fair value adjustment.

A second double entry is then made to recognise the movement in the loss allowance in profit or loss with the other side of the entry in OCI.

Credit impairment

A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired include (but is not limited to) observable data about the following events:

  • significant financial difficulty of the issuer or the borrower;
  • a breach of contract, such as a default or past due event;
  • the lender has granted to the borrower a concession for economic or contractual reasons relating to the borrower’s financial difficulty that the lender would not otherwise have considered:
  • it is becoming probable that the borrower will enter bankruptcy or other financial reorganisation;
  • the disappearance of an active market for that financial asset because of financial difficulties; or
  • the purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses.

A financial asset might become credit impaired after initial recognition. If an entity revises its estimates of receipts it must adjust the gross carrying amount of the financial asset to reflect actual and revised estimated contractual cash flows. The financial asset must be remeasured to the present value of estimated future cash flows from the asset discounted at the original effective rate.

Future revenue recognition

Interest is recognised in the future by applying the effective rate to the new amortised cost (after the recognition of the impairment loss).

Impairment loss double entry

The impairment loss is charged to profit or loss taking into account the balance on the loss allowance account already recognised for the asset.

Other issues

Embedded derivatives

A non-derivative contract might include terms that cause some of its cash flows to behave in the same way as those of a derivative. Such a contract is described as being a hybrid. A hybrid is made up of two components, a host and an embedded derivative.

It may be necessary to separate the embedded derivative from its host and account for each separately. The result is that the embedded derivative would be measured at fair value though profit and loss.

Whether an embedded derivative is separated, depends on whether its host is an asset within the scope of IFRS 9, and if not, whether certain criteria are met.

Hosts which are financial assets within the scope of IFRS 9

An embedded derivative embedded in a financial asset host that is within the scope of IFRS 9 is not separated. The normal rules of classification and accounting would apply to such a contract.

Other hybrid contracts (financial assets outside the scope of IFRS 9 and financial liabilities)

If a hybrid contract contains a host that is not an asset within the scope of IFRS 9, an embedded derivative must be separated from the host and accounted for as a derivative if, and only if:

  1. the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host
  2. a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
  3. the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

When these conditions are met, the embedded derivative is separated from the host contract and accounted for like any other derivative. The host contract is accounted for in accordance with the relevant accounting standard, separately from the derivative.

Derecognition of Financial instruments

Derecognition of a financial liability

A financial liability (or a part of a financial liability) is derecognised when, and only when, it is extinguished. This is when the obligation specified in the contract is discharged or cancelled or expires.

Derecognition of a financial asset

A financial asset is derecognised if one of three combinations of circumstances occur:

  • The contractual rights to the cash flows from the financial asset expire; or
  • The financial asset is transferred and substantially all of the risks and rewards of ownership pass to the transferee; or
  • The financial asset is transferred, substantially all of the risks and rewards of ownership are neither transferred nor retained but control of the asset has been lost.

Most transactions being considered involve the receipt of cash.

  • Transactions where the asset is derecognised may lead to the recognition of a profit or loss on disposal.
  • Transactions where the asset is not derecognised lead to the recognition of a liability for the cash received.

Reclassification of financial assets

Financial liabilities cannot be reclassified.

Generally, financial assets should not be reclassified. However, it might be necessary to reclassify a financial asset when an entity changes its business model.

Reclassification applies prospectively from the reclassification date. Previously recognised gains, losses etc. are not restated as a result of the reclassification.

Hedge accounting

Hedging is the process of entering into a transaction in order to reduce risk. Companies may use derivatives to establish ‘positions’, so that gains or losses from holding the position in derivatives will offset losses or gains on the related item that is being hedged.

The logic of accounting for hedging should be that if a position is hedged, gains (or losses) on the hedged position that are reported in profit and loss should be offset by matching losses (or gains) on the hedging position in derivatives also reported in profit or loss.

IFRS 9 only allows hedge accounting when certain conditions are satisfied.

Hedged item

A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation.

  • The hedged item can be a single item or a group of items (subject to certain conditions).
  • A hedged item can also be a component of such an item or group of items.

Only the following types of components (including combinations) may be designated as hedged items:

  • changes in the cash flows or fair value of an item attributable to a specific risk or risks (risk component) as long as the risk component is separately identifiable and reliably measurable;
  • one or more selected contractual cash flows; or
  • components of a nominal amount, i.e. a specified part of the amount of an item.

