IFRS 9 is a new financial instrument accounting standard applicable to businesses reporting under IFRS in the financial statements beginning on or after 1 January 2018. The major change expected to the loss impairment model is the critical well-publicised change for money lenders. Here we look at some of the potential highlights for corporate entities on the initial application of the standard.
|Area||IFRS 9 change VERSUS IAS 39|
|Financial asset classification and measurement||Complete change based on two tests||- Fair value or amortised cost depends on tests – no embedded derivatives.
- Significant change for money lending assets (if any).
- Intercompany receivables may require attention.
|Financial asset impairment||Major change to expected loss model||- Significant complexity for long-term lending and intercompany receivables.
- Expected credit loss provision on trade receivables
|Financial liability classification and measurement||Almost identical to IAS 39||Only change relates to credit risk re liabilities designated at FVTPL|
|Financial liability – non substantial modification||End of no gain no loss practice||Applies retrospectively, ie to those liabilities modified, but not derecognised pre-transition.|
|Hedge accounting||Some similarities but changes in a number of areas||- Bright-line effectiveness test requirement is removed.
- Some increased availability of hedge accounting.
- Hedge documentation needs to be updated at transition.
Classification and measurement of financial assets
Although the classification and measurement of financial assets under IFRS 9 represents a significant change to IAS 39 – it will in many cases bring little change to those entities that hold trade receivables, which will remain carried at amortised cost. Intra-group balances could be more problematic and require detailed assessment. In particular, where subsidiaries are fully funded by intra-group loans with the consequence that the lender is in effect exposed to risks of changes in equity prices, the IFRS 9 guidance would require careful consideration. In general if a business enters into money lending activities (including related party lending) then the “contractual cash flows test” should be carefully considered, which could impact the classification. The “contractual cash flows test”, which is also commonly referred to as the “solely payment of principal and interest test” (SPPI test) is one of two tests which determines the financial asset classification. Contractual cash flows inconsistent with the SPPI test leads to the instrument being carried at fair value through profit and loss.
Accounting for equity investments
The option to carry unquoted equity investments at cost is no longer available under IFRS 9 and such instruments will need to be measured at fair value through profit or loss (FVTPL). IFRS 9, however, allows an irrevocable election to present in other comprehensive income (FVOCI) subsequent changes in the fair value of such instruments subject to limited exceptions. This election needs to be made on initial recognition or initial application of the standard.
Modifications and exchanges of financial liabilities that do not result in derecognition
Whilst the requirements of IFRS 9 in respect of financial liability accounting are largely the same as those in IAS 39, a recent amendment to IFRS 9 represents a notable area of change. The amendment includes commentary in the basis for conclusions which puts an end to the current no gain no loss practice in this area of accounting and requires retrospective application. This means that for those financial liabilities that are modified prior to the adoption of IFRS 9 and not derecognised before the date of initial application of that standard, prior year restatement will be required.
Entity A has an existing loan liability for £1M pays interest at 5% with 10 years maturity remaining. The loan is due for repayment via a single bullet payment with interest paid annually. On 1 Jan X0, the loan terms are renegotiated with the interest rate changing to 4% with maturity remaining at 10 years. Assuming this is not considered to be a derecognition event, this would be accounted for as a non-substantial modification. Traditionally, interpretation under IAS 39.AG62 was often that this was accounted for as no gain no loss transaction with the effective interest rate changed to 4% from date of modification. However, the clarification in IFRS (which applies from IFRS 9 adoption) is such that the loan balance would be restated to the net present value of the revised cash flows, discounted at the original effective interest rate. This amounts to £923K. An immediate gain of £77K is recognised in profit and loss. The effective interest rate remains at 5%.
Hedge accounting requirements represents the most notable area of change under IFRS 9. The revised model is more aligned to the actual risk management activities of preparers, in particular due to different approach to effectiveness with the bright line 80-125% effectiveness requirement eliminated. However, this, along with other requirements of IFRS 9, means any existing hedge documentation needs to be updated. The standard includes increased eligibility for both hedging instruments and hedged items. In particular, the IFRS 9 approach to risk components is significantly different compared to IAS 39 particularly relating to components of non-financial items (such as a crude oil component of a jet fuel purchase or RPI component of inflation linked income). This may make hedge accounting more attractive in certain situations. However, hedge accounting could only commence once designations are in place.
The standard moves away from the incurred credit loss model to the expected credit loss model. This means, that entities need to take into account forward looking information for calculating their impairment loss provisions. There is a simplified approach for short-term trade and lease receivables, where entities can elect to calculate life-time expected credit losses, instead of having to closely monitor changes in credit risk of their counterparties. However, even with this simplification –entities still need to measure and book provision for expected credit loss. This means that an impairment provision is recognised based on the probability weighted expected loss, even if there are no indicators of impairment. For trade receivables a strong starting point will be impairment provisions based on historical bad debt experience. Many entities might apply a “matrix” type approach as outlined in the standard. There is no similar simplifications for long-term lending. Consequently, measuring impairment losses on such assets will represent a significant complexity. The IFRS 9 impairment model is proving a very major change for money lending businesses.
The implementation of this new standard will affect entities in different ways, depending on business model and financial risk management. However, changes are likely to be significant for many entities. Assessment of the impact areas will require considerable thought and some decisions need to be made pre-transition. For more information, please contact Alan Chapman, who is the firm’s leading expert on financial instrument accounting. Additional guidance