The IFRS 9 standard adoption went into effect on Jan. 1, 2018. It is a simpler replacement for the IAS 39, launched in 2005. It incorporates new guidelines intended to improve forward transparency by placing more focus on legal over economic substance. The trade-off is the potential for more volatility in reporting profits and losses. It provides many “tests” to help companies navigate the enhanced reporting standards.
The basic components of IFRS 9 financial instruments
IFRS was completed in 2014 and fully implemented in 2018. It serves as the final standard for reporting the three phases of financial instruments projects, which are classification and measurement, impairment and hedge accounting. Financial instruments are recognized when an entity “becomes a party to the contractual provisions of the instrument,” notes Deloitte. Financial instruments must eventually be recognized and derecognized according to the qualifications.
Financial assets recognition and derecognition
Financial assets fall under three categories: debt, equity and derivatives. The initial recognition with regular way transactions are straightforward with the trade date accounting indicating when the trade is initiated or when the asset is purchased or acquired. Settlement date accounting indicates when the asset is delivered.
Derecognition of a financial asset gets tricky as IFRS 9 seeks to prevent entities from trying to hide assets (i.e., bad loans or toxic assets) in their financial statements. According to Deloitte, companies can only derecognize a financial asset when:
Derecognition of financial liabilities are made when the liability is extinguished through discharge, cancellation or expiration. Discharge pertains to meeting the obligation through delivery of cash or goods. Cancellation applies when legally released from the obligation. Expiration applies when the liability is terminated because of passage of time.
Classification and measurement changes
IFRS 9 classification for financial assets depends on a contractual cash flow test and a business model assessment. The three classifications are amortized cost (AC), fair value through profit and loss (FVTPL) and fair value through other comprehensive income (FVOCI).
AC is applied to instruments held by entities with a business model that holds the financial asset to collected contractual cash flows or solely payments of principle and interest (i.e., a repayable three-year bond paying a scheduled fixed interest rate).
FVTPL is applied to instruments held by entities with a business model that manages the financial asset on a fair value basis, collecting payments other than principal and interest. These assets may be held for trading purposes or sold (i.e., equities and derivatives).
FVOCI is applied to instruments held by entities with a dual business model objective of holding the financial asset to collect contracted cash flows and to sell the financial asset (i.e., trade receivables, nonrecourse loans and investment in debt securities with prepayable attributes).
IFRS 9 implements an “expected loss” model for loans and receivables. Impairment applies to debt instruments measured at FVOCI including financial guarantees and loans that aren’t measured at FVTPL, lease receivables and contract assets under IFRS 15 revenue standards.
The previous IAS 39 required impairment to be reported after the loss is incurred, but now, financial asset impairment must be reported on the expected credit loss (ECL). This improves forward transparency but can also cause volatility in reporting profit and losses.
The 3 stages of impairment
Debt instruments are initially recognized with a loss under IFRS 9 implementation of ECL. Stage one ECL is reported on a 12-month loss allowance with effective interest rate on gross carrying amount. Stage two requires full lifetime loss allowance when significant increase in credit risk forms. Stage three occurs when the instrument becomes credit impaired and the effective interest rate is reported on AC.
Hedge accounting changes
The main hedge accounting changes pertain to the qualifying criteria. IAS 39 required hedge relationships to meet the 80 to 125 percent effectiveness bright line on both prospective and retrospective bases. Under IFRS 9, the effectiveness bright line is replaced with the hedge ratio being consistent with the risk management strategy, thereby expanding valid hedge items that qualify and enabling broader participation for organizations that choose to implement hedge accounting. Companies reporting in the United States need to be aware of differing GAAP/FASB and IFRS 9 interpretations, especially if they have foreign operations or subsidiaries, according to KPMG US.
Levering internal data
It’s highly encouraged to invest in automated data flow optimization. Leveraging this information with big data analytics and cognitive learning technologies can provide additional intelligence into operations and ways to improve risk and investment strategies.
To learn more about how Openlink Solutions can work to improve ROI and streamline operations in your business, contact us for a free consultation or no obligation demo.