Hedged item limitations

Hedge accounting can be applied to transactions between entities in the same group only in the individual or separate financial statements of those entities but not in the consolidated financial statements of the group.

Hedging instrument

The following instruments may be designated as a hedging instrument:

  • A derivative measured at fair value through profit or loss (except for some written options);
  • A non-derivative financial asset measured at fair value through profit or loss;
  • A non-derivative financial liability measured at fair value through profit or loss
  • the foreign currency risk component of a non-derivative financial instrument

Qualifying criteria for hedge accounting

Hedge accounting can only be used where all of the following criteria are met:

  • the hedging relationship consists only of eligible hedging instruments and eligible hedged items.
  • at the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
  • 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 economic relationship; and

Hedge accounting is allowed but not required. Where the conditions for using hedge accounting are met, the method of hedge accounting to be used depends on the type of hedge. IFRS 9 identifies three types of hedging relationship:

  1. fair value hedge
  2. cash flow hedge
  3. hedge of a net investment in a foreign entity (accounted for as a cash flow hedge).

Fair value hedge

A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss

Accounting treatment of fair value hedges

Accounting for a fair value hedge is as follows:

  • The gain or loss on the hedging instrument (the derivative) is taken to profit or loss, as normal.
  • The carrying amount of the hedged item is adjusted by the loss or gain on the hedged item attributable to the hedged risk with the other side of the entry recognised in profit or loss.

Financial asset measured at fair value through other comprehensive income

A financial asset measured at fair value through other comprehensive income would (of course) normally result in the recognition of the full fair value change in OCI. If such an asset is a hedged item in a relationship that qualifies for fair value hedge accounting, that part of the value change due to the hedged risk is recognised in profit or loss.

Exception

IFRS 9 allows an entity to may make an irrevocable election at initial recognition for an investment in equity instruments that would otherwise be measured at fair value through profit or loss to be measured at fair value through other comprehensive income.

If such an asset is a hedged item the fair value hedge accounting rules are different and are as follows:

  • The gain or loss on the hedging instrument (the derivative) is taken to OCI.
  • The fair value difference on the hedged item (which would include that part attributable to the hedged risk) is recognised in OCI in the usual way.

Hedge of a firm commitment

Firm commitments are not recognised but may be hedged. For fair value hedges of firm commitments, the gain or loss attributable to the hedged risk is recognised as an asset or liability in its own right.

A hedged item may be a firm commitment to acquire an asset (or to assume a liability). In such a case carrying amount of an asset (or liability) that results from the firm commitment being met is adjusted to include the cumulative change in the fair value of the hedged item recognised in the statement of financial position.

Cash flow hedge

A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction, and could affect profit or loss.

Hedges relating to future cash flows from interest payments or foreign exchange receipts are common cash flow hedges.

Accounting treatment of cash flow hedges

Accounting for a cash flow hedge is as follows:

  • The change in the fair value of the hedging instrument is analysed into ‘effective’ and ‘ineffective’ elements.
  • The ‘effective’ portion is recognised in other comprehensive income (and accumulated as a reserve in equity).
  • The ‘ineffective’ portion is recognised in profit or loss.
  • The amount recognised in other comprehensive income is subsequently released to the profit or loss as a reclassification adjustment in the same period as the hedged forecast cash flows affect profit or loss.

Cash flow hedge – Basis adjustment

A cash flow hedged transaction might be the future purchase of a non-financial asset.

IFRS 9 says that if a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability (or a hedged forecast transaction for a non-financial asset or a non-financial liability becomes a firm commitment for which fair value hedge accounting is applied), the amount held in the cash flow hedge reserve is included directly in the initial cost of the asset or the liability. This is known as a basis adjustment.

A basis adjustment is required for hedges of non-financial assets and liabilities but is not allowed for hedges of financial assets and liabilities.

Hedges of a net investment in a foreign operation

The net assets of the foreign subsidiary are translated at the end of each financial year, and any foreign exchange differences are recognised in other comprehensive income (until the foreign subsidiary is disposed of, when the cumulative profit or loss is then reclassified from ‘equity’ to profit or loss).

IFRS 9 allows hedge accounting for an investment in a foreign subsidiary. An entity may designate an eligible hedging instrument for a net investment in a foreign subsidiary, provided that the hedging instrument is equal to or less than the value of the net assets in the foreign subsidiary.