IFRS 9 – July 2014 version replaces all earlier versions of IFRS 9 viz., IFRS 9 (2009), IFRS 9 (2010) and IFRS 9 (2013). The good news is that the project is complete. The final version encompasses classification and measurement, new impairment model, revised hedge accounting aspects and replaces IAS 39: Financial Instruments, Recognition & Measurement. Accounting for dynamic risk management is considered as a separate project from IFRS 9 and is still pending.
Salient features of this revised, updated and final IFRS 9 standard that is effective for annual periods beginning on or after 1-Jan-2018 are as follows:
- Logical single classification and measurement approach for financial assets that reflects the business model of the entity;
- Forward-looking expected credit loss model;
- Own credit gains and losses presented in OCI for FVO liabilities instead of recognizing the same in profit or loss. This removes the counter-intuitive paradox of entities booking gains when the value of their own debt falls due to decrease in their own credit worthiness;
- Improved hedge accounting model that reflects the economics of risk management while accounting for the same.
It is disheartening to note that IASB and FASB, being the officially recognized standard setting bodies on both sides of the Atlantic were unable to see eye to eye while finalizing the proposals for impairment model while drafting the standards for financial instruments.
IFRS 9 emerges as a principle based standard where the classification is based on business model and nature of cash flows as opposed to intention and ability to hold which were the bases for classification in the earlier IAS 39 standard. Also IFRS 9 simplifies the reclassification process which again is closely tied to the business model rather than the complicated rule-based reclassification provisions.
- Classification & measurement: Under the new requirements debt instruments can only be measured at fair value through OCI if they are held in a particular business model. That is different to the available-for-sale category today, which is generally an unrestricted option. In order to be classified at fair value through OCI, a debt instrument needs to both have simple principal and interest cash flows and be held in a business model in which both holding and selling financial assets are integral to meeting management’s objectives. This change provides more structure around the classification of these types of assets, which results in better information in the primary financial statements because it directly reflects both the nature of the instrument’s contractual cash flows and the business model in which that instrument is held.
- New impairment model: The new impairment model address the concerns of the ‘incurred loss model’ where the recognition of impairment is considered to be ‘too little and too late’. Measurement of impairment will be the same regardless of the type of instrument held and how it is classified. The new impairment model provides two important pieces of information to assist users of financial statements in understanding changes in the credit risk performance of financial instruments.
- A portion of expected credit losses (a 12-month measure) is recognized for all relevant financial instruments from when they are first originated or acquired. In subsequent reporting periods, if there has been a significant increase in the credit risk of a financial instrument since it was first entered into or acquired, full lifetime expected credit losses would then be recognized.
- The way in which interest revenue is calculated depends on whether an asset is considered to be actually credit-impaired. Initially interest is calculated by applying the effective interest rate to the gross amount of an asset. However, if an asset is considered to be credit-impaired, the calculation changes to applying the effective interest rate to the amortized cost amount (i.e. net of the impairment allowance) of the asset.
New requirements of the impairment model:
- Based on entity’s expected credit losses on financial instruments, recognize expected credit losses at all times and update the changes in the credit risk of financial instruments
- Model is forward-looking
- Eliminates the threshold for the recognition of expected credit losses
- More timely information provided about expected credit losses
- Same impairment model applied to all financial instruments
- 12 month expected credit losses recognized in profit or loss through a loss allowance as soon as a financial instrument is purchased
- Proxy for initial expectation of credit losses
- For financial assets, interest revenue is calculated on the gross carrying amount (before adjusting for the expected credit losses)
- If the credit increases significantly and the resulting credit quality is not considered to be low credit risk, full life-time expected credit losses are recognized
- For financial assets, interest revenue is calculated on the gross carrying amount (before adjusting for the expected credit losses) – Same as for Stage 1
- If the credit increases to the point that it is considered credit-impaired, full life-time expected credit losses are recognized – Same as in Stage 2
- For financial assets, interest revenue is calculated on the amortized cost (gross carrying amount less life-time expected credit losses)
- Financial assets in Stage 3 will generally be individually assessed
- Accounting for changes in ‘own credit’: IFRS 9 requires liabilities that an entity elects to measure at fair value to be recognized on the balance sheet at (full) fair value as changes in fair value provide useful early warning signals of changes in an entity’s own credit risk. However, to address the concerns about accounting for ‘own credit’, IFRS 9 will require the portion of fair value changes caused by changes in the entity’s own credit risk to be recognized in Other Comprehensive Income (OCI) rather than in profit or loss. This will remove the counter intuitive effects that result from accounting for changes in ‘own credit’ through profit or loss.