ACCA Technical Article : IFRS 9 - What is a financial instrument
This article is reprinted from ACCA's website
Arguably, IFRS 9 has simplified and improved accounting for financial assets in comparison with its predecessor, IAS® 39. There is increased emphasis on fair value accounting and reporting, which is regarded as both relevant and reliable information to those interested in financial reports. IFRS 9 has also reduced the degree of discretion for classification and accounting treatment of financial assets, which should support consistent reporting of financial information relating to financial assets and enhance understanding and comparability of that information.
If we begin with the classification of financial assets, IFRS 9 now classifies financial assets under three headings as follows:
Classification of financial assets
(1) Financial assets at fair value through profit or loss (FVTPL)
This is the normal default classification for financial assets and will apply to all financial assets unless they are designated to be measured and accounted for in any other way. This classification includes any financial assets held for trading purposes and also derivatives, unless they are part of a properly designated hedging arrangement. Debt instruments will be classified to be measured and accounted for at FVTPL unless they have been correctly designated to be measured at amortised cost (see later). Initial recognition at fair value is normally cost incurred and this will exclude transactions costs, which are charged to profit or loss as incurred. Remeasurement to fair value takes place at each reporting date, with any movement in fair value taken to profit or loss for the year, which effectively incorporates an annual impairment review.
(2) Financial assets at fair value through other comprehensive income (FVTOCI)
This classification applies to equity instruments and simple debt instruments and must be designated upon initial recognition. It will be applicable to financial assets that an entity holds within a business model whose objective is achieved by both collecting the contractual cash flows and selling the financial assets. The contractual cash flows will usually be collected on a specific date will consist of payments of principle and interest. Initial recognition at fair value would normally include the associated transaction costs of purchase. The accounting treatment automatically incorporates an impairment review, with any change in fair value taken to other comprehensive income in the year.
Upon derecognition, any gain or loss is based upon the carrying amount at the date of disposal. One important point is that there is no recycling of any amounts previously taken to equity in earlier accounting periods. Instead, at derecognition, an entity may choose to make an equity transfer from other components of equity to retained earnings as any amounts previously taken to equity can now be regarded as having been realised.
(3) Financial assets measured at amortised cost
This classification can apply only to debt instruments and must be designated upon initial recognition. For the designation to be effective, the financial asset must pass two tests as follows:
- The business model test – to pass this test, the entity must be holding the financial asset to collect in the contractual cash flows associated with that financial asset. If this is not the case, such as the financial asset being held and then traded to take advantage of changes in fair value, then the test is failed and the financial asset reverts to the default classification to be measured at FVTPL.
- The cash flow characteristics test – to pass this test, the contractual cash flows collected must consist solely of payment of interest and capital. If this is not the case, the test is failed and the financial asset reverts to the default classification to be measured at FVTPL.
One example of a financial asset that would fail this test is a convertible bond. While there is receipt of the nominal rate of interest payable by the bond issuer, and the bond will be converted into shares or cash at a later date, the cash flows are affected by the fact that the bond holder has a choice to make at some later date – either to receive shares or cash at the time the bond is redeemed. The nominal rate of interest received will be lower than for an equivalent financial asset without conversion rights to reflect the right of choice the bondholder will make at some later date.
This classification of financial asset requires annual review for evidence of possible impairment and, if there is evidence, there must be an impairment review. Any impairment identified must be charged to profit or loss in full immediately.
One problem that may arise in relation to financial assets measured at fair value is whether a reliable fair value can be determined at the reporting date. For exchange-traded financial assets, such as equity shares in a listed entity, this may be a relatively straightforward process. If, however, the financial assets in question are not traded on an exchange, there may be no definitive method to determine fair value at a particular date. This could result in the exercise of judgment or discretion, which could undermine the reliability or relevance of any amounts accounted for as a fair value.
Illustration 1 – classification and measurement of financial assets
An entity, Suarez, purchased a five-year bond on 1 January 2010 at a cost of $5m with annual interest of 5%, which is also the effective rate, payable on 31 December annually. At the reporting date of 31 December 2010 interest has been received as expected and the market rate of interest is now 6%.
Account for the financial asset at 31 December 2010 on the basis that:
(i) it is classified as FVTPL, and
(ii) it is classified to be measured at amortised cost, on the assumption it passes the necessary tests and has been properly designated at initial recognition.
