Introduction to Accounting for Financial Instruments
IFRS 9 and IAS 39 are two most important accounting standards for corporate treasurers because they address how to account for financial instruments, or how they are measured on an ongoing basis.
IFRS 9 Financial Instruments is the more recent Standard released on 24 July 2014 that will replace most of the guidance in IAS 39 Financial Instruments: Recognition and Measurement.
Treasurers should examine these standards closely to understand their implications on risk management, tax, internal controls and processes.
Under IAS 39, many preparers, auditors and users of financial statements had given feedback that the requirements for reporting financial instruments were too complex and difficult to apply.
There were too many exceptions in the application of IAS 39, and companies struggled to apply the Standard correctly and consistently. Therefore, after the Global Financial Crisis (GFC), with strong interest from the G20, the Financial Advisory Group and other groups, the IASB decided to accelerate the project for IFRS 9 to supersede IAS 39.
After about a decade of consultations and outreaches with different constituents and stakeholders, the IASB finally issued the complete version of IFRS 9 Financial Instruments on 24 July 2014, to replace the notoriously cumbersome IAS 39 Financial Instruments: Recognition and Measurement. This new Standard IFRS 9 will be effective for annual periods on or after 1 January 2018.
There are 3 main sections of IFRS 9, which will be explained in greater detail in the sections below:
(a) Classification and measurement. This explains how financial instruments, assets or liabilities, are classified and should be recorded in financial statements. Should financial assets be measured and recorded as fair value or amortized cost? Should the gains or losses on financial instruments be recorded in the income statement or are they recorded directly to equity?
(b) Impairment. After we have classified and recorded the financial instruments in part (a), how do we determine record any potential impairment of the financial instruments? What is the difference between the ‘incurred loss’ model in IAS 39 and ‘expected loss’ impairment model in IFRS 9?
(c) Hedge accounting. Financial instruments for hedging may result in large fluctuations in profit and loss due to fair value accounting. How do we properly implement hedge accounting, and how will the income statement be affected if we opt to apply hedge accounting to our hedging instruments?
Classification and Measurement of Financial Instruments (under IAS 39)
Previously, under IAS 39, financial assets are classified into 4 broad categories:
- Financial asset at fair value through profit or loss (FVTPL): These are financial assets that are held for trading. These financial instruments are measured at fair value. Gains and losses are passed into the income statement.
- Held to maturity financial investments (HTM): These are non-derivative financial assets with fixed or determinable payments that an entity has intention to hold to maturity. These are measured at amortized cost using the effective interest method. Gains and losses are passed into the income statement.
- Loans and receivables: These are non-derivative financial assets with fixed or determinable payments that are not quoted in active market. Like HTM instruments, these are measured at amortized cost using the effective interest method. Gains and losses are passed into the income statement.
- Available for sale financial assets (AFS): These are non-derivative financial assets not classified under the above three categories. These instruments are measured at fair value. Gains and losses are passed into Other Comprehensive Income (OCI).
Financial liabilities under IAS 39 are classified into two main categories.
- Financial liabilities at fair value through profit or loss: These are financial liabilities that are held for trading. They are measured at fair value. Gains and losses are passed into the income statement.
- Other financial liabilities: These are measured at amortized cost using the effective interest method. Gains and losses are passed into the income statement.
Regardless of the initial classification of the financial assets, IAS 39 allows entities to initially designate them at FVTPL, if fair value can be reliably measured.
Classification and Measurement of Financial Instruments (under IFRS 9)
The new Standard, IFRS 9 is more principles-based, and therefore requires more judgment in its application. In contrast with IAS 39, it applies a two-step approach to classify all types of financial assets, which are either measured at fair value or amortized cost.
Under IFRS 9, the classification of financial assets are dependent on the ‘business model’ test and ‘contractual cash flow’ test to determine whether they are measured at fair value or amortized cost.
1) Business Model Test: Financial asset is held in order to collect contractual cash flows.
2) Contractual Cash Flow Test: Contractual cash flows represent solely payments of principal and interest (SPPI).
In the examples below, we will use both tests to illustrate when financial assets should be measured at amortized cost, fair value (recorded in OCI), or fair value (recorded in P&L)
- Financial Asset Measured at Amortized Cost. Gains and losses passed into income statement.
Both Business Model Test and Contractual Cash Flow Test need to pass for the financial asset to be measured at amortized cost. Take for example, entities may hold some debt financial investments for their contractual cash flows.
