IAS 39 Financial Instruments: Recognition and Measurement has been the accounting standard for financial instruments since 2001. At that time, it was an overhaul of existing accounting requirements for financial instruments as, for the first time, credit institutions had to account for all derivative financial instruments on the balance sheet.
Since 2005, they are also required to be accounted for at fair value. This has been a controversial area for standard-setters. The requirements of IAS 39 have been cited by some as contributing to Ireland’s banking crisis. Most recently, CARB concluded that IAS 39 “did not work” in relation to the banking crisis in Ireland by “prohibiting provisions in respect of losses thought likely to be incurred in the future”. This refers to the incurred loss impairment model that IAS 39 used for financial assets.
Credit institutions and other entities applying IAS 39 are prevented from impairing a loan until the loss event occurs, as opposed to predicting when a loan is expected to become impaired and providing for it prospectively. The objective of IAS 39 in that regard was to prevent ‘big bath’ provisioning whereby earnings could be managed by timing the release of general provisions. It seems that in solving one problem, IAS 39 created another and the accounting requirements for the impairment of financial assets have now gone full circle. IFRS 9 will implement the expected loss impairment model, enabling banks to recognise expected credit losses on loans from the implementation date.
Implications of IFRS 9
In response to the controversy surrounding IAS 39, the International Accounting Standards Board (IASB) will replace it with IFRS 9. In July 2014, the project was completed with the exception of macro hedging and will become effective for annual periods beginning on or after 1st January 2018, with early adoption permitted. IFRS 9 brings together the classification, measurement, impairment and hedge accounting phases of the IASB’s project to replace IAS 39. It also brings about two major changes to financial instrument accounting. In future, financial assets will be classified and measured in accordance with the business model in which they are managed and their cash flows.
In relation to financial instruments subject to impairment accounting, there is also a move from an incurred loss to a forward-looking expected credit loss model. This aims to achieve a more timely recognition of loan losses.
In relation to credit institutions, meanwhile, IFRS 9 has addressed two issues that arose with the application of IAS 39. Firstly, when applying IAS 39 and electing to measure debt at fair value, credit institutions would be required to book a gain in the profit and loss if their own credit worthiness decreased, which does not seem logical. This issue has been amended by IFRS 9 whereby gains of this nature are no longer recognised in the profit and loss account. Second, the hedge accounting requirements of IAS 39 did not reflect the institution’s day-to-day activities. IFRS 9 presents an improved hedge accounting model to better link the economics of risk management with its accounting treatment.
IAS 39 contained four different asset classification categories: trading, loans and receivables, available for sale, and held to maturity. The classification determines how financial assets are accounted for and their measurement from the date of acquisition (initially measured at fair value). IFRS 9 reduces the number of asset classes to three: amortised cost, fair value through the profit and loss (FVTPL), and fair value through OCI (FVOCI).The accounting standard also stipulates two criteria to determine how financial assets should be classified and measured: the entity’s business model and the contractual cash flow characteristics of the financial asset.
If the entity intends to hold assets to collect contractual cash flows and the contractual terms of the financial asset give rise on specified dates to cash flows that are subsequent changes in fair value in other comprehensive income.
Impairments and Credit Risk
The delayed recognition of credit losses was identified as a weakness in IAS 39. IFRS 9 moves to an expected-loss impairment model that requires more timely recognition of expected credit losses. The model requires an entity to recognise expected credit losses at all times, from the date of inception. The entity is further required to update the amount of expected credit losses at each reporting date to reflect changes in forecasted future economic conditions. This is a huge task for credit institutions, which hold a high quantity and range of financial assets. The new requirements are expected to involve updating not only accounting policies, but also credit management systems.
The IASB recognised this and established the Impairment Transition Group to support stakeholders. At the time of writing, the group had met twice and the following issues were considered at the most recent meeting in April 2015: forecasts of future economic conditions; loan commitments and scope; expected credit losses and measurement date; assessment of significant increase in credit risk for guaranteed debt instruments; the maximum period to consider when measuring expected credit losses; revolving credit facilities; measurement of expected credit losses for an issued financial guarantee contract; and measurement of expected credit losses in respect of a modified financial asset.
IAS 39 required an entity to book a gain in the profit and loss if its own credit worthiness decreased when a debt instrument was measured at fair value. This caused unnecessary profit and loss volatility, which perhaps did not reflect the true nature of the entity’s position. IFRS 9 removes this volatility by ensuring that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer solely payments of principal and interest (SPPI) on the principal amount outstanding, the assets may be classified as amortised cost.
On the other hand, if the business model is to hold assets to collect contractual cash flows and subsequently sell the assets, and the contractual terms of the financial asset give rise on specified dates to cash flows that are SPPI on the principal amount outstanding, they may be classified as FVOCI. All other assets that do not qualify as amortised cost or FVOCI will be classified as FVTPL. It is important to note, however, that an entity may make an irrevocable election at initial recognition for particular investments in equity instruments, which would otherwise be measured at FVTPL, to present recognised in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted.
Financial Liabilities and Disclosures
IFRS 9 stipulates that all financial liabilities shall be initially measured at fair value and subsequently measured at amortised cost, with the exception of financial liabilities which will be measured at FVTPL. The FVTPL option is available if, by doing so, it results in more relevant information being provided for users of the financial statements. An example would be eliminating or significantly reducing an inconsistency in measurement or recognition.
In relation to the expected credit loss calculations outlined above, entities are required to provide explanatory information in their financial statements. Entities are also required to provide the following reconciliations: reconciliation from opening to closing balances for 12-month loss allowances separately from lifetime loss allowance balances; and reconciliation from opening to closing balances of related carrying amounts of financial instruments subject to impairment.
Hedging Accounting Requirements
The hedge accounting requirements of IAS 39 did not reflect the practical risk management side of a credit institution’s day-to-day activities. IFRS 9 has introduced changes that should enable entities to more accurately reflect hedging activities in their financial statements. The model for hedge accounting has been changed and enhanced, and disclosures will be required in relation to risk management activity which will enable users to understand the nature of the hedging undertaken from a risk perspective. Hedge accounting requirements should therefore be more aligned with risk management activities into the future, enabling entities to better-reflect these activities in their financial statements.
A hedging relationship qualifies for hedge accounting under IFRS 9 provided all of the following criteria are met:
- The hedging relationship consists of eligible hedging instruments and eligible hedged items;
- There is formal designation and documentation of both the hedging relationship at inception and the entity’s risk management objective for undertaking the hedge;
- The hedging relationship meets all of the hedge effectiveness requirements: economic relationship between the hedged item and the hedging instrument; the value changes are not dominated by credit risk; and the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of the hedged item.
For a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities only, an entity may apply the hedge accounting requirements in IAS 39 as opposed to those in IFRS 9.The IASB issued a discussion paper in this regard, called Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging.
Financial Instrument accounting standards have been challenged in a number of ways by the events leading to and during the financial crisis. While the role played by accounting standards in our view is debatable and perhaps even overstated, the IASB has sought to re-examine the relevant issues at a fundamental level. IFRS 9 attempts to deal with these issues by establishing principals for the financial reporting of financial assets and financial liabilities that will, if adopted in a spirit of fair and transparent reporting, present relevant and useful information to users of financial statements. Time will tell if the standard achieves its objective.
This article first appeared in Accountancy Ireland magazine December 2015.