(i) If classified as FVTPL
This requires that the fair value of the bond is measured based upon expected future cash flows discounted at the current market rate of interest of 6% as follows:
|Year||Expected cash flows||6% discount factor||Present value $m|
|31 December 2011||$5m x 5% = $0.25m||0.9434||0.2358|
|31 December 2012||$0.25m||0.8900||0.2225|
|31 December 2013||$0.25m||0.8396||0.2099|
|31 December 2014||$0.25m + $5m||0.7921||4.1585|
Therefore, at the reporting date of 31 December 2010, the financial asset will be stated at a fair value of $4.8267m, with the fall in fair value amounting to $0.1733m taken to profit or loss in the year. Interest received will be taken to profit or loss for the year amounting to $0.25m.
(ii) If classified to be measured at amortised cost
This requires that the fair value of the bond is measured based upon expected future cash flows discounted at the original effective rate of 5%. This will continue to be at $5m as the following calculation confirms:
|Year||Expected cash flows||5% discount factor||Present value $m|
|31 December 2011||$5m x 5% = $0.25m||0.9524||0.2381|
|31 December 2012||$0.25m||0.9070||0.2267|
|31 December 2013||$0.25m||0.8638||0.2160|
|31 December 2014||$0.25m + $5m||0.8227||4.3192|
In addition, interest received during the year of $0.25m will be taken to profit or loss for the year.
Impairment of financial assets
IFRS 9 requires an entity to account for expected credit losses – ie a credit event does not need to have occurred for a credit loss to be recognised. An impairment review is required for financial assets that are measured at fair value and any fall in fair value is taken to profit or loss or other comprehensive income for the year, depending upon the classification of the financial asset (see earlier).
For financial assets designated to be measured at amortised cost, an entity must make an assessment at each reporting date whether there is evidence of possible impairment; if there is, then an impairment review should be performed. If impairment is identified, it is charged to profit or loss immediately. Quantification of the recoverable amount would normally be based upon the present value of the expected future cash flows estimated at the date of the impairment review and discounted to their present value based on the original effective rate of return at the date the financial asset was issued.
Illustration 2 – impairment of financial assets measured at amortised cost
Using the information contained within Illustration 1, where the carrying amount of the financial asset at 31 December 2010 was $5m. If, in early 2011, it was identified the bond issuer was beginning to experience financial difficulties, and there was doubt regarding full recovery of the amounts due to Suarez, an impairment review would be required. The expected future cash flows now expected by Suarez from the bond issuer are as follows:
|Year||Expected cash flows|
|31 December 2011||$0.20m|
|31 December 2012||$0.20m|
|31 December 2013||$0.20m|
|31 December 2014||$0.20m + $4.4m|
Required: Calculate the extent of impairment of the financial asset to be included in the financial statements of Suarez for the year ending 31 December 2011.
Answer: The future cash flows now expected are discounted to present value based on the original effective rate associated with the financial asset of 5% as follows:
|Year||Expected cash flows||5% discount factor||Present value $m|
|31 December 2011||$0.20m||0.9524||0.1905|
|31 December 2012||$0.20m||0.9070||0.1814|
|31 December 2013||$0.20m||0.8638||0.1727|
|31 December 2014||$0.20m + $4.4m||0.8227||3,7844|
Therefore, impairment amounting to the change in carrying value of ($5.0m – $4.329m) $0.671m will be recognised as an impairment charge in the year to 31 December 2011. Additionally, there will also be recognition of interest receivable in the statement of comprehensive income for the year amounting to (4.329m x 5%) $0.2165m.
Both the Board and FASB in the US continue their work on accounting for impairment of financial assets, with a reporting standard expected before the end of 2011.
Classification of financial liabilities
Financial liabilities should be accounted for as follows:
- Financial liabilities at fair value through profit or loss (FVTPL): like the equivalent classification for financial assets, this will include financial liabilities incurred for trading purposes and also derivatives that are not part of a hedging arrangement.
- Other financial liabilities measured at amortised cost: if financial liabilities are not measured at FVTPL, they are measured at amortised cost.
IFRS 9 also retains the option for some liabilities, which would normally be measured at amortised cost to be measured at FVTPL if, in doing so, it eliminates or reduces an accounting mismatch, sometimes referred to as ‘the fair value option’. Where this is the case, to the extent that part of the change in fair value of the financial liability is due to a change in the entity’s own credit risk, this should be taken to other comprehensive income in the year, with the balance of any change in fair value taken to profit or loss. If this accounting treatment for the credit risk creates or enlarges an accounting mismatch in profit or loss then the gain or loss relating to credit risk should also be taken to profit or loss.
The overall impact of IFRS 9 is that there is likely to be increased emphasis on fair value accounting for financial assets, rather than the use of other forms of measurement such as amortised cost or historical cost. In addition, accounting for impairment of financial assets has become less complex.
There have been no significant changes to accounting for financial liabilities.
Tony Sweetman is a content specialist and tutor at Kaplan Publishing and Kaplan Financial