The entities may decide to sell their financial assets when assets’ credit risk is high. Selling the financial assets for this reason may not be inconsistent with a business model whose objective is to collect contractual cash flows because a lower credit quality can impact the entity’s ability to collect contractual cash flows.
Therefore, selling financial assets to manage credit concentration risk may also be consistent with a business model whose objective is to collect contractual cash flows. Entities will need to examine factors like frequency of sales of financial assets, timings and reasons for those sales to demonstrate that the sales do not reflect a change in the entity’s business model.
- Financial Asset Measured at Fair Value. Gains and losses passed into Other Comprehensive Income (OCI).
If business model test fails, e.g. the business model of holding the financial asset is achieved by both collecting contractual cash flows and selling the financial asset, the financial asset is measured at FVOCI.
Entities may invest in debt instruments for yield, but might also sell its financial assets to reinvest in better yielding financial assets or to rebalance its portfolio’s risk or duration of its liabilities.
In this case, the business objective of the entity is to maximize the return on portfolio and is therefore more aligned with the FVOCI category.
- All other financial assets that cannot be classified under amortized cost or FVOCI have to be measured at fair value, with gains and losses passing through profit and loss (FVTPL). This means all financial assets that fail the ‘business model’ test and ‘contractual cash flow’ test will be classified as FVTPL.
Regardless of the ‘business model’ test and ‘contractual cash flow’ test, an entity may designate a financial asset as FVTPL if doing so results in more relevant information and reduces recognition inconsistency or an accounting mismatch.
The classification of financial liabilities under IFRS 9 remain broadly the same as in IAS 39.
- Financial liabilities that are held for trading are measured at FVTPL.
- Other financial liabilities are classified as FVOCI.
The only change in the classification of financial liabilities is that fair value gains or losses that are related to changes in the entity’s own credit risk should be recognised in OCI, with the remainder recognized in profit or loss. Amounts in OCI related to its own credit are not recycled to profit or loss, when the financial liability is derecognized and amounts are realized.
Impairment of Financial Instruments
Previously under IAS 39, impairment or credit losses are only recognised when a credit loss event occurs (‘incurred loss model’).
Under IFRS 9, the new impairment requirements are based on expected credit losses (‘expected credit loss model’). Expected credit losses (ECLs) are an estimate of credit losses over the life of a financial instrument, and are recognised as a loss allowance or provision. The amount of ECLs to be recognised depends on the extent of credit deterioration since initial recognition, and an entity will need to take into account:
- probability-weighted outcomes;
- the time value of money; and
- reasonable and supportable information that is available without undue cost or effort.
The main difference between the two accounting standards is that the new standard (IFRS 9) requires a recognition of credit loss allowances on initial recognition of financial assets, whereas previously under IAS 39, impairment is recognized at a later stage, when a credit loss event has occurred.
While this change will result in credit losses being recognized more evenly over the lives of financial assets, it will require more judgment by preparers to estimate the amount of ECL provision for financial assets.
‘General’ approach for impairment
This new model is a ‘three-stage’ model, also known as ‘three-bucket’ approach or ‘general’ approach. It should be applied to investments in debt instruments (e.g. loans, debt securities) measured at amortized cost and FVOCI, loan commitments not measured at FVTPL, financial guarantee contracts not accounted for at FVTPL and lease receivables under IAS 17.
Stage 1: If credit risk on a financial instrument has not increased significantly since the initial recognition, a 12-month ECL shall be recognized at reporting date. 12-month ECL are the expected credit losses that result from default events that are possible within 12 months after the reporting date.
Stage 2: If credit risk on a financial instrument has increased significantly since the initial recognition, a lifetime ECL shall be recognized. Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the financial instrument. Interest revenue is calculated on the gross carrying amount of the financial assets.
Stage 3: If the financial instrument is credit-impaired, i.e. non-performing or there is objective evidence of impairment, a lifetime ECL is recognized. Interest revenue is calculated on the net carrying amount (gross carrying amount less loss allowance).
Alternatives to the ‘general’ approach for impairment
Alternative #1: Simplified Approach
The simplified approach can be applied for trade receivables, contract assets and lease receivables that do not have significant financing component (normally held by entities that do not have sophisticated credit risk management systems like financial institutions).
Under the simplified approach, there is no need to calculate a 12-month ECL and assess whether a significant increase in credit risk has occurred. A loss allowance should be measured at initial recognition and throughout the life of the receivable at an amount equal to lifetime ECLs for the assets.
