In this article we shall dive into one of the trickiest parts of the specific standard. The question to be addressed below is: how can we eliminate/reduce an accounting mismatch?
ABC Ltd, an investment property company, adopts the fair value model to measure its investment properties. The fair value of the investment properties is highly dependent on interest rates.
On 31 December 2015, ABC Ltd took out a $5.000.000 bank loan specifically to finance the purchase of some new investment properties. Fixed interest at the market rate of 6% is charged for the 8-year term of the loan. Transaction costs of $120.000 were incurred.
A bank loan would normally be initially measured at fair value less transaction costs and subsequently at amortized cost.
In the case of ABC Ltd, the initial measurement at fair value less transaction costs on 31 December 2015 would result in a financial liability $4.880.000 ($5.000.000 – $120.000).
Subsequent measurement would then be at amortized cost. An effective interest rate would then need to be calculated to incorporate the 6% interest and the $120.000 transaction costs. This effective interest would be recognized as an expense in P/L from the year ended 31 December 2016.
However, IFRS 9 offers an option to designate a financial liability on initial recognition as at FVTPL in order to eliminate or significantly reduce a measurement or recognition inconsistency (an ‘accounting mismatch’).
This option is available to ABC Ltd here because the bank loan is being used specifically to finance the purchase of investment properties.
Under the accounting policy of ABC Ltd, these investment properties will be measured at fair value with gains or losses recognized in P/L. Therefore, if the loan were measured at amortized cost, there would be a measurement inconsistency.
To eliminate this accounting mismatch, ABC Ltd may choose to designate the bank loan on initial recognition on 31 December 2015 as at FVTPL.
If this option is chosen, the loan will be initially recognized at its fair value of $5.000.000 and the transaction costs of $120.000 will be expensed through profit or loss.
Subsequently, the loan will be measured at fair value with any gains or losses being recognized in profit or loss, in line with the accounting treatment of the investment properties it was used to finance.