Transition from IAS 39 to IFRS 9
Roadmap to a Forward Looking Approach in
Apart from the much discussed and debated IFRS 15 on revenue recognition, IFRS 9: 'Financial Instruments' is another standard which will have widespread and far reaching implications. Contrary to common belief, IFRS 9 affects more than just financial institutions. Any entity could have significant changes to its financial reporting as a result of this standard. That is certain to be the case for those with long-term loans, equity investments, or any non-vanilla financial assets. It might even be the case for those only holding short term receivables. IFRS 9 fundamentally redefines the accounting rules for financial instruments. It introduces significant changes and a fresh approach for financial asset classification; a much more forward-looking expected loss model; and a host of new requirements on hedge accounting.
IFRS 9 fundamentally redefines the accounting rules for financial instruments. It introduces significant changes and a fresh approach for financial asset classification
Classification and measurement of financial assets after initial recognition
IFRS 9 replaces IAS 39's arbitrary bright line tests and options for the classification and measurement of financial assets after initial recognition with a single model that has fewer exceptions. The new standard is based on the concept that financial assets should be classified and measured at fair value, with changes in fair value recognized in profit and loss as they arise ("FVPL"), unless restrictive criteria are met for classifying and measuring the asset at either Amortized Cost or Fair Value Through Other Comprehensive Income ("FVOCI").
IFRS 9 eliminates 'the held to maturity' category and the related 'tainting' rules, and also the 'available for sale' and 'loans and receivables' categories by requiring that on initial recognition, all financial assets are classified into one of just two measurement categories - amortised cost or fair value (FV).
A financial asset is measured at amortised cost only if it meets two conditions: the objective of an entity's business model is to hold the financial asset in order to collect contractual cash flows; and the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Investments in equity instruments do not meet the conditions to be measured at amortised cost because they do not contain contractual terms that give rise to cash flows on specified dates that are solely payments of principal and interest on the principal amount outstanding. Consequently, investments in equity instruments are measured at FV. IFRS 9 has no exemption from FV measurement for those instruments for which FV cannot be reliably measured.
The IFRS 9 model is arguably simpler than IAS 39 but possibility of volatility in profit and loss cannot be ruled out. As the default measurement under IAS 39 for non-trading assets is FVOCI, under IFRS 9 it is FVPL and that is a major change. This can have major consequences for entities holding instruments other than plain vanilla loans or receivables, whose business model for realising financial assets includes selling them or have portfolio investments in equity instruments.
Accounting for impairments is the second major area of fundamental change. IFRS 9 introduces new impairment requirements to address the criticism that during the financial crisis the recognition of credit losses on financial assets was a case of 'too little, too late'.
On the one hand, IFRS 9 eliminates impairment assessment requirements for investment in equity instruments because they now can only be measured at FVPL or FVOCI without recycling of fair value changes to profit and loss. On the other hand, IFRS 9 establishes a new approach for loans and receivables, including trade receivables - an "expected loss" model - that focuses on the risk that a loan will default rather than whether a loss has been incurred.
Yes, the new standard moves from an 'incurred' loss to 'expected' loss model, meaning that expected credit losses must be recognised at the point at which an entity makes a loan or invests in a relevant financial asset. Under the "expected credit loss" model, an entity calculates the allowance for credit losses by considering on a discounted basis the cash shortfalls it would incur in various default scenarios for prescribed future periods and multiplying the shortfalls by the probability of each scenario occurring. The allowance is the sum of these probability of weighted outcomes. In short, expected credit losses represent possible outcomes weighted by the probability of their occurrence, these amounts rather represent measures of an asset's credit risk. Because every loan and receivable, including bank balances, carries with it some risk of default, every such asset has an expected loss attached to it, right from the moment of its origination or acquisition.
IFRS 9 (2014) requires an entity to recognise a loss allowance for expected credit losses on:
- Debt instruments measured at amortised cost;
- Debt instruments measured at fair value through other comprehensive income;
- Lease receivables;
- Contract assets (as defined in IFRS 15 'Revenue from Contracts with Customers');
- Loan commitments that are not measured at fair value through profit or loss;
- Financial guarantee contracts (except those accounted for as insurance contracts).
IFRS 9 requires an expected loss allowance to be estimated for each of these types of asset or exposure. However, the Standard specifies three different approaches depending on the type of asset or exposure which are referred to below. (Refer Figure 2: Expected Loss Model: Approaches).
