How have entities prepared for International Financial Reporting Standard (IFRS)?
This is the second part in a series of our commentaries on IFRS 9-Financial Instruments that became effective from 1st January, 2018. In our first commentary that was carried in this paper on Thursday, January 18, 2018, we reviewed the new key provisions for financial assets and financial liabilities. The new key provisions of: (i) classification and measurement; (ii) impairment methodology; and (iii) the new hedge accounting were reviewed in our earlier commentary. That paper noted that classification and measurement procedures as contained in the International Accounting Standard (IAS) 39 Recognition and Measurement relating to financial liability have substantially been retained.
Our coverage in this series are detailed review of the standard with regards to: (a) business model; (b) contractual cash flow characteristics; and (c) financial assets held with the objective of collecting contractual cash flows and selling the financial assets. These are the factors that will guide entities in transiting from IAS 39 to IFRS 9. Our initial commentary referred to above discussed the measurement bases and accounting for financial assets that meet (a) and (b) and also those that meet (a), (b) and (c) above. This paper also reviews some sundry issues including issues on debt instruments; exception for unquoted equity instruments; and gains and losses on equity instruments.
Assessment of business model
A business model assessment is an essential step to determine the classification of financial assets as required by IFRS 9. An organisation’s business model refers to how the entity manages its financial assets in order to generate cash flows. The business model therefore, determines whether cash flows will arise from collecting contractual cash flows, selling the financial assets or both. The assessment is not performed on the basis of scenarios that the entity does not reasonably expect to occur, such as so-called ‘worst case’ or ‘stress case’ scenarios. The standard notes that if an entity expects that it will sell a particular portfolio of financial assets only in a stress case scenario, that scenario would not affect the entity’s business model for those assets if the entity reasonably expects that such scenario will not occur. If cash flows are realised in a way that is different from the entity’s expectations at the date that the entity assessed the business model (for example if the entity sells more or fewer financial assets than it expected when it classified the assets that does not give rise to a prior period error in the entity’s financial statements (per IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors) nor does it change the classification of the financial assets held in that business model as long as the entity considered all relevant information that was available at the time it made the business model assessment (:B4.1.2A).
It should be noted that where cash flows are realised in a way that is different from the entity’s expectations at the date that the entity assessed the business model, such as when the entity sells more or less financial assets than it expected when the financial asset was classified, that does not change the classification of the remaining financial assets held in that business model provided the entity made the business model classification taking into account all available and objective information at that time. When an entity however, is assessing business model for newly originated or newly purchased financial assets, it must consider information about how cash flows were realised in the past along with all other relevant information (:B4.1.2A). Further, an entity’s business model is a matter of fact and not merely an assertion. The standard notes that it is typically observable through the activities that the entity undertakes to achieve the objectives of the business model. An entity would therefore need to use its judgement when it assesses its business model for managing financial assets and that assessment is not determined by a single factor or activity. Instead, the entity must consider all relevant evidence that is available at the date of assessment. Such relevant evidence includes but not limited to:
• how the performance of the business model and the financial assets held within the business model are evaluated and reported to the entity’s key management personnel;
• the risks that affect the performance of the business model (and the financial assets held within that business model) in particular, the way in which the risks are managed; and
• how managers of the business are compensated (for example, whether the compensation is based on the fair value of the assets managed or on actual cash flow collected (: B4.1.2B).
It should be noted that the standard contains provision for reclassification between categories of financial assets in certain circumstances and this is when (and only, when) an entity changes its business model for managing the financial assets. Such reclassification would need to be undertaking in accordance with the provisions of (:B4.1.2A and :B4.1.2B) shown above.
Business model whose objective is to hold financial assets to collect contractual cash flows
The standard sets out clear basis of assessing financial asset to ascertain whether it meets the requirements to be included under this category of financial assets. It notes that financial assets that are held within a business model whose objective is to hold assets in order to collect contractual cash flows are managed to realise cash flows by collecting contractual cash payments over the life of the instrument. That is the entity manages the assets held within the portfolio to collect those particular contractual cash flows (instead of managing the overall return on the portfolio by both holding and selling the assets). In determining whether cash flows are going to be realised by collecting the financial asset’s contractual cash flows, it is necessary to consider the frequency, value and timing of sales in prior periods the reasons for those sales and expectations about future sales activity… (: B4.1.2C).
