IFRS 9 Financial Instruments

This briefing document provides a detailed review of the main themes and important ideas related to IFRS 9 Financial Instruments, as derived from the provided source materials. It covers the scope, classification and measurement, impairment, and hedge accounting aspects of the standard, drawing upon specific examples and application guidance.

1. Scope of IFRS 9:

IFRS 9 has a broad scope, generally encompassing financial instruments that were previously within the scope of IAS 39. However, it also includes certain items that were treated differently under IAS 39 or are new.

• Inclusions:
• Certain loan commitments not measured at Fair Value Through Profit or Loss (FVTPL).
• Contract assets as defined by IFRS 15.
• Contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument (unless the “own-use” exemption applies). According to one source, “a contract to buy or sell a non-financial item that can be settled net in cash or in another financial instrument is excluded from the scope of IAS 39 if the contract was entered into, and continues to be held, for the purposes of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. This is commonly referred to as the ‘own-use’ exemption.”
• Loan commitments designated as financial liabilities at FVTPL.
• Loan commitments with a past practice of selling the resulting assets shortly after origination.
• Commitments to provide a loan at a below-market interest rate.
• Written options to buy or sell a non-financial item that can be net settled.
• Exclusions:
• Financial instruments, contracts, and obligations under share-based payment transactions (subject to exceptions for net-settled non-financial items).
• Rights to reimbursement for expenditure to settle a liability recognised under IAS 37, or for which a provision was recognised earlier.
• Rights and obligations within the scope of IFRS 15 that are financial instruments (except those IFRS 15 specifies are accounted for under IFRS 9).

2. Classification and Measurement of Financial Assets:

The classification and subsequent measurement of financial assets under IFRS 9 are primarily driven by two assessments:

• The entity’s business model for managing the financial assets: This assessment is made at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. As stated in one source, “Ultimately the level at which the business model assessment is made is the level at which decisions are taken about how an entity manages its financial assets.” Different objectives can exist at different levels within a consolidated group. For public sector entities, “the business model assessment may result in different objectives at different levels within the same consolidation group.” Changes in government policy or significant private sector policy changes can lead to a reclassification if they affect the underlying entity’s business model. The assessment is based on facts and circumstances at the date of initial application (DIA) and does not require consideration of past business models.
• The contractual cash flow characteristics of the financial asset (SPPI criterion): This assesses whether the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. “The holder analyses the contractual terms of the instrument to determine whether it meets the SPPI criterion.” Certain features, such as contractual bail-in clauses where principal and interest can be written off due to insufficient regulatory capital, could cause an instrument to fail the SPPI criterion. Modifications to the time value of money element are also considered to determine if the contractual cash flows are significantly different from a benchmark instrument.

Based on these assessments, financial assets are classified into one of three categories:

• Amortised Cost: This applies to debt instruments held within a business model whose objective is to hold assets in order to collect contractual cash flows, and those cash flows represent solely payments of principal and interest (SPPI).
• Fair Value Through Other Comprehensive Income (FVOCI): This applies to debt instruments held within a business model whose objective is achieved by both collecting contractual cash flows and selling the financial assets, and the contractual cash flows also represent SPPI. Entities can also make an irrevocable election at initial recognition to present changes in fair value of certain equity investments that are not held for trading in OCI.
• Fair Value Through Profit or Loss (FVTPL): This is the residual category and applies to financial assets that do not meet the criteria for amortised cost or FVOCI. This includes assets held for trading or managed on a fair value basis. “Business model is neither held-to-collect nor held to collect and for sale… Collection of contractual cash flows is incidental to the objective of the model.” In this case, the “SPPI criterion is irrelevant – assets in all such business models are measured at FVTPL.”

Sales of financial assets can occur even within a held-to-collect business model, for example, to manage concentrations of credit risk or due to regulatory changes. Isolated sales do not necessarily change the business model assessment.

3. Classification and Measurement of Financial Liabilities:

The classification and measurement of financial liabilities are less complex than for financial assets. Generally, financial liabilities are subsequently measured at amortised cost using the effective interest method. However, there are exceptions:

• Financial liabilities held for trading (including derivatives): Measured at FVTPL.
• Financial liabilities designated as at FVTPL on initial recognition: This designation is permitted when it eliminates or significantly reduces a measurement inconsistency or when a group of financial liabilities is managed and its performance is evaluated on a fair value basis.
• Financial liabilities arising from transfers of financial assets that do not qualify for derecognition or when the continuing involvement approach applies: Measured under specific guidance carried forward from IAS 39.
• Financial guarantee contracts: Subject to specific accounting.
• Changes in credit risk for liabilities designated at FVTPL: The portion of the change in fair value attributable to changes in the liability’s own credit risk is presented in OCI, unless this creates or enlarges an accounting mismatch in profit or loss.

Financial liabilities are derecognised when they are extinguished, i.e., when the obligation is discharged, cancelled, or expires. Substantial modifications of the terms of existing financial liabilities or the exchange of debt instruments with substantially different terms are accounted for as an extinguishment of the original liability and the recognition of a new one.

4. Impairment of Financial Assets:

IFRS 9 introduces a forward-looking expected credit loss (ECL) model, replacing the incurred loss model of IAS 39. This model applies to a broader range of financial instruments, including:

• Financial assets measured at amortised cost and FVOCI (debt instruments only).
• Lease receivables.
• Contract assets.
• Loan commitments not measured at FVTPL.
• Financial guarantee contracts not measured at FVTPL.

