This article was first published in the March 2010 edition of Accounting and Business magazine.
The International Accounting Standards Board (IASB) issued IFRS 9, Financial Instruments, in November 2009. This is the first instalment of a phased replacement of the existing standard IAS 39, Financial Instruments.
Recognition and measurement
This standard introduces new requirements for the classification and measurement of financial assets and is effective from 1 January 2013, with early adoption permitted. New requirements for classification and measurement of financial liabilities, derecognition of financial instruments, impairment and hedge accounting are to be added to IFRS 9 in 2010.
Early adoption of the standard is a major step for any entity, because an early adopter of IFRS 9 continues to apply IAS 39 for other accounting requirements for financial instruments that are not covered by IFRS 9, that is classification and measurement of financial liabilities, recognition and derecognition of financial assets and financial liabilities, impairment of financial assets and hedge accounting.
In some jurisdictions, the new standards will have to be adopted before they can be applied, and in others there will be some restrictions on early adoption. It would seem wise to wait until the whole of the new standard has been finalised.
The standard retains a mixed-measurement model, with some assets measured at amortised cost and others at fair value. The distinction between the two models is based on the business model of each entity and a requirement to assess whether the cashflows of the instrument are only principal and interest.
The business-model approach is fundamental to the standard, and is an attempt to align the accounting with the way in which management uses its assets in its business while also looking at the characteristics of the business.
A debt instrument generally must be measured at amortised cost if both the 'business model test' and the 'contractual cash flow characteristics test' are satisfied. The business model test is whether the objective of the entity's business model is to hold the financial asset to collect the contractual cashflows rather than have the objective to sell the instrument before its contractual maturity to realise its fair value changes.
The contractual cashflow characteristics test is whether the contractual terms of the financial asset give rise, on specified dates, to cashflows that are solely payments of principal and interest on the principal amount outstanding.
All recognised financial assets that are in the scope of IAS 39 will be measured at either amortised cost or fair value. The standard contains only the two primary measurement categories for financial assets, unlike IAS 39 where there were multiple measurement categories. Thus the existing IAS 39 categories of held to maturity, loans and receivables and available for sale are eliminated, as are the tainting provisions of the standard.
A debt instrument, such as a loan receivable, that is held within a business model whose objective is to collect the contractual cashflows and has contractual cashflows that are solely payments of principal and interest generally must be measured at amortised cost.
All other debt instruments must be measured at fair value through profit or loss (FVTPL). An investment in a convertible loan note would not qualify for measurement at amortised cost because of the inclusion of the conversion option, which is not deemed to represent payments of principal and interest.
This criterion will permit amortised cost measurement when the cashflows on a loan are entirely fixed, such as a fixed-interest-rate loan or where interest is floating or a combination of fixed and floating interest rates.
IFRS 9 contains an option to classify financial assets that meet the amortised cost criteria as at FVTPL if doing so eliminates or reduces an accounting mismatch. An example of this may be where an entity holds a fixed-rate loan receivable that it hedges with an interest rate swap that changes the fixed rates for floating rates.
Measuring the loan asset at amortised cost would create a measurement mismatch, as the interest rate swap would be held at FVTPL. In this case, the loan receivable could be designated at FVTPL under the fair value option to reduce the accounting mismatch that arises from measuring the loan at amortised cost.
Gains and losses
All equity investments within the scope of IFRS 9 are to be measured in the statement of financial position at fair value with the default recognition of gains and losses in profit or loss. Only if the equity investment is not held for trading can an irrevocable election be made at initial recognition to measure it at fair value through other comprehensive income (FVTOCI) with only dividend income recognised in profit or loss. The amounts recognised in other comprehensive income (OCI) are not recycled to profit or loss on disposal of the investment although they may be reclassified in equity.
The standard eliminates the exemption allowing some unquoted equity instruments and related derivative assets to be measured at cost. However it includes guidance on the rare circumstances where the cost of such an instrument may be appropriate estimate of fair value.
The classification of an instrument is determined on initial recognition and reclassifications are only permitted on the change of an entity's business model and are expected to occur only infrequently. An example of where reclassification from amortised cost to fair value might be required would be when an entity decides to close its mortgage business, no longer accepting new business, and is actively marketing its mortgage portfolio for sale.
When a reclassification is required it is applied from first day of the first reporting period following the change in business model.
All derivatives within the scope of IFRS 9 are required to be measured at fair value. IFRS 9 does not retain IAS 39's approach to accounting for embedded derivatives. Consequently, embedded derivatives that would have been separately accounted for at FVTPL under IAS 39 because they were not closely related to the financial asset host will no longer be separated. Instead, the contractual cash flows of the financial asset are assessed as a whole and are measured at FVTPL if any of its cashflows do not represent payments of principal and interest.
A frequent question is whether IFRS 9 will result in more financial assets being measured at fair value. It will depend on the circumstances of each entity in terms of the way it manages the instruments it holds, the nature of those instruments and the classification elections it makes. One of the most significant changes will be the ability to measure some debt instruments, such as investments in government and corporate bonds, at amortised cost. Many available-for-sale debt instruments measured at fair value will qualify for amortised cost accounting.
Many loans and receivables and held to maturity investments will continue to be measured at amortised cost but some will have to be measured at FVTPL. For example, some instruments, such as cash-collateralised debt obligations, that may under IAS 39 have been measured entirely at amortised cost or as available-for-sale, will more likely be measured at FVTPL.
Measured in entirety
Some financial assets that are currently disaggregated into host financial assets that are not at FVTPL will instead by measured at FVTPL in their entirety.
Assets that are classified as held-to-maturity are likely to continue to be measured at amortised cost as they are held to collect the contractual cash flows and often give rise to only payments of principal and interest.
IFRS 9 does not address impairment. However as IFRS 9 eliminates the available for sale (AFS) category, it also eliminates the AFS impairment rules. Under IAS 39 measuring impairment losses on debt securities in illiquid markets based on fair value often led to reporting an impairment loss that exceeded the credit loss management expected.
Additionally, impairment losses on AFS equity investments cannot be reversed under IAS 39 if the fair value of the investment increases. Under IFRS 9, debt securities that qualify for the amortised cost model are measured under that model and declines in equity investments measured at FVTPL are recognised in profit or loss and reversed through profit or loss if the fair value increases.
The aim of the revision of IAS 39 is to remove inconsistencies between US GAAP and IFRS in accounting for financial instruments. This will enable easy comparisons to be made between entities applying IFRSs and those using US GAAP. IFRS 9 was a first step in this direction. In order to work towards convergence of their requirements both the IASB and the US Financial Accounting Standards Board (FASB) are reconsidering the financial instruments standards.
Graham Holt, ACCA examiner and principal lecturer in accounting and finance, Manchester Metropolitan University Business School