IFRS 9 Financial instruments, a standard on which the IASB had been working since 2008, has become effective for annual periods commencing on or after 1st January 2018. This standard replaces IAS 39 Financial Instruments: Recognition and Measurement, and encompasses a phased approach, consisting of three phases:
- Classification and measurement of financial instruments;
- Impairment; and
- Hedge Accounting.
Classification of Financial Assets
The objective of the business model of the entity holding financial assets determines the classification of such financial assets. Such assets must pass the contractual cash flows test. This states that such assets come with contractual terms that give rise to cash flows on specific dates that are solely payments of principal and interest on the principal amount outstanding (SPPI).
If the objective of the entity is to hold the assets to collect the contractual cash flows, then such assets will be measured at amortised cost. The entity may also decide to measure such assets either at fair value through other comprehensive income (FVTOCI) or at fair value through profit and loss (FVTPL). In the case of FVTPL, such a decision is irrevocable.
On the other hand, if the objective is to collect contractual cash flows and sell financial assets, then those assets are to be measured at FVTOCI with any fair value gains or losses being reclassified to the income statement upon disposal of the asset. Once again, the entity may make an irrevocable decision to measure the financial asset under FVTPL.
All other assets which do not fall within the above two scenarios must be measured at FVTPL.
Classification of Financial Liabilities
Under IFRS 9, financial liabilities are classified under two categories, at fair value through profit or loss and at amortised cost. Financial liabilities held for trading are classified under the first category (FVTPL).
Derivatives which fall under the scope of IFRS 9 are measured at fair value, with any changes in their value being recognised in the income statement. This applies unless the entity had not elected to designate such derivatives as a hedging instrument.
Measurement of Financial Instruments
Upon recognition, all financial instruments must be measured at fair value plus or minus any transaction costs, unless a financial asset or liability will be measured at fair value through profit or loss.
Subsequent measurement depends on the classification of the individual financial instrument. All instruments measured at fair value should subsequently be remeasured at fair value at any date of remeasurement. Any other financial assets and liabilities are to be remeasured at amortised cost using the effective interest method.
The changes in the fair value of financial instruments measured at FVTPL will be attributed to the profit or loss unless the instrument is a non-derivative financial liability. In this case, the gain or loss is attributable to changes in credit risk.
The changes in the fair value of financial instruments measured at FVTOCI, such as equity instruments, are recognized in other comprehensive income with no possibility of reclassification to profit or loss. Only interest and dividend derived from such equity instruments are to be recognized in profit or loss.
Impairment of Financial Assets
As a general rule, an entity shall recognize impairment not when there are objective indicators of impairment, but from day one based on the expected credit losses on the following financial assets:
- Financial assets measured at amortised cost;
- Financial assets measured at FVTOCI;
- Lease receivables;
- Contract assets;
- Specified written loan commitments; and
- Financial guarantee contracts.
IFRS 9 provides two approaches for measuring the loss allowance, being the general approach and the simplified approach.
Under the general approach, expected credit losses are measured according to the stage of the credit quality of the asset. This approach measures the loss allowance either at an amount equal to the 12-month expected credit loss or if the credit risk has increased substantially, at an amount equal to the lifetime expected credit losses.
On the other hand, the simplified approach measures the loss allowance at the lifetime expected credit losses.
The general approach should be applied to all financial assets except for trade receivables and contract assets falling within the scope of IFRS 15. In these cases, the simplified approach is to be applied, and, if an entity chooses, also in the case of lease receivables under IFRS 16.
Under IFRS 9, hedge accounting requirements are optional. If certain criteria are met, hedge accounting allows the entity to match the gains or losses on a hedging instrument with losses or gains on the hedged item.
The three hedge accounting models within IAS 39, Fair Value Hedge, Cash Flow Hedge, and Net Investment Hedge, were broadly retained by IFRS 9.