Impairment losses recognised in the financial statements should now also be based on more complete information, as the standard requires 'reasonable and supportable' forward-looking information to be taken into account, along with historical losses and current information.
Another criticism of financial instruments accounting highlighted by the financial crisis was the counter-intuitive results produced by the inclusion of changes in an entity's own credit risk in profit or loss in the valuation of financial liabilities. IFRS 9 addresses this by requiring the portion of fair value changes represented by changes in own credit risk to be reported in OCI instead of profit or loss.
The third major change that IFRS 9 introduces relates to hedging as hedge accounting is one of the most complex areas to apply and understand - IFRS 9 introduces a model more closely aligned with an entity's own risk management approach, with more qualifying hedging instruments and hedged items.
Companies that have shown reluctance in using hedge accounting in the past because of its complexity and impracticability, and those wishing to simplify, refine or extend their existing hedge accounting, may find the new hedging requirements more acceptable than those in IAS 39. IFRS 9 establishes new criteria for hedge accounting that are somewhat less complex and more aligned with the way that entities manage their business and related risks than under IAS 39.
This should enable entities to better represent their underlying hedging activities. Along with new disclosures about hedge accounting, these changes should give investors and other users of the accounts better information about the effects of entities' risk management activities.
However, this change comes with a price - the further threat of volatility in profit and loss, which is treatment of derivatives embedded in financial assets. Under IAS 39, embedded derivatives not closely related to a non-trading host contract must be measured at FVPL, but the host contract often still can be measured at Amortized Cost. Under IFRS 9, the entire contract will have to be measured at FVPL.
There are significant consequential amendments to IFRS 7, Financial Instruments: Disclosures, especially in respect of credit risk and expected credit losses.
IFRS 9 generally is effective for years beginning on or after January 1, 2018, with earlier adoption permitted. This means that the provisions of IFRS9 will need to be applied at the beginning of their accounting period as well as at the end. However, entities whose predominant activities are insurance related have the option of delaying implementation until 2021.
We have significant experience in the new accounting standard implementations and we have developed insights on different aspects of the major changes for IFRS 9.
We can provide assistance with the implementation of the IFRS 9 requirements using established methodology whilst maintaining integrity and independence which can include impairment testing, valuation of investment in unquoted equity investments, impact assessment, design and advice on the implementation of models, processes, systems and changes to internal controls.
Some entities may find that classification and measurement of their financial assets will be significantly the same as under IAS 39, and that their impairment allowances may not be materially affected. Others will change substantially. Regardless, every entity will have to go through the process of re-evaluating their accounting policies, financial statement notes disclosures and other areas affected by the new requirements and making appropriate changes to their accounting systems and internal controls.
The accounting changes beyond those specific to IFRS 9 are not insignificant - several require more disclosures and changes to the financial statement presentation. The management of the companies also need to consider the capital and regulatory impact as well.
The new impairment rule of calculating expected loss will require evaluating available qualitative data, data processes used by risk and reconciliation with finance function. This is the most significant of all the expected changes. The new implementation will require tracking and determining significant changes in credit risk throughout the lifetime of financial assets. The proposed changes to hedge accounting may allow additional hedging opportunities but will also cause changes to existing processes. The upcoming accounting changes will impact several processes and systems, e.g. the impairment process system. The interaction between fair value hedge accounting and impairment will be more complex under the new impairment model of IFRS 9. Alignment of key controls within the new processes will be required with the adoption of the IFRS 9 standard; There will be a requirement of change in IT systems due to the implementation of IFRS 9 as well.
However, management may take this opportunity to further align the risk and finance functions.
IFRS 9 raises the risk that more assets will have to be measured at fair value with changes in fair value recognized in profit and loss as they arise resulting in more judgements and volatility to income statement. Further, entities will have to start providing for possible future credit losses in the very first reporting period a loan goes on the books - even if it is highly likely that the asset will be fully collectible.
With careful planning, measured and thoughtful approach the changes that IFRS 9 introduces might provide a great deal of opportunity for financial position optimisation, or enhanced efficiency of the reporting process and cost savings. If not addressed now, there could lead to some radical challenges and surprises. It is still not too late if you haven't begun assessing the implications of IFRS 9.
(This article is compiled by Mr. Vinod Joshi, Director based in Dubai.)