As international financial reporting standard takes effect, how have entities prepared?
International Financial Reporting Standard (IFRS) 9-Financial Instruments, became effective from January 1, 2018. It contains financial reporting requirements with wide ranging issues around financial assets’ and financial liabilities’ classifications and measurements
It introduces a new impairment methodology that provides entities the basis of accounting for expected credit losses that is not on “incurred loss” model basis as contained in the International Accounting Standards (IAS) 39-Recognition and Measurement. The new impairment model applies forward-looking information (IFRS 9: BCE.90) methodology to enhance users’ information needs. It also applies to commitments to extend credit facilities. Further, the new standard added a third new requirement to improve hedge accounting. The new requirement for hedge accounting aims to remove the complex and incomprehensible information provision that was largely based on IAS 39, which was rule-based.
With respect to financial liabilities, the new standard retains most of the classifications and measurements as contained currently in the International Accounting Standard (IAS) 39 (IFRS 9: BCE.9(e)) and (: BCE.12) but introduces a measurement relating to the effect of changes in a liability’s credit risk. It is now required that changes in fair value attributed to changes in the entity’s liability’s credit risk be recognised in Statement of other comprehensive income (OCI) where the entity has elected to measure the financial liability at fair value (: BCE.12)
The definition of financial instrument remains as contained in IAS 32 Financial Instruments-Presentation, which states that a financial instrument is “any contract that gives rise to both financial asset in one entity and a financial liability or equity instrument in another entity” (IAS 32:11). That standard also identifies what a financial asset and a financial liability and these are set out below and are retained in the new standard.
Both definitions are extensive to reflect variety of transactions that give rise to one entity being the holder of the asset with right to receive cash in the future and the other holding the liability or the equity instruments corresponding with a contractual obligation to deliver cash in future. Application guide to the standard provides extensive guide to presentation of the various items recognised in the definition.
Items identified as Financial instruments have in the past been subject to varying methods of classifications and measurement both at initial and subsequent recognition, inconsistent valuation methods and some degree of variation in accounting and reporting and needed therefore, a harmonised standard(s) applicable to a wide range of items of financial instruments in various industries across the globe. In the suite of IFRS standards, four standards are in place for Financial Instruments as follows:
IAS 32-Financial Instruments-Presentation;
IAS 39-Financial Instruments-Recognition and Measurement;
IFRS 7-Financial Instruments-Disclosure; and
IFRS 9-Financial Instruments
Of all the four standards, the one most identified to contain major challenges is IAS 39-Financial Instruments-Recognition and Measurement as users found it difficult to understand, apply and interpret (IFRS 9: BCE.7). The need for a new standard to replace IAS 39 became more urgent and this was exacerbated by the financial crisis of 2007-2008 and led to the International Accounting Standards Board (IASB) deciding to replace IAS 39 in its entirety (: BCE.7).
IFRS 9 replaces to a greater extent, the entire contents of IAS 39 and introduces new requirements in three main areas. This paper looks at the three main provisions of IFRS 9 and discusses potential work necessary (if not already being undertaken) to ensure compliance with the provisions of the new standard.
Classification and measurement of financial assets
Entities that have complied with the provisions of IFRS 7 Financial Instruments: Disclosures would have been familiar with most of the disclosure requirements that are similar to the requirements of IFRS 9. For example, IFRS 7:8 (a)(f)(h) require the carrying amount of the following categories of financial assets (as specified in IFRS 9:5.2.1) to be disclosed either in the statement of financial position (Balance Sheet) or in the notes to the accounts:financial assets measured at fair value through profit or loss (FVTPL); financial assets measured at amortised cost; financial assets measured at fair value through other comprehensive income (FVTOCI), which separately showing (i) financial assets measured at FVTOCI in accordance with para. 4.1.2A of IFRS 9; and (ii) investment in equity designated as such upon initial recognition in accordance with para. 5.7.5 of IFRS 9
The new standard requires that except for trade receivables, financial asset or financial liability shall at initial recognition be measured at its fair value plus or minus (in the case of financial asset or financial liability not at fair value through profit or loss) (FVTPL), transactions costs directly attributable to acquisition or issue of the financial asset or financial liability IFRS 9:5.1.1
At subsequent measurement, the new standard similarly, provides the following three bases under which financial assets shall be measured IFRS 9:5.2.1:at amortised cost; fair value through other comprehensive income (FVTOCI); and fair value through profit or loss (FVTPL).