Further the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity. Thus, an entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur or are expected to occur in the future (: B4.1.3). The standard notes at (: B4.1.3A) that the business model may be to hold assets to collect contractual cash flows even if the entity sells financial assets when there is an increase in the assets’ credit risk. To determine whether there has been an increase in the assets’ credit risk, the entity considers reasonable and supportable information including forward looking information…
The standard notes that selling financial assets because it no longer meets the credit criteria specified in the entity’s documented investment policy is an example of a sale that has occurred due to an increase in credit risk. However, the standard notes that in the absence of such a policy, the entity may demonstrate in other ways that the sale occurred due to an increase in credit risk (: B4.1.3A). Also, sales that occur for other reasons, such as sales made to manage credit concentration risk (without an increase in the assets’ credit risk), may also be consistent with a business model whose objective is to hold financial assets in order to collect contractual cash flows… (B4.1.2B).
The standard also notes that whether a third party imposes the requirement to sell the financial assets, or that activity is at the entity’s discretion, is not relevant to this assessment. An increase in the frequency or value of sale in a particular period is not necessarily inconsistent with an objective to hold financial assets in order to collect contractual cash flows, if an entity can explain the reason for those sales and demonstrate why those sales do not reflect a change in the entity’s business model. Further, sales may be consistent with the objective of holding financial assets in order to collect contractual cash flows if the sales are made close to the maturity of the financial assets and proceeds from the sales approximate the collection of the remaining contractual cash flows. (: B4.1.3B)
Business model whose objective is achieved by both collecting contractual cash flows and selling the financial assets
The standard provides that an entity may hold financial assets in a business model whose objective is achieved by both collecting contractual cash flows and selling the financial assets. In this type of business model, the standard notes, the entity’s key management personnel have made a decision that both collecting contractual cash flows and selling the financial assets are integral to achieving the objective of the business model. There are various objectives that may be consistent with this type of business model. For example, the objective of the business model may be to manage everyday liquidity needs, to maintain a particular interest yield profile or to match the duration of the financial assets to the duration of the liabilities that those assets are funding. To achieve such an objective, the entity will both collect contractual cash flows and sell financial assets (: B4.1.4A). Further, the standard notes that when compared with the business model whose objective is to hold financial assets to collect contractual cash flow, this business model will typically involve greater frequency and value of sales. This is because selling financial assets is integral to achieving the business model’s objective instead of being only incidental to it. However, there is no threshold for the frequency or value of sales that must occur in this business model because both collecting contractual cash flows and selling the financial assets are integral to achieving it objective (: B4.14B).
IASB’s strategic view in addressing challenges entities might face in implementing new or amended standard(s).
Financial asset assessment in the context of the new standard is with a view to transiting from the previous classification and measurement under IAS 39 to IFRS 9. From the onset, the International Accounting Standards Board (IASB) recognised the wide application of IFRS 9 to all entities (including the small and medium sized entities-SMEs) and to all types of financial instruments (IFRS 9: 2.1) except those excluded from its scope (:2.1 (a) to (j)). IASB therefore, carried out wider evaluation to determine the costs and benefits, which collectively IASB tagged, as “effects” (: BCE:4) leading to considering the following and asking how? (: BCE.5); (i) activities would be reported in the financial statements of those applying IFRS; (ii) comparability of financial information would be improved both between different reporting periods for the same entity and between different entities in a particular reporting period; (iii) more useful financial reporting would result in better economic decision making; (iv) better economic decision-making as a result of improved financial reporting could be achieved; (v) the compliance costs for preparers would likely be affected; and
(vi) the cost of analysis for users of financial statements would likely be affected. IASB noted that during the global financial crisis some users of financial statements were confused because the same financial assets were impaired differently simply because they were classified differently for accounting purposes (: BCF.30). IAS 39 contains for example, four financial asset classification bases: (i) loans and receivables; (ii) held-to-maturity investments (which are non-derivative assets); (iii) available-for-sale financial assets; and (iv) those at fair value through profit or loss (FVTPL) (IAS 39:9), (:AG.53) Therefore, from our assessment, IASB expects that detailed analyses of existing financial instruments accounted for under the above classifications in IAS 39 would have by now begun and at reasonable level of progress if not already completed particularly, for entities with interim reporting period in line with IAS 34-Interim financial reporting for quarter ended 31st March, 2018 and/or half year report for 30th June, 2018. Our research shows that many entities reported in their 2017 year-end financial statements that they had not yet undertaking assessment to determine impact the new standard will have on their financial statements.
Current bases under IAS 39 of accounting for financial instruments depend on whether it is carried at historical cost, fair value or some other amount and whether remeasurement gains are reported immediately in profit or loss or in other comprehensive income (OCI) all of which also depended to some extent on some or all of the following:
• the purpose for which it is held, whether for trading, long term investment or for hedging;
• its contractual characteristics, whether held as a derivative, equity investment or debt instrument;
• the industry in which the reporting entity operates;
• whether the instrument is listed on an exchange; and
• accounting policy or similar choice of the reporting entity.
