🏦Financial Services Reporting Unit 3 – Financial Instruments: IFRS 9 & IAS 39

Key Concepts and Definitions

• Financial instruments include contracts that give rise to a financial asset of one entity and a financial liability or equity instrument of another entity
• Financial assets encompass cash, equity instruments of another entity, contractual rights to receive cash or another financial asset, and contracts settled in an entity's own equity instruments
• Financial liabilities are contractual obligations to deliver cash or another financial asset to another entity or to exchange financial instruments with another entity under potentially unfavorable conditions
• Equity instruments represent residual interests in the assets of an entity after deducting all of its liabilities
• Derivative financial instruments derive their value from an underlying variable (interest rates, foreign exchange rates, commodity prices) and require little or no initial investment
• Embedded derivatives are components of hybrid contracts that affect the cash flows of the host contract in a manner similar to a standalone derivative
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

Historical Context and Evolution

• IAS 39, issued in 1998, was the first comprehensive standard on financial instruments, addressing recognition, measurement, and hedge accounting
• The complexity and rule-based nature of IAS 39 led to criticisms and calls for simplification
• The global financial crisis of 2007-2008 highlighted weaknesses in accounting for financial instruments, particularly in the areas of impairment and classification
• In response, the IASB initiated a project to replace IAS 39 with a more principles-based and forward-looking approach
• IFRS 9, issued in 2014, introduced significant changes to the classification and measurement of financial assets, impairment methodology, and hedge accounting
• The implementation of IFRS 9 aimed to enhance the transparency and comparability of financial reporting for financial instruments across entities and jurisdictions

Scope and Application

• IFRS 9 applies to all entities and all types of financial instruments, with some exceptions
• Excluded from the scope are interests in subsidiaries, associates, and joint ventures accounted for under IFRS 10, IAS 27, or IAS 28
• Also excluded are rights and obligations under leases (IFRS 16), employee benefit plans (IAS 19), and insurance contracts (IFRS 4 or IFRS 17)
• Financial guarantee contracts and loan commitments may be within the scope of IFRS 9 if they meet certain criteria
• Contracts to buy or sell non-financial items (such as commodities) may fall within the scope of IFRS 9 if they can be settled net in cash or another financial instrument
• Entities have the option to apply hedge accounting under IFRS 9 or continue using the hedge accounting requirements of IAS 39

Classification of Financial Instruments

• IFRS 9 introduces a principles-based approach to the classification of financial assets based on the entity's business model and the contractual cash flow characteristics of the assets
• Financial assets are classified into three categories:
  1. Amortized cost
  2. Fair value through other comprehensive income (FVOCI)
  3. Fair value through profit or loss (FVTPL)
• The business model assessment determines whether the objective is to hold the assets to collect contractual cash flows, to sell the assets, or both
• The contractual cash flow characteristics test (SPPI test) assesses whether the cash flows are solely payments of principal and interest on the principal amount outstanding
• Financial liabilities are generally classified as subsequently measured at amortized cost, with some exceptions (FVTPL for derivatives and financial liabilities held for trading)
• Embedded derivatives are no longer separated from financial asset host contracts but are assessed as a whole for classification

Initial Recognition and Measurement

• Financial assets and liabilities are initially recognized when the entity becomes a party to the contractual provisions of the instrument
• At initial recognition, financial assets and liabilities are measured at their fair value, plus or minus directly attributable transaction costs (except for FVTPL instruments)
• For financial assets measured at FVTPL, transaction costs are expensed immediately in profit or loss
• Trade receivables without a significant financing component are initially measured at their transaction price
• The fair value at initial recognition is normally the transaction price (the fair value of the consideration given or received)
• If the fair value at initial recognition differs from the transaction price, the difference is recognized as a gain or loss only if the fair value is evidenced by a quoted price in an active market or based on a valuation technique using only observable market data

Subsequent Measurement

• Financial assets classified as amortized cost are subsequently measured at amortized cost using the effective interest method
  • Interest income, foreign exchange gains and losses, and impairment are recognized in profit or loss
  • Any gain or loss on derecognition is also recognized in profit or loss
• Financial assets classified as FVOCI are subsequently measured at fair value
  • Interest income, foreign exchange gains and losses, and impairment are recognized in profit or loss
  • Other gains and losses are recognized in OCI until derecognition, when they are reclassified to profit or loss
• Financial assets classified as FVTPL are subsequently measured at fair value, with all gains and losses recognized in profit or loss
• Financial liabilities are generally subsequently measured at amortized cost using the effective interest method, with interest expense recognized in profit or loss
• Financial liabilities designated as FVTPL are measured at fair value, with changes in fair value attributable to changes in the entity's own credit risk recognized in OCI and other changes recognized in profit or loss