The ECL model requires entities to recognise expected credit losses from initial recognition of a financial instrument. Financial instruments are categorised into three stages based on the change in credit risk since initial recognition:

• Stage 1: For instruments where there has not been a significant increase in credit risk since initial recognition. A 12-month expected credit loss is recognised.
• Stage 2: For instruments where there has been a significant increase in credit risk since initial recognition, but that are not credit-impaired. Lifetime expected credit losses are recognised.
• Stage 3: For instruments that are credit-impaired. Lifetime expected credit losses are recognised, and interest revenue is calculated on the net carrying amount (gross carrying amount less loss allowance).

The assessment of whether there has been a significant increase in credit risk considers the change in the probability of default (PD) occurring over the expected life of the financial instrument. Factors considered can include significant adverse changes in the borrower’s financial condition, actual or expected adverse changes in the operating environment, or a significant increase in credit spread. One illustrative disclosure highlights the use of lifetime PD bands and increases in lifetime PD at the reporting date to determine significant increases in credit risk.

The definition of default under IFRS 9 is aligned with the definition of credit-impaired and occurs when one or more criteria are met, such as a breach of contract, the granting of a concession by the lender due to the borrower’s financial difficulty, or it becoming probable that the borrower will enter bankruptcy.

Public sector entities may have exemptions from recognising stage 1 and stage 2 impairments for certain liabilities with core central government departments and the Bank of England, which are assessed as having zero ‘own credit risk’.

The Financial Services Authority in Indonesia issued regulations (POJK No. 40/POJK.03/2019) concerning asset quality assessment for commercial banks, alongside the implementation of PSAK 71 (the Indonesian equivalent of IFRS 9) by entities like PT Bank X.

5. Hedge Accounting:

IFRS 9 introduces a more principles-based approach to hedge accounting, aiming to better align accounting with risk management activities. Key aspects include:

• Eligibility of Hedged Items and Hedging Instruments: Hedged items can be recognised assets, liabilities, firm commitments, highly probable forecast transactions, or a net investment in a foreign operation. Hedging instruments are typically derivatives, but in some cases, non-derivative financial assets or liabilities can be used to hedge foreign currency risk. Combinations of derivatives or proportions thereof can also be jointly designated as hedging instruments, provided they do not constitute a net written option at the date of designation.
• Hedge Effectiveness: A hedging relationship qualifies for hedge accounting only if it meets certain effectiveness requirements, including an economic relationship between the hedged item and the hedging instrument, and the effect of credit risk does not dominate the value changes. Hedge effectiveness is assessed prospectively and retrospectively.
• Types of Hedges: IFRS 9 continues to recognise three main types of hedging relationships:
• Fair Value Hedge: Hedging the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment.
• Cash Flow Hedge: Hedging the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction, and could affect profit or loss.
• Hedge of a Net Investment in a Foreign Operation: Accounting for the hedging of the foreign currency risk arising from a net investment in a foreign operation.
• Risk Components: In certain circumstances, an entity can designate a component of an item as the hedged item, provided the risk component is separately identifiable and reliably measurable. For interest rate risk on debt instruments, a benchmark rate (e.g., LIBOR) can often be identified as a hedgeable component. However, inflation risk is generally presumed not to be separately identifiable and reliably measurable unless contractually specified and market conditions support it.
• Rebalancing: The weightings of the hedged item and the hedging instrument in a hedging relationship can be adjusted (rebalanced) without the hedging relationship being discontinued if the risk management objective remains the same.
• Hedge of a Group of Items (including Net Positions): A net position can be a hedged item only if the entity hedges on a net basis for risk management purposes as part of an established risk management strategy.

Disclosures under IFRS 9 for hedge accounting require information about the extent and nature of hedging activities, including details of the hedging instruments, hedged items, and their effects on financial position and performance. This often includes tabular presentations of the impact on assets and liabilities and the line items affected in the financial statements.

6. Public Sector Considerations:

While the fundamental principles of IFRS 9 apply to the public sector, there are unique considerations. The business model assessment needs to account for the specific objectives and accountability structures of public sector entities, where each Accounting Officer is separately accountable to Parliament, and Non-Departmental Public Bodies (NDPBs) have varying degrees of operational autonomy. Changes in government policy significantly impacting the management of financial assets may necessitate reclassification.

7. IFRS for SMEs Standard:

The IFRS for SMEs Standard offers a simplified approach to accounting for financial instruments in Section 11 (Basic Financial Instruments) and Section 12 (Other Financial Instruments Issues), which are based on earlier versions of IFRS (primarily IAS 39). The 2015 amendments to the IFRS for SMEs Standard continue to allow preparers to apply the recognition and measurement requirements of IAS 39 instead of those in Sections 11 and 12. For SMEs not choosing this option, Section 11 covers debt instruments with returns that are fixed, a fixed rate, or a variable rate linked to market interest rates. More complex financial instruments fall under Section 12, which has fewer options and often requires fair value measurement.

Conclusion:

IFRS 9 represents a significant change in the accounting for financial instruments, moving towards a more forward-looking impairment model and a more principles-based approach to classification and hedge accounting. Understanding the business model assessment, the SPPI criterion, and the staging of expected credit losses are crucial for the correct application of the standard. The provided sources offer valuable insights into the scope, application guidance, and illustrative disclosures related to IFRS 9 across various sectors and jurisdictions.