The provisions of IFRS 9 follow closely the three disclosure components relating to financial assets in IFRS 7:8(a)(f)(h) discussed above.However, IFRS 9 requires that for a financial asset to be classified under any of the above three bases, it must meet the following conditions, which we call ‘primary’ the entity must have business model for managing the financial assets; and the contractual cash flow characteristics of the financial assets.
Financial assets at amortised cost
IFRS 9 requires that for a financial asset to be classified at amortised cost, in addition to meeting the above ‘primary’ conditions, the contractual terms of such financial asset must be that which give rise at specified dates to cash flows that are solely payments of principal and interest on the outstanding IFRS 9:4.1.2(b). Examples of financial assets classified at amortised cost include trade and other receivables (the latter, exclude prepayments); and also held-to-maturity financial assets such as debentures and bonds. IFRS 9 defines amortised cost as the amount at which the financial asset or financial liability is measured at initial recognition minus the principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount and for financial instrument, adjusted for any loss allowance. This definition differs from that provided in IAS 39 and this must be recognised both at initial recognition of financial asset or financial liability and subsequent measurement.
Financial assets at FVTOCI
For a financial asset to be classified at FVTOCI, in addition to meeting the above ‘primary’ conditions, it must also meet a condition of there being a contractual terms of the financial asset which give rise on specified dates to cash flows that are solely payments of principal and interest on the outstanding IFRS 9:4.1.2(b) and also that such financial asset must be held within a business model whose objective is achieved by collecting contractual cash flows and selling the financial asset IFRS 9:4.1.2(A)(a).
Financial assets under this classification are those previously classified as available-for-sale financial assets. Example include, listed and unlisted equity instruments but do not include loan and receivables, financial assets held-to-maturity or financial assets held at fair value through profit or loss. Technically, these financial assets could include contingent liabilities that have arisen from discontinued operation.
Financial assets at FVTPL
For a financial asset to be classified at FVTPL, it must not have been classified as either at amortised cost or at FVTOCI. However, entities may make an irrevocable election at the initial recognition of certain investments in equity instruments that would otherwise be measured at FVTPL to be measured at FVTOCI IFRS 9: 4.1.4. However, the standard notes that notwithstanding the provision in IFRS 9:4.1.4 above, entities at the initial recognition may irrevocably designate a financial asset at FVTPL if doing so eliminates or significantly reduces measurement inconsistencies (IFRS 9: 4.1.5) that was witnessed when measuring financial asset or financial liability or recognising the gains or losses on them on different bases.
The standard provides for early adoption but not many entities took this option from results of our research. In each of the classification and measurement bases, additional work would need to be undertaken by entities to identify those financial assets to be appropriately disclosed under non-current assets or current assets as a class of financial assets could fall under both categories. Given that IFRS 9 was issued in July 2014 and becomes effective from 1/1/2018, it is expected that processes, systems, and knowledgeable individuals would already have been put in place to undertake the complex identification, analyses, classifying and/or reclassifying existing or new accounting transactions or items that may fall to be classified as either financial assets or financial liabilities. Further, work-through processes and policies would also need to be drawn up (if not already in place) to identify impact these new classifications and measurements would have on the entity’s reported performance including the required movements between other comprehensive income and statement of changes in equity resulting from changes in fair value of financial asset or financial liability and also changes that fall to be reflected in profit or loss.
The new standard added impairment methodology in accounting for expected credit losses on entity’s financial assets and commitments to extend credit facilities. This new provision is particularly important to financial institutions most of whom already may have internal processes or regulatory processes for accounting for credit losses. Given the principle-based nature of IFRS generally, including the provisions in IFRS 9, the accounting requirements under this provision eliminate threshold-basis provided in IAS 39 that was rule-based and caused inconsistencies in reporting expected credit losses. Further, credit loss assessment and accounting were based on “incurred loss” model, which did not incorporate information that reflected the future whether real or potential.
The new standard does not any longer require a credit event to occur before credit losses are recognised. IFRS 9 requires that expected credit losses be measured and recognised on financial assets measured either at amortised cost or at FVTOCI IFRS 9: 5.5.1 and: BC5.119. Where the loss allowance relates to financial assets measured at FVTOCI, the loss allowance shall be recognised in OCI and shall not reduce the carrying amount of the financial instrument in the statement of financial position (:5.5.2).
