Preparers of financial statements may think two significant standards that have just come into force won't affect them. Check the detail, warns Adam Deller
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This article was first published in the March 2018 international edition of Accounting and Business magazine.
Major changes are coming down the pipe as a result of two new standards, both effective from 1 January 2018: IFRS 9, Financial Instruments, and IFRS 15, Revenue from Contracts with Customers.
IFRS 9 replaces IAS 39, Financial Instruments: Recognition and Measurement, while IFRS 15 replaces both IAS 18, Revenue, and IAS 11, Construction Contracts. This article will consider each standard in turn.
What’s the same in IFRS 9? Plenty. The general way in which transaction costs are incurred remains consistent with IAS 39, as does the way in which fair value gains and losses are recorded. Amortised cost calculations will also be consistent with IAS 39. The treatment of the issue of convertible instruments will likewise remain unchanged.
What’s new in IFRS 9? There are three major areas of change: classification, impairment and hedging. We will look here solely at the changes to classification and impairment.
What is categorised as available for sale in IAS 39 is termed fair value through other comprehensive income (FVOCI) in IFRS 9. The new standard also merges the classifications ‘held to maturity’ and ‘loans and receivables’ (two separate categories in IAS 39) into a single category: ‘amortised cost’.
Equity instruments will be held as either fair value through profit or loss (FVPL) or FVOCI. The default category for holding equity instruments will be FVPL. If such instruments are to be held under FVOCI by an entity, they must not be held for trading, and the FVOCI designation is irrevocable.
For debt instruments, an entity can use amortised cost if it passes two tests:
- business model – the entity must intend to hold the instrument to collect the contractual cashflows (rather than selling it to make use of any fair value gains)
- contractual cashflow characteristics – the contractual cashflows within the instrument are solely repayments of the principal and the interest.
This may mean that embedded derivatives, such as a convertible loan asset, are more likely to fall under FVPL, as the cashflows are likely to be lower than for a normal loan asset, reflecting the value of the embedded option. Under IAS 39, the loan aspect can be held at amortised cost, with the option itself being FVPL. Under IFRS 9, it is likely that the whole instrument would be held under FVPL. This may have introduce more profit or loss volatility, as the whole instrument is revalued to fair value at the reporting date, rather than just the option element.
An entity can hold a debt instrument as FVOCI if it passes two tests:
- business model – the asset is held within a business model whose objective is achieved by both collecting contractual cashflows and selling financial assets
- contractual cashflow characteristics – the contractual cashflows within the instrument are solely repayments of principal and interest.
An entity can designate a debt instrument as FVPL if doing so removes or reduces an accounting mismatch with other items.
Perhaps the most significant change in IFRS 9 is the way in which impairments are recorded. Previously, financial assets were impaired only if there was objective evidence of impairment (the incurred loss model). Losses expected as a result of future events, no matter how likely, could not be recognised.
Under IFRS 9, an expected loss model has been introduced. Entities now determine and account for expected credit losses instead of waiting for an actual default, which means that loss allowances must be recognised as FVOCI assets or assets held at amortised cost. Changes in the loss allowance must be recorded in the statement of profit or loss each year.
The loss allowance should equal the expected credit losses within 12 months, or the expected lifetime credit losses if the credit risk on the asset has increased significantly since acquisition. To assess if there has been a significant increase in credit risk, an entity should compare the asset’s risk of default at the reporting date with its risk of default at the date of original recognition. There is also a rebuttable presumption that credit risk has increased significantly if contractual payments are more than 30 days overdue at the reporting date.
Meanwhile in the IFRS 15 standard, what is likely to remain the same is the recognition of revenue in many straightforward contracts involving revenue. The aim is still to recognise revenue in an amount that reflects the consideration to be received in exchange for goods or services.
So what’s new? There are changes in some revenue arrangements, which are detailed in the application guidance in IFRS 15. Rather than cover each of these here, we will take an overview of the major principles of the new standard.
IFRS 15 takes the principles previously applied in revenue standards relating to control and the transfer of risks and rewards, and develops them into a five-step process (see panel opposite).
In terms of the presentation in the statement of financial position, an entity recognising revenue before receiving consideration should recognise a receivable if the right to consideration is unconditional or a contract asset. If an entity receives consideration before the related revenue has been recognised, it should record a contract liability.
For many entities, the requirements of the new standards may not have any significant impact on the preparation of the financial statements. But even if this may appear to be the case, most preparers should still familiarise themselves with the details of the changes. The International Accounting Standards Board has produced implementation webinars, summaries and materials to help preparers cope with the transition.
Adam Deller is a financial reporting specialist and lecturer
CPD technical article
"Entities now determine and account for expected credit losses instead of waiting for an actual default"