Alternative #2: Purchased or Originated Credit-impaired Assets
Purchased or originated credit-impaired assets refer to assets that have observable evidence of impairment at the point of initial recognition (for example, the financial asset was purchased at a deep discount, or the borrower had significant financial difficulty at initial recognition of asset).
In such a scenario, the initial 12-month ECLs would have already been reflected in the fair values at which they were initially recognized. Recording a 12 month-ECL allowance over the discounted financial assets would be double counting the credit losses for these assets with high credit risk.
For such assets, there is therefore no need to account for an additional 12-month ECL allowance on initial recognition. For subsequent reporting periods, the entity would need to recognize changes in lifetime ECLs, either as an impairment gain or loss, in P&L.
Most businesses implement some risk management strategies to manage their exposures to different risks like interest rate, exchange rate or commodity price risks. Applying hedge accounting to its financial instruments for hedging is a matter of choice for companies.
To apply hedge accounting, entities will first need to maintain proper hedge documentation set out in IFRS 9 or IAS 39. Hedge accounting affects the timing of recognition of hedging gains and losses. By applying hedge accounting, entities can better match the gains or losses of the hedging instrument with gains or losses of their corresponding hedged items.
If an entity chooses not to apply hedge accounting, hedging instruments will need to be classified and measured like any other financial instruments, as required by IFRS 9. Gains and losses on the hedging instruments may not be recognized in P&L or OCI in the same accounting period as the gains and losses on their corresponding hedged items.
With hedge accounting, the hedging instrument will be matched with its corresponding hedged item, so that gains and losses on both the hedging instrument and hedged item are recognized in the same accounting period. Hedge accounting is thus based on the fundamental ‘matching’ concept, and helps to reduce the volatility in the income statement caused by the accounting mismatch between the hedging instrument and hedged item.
There are 3 main types of hedge relationships:
- Fair value hedge: a hedge of exposure to changes in fair value of a recognized asset, liability or an unrecognized firm commitment. Change in fair value could be due to a change in interest rates for fixed rate loans, foreign currency, equity and commodity prices. Gains or losses on both hedging instrument and hedged item shall be recognized in P&L in each accounting period (matching concept).
[However, if the hedged item is an equity instrument accounted for at FVOCI, changes in fair value of hedging instrument should also be recorded in OCI without recycling to P&L. This is a new change under IFRS 9.]
- Cash flow hedge: a hedge of the exposure to variable cash flows that is attributable to a recognized asset, liability or a highly probable forecast transaction that could affect profit or loss. The variable cash flows could be due to change in interest rates, foreign currency, equity or commodity prices.
Gains or losses on the hedging instrument to be recognized in OCI (cash flow hedge reserve) should be the lower of:
- Cumulative gain or loss on the hedging instrument from inception of hedge
- Cumulative change in the fair value of expected cash flows on hedged item from inception of hedge
In other words, if the amount in (i) exceeds the amount in (ii), i.e. ‘over-hedge’ situation, an ineffectiveness of (ii) – (i) will be recognized in P&L. In an ‘under-hedge’ situation, the amount in (ii) will exceed the amount in (i), no ineffectiveness is recognized and all gains and losses on the hedging instrument can be recognized in OCI.
For forecast transactions that result in recognition of a non-financial asset or liability (e.g. inventory or fixed asset), the cash flow hedge reserve will be removed from OCI and included directly in the carrying amount of the non-financial asset or liability.
For forecast transactions that result in future cash flows affecting P&L (e.g. interest income, expense or forecast sales), the cash flow hedge reserve will need to be transferred from OCI to P&L in the same period or periods during which the hedged expected future cash flows affect P&L.
- Net investment hedge: a hedge in an entity’s interest in the net assets of its foreign operations, i.e. overseas subsidiaries, associates, joint ventures or branches, including any recognized goodwill.
The accounting for net investment hedges is similar to that of cash flow hedges. The effective portion of the hedge is recognized in OCI, while the ineffective portion is recognized in P&L. As exchange differences arising from consolidation of net assets (hedged item) are recognized as foreign currency translation reserve in OCI, gains or losses on the hedging instrument are also recognized in OCI, to the extent that the hedge is effective.
When the foreign operations are disposed, the foreign currency translation reserve from consolidation will be reclassified from equity to P&L. Previous gains or losses on hedging instrument should therefore also be transferred from OCI to P&L to match the foreign currency gains or losses from foreign currency translation reserve.
Hope this gives you a good understanding of the main points covered in IFRS 9 and IAS 39, and you can better appreciate how financial instruments are recorded in the financial statements!