IFRS 9 Financial Instruments, published in July 2014, is the new financial instruments standard which replaced IAS 39 Financial Instruments: Recognition and Measurement, and is effective for annual periods beginning on or after 1 January 2018. This new standard brings about major changes to the classification and measurement of an entity’s financial assets and the calculation of impairment thereon, and is expected to have a major impact across all organisations, particularly financial institutions. Entities need to start planning for the transition from IAS 39 to IFRS 9 in order to understand the time, resources, processes and system changes which are needed to capture the new requirements of this new standard.

Although the new impairment model is expected to hit banks and other financial services companies the hardest, Non-Financial Institutions (NFIs) will also be impacted generally to a lesser extent. This article will review the classification and measurement implications on NFIs. The second part of this article, to be published in the next issue of the Accountant, will in turn look into the new impairment model’s implications for NFIs.

Classification and measurement

The new classification requirements are based on the contractual cash flow characteristics test and the business model under which financial assets are held and managed. IFRS 9 has three primary measurement categories for financial assets, and whilst similar measurement bases also exist under IAS 39 (see Table 1), the criteria for measuring said assets under these bases will be significantly different.

 

IAS 39	IFRS 9
FVTPL	FVTPL
Amortised cost	L&R/HTM
FVOCI	AFS

FVTPL – Fair Value through Profit or Loss
L&R – Loans and receivables
HTM – Held to maturity
AFS – Available-for-Sale
FVOCI – Fair Value through Other Comprehensive Income

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Table 1 – Measurement categories

Debt financial assets at amortised cost

Financial assets are classified and measured at amortised cost when the contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest (the ‘SPPI criterion’) and the assets are held in a business model whose objective is to hold them in order to collect contractual cash flows. For example, plain vanilla bonds and trade receivable normally pass the SPPI test. If an entity holds such assets to collect contractual cash flows i.e. coupon and principal payments upon maturity, and amounts due from debtors, those will be measured at amortised cost.

To meet the SPPI criterion, cash flows received under said financial assets must consist only of principal (the fair value of an asset on initial recognition) and interest (consideration for time value of money, credit risk and other basic lending risks, other associated costs and a profit margin).

Under the held-to-collect (HTC) business model, sales of financial assets are only incidental to the objective of holding them to collect contractual cash flows.

Subsequent to initial recognition, entities will recognise in profit or loss, with respect to said financial assets, (i)interest revenue using the effective interest method, (ii) impairment losses and reversals, and (iii) any foreign exchange movements. On derecognition, the gain or loss is also recognised in profit or loss.

Financial assets at FVOCI

Debt financial assets are classified and measured at FVOCI when they meet the SPPI criterion and are held in a business model whose objective is achieved by both (i) collecting contractual cash flows and, (ii) selling financial assets. For example, a portfolio of plain vanilla bonds that pass the SPPI test which an entity holds to collect the contractual cash flows but, when an opportunity arises, investments are sold to re-invest the cash in investments with a higher return, would be classified under the FVOCI category.

The general rule for debt instruments measured at FVOCI is that any gains or losses are recognised in OCI except for interest revenue, impairment losses and reversals, and foreign exchange movements, which are instead recognised in profit or loss. When these debt instruments are derecognised, the cumulative gain or loss previously recognised in OCI is reclassified from equity to profit or loss.

On the other hand, equity instruments follow a different measurement methodology. Firstly, they fail to meet the SPPI criterion and thus can never be measured at amortised cost. They are instead measured at FVTPL, with an irrevocable FVOCI option at initial recognition for equity instruments not held for trading. Under this FVOCI option, any gains or losses can never be reclassified to profit or loss even if the investment is sold, unlike with debt instruments at FVOCI. Only dividends are recognised in profit or loss – unless they clearly represent a repayment of part of the cost of the investment.

Financial assets at FVTPL

Financial assets classified and measured at FVTPL include all other instruments which are not measured at amortised cost or FVOCI, and includes financial instruments which are held for trading. There is also an irrevocable designation option to measure financial instruments at FVTPL if this eliminates or significantly reduces an accounting mismatch, which is the only designation option for financial assets explicitly retained from IAS 39.

