It belongs to the “Big 3” – the three difficult standards that need to be implemented in the near future:
- IFRS 9 Financial Instruments: adoption date = 1 January 2018
- IFRS 15 Revenues from Contracts with Customers = 1 January 2018
- IFRS 16 Leases = 1 January 2019 (I recommend to apply earlier together with IFRS 9 and IFRS 15).
The trouble with IFRS 9 is that many accountants believe it does not affect them.
“We don’t have any financial instruments, we are a manufacturing company, so why should we care?”
Well, not so true.
At the moment you start selling on credit and issue invoices, you acquire the financial instruments – trade receivables. And yes, IFRS 9 applies here.
Therefore, no procrastinating, time to get ready!
In this article I summarize the main requirements of IFRS 9 as valid in 2017.
I don’t go into many details here – the purpose of this article is to give you the overview.
However, as I want to help you understand and smoothly implement IFRS 9, a few articles dealing with the specific topics were and will be published on IFRSbox. You can read their list at the end.
If you enjoy the video learning more than reading, then please scroll down and watch the video with the summary of IFRS 9.
All set? Let’s start.
Why IFRS 9?
IFRS 9 establishes principles for the financial reporting of financial assets and financial liabilities.
Please note that:
- IFRS 9 does NOT define financial instruments. You can find the definitions of financial instruments in IAS 32 Financial Instruments: Presentation.
- IFRS 9 does NOT deal with your own (issued) equity instruments like your own shares, issued warrants, written options for equity, etc.
- IFRS 9 DOES deal with the equity instruments of someone else, because they are financial assets from your point of view.
- IFRS 9 does NOT deal with your investments in subsidiaries, associates and joint ventures (look to IFRS 10, IAS 28 and related).
When to recognize a financial instrument?
You should recognize a financial asset or a financial liability in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument (please refer to IFRS 9 par. 3.1.1).
Unlike in other IFRS standards that put emphasis on the future economic benefits, IFRS 9 is more about the contract.
When to derecognize a financial instrument?
In other words, when to remove a financial instrument from your financial statements?
IFRS 9 treats the derecognition of financial assets differently from the derecognition of financial liabilities, so let’s break it down.
Derecognition of financial assets
While it’s very easy to recognize a financial asset, it’s very difficult and complicated to derecognize it in some cases.
IFRS 9 is very “sticky” and the reason is to prevent companies from hiding toxic assets out of their balance sheets.
Before you decide whether to derecognize or not, you need to determine WHAT you’re dealing with (IFRS 9 par. 3.2.2):
- A financial asset (or a group of similar financial assets) in its entirety, or
- A part of a financial asset (or a part of a group of similar financial assets) meeting specified conditions.
After you determine WHAT you derecognize, then you need derecognize the asset when (IFRS 9 par. 3.2.3):
- The contractual rights to the cash flows from the financial asset expire – that’s an easy and clear option; or
- An entity transfers the financial asset and the transfer qualifies for the derecognition – that’s more complicated.
Transfers of financial assets are discussed in more details and to sum it up, you need to go through the following steps:
- Decide whether the asset (or its part) was transferred or not,
- Determine whether also risks and rewards from the financial asset were transferred.
- If you have neither retained nor transferred substantially all of the risks and rewards of the asset, then you need to assess whether you have retained control of the asset or not.
Transfers of financial assets are then discussed in much greater detail in IFRS 9 and also, application guidance summarizes the derecognition steps in a simple decision tree. You can familiarize yourself with the decision tree in the video below this summary.
Derecognition of a financial liability
An entity shall derecognize a financial liability when it is extinguished.
It happens when the obligation specified in the contract is discharged, cancelled or expires.
Classification of financial instruments
How to classify the financial assets?
IFRS 9 classifies financial assets based on two characteristics:
- Business model test
What is the objective of holding financial assets? Collecting the contractual cash flows? Selling?
- Contractual cash flows’ characteristics test
Are the cash flows from the financial assets on the specified dates solely payments of principal and interest on the principal outstanding? Or, is there something else?
Based on these two tests, the financial assets can be classified in the following categories:
- At amortized cost
A financial asset falls into this category if BOTH of the following conditions are met:
- Business model test is met, i.e. you hold the financial assets only to collect contractual cash flows (not to sell them), and
- Contractual cash flows’ characteristics test is met, i.e. the cash flows from the asset are only the payments of principal and interest.
Examples: debt securities, receivables, loans.
- At fair value through other comprehensive income (FVOCI)
Here, there are 2 subcategories:
- 2a. If a financial asset meets contractual cash flows characteristics test (i.e. debt assets only) and the business model is to collect contractual cash flows AND SELL financial assets, then such an asset mandatorily falls into this category (unless FVTPL option is chosen; see below)
- 2b. You can voluntarily choose to measure some equity instruments at FVOCI. This is an irrevocable election at initial recognition.
- At fair value through profit or loss (FVTPL)
All other financial assets fall in this category.
Derivative financial assets are automatically classified at FVTPL.
Moreover, regardless above 2 categories, you may decide to designate the financial asset at fair value through profit or loss at its initial recognition.
The following scheme explains it:
How to classify financial liabilities?
