Post the economic crisis of 2008-09, the International Accounting Standards Board (IASB) declared that the financial reporting process needed significant improvements. Therefore, the IFRS 9 was introduced as a replacement to the IAS 39 standard that was marked with inherent complexities and internal inconsistencies. Here, we talk about the changes being introduced by IFRS 9 with respect to classification, measurement, impairment, and hedge accounting of financial instruments.
So, what is IFRS9?
Asset classification: IFRS 9 requires all financial assets to be classified based on two tests: the contractual cash flow characteristics (CCFC) test and the business model test. The CCFC test assesses if CCFs are solely payments of principal and interest, and the business model test evaluates how financial assets are managed to generate cash flows (for instance, by collecting contractual cash flows or selling financial assets, or both).
Only financial assets with such cash flows are eligible for classification as amortized cost or fair value through other comprehensive income (FVOCI) based on the business model in which the asset is held. In case the business model type of a financial asset doesnt meet the objective of collecting contractual cash flows and/or selling them, then such a financial asset is classified under residual category fair value through profit or loss (FVTPL).
Thus, the IFRS 9 has three categories for classification of financial assets amortized cost, FVOCI, and FVTPL, whereas the IAS 39 had four Held to Maturity, Available for Sales, and Loans and Receivables, and FVTPL. Moreover, the IFRS 9 prohibits the reclassification of financial assets after initial recognition, unless there is a fundamental change in the business model, in which case, reclassification is required with exhaustive disclosures as mentioned in IFRS 7 Financial Instruments: Disclosures.
Measurement of liabilities: The classification and measurement of financial liabilities remain the same under IFRS 9 as was with IAS 39, except in the case where an entity measures a financial liability at FVTPL. For such financial liabilities, changes in fair value related to changes in own credit risk (for instance, a change in the credit score of an entity issuing a bond), are required to be presented separately in FVOCI. Here, amounts in FVOCI relating to own credit are not recycled to profit or loss even when the liability is derecognized and the amounts are realized.
Impairment accounting: When it comes to impairment and interest income calculation, IFRS 9 adopts a forward-looking expected credit loss model that is applicable to all types of financial instruments subject to impairment accounting, as opposed to the incurred loss model under IAS 39. Among other things, IFRS 9 requires calculation of credit adjusted effective interest rate (CEIR) for financial assets that are classified as amortized cost and are credit impaired at the time of origination or purchase. Interest income on such financial asset should be recognized using the CEIR. This new impairment model requires extra, detailed disclosures about the recognized expected credit losses, and the impact of changes in credit risk of financial instruments.
Hedge accounting: IFRS 9 also introduces an improved hedge accounting model to better link the economics of risk management with its accounting treatment, known as the general hedge accounting model. This model applies to static or closed hedging relationships, that is, when the designated volumes of the hedged item and the hedging instrument do not change frequently once the hedging relationship is designated and documented.
And, what should financial institutions do now?
IFRS 9 brings to fore new complexities and challenges, and has considerable impact on existing processes and systems. The business model and CCFC tests for classification and measurement may require careful judgment to ensure appropriate classification of financial assets. This means that banks and financial institutions require new processes to classify financial assets into appropriate categories.
The only exception to the changes being brought about by this new standard with regard to classification and measurement of financial liability, is the recognition of changes in own credit risk on financial liabilities classified as FVTPL category.
The estimation of impairment would involve difficult decisions about whether loans will be received as due, and if not, the manner and the time in which they would be recovered. The new impairment model has widened the scope as it relies on robust estimation of expected credit loss and the point at which there is a significant increase in credit risk.
Financial institutions will now need to clearly define key conditions of significant increase, default, and so on. This new model will have notable impact on systems and business processes of banks and financial services firms on account of a plethora of new requirements for data collation and calculation.
The final version of IFRS 9 Financial Instruments comes into force on January 1, 2018. Banks and financial institutions must therefore brace themselves to accommodate these changes and prepare their technology systems well in advance to avoid last minute chaos.