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IFRS 9 – Financial Instruments

In this article, Steve Collings provides a summary of the new standard issued in November 2009, that of IFRS 9 ‘Financial Instruments’ which is due to replace IAS 39 ‘Financial Instruments: Recognition and Measurement’.

The International Accounting Standards Board (IASB) is in the process of revising the way that entities account for their financial instruments. On 12 November 2009, the IASB issued IFRS 9 ‘Financial Instruments’ in their plans to replace the current IAS 39 ‘Financial Instruments: Recognition and Measurement’ over the next year.

The objective of the IASB’s project is to simplify the way in which entities account for their financial instruments. Their aim is to also reduce the complexity involved as anybody who has any knowledge of IAS 39 will undoubtedly agree that this standard is, by far, one of the most complex standards currently in issue. The IASB plan that by the end of 2010, IFRS 9 will be a complete replacement for IAS 39.

IFRS 9 is based on Exposure Draft (ED) 2009/7: Financial Instruments: Classification and Measurement which was published by the IASB in July 2009. However, in contrast to the ED, IFRS 9 contains some fundamental changes to its ED counterpart.

Amortised Cost vs. Fair Value

All financial assets are initially measured at fair value plus, in the case of a financial asset not at fair value through profit or loss, transaction costs.

IFRS 9 only deals with the classification and measurement of financial assets only. IFRS 9 is consistent with the ED in that it requires financial assets to be classified on initial recognition as measured at:

· amortised cost; or

· fair value.

A financial asset is measured at amortised cost if the objective of the business model is to hold assets in order to collect contractual cash flow. In addition, the contractual terms must give rise (on specified dates), to cash flow that are solely payments of capital and interest (also referred to as ‘principal’ and ‘interest’) on the capital amount (principal amount) outstanding.

Any other financial asset is measured at fair value.

IAS 39 currently has the following categories of financial assets:

· Held-to-Maturity Assets.

· Available-for-Sale Assets.

· Loans and receivables.

IFRS 9 eliminates the above categories of assets in an attempt to simplify the accounting for such financial instruments.

Business Model for Managing Financial Assets

An entity’s business model is determined by its management and key personnel (per IAS 24 ‘Related Party Disclosures’) and the business model approach in IFRS 9 brings into line the accounting for financial assets with the way in which management deploy the assets in the business whilst at the same time considering the characteristics of the assets.

Contractual Cash Flows

One of the criteria for recognising financial assets at amortised cost under the new IFRS 9 is that the contractual terms give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding. IFRS 9 does contain several examples to illustrate this condition. For the purposes of IFRS 9, interest is defined as consideration for the time value of money and credit risk.

Embedded Derivatives

Under IAS 39, an embedded derivative is a feature within a contract. It acts as a component part of a ‘hybrid’ financial instrument which also includes a non-derivative host contract with the effect that some of the cash flows of the hybrid instrument vary in a similar way to a stand-alone derivative. A ‘hybrid’ instrument is a combination of both the hose contract and the embedded derivative.

Under IFRS 9, embedded derivatives are no longer separated from hybrid contracts that have a financial asset host. Instead, the entire hybrid contract is assessed for classification using the principles above.

Fair Value Option

IFRS 9 allows an entity to designate a financial instrument on initial recognition at fair value through profit or loss even if it meets the criteria for recognition at amortised cost. However, care must be taken here because the option to measure at fair value should only be exercised where it eliminates, or significantly reduces a measurement or recognition inconsistency, often referred to as an ‘accounting mismatch’.

Reclassification

Only in rare circumstances will reclassification of financial assets occur. However, reclassification may be necessary if the objective of an entity’s business model changes in such a way that is significant to the entity’s operations and demonstrable to third parties.

Investments in Equity Instruments

Where an entity has investments in equity instruments, then these should be measured at fair value and any gains or losses on remeasurement are recognised in profit or loss. However, under IFRS 9, dividends on investments in equity instruments are recognised in profit or loss as opposed to other comprehensive income. This accords with the principles laid down in IAS 18 ‘Revenue’ provided that they do not represent recovery of the cost of the investment.

For an investment in an equity instrument that is not held for trading, IFRS 9 allows an entity, on initial recognition, to irrevocably elect to present all fair value changes from the investment in other comprehensive income. No amount recognised in other comprehensive income is ever reclassified to profit or loss at a later date.

Measurement

Under IAS 39, investments in unquoted equity instruments can be measured at cost where fair value cannot be reliably determined. IFRS 9 now eliminates this exception and stipulates that all such instruments are measured at fair value. The standard does recognise that in some limited circumstances, cost may be an appropriate estimate of fair value.

IAS 39 also considers impairment of financial assets and the guidance contained in IAS 39 still continues to apply, though as a result of the IASB’s simplification, the numerous impairment methods detailed in IAS 39 have been reduced to a single impairment method.

Any changes in the fair value of financial assets that are measured at fair value are recognised in profit or loss. However, as referred to earlier in the article, equity investments for which the option to recognise such changes in other comprehensive income should not be measured in profit or loss. This also applies to any gains or losses relating to financial assets that are also part of a hedge relationship.

Any gains or losses on financial assets which have been measured at amortised cost are recognised in profit or loss upon derecognition, impairment or reclassification of the asset, and through applying the effective interest method.

Effective Date

IFRS 9 applies for accounting periods beginning on or after 1 January 2013, but earlier adoption is permitted. Where entities apply this standard, this will normally give rise to a change in accounting policy, with retrospective application in accordance with the provisions laid down in IAS 8 ‘Accounting Policies’. However, it is to be noted that there are several exceptions to this principle, for example if an entity adopts IFRS 9 for accounting periods beginning before 1 January 2012 it is not require to restate prior periods.

About the author:

Steve Collings FMAAT ACCA DipIFRS is the audit and technical manager at LWA Limited. He is also a partner in AccountancyStudents.co.uk and a freelance technical author. Steve also lectures on financial reporting and auditing issues.

www.AccountancyStudents.co.uk
8th February 2010