IFRS 9 classifies financial liabilities as follows:
- Financial liabilities at fair value through profit or loss: these financial liabilities are subsequently measured at fair value and here, all derivatives belong.
- Other financial liabilities measured at amortized cost using the effective interest method.
IFRS 9 mentions separately some other types of financial liabilities measured in a different way, such as financial guarantee contracts and commitments to provide a loan at a below market interest rate, but here, we will deal with 2 main categories.
How to measure financial instruments?
Financial asset or financial liability shall be initially measured at:
- Fair value: all financial instruments at fair value through profit or loss;
- Fair value plus transaction cost: all other financial instruments (at amortized cost or fair value through other comprehensive income).
Subsequent measurement depends on the category of a financial instrument and I think it’s self-explanatory according to the title of a category:
- Financial assets shall be subsequently measured either at fair value or at amortized cost;
- Financial liabilities are measured at amortized cost unless the fair value option is applied.
With regard to recognizing gains and losses from subsequent measurement, here’s the scheme for your convenience:
Impairment of financial assets
This is exactly the most important part for all of you who “have no financial instruments in their financial statements”.
Because, I explained above, even trade receivables are financial instruments.
Are you booking the bad debt provision?
So here you go.
Using the IFRS 9 terminology, “bad debt provision” = impairment of financial assets, or a loss allowance.
The new rules about the impairment of financial assets were added only in July 2014.
It does NOT affect all financial assets. For example, shares and other equity instruments are excluded, because their potential impairment is taken into account when re-measuring these investments to their fair value.
IFRS 9 requires entities to estimate and account for expected credit losses for all relevant financial assets (mostly debt securities, receivables including lease receivables, contract assets under IFRS 15, loans), starting from when they first acquire a financial instrument.
When measuring expected credit losses, entities will be required to use all relevant information that is available to them (without undue cost or effort).
IFRS 9 offers two approaches:
- General model for measuring a loss allowance:
This model recognizes loss allowance depending on the stage in which the financial asset is. There are 3 stages:
- Stage 1 – Performing assets: Loss allowance is recognized in the amount of 12-month expected credit loss;
- Stage 2 – Financial assets with significantly increased credit risk: Loss allowance is recognized in the amount of lifetime expected credit loss, and
- Stage 3 – Credit-impaired financial assets: Loss allowance is recognized in the amount of lifetime expected credit loss and interest revenue is recognized based on amortized cost.
- Simplified model:
You don’t need to determine the stage of a financial asset, because a loss allowance is recognized always at a lifetime expected credit loss.
If you subscribe to the free newsletter, you’ll receive an exclusive article with the video about the new impairment model.
An embedded derivative is simply a component of a hybrid instrument that also includes a non-derivative host contract.
Accounting of embedded derivatives depends on WHAT the host contract is:
- If host = financial asset within the scope of IFRS 9, then the whole hybrid contract shall be measured as one and not separated.
- If host = financial liability within the scope of IFRS 9 OR a contract outside the scope of IFRS 9 (e.g. service contract, lease contract…), then you should separate when the conditions are met.
Separation means that you account for embedded derivative separately in line with IFRS 9 and the host contract in line with other appropriate standard.
If an entity is not able to do this, then the whole contract must be accounted for as a financial instrument at fair value through profit or loss.
Hedge accounting is designating one or more hedging instruments so that their change in fair value is an offset to the change in fair value or cash flows of a hedged item.
If you’d like to see a simple illustration, please watch the video below this article (somewhere around the minute 17:43).
One very important remark:
Hedge accounting is NOT mandatory!
You do NOT have to do it, only if you want to (+meet the conditions).
Let’s say you try to protect your company against foreign currency risk and you enter into foreign currency forward contract. Even if you meet the conditions for the hedge accounting, you can still measure the derivative at fair value through profit or loss and not apply hedge accounting – up to you.
But, I strongly recommend reading the article about how ignoring hedging can hurt your business – maybe you’ll want to apply it voluntarily then.
If you want to apply hedge accounting, 3 criteria must be met (IFRS 9, par. 6.4.1):
- There are only eligible hedging instruments and eligible hedged items in the relationship;
- You have the hedge documentation at the inception of the hedge, in which you designate and describe your hedging,
- Hedge effectiveness criteria are met.
IFRS 9 sets the rules for 3 types of hedges:
- Cash flow hedge,
- Fair value hedge, and
- Hedge of the net investment in the foreign operation.
The overview of the accounting for these hedges is shown in the following scheme:
You can read more about hedging in one of our articles referred to below.
Further reading and video
To give you a helping hand in the understanding and application of IFRS 9, we published a few IFRS 9 related articles:
- How to Implement IFRS 9 (by Mr. Spark Wang Jun)
- How New Impairment Rules in IFRS 9 Affect You (by Silvia)
- How Ignoring Hedging Can Hurt Your Business (by Mr. James Philcox)
- Hedge Accounting: IAS 39 vs. IFRS 9 (by Silvia)
- Hedge Accounting Under IFRS 9: Rebalancing – What Is This New Concept? (by Mr. Kevin Mitchel and Silvia)
- Difference Between Fair Value Hedge and Cash Flow Hedge (by Silvia)
Here’s the video with the summary of IFRS 9: