IFRS 9 was issued in July 2014 and applies to an annual reporting period beginning on or after 1 January 2018.
Financial assets and liabilities are required to be recognized in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument.
- When the contractual rights to the cash flows expire (e.g. because a customer has paid their debt or an option has expired worthless); or
- The financial asset is transferred (e.g. sold), based on whether the entity has transferred substantially all the risks and rewards of ownership of the financial asset.
- When the obligation is discharged (e.g. paid off), cancelled or expires.
Under IFRS 9 all financial instruments are initially measured at fair value plus (in the case of a financial asset) or minus (in the case of a financial liability) transaction costs. For any instruments held at FVTPL, the transaction costs should be expensed.
Subsequent to initial recognition, all assets within the scope of IFRS 9 are measured at:
- Amortized cost; or
- Fair value through other comprehensive income (FVTOCI); or
- Fair value through profit or loss (FVTPL).
Under this category investments in debt instruments (e.g. bonds, loans etc.) are included. In order for the debt instruments to fall in this category we need both of the following conditions:
- Business model test is met i.e. the investment is held to collect contractual cash flows; and
- The cash flows are solely principal and interest.
Under this category we include:
- Debt instruments for which an entity has a dual business model, i.e. the business model is achieved by both holding the financial asset to collect the contractual cash flows and through the sale of the financial assets. The characteristics of the the contractual cash flows of instruments in this category, must still be solely payments of principal and interest. Any interest income, foreign exchange gains/losses and impairments are recognised immediately in profit or loss.
- Equity instruments not ‘held for trading’. This is an optional irrevocable election on initial recognition. Any dividend income is recognized in P/L.
There is a difference between debt and equity instruments on derecognition. For a debt instrument any fair value changes that have been recognised in OCI are recycled to profit or loss upon disposal. In the case of an equity instrument, gains or losses recognised in OCI are never reclassified from equity to profit or loss.
All other financial assets should be measured at fair value through profit or loss.
ABC Ltd made a $100.000 interest-free loan on 1 January 20X1 to an employee to be paid back on 31 December 20X2. The market rate on an equivalent loan would have been 5%.
This is an investment in debt where the business model is to collect the contractual cash flows. It should be initially measured at fair value plus transaction costs (none here). However, as this is an interest free loan, the cash paid is not equivalent to the initial fair value. Therefore, the initial fair value is calculated as the present value of future cash flows discounted at the market rate on interest of an equivalent loan:
$100.000 * 0,907= $90.700
The loan should be subsequently measured at amortized cost:
Fair value on 1 January 20X1 90.700
Effective interest income (90.700 * 5%) 4.535
Coupon received (100.000 * 0%) (0)
Amortized cost at 31 December 20X1 95.235
Reclassification of financial assets
Financial assets are reclassified under IFRS 9 when, and only when, an entity changes its business model (in certain rare circumstances) for managing financial assets. The reclassification should be applied prospectively from the reclassification date.
These rules only apply to investments in debt instruments as investments in equity instruments are always held at fair value and any election to measure them at fair value through other comprehensive income is an irrevocable one.
Most financial liabilities (e.g. trade payables, loans, preference shares classified as a liability) should be measured at amortized cost.
Some examples of instruments that are included in this category are:
- held for trading liabilities
- derivatives that are liabilities
*IFRS 9 also mentions some other categories of financial liabilities measured in a different way, such as financial guarantee contracts but in this article, we will deal with 2 main categories.
On 1 October 20X2 DEF Ltd took out a speculative forward contract to buy coffee beans for delivery on 30 April 20X3 at an agreed price of $7.000 intending to settle net in cash. Due to a surge in expected supply, a forward contract for delivery on 30 April 20X3 would have cost $5.500 on 31 December 20X2.
A forward contract not held for delivery of the entity’s expected physical purchase, sale or usage requirements (which would be outside the scope of IFRS 9) and not held for hedging purposes is accounted for at fair value through profit or loss.
The fair value of a forward contract at inception is zero.
The fair value of the contract at the year end is:
Market price of forward contract at year end 5.500
DEF’s forward price (7.000)
A financial liability of $1,500 is therefore recognized with a corresponding charge of $1,500 to profit or loss.
Some contracts (that may or may not be financial instruments themselves) may have derivatives embedded in them.
For example, an entity may issue a bond which is redeemable in five years’ time with part of the redemption price being based on the increase in the FTSE 100 index.
IFRS 9 requires embedded derivatives that would meet the definition of a separate derivative instrument to be separated from the host contract unless:
- the economic characteristics and risks of the embedded derivative are closely related to those of the host contract; or
- the hybrid (combined) instrument is measured at fair value through profit or loss; or
- the host contract is a financial asset within the scope of IFRS 9; or
- the embedded derivative significantly modifies the cash flows of the contract.
Impairment of financial assets
IFRS 9’s approach uses an ‘expected loss’ model. Credit losses should be recognized in three stages:
- Stage 1 – On initial recognition. Credit losses recognized will be based on the 12-month expected credit losses. Calculation of effective interest will be based on the gross carrying amount.
- Stage 2 – When credit risk increases significantly (rebuttable presumption if > 30 days past due). Credit losses recognized will be based on lifetime expected credit losses. Calculation of effective interest will be based on the gross carrying amount
- Stage 3 – When objective evidence of impairment exists at the reporting date. Credit losses recognized will be based on lifetime expected credit losses. Calculation of effective interest will be based on the carrying amount net of allowance for credit losses
Trade receivables, contract assets and lease receivables
A simplified approach is permitted for trade receivables, contract assets and lease receivables.
Adopting the hedge accounting provisions of IFRS 9 is mandatory where the hedging relationship meets all of the following criteria:
- the hedging relationship consists only of eligible hedging instruments and eligible hedged items.
- it was designated at its inception as a hedge with full documentation of how this hedge fits into the company’s strategy.
- the hedging relationship meets all of the following hedge effectiveness requirements:
- there is an economic relationship between the hedged item and the hedging instrument
- the effect of credit risk does not dominate the value changes that result from that economic relationship
- the hedge ratio of the hedging relationship (quantity of hedging instrument vs. quantity of hedged item) is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.
Practically however, hedge accounting is effectively optional in that an entity can choose whether to set up the hedge documentation at inception or not.
Types of hedges
IFRS 9 identifies different types of hedges which determines their accounting treatment:
- fair value hedges;
- cash flow hedges; and
- hedge of a net investment in a foreign operation.
Fair value hedges
These hedge the change in value of a recognized asset or liability (or unrecognized firm commitment) that could affect profit or loss, e.g. hedging the fair value of fixed rate loan notes due to changes in interest rates.
All gains and losses on both the hedged item and hedging instrument are recognized immediately in profit or loss. The gain or loss on the hedged item adjusts the carrying amount of hedged item.
However, if the hedged item is an investment in an equity instrument held at fair value through other comprehensive income, the gains and losses on both the hedgedinvestment and the hedging instrument will be recognized in other comprehensive income.
Cash flow hedges
These hedge the risk of change in value of future cash flows from a recognized asset or liability (or highly probable forecast transaction) that could affect profit or loss, e.g. hedging a variable rate interest income stream. The hedging instrument is accounted for as follows:
- The portion of the gain or loss on the hedging instrument that is effective (i.e. up to the value of the loss or gain on cash flow hedged) is recognized in other comprehensive income (‘items that may be reclassified subsequently to profit or loss’) and the cash flow hedge reserve.
- Any excess is recognized immediately in profit or loss.
Hedge of a net investment in a foreign operation
Same as cash flow hedge.