Financial liabilities

On the other hand, most financial liabilities are measured at amortised cost, with some exceptions that include liabilities which are held for trading, or those liabilities for which the irrevocable designation option to measure them at FVTPL was taken. Classification and measurement of financial liabilities has not changed significantly when compared to IAS 39, except for the presentation of changes in the fair value of an FVTPL liability that is attributable to changes in the issuer’s credit risk is now presented in OCI.

Measurement

Table 2 illustrates a summary of the typical business models and the measurement of the financial instruments under the said models.

Classification	Key Features	Measurement
Debt instruments held-to-collect contractual cash flows	- Objective: hold assets to collect contractual cash flows  - Sales are incidental to the objective  - Typically lowest sales (in frequency and volume)	Amortised cost*
Debt instruments held both to collect contractual cash flows and for sale	- Objective: both collecting contractual cash flows and sales are integral to achieving the objective of the business model  - Typically more sales (in frequency and volume) than held-to-collect business model	FVOCI*(fair value changes are presented in OCI, recycling to P&L)
Equity instruments at FVOCI	- Equity instruments not held for trading  - Option available at initial recognitionOption is irrevocable	FVOCI(fair value changes are presented in OCI without recycling to P&L)
Others	- Equity instruments not at FVOCI  - Debt instruments that (i) fail the SPPI test or (ii) pass the SPPI test but are neither held-to-collect nor held-to-collect and for sale	FVTPL**(fair value changes are presented in P&L)

* Subject to meeting the SPPI criterion

** SPPI criterion is irrelevant – instruments in all such business models are measured at FVTPL

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Table 2 – Business models

Impact of classification and measurement requirements on NFIs

The expected impact on NFIs with respect to classification and measurement will mainly depend on the cash flow characteristics of its financial instruments. The common types of financial instruments held by NFIs can broadly be grouped into two:

Loans, trade and lease receivables and contract assets

The new classification model must be applied to all receivables. If an entity mainly has financial instruments classified as ‘loans and receivables’ (IAS 39), little to no changes are anticipated on transition to IFRS 9 as they are generally expected to meet the criteria to be classified at amortised cost (IFRS 9), provided that the SPPI criterion are met.

NFIs should review the contractual terms to comply with IFRS 9. In doing so, they must evaluate the impact of different accounting policy choices, and review management information under the current requirements, and asses how this could be aligned with the new classification and measurement requirements

Investment securities

The classification of investments will depend on each investment’s contractual cash flows and how NFIs manage groups of investments. All investments in equity instruments, including unquoted shares, will be classified at FVTPL subject to an option to classify them at FVOCI if the investment is not held for trading. The cost exemption under IAS 39 for unquoted equity investments has been removed – consequently NFIs must now measure the fair value of these investments and can no longer retain their measurement at cost.

Corporate debt and equity securities will require careful analysis to determine their new classification and measurement under IFRS 9. A financial instrument which is classified as HTM under IAS 39, and which will now be measured at amortised cost, will possibly only result in a minor change in presentation from “HTM debt security” to “debt security at amortised cost”. On the other hand, an AFS debt security, which is measured at fair value under IAS 39, might now be classified at amortised cost, FVOCI or FVTPL under IFRS 9, depending on the business model it is held in, thus resulting in different measurements. Therefore, a thorough assessment is key, as each classification and measurement category may significantly change the way an NFI accounts for these types of financial instruments.

NFIs should thus review the contractual terms of investments and analyse and document the business models for managing investments.

 

Conclusion

Transitioning to the new classification and measurement models under IFRS 9 may result in P/L volatility and balance sheet impact to varying degrees, depending on the nature of an NFI’s financial assets and the underlying business models. At post-implementation stage entities may have to implement new processes and controls to monitor financial assets’ cash flow characteristics and demonstrate adherence to their business models.

In the second part of this article we will review how the new impairment model will apply to NFIs as they need to provide for expected credit losses on their trade, lease receivables, contract assets and financial investments.

 

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This article was written by Jonathan Dingli (Director) and Georges Xuereb (Assistant Manager) and was published on The Accountant.