Impairment Model

• IFRS 9 introduces a forward-looking expected credit loss (ECL) model for impairment, replacing the incurred loss model under IAS 39
• The ECL model applies to financial assets measured at amortized cost, debt instruments measured at FVOCI, and certain loan commitments and financial guarantee contracts
• ECLs are a probability-weighted estimate of credit losses over the expected life of the financial instrument
• The impairment model has three stages:
  1. Stage 1: 12-month ECLs for instruments with no significant increase in credit risk since initial recognition
  2. Stage 2: Lifetime ECLs for instruments with a significant increase in credit risk since initial recognition
  3. Stage 3: Lifetime ECLs for credit-impaired instruments
• Significant increases in credit risk are assessed by comparing the risk of default at the reporting date with the risk of default at initial recognition
• Credit-impaired financial assets are those for which one or more events have occurred that have a detrimental impact on the estimated future cash flows

Hedge Accounting

• Hedge accounting aims to represent the effect of an entity's risk management activities that use financial instruments to manage exposures arising from specific risks
• IFRS 9 introduces a more principles-based approach to hedge accounting, aligning it more closely with risk management practices
• Three types of hedging relationships are eligible for hedge accounting:
  1. Fair value hedges
  2. Cash flow hedges
  3. Hedges of a net investment in a foreign operation
• Qualifying criteria for hedge accounting include formal designation and documentation, economic relationship between the hedged item and hedging instrument, and effectiveness requirements
• Effectiveness is assessed both prospectively and retrospectively, with a focus on the economic relationship and the hedge ratio
• For fair value hedges, the gain or loss on the hedging instrument and the hedged item attributable to the hedged risk are recognized in profit or loss
• For cash flow hedges, the effective portion of the gain or loss on the hedging instrument is recognized in OCI, while the ineffective portion is recognized in profit or loss
• Amounts accumulated in OCI are reclassified to profit or loss when the hedged item affects profit or loss or when the hedging relationship ends

Disclosure Requirements

• IFRS 7, Financial Instruments: Disclosures, sets out the disclosure requirements for financial instruments
• The objective of the disclosures is to provide information that enables users to evaluate the significance of financial instruments for the entity's financial position and performance and the nature and extent of risks arising from financial instruments
• Entities must disclose the carrying amounts of each category of financial assets and liabilities, as well as information about fair values, credit risk, liquidity risk, and market risk
• For transferred financial assets that are not derecognized, entities must disclose the nature of the assets, the risks and rewards retained, and the carrying amounts
• Entities must also provide a reconciliation of the allowance account for credit losses, showing the movements during the period
• For hedge accounting, entities must disclose information about the risk management strategy, the amount, timing, and uncertainty of future cash flows, and the effects of hedge accounting on financial position and performance

Practical Examples and Case Studies

• Example 1: Classification of debt instruments
  • Company A holds a portfolio of government bonds with the objective of collecting contractual cash flows (principal and interest) and selling the bonds to manage liquidity
  • The bonds have contractual cash flows that are solely payments of principal and interest (SPPI)
  • Based on the business model and SPPI test, the bonds are classified as measured at FVOCI
• Example 2: Impairment of trade receivables
  • Company B has a portfolio of trade receivables with a gross carrying amount of $1,000,000
  • The company applies the simplified approach for trade receivables and recognizes lifetime ECLs
  • Based on historical experience and forward-looking information, the estimated lifetime ECLs are $50,000
  • The company recognizes an impairment loss of $50,000 and reduces the carrying amount of the trade receivables to$950,000
• Example 3: Cash flow hedge of forecast transactions
  • Company C is exposed to foreign currency risk on highly probable forecast sales in USD
  • The company enters into forward contracts to hedge the foreign currency risk, designating the forward contracts as cash flow hedges
  • The effective portion of the gain or loss on the forward contracts is recognized in OCI and accumulated in a cash flow hedge reserve
  • When the forecast sales occur, the amount accumulated in the cash flow hedge reserve is reclassified to profit or loss

Challenges and Controversies

• The complexity of IFRS 9, particularly in the areas of classification and impairment, may pose implementation challenges for entities
• The forward-looking nature of the ECL model requires significant judgment and estimates, which may reduce comparability across entities
• The interaction between IFRS 9 and other standards, such as IFRS 17 for insurance contracts, can create additional complexity and potential accounting mismatches
• The application of hedge accounting remains optional, which may limit comparability between entities that apply hedge accounting and those that do not
• The increased use of fair value measurement may introduce greater volatility in financial statements and raise concerns about the reliability and relevance of the information
• The disclosure requirements under IFRS 7 are extensive and may be burdensome for entities to comply with

Future Developments and Trends

• The IASB continues to monitor the implementation of IFRS 9 and may issue further guidance or amendments to address any issues or inconsistencies that arise
• The interaction between IFRS 9 and IFRS 17 for insurance contracts is an area of ongoing focus, with potential amendments to IFRS 17 being considered to address accounting mismatches
• The increasing importance of sustainability and environmental, social, and governance (ESG) factors may influence the development of accounting standards for financial instruments
  • For example, the classification and measurement of financial instruments with sustainability-linked features or the incorporation of climate risk into impairment models
• Technological advancements, such as blockchain and smart contracts, may impact the recognition, measurement, and disclosure of financial instruments
• The ongoing reform of interest rate benchmarks (e.g., LIBOR) may require amendments to IFRS 9 to address the accounting implications of the transition to alternative reference rates