The introduction of IFRS 9 requires that financial instruments that have been accounted for based on one or all of the above accounting bases now have to be reassessed and evaluated for evidence of their meeting the classification bases contained in IFRS 9:4.1.1, :4.1.2 and :4.1.2A. A business model assessment is an essential step to determine the classification of financial assets as required by IFRS 9. There is therefore, the task of reassessing and evaluating each financial instrument and/or their entire portfolio for purposes of transiting those financial instruments (some of which could be in volumes) from their existing bases as required in IAS 39 to that provided in IFRS 9 including the following analyses: (i) debt instruments at amortised cost; (ii) debt instruments at fair value through other comprehensive income (FVTOCI) with cumulative gains and losses reclassified to profit or loss on derecognition); (iii) debt instruments, derivatives and equity instruments at fair value through profit or loss (FVTPL); and (iv) equity instruments designated as measured at fair value through other comprehensive income (FVTOCI) (gains and losses remaining in other comprehensive income are not recycled).
It could be seen from the above that the main bases of measurements under IFRS 9 fall into three categories. These are those at amortised costs; FVTOCI and FVTPL as discussed in our previous commentary. Detailed analysis of debt instruments will show that they fall into the three categories of amortised cost; FVTOCI or FVTPL. Equity instruments on the other hand, fall into FVTPL. The capacity to carry out these tasks should not be under estimated given that some auditors are aware of the requirements of this new standard and entities would need to understand the requirements particularly, documentation of their processes for transiting to the new standard as that may help to avoid or reduce regulatory costs when the assessment and analysing functions are undertaking externally.
These tasks appear to have been made more manageable and to some extent less challenging with the provision in IFRS 9 where the standard notes that the choice of a single basis of classification in the new standard brings in logical structure, which requires financial asset classification only to be based on entity’s business model for managing the financial asset and the characteristics of the financial asset’s contractual cash flow (IFRS 9: (: BCE.20).
The standard notes that the provision in BCE.20 is to enable entities to carry out assessment to determine whether entity’s future cash flow will arise from contractual amount or by realising the fair value through selling the financial instrument (: BCE.21) as that would determine which category the financial asset would fall to be classified. Further, it notes that the relevance of cash flows on a financial asset can properly and adequately be reflected by amortised cost measurement that is simply a technique for allocating interest over the life of the financial instrument and these cash flows are “solely payment of principal and interest on the outstanding amount” (: BCE.21). Therefore, unless a financial asset meets the requirement of having a business model in managing the entire portfolio of the financial assets with clear contractual cash flow characteristics of the financial assets, it may not be classified at amortised cost or FVTOCI but may fall to be classified at FVTPL.
Given that debt instruments are now becoming a major source of financing for most large entities, implications of measuring and/or remeasuring debt instruments can be challenging as their measurement and/or remeasurement outcomes may have impact across many other IFRS. FVTOCI has been introduced by IFRS 9 in accounting for financial instruments including debt instruments measured at amortised costs and at FVTOCI. Entries to FVTOCI are required to be clearly identified. For example, measurement or remeasurement of financial instruments may result in the following accounting treatments: (i) other fair value gains and losses are recognised in OCI; (ii) expected credit losses are recognised in profit or loss; (iii) foreign currency gains and losses derived from amortised cost calculation are recognised in the profit or loss; (iv) interest calculated using the effective interest method are recognised in the profit or loss; and (v) on derecognition of financial asset, the cumulative gain or loss previously recognised in OCI is reclassified from equity to profit or loss as a reclassification adjustment. (IFRS 9: 5.7.10; (: B.5.7.2; :B.7.2A).
Other sundry issues:
Where debt instruments meet the requirements of IFRS 220.127.116.11A and are measured at FVTOCI as set out in (: BCE.23), the statement of financial position will reflect the fair value carrying amount while the amortised cost information will be presented in the profit or loss. The difference between the fair value information and amortised cost information is recognised in OCI.
Unquoted equity instruments
IAS 39 contains an exception to the measurement for investment in unquoted equity instruments that do not have a quoted market price in an active market (and derivatives of such instrument) and for which fair value can therefore be measured reliably. Such financial instruments are measured at cost. IFRS 9 removes this exception, requiring all equity instruments (and derivatives of such instruments) to be measured at fair value (: BCE.33). References to fair value measurements are now to be derived from IFRS 13 Fair Value Measurements.
Losses and gains from equity instruments
IFRS 9 permits an entity to make an irrevocable election on an instrument-by-instrument basis to present in other comprehensive income (OCI) changes in the fair value of an investment in an equity instrument that is not held-for-trading. Dividends received from those investments are presented in the profit or loss. Gains or losses presented in OCI cannot be subsequently transferred to profit or loss (i.e. recycling is not permitted). However, an entity may transfer the cumulative gain or loss within equity.
Ogbonnaya is CEO/MD Premier Training & Consulting.
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