Expected loss on financial instrument, be measured at an amount equal to the lifetime expected credit losses and changes to that initial measurement at subsequent measurement be recognised and accounted for depending on whether the financial asset is measured at amortised cost or at FVTOCI. Changes to the expected credit losses be measured by reference to the lifetime loss allowance and significant increases to the credit risk on such financial instrument representing changes in expected credit losses should be recognised and reported at each reporting date to reflect credit risk since initial recognition as this would lead to more timely information being provided on expected credit losses. In respect of loan commitments and financial guarantees, the standard requires that when an entity becomes a party to an irrevocable commitment that date shall be considered the date of initial recognition for purposes of applying the impairment requirements IFRS 9:5.5.6.
Fair value option and its impact on financial institutions
In line with the International Accounting Standards Board’s (IASB’s) quest for financial statements to provide users with information about entity’s financial position, financial performance, to assess the timing, amount and uncertainty of the entity’s cash flows and other relevant information including approaches to managing risks in the entity, financial institutions were considered to be more exposed to the effect of fair value option and in accounting for changes in fair value application. Given the potential risk with possible inconsistencies in the application of fair value accounting in financial institutions, the need for their internal policies in accounting for financial assets measured at FVTPL to be disclosed was considered by the IASB. The Board noted that while there may be internal regulated processes adopted by financial institutions, it stated that “it recognised that regulated financial institutions are extensive holders and issuers of financial instruments and are among the largest potential users of the fair value option”.
It seems therefore, obvious that the prudential supervisors would be more concerned at the processes in place in individual financial institutions in applying and accounting for fair value option as this could have potential impact on reported profit or loss of financial institutions. Consequently, impacting the level of capital requirement as may be imposed by the prudential authority of the financial institution for instance, Central Bank of Nigeria (CBN). Given the risk of making judgement that may be inconsistent with the provisions of IFRS 9 in accounting for the effect and application of fair value option in financial reporting as they affect financial assets and financial liabilities, it is expected that financial institutions would need to pay attention to how impairment accounting is applied to the various classifications and measurements of financial assets and financial liabilities as provided in the new standard. While all financial liabilities are measured initially at fair value their subsequent measurements are at amortised cost and care would need to be taken to ensure that internal processes for initial and subsequent measurements are capable to recognise the requirements of IFRS 9.
For example, in accounting for financial guarantees and commitments, IFRS 9 requires that following initial recognition at fair value, subsequent measurement shall be conducted referencing the higher of (a) amount of credit loss allowance determined by applying lifetime expected credit loss computation IFRS 9:5.5.3, where there has been significant increase in credit risk since initial recognition or where the credit risk on the financial instrument has not increased significantly IFRS 9:5.5.5; and (b) the amount initially recognised less where appropriate, the cumulative amount of income recognised in accordance with IFRS 15 Revenue from Contracts with Customers. The above (a) and (b) requirements are particularly applicable on commitment to provide loan at below-the market interest rate. Note that these requirements are in variance with the provision of IAS 39, which left the recognition decision in IAS 39 and measurement guidance in IAS 37 Provisions, Contingent Assets and Contingent Liabilities. Entities would need to ensure that systems and processes are in place to undertake this new accounting for financial assets and financial liabilities. With respect to fair value as contained in IAS 39, references are to be made to IFRS 13 Fair Value Measurement as the computation of fair value for financial reporting are now to be made by reference to IFRS 13.
IFRS 9 addresses challenges within IAS 39 that created arbitrary application given its rule-based methodology. The new standard aims to align closely entity’s risk management with its risk exposure and reporting to entity’s management. Given that it is principle-based it does not separate risk components from the underlying hedging instrument for example in accounting for debt instruments and any underlying LIBOR component. The new standard notes that a qualifying instrument must be designated in its entirety as hedge instrument IFRS 9:6.2.4. The new standard however, provides some limited exceptions to the provision of IFRS 9:6.2.4 at IFRS 9:6.2.4 (a)(b) and (c). It provides that for hedge accounting purposes, only assets, liabilities, firm commitments, or highly probable forecast transactions with a party external to the entity can be designated as hedge items IFRS 9:6.3.5. IFRS 9 therefore, looks at whether the risk component can be identified and measured and does not separate between items. With this process, entities are more able to reflect their risk management in the financial statements. The new standard provides entities with the option to continue applying the provisions relating to hedge accounting for a portfolio hedge as contained in IAS 39. Incorporating the provisions of the new standard into existing internal processes and systems in entities should have begun before now.
Ogbonnaya MSc, FCCA, FCA CEO/MD, Premier Training & Consulting.
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