Introduction
IFRS 9 Financial Instruments fundamentally rewrites the accounting rules for financial instruments, introduces a new approach for financial asset classification, and (beyond the scope of these blog entries) major new requirements for hedge accounting.
Effective from 1st January 2018, businesses need to start to evaluate the impact of this new standard now. Businesses should start compiling the information necessary to implement the standards, and if applicable to the nature of the business they run, review loan covenants and agreements, because these could have an impact on the financial statements of the business from the implementation date.
Why is there a need for a New Standard?
One of the major perceived weaknesses of IAS 39 came to light during the financial crisis of 2007. Recognition and measurement of impairment losses came too late because IAS 39 used an incurred loss model. This delayed the recognition of impairment losses until objective evidence of a credit loss had been identified.
The New Impairment Requirements in Brief – Recognising a Loss from Day One
Under the new standard recognition of impairment no longer depends on a reporting entity first identifying a credit loss event. This is a major shift from the current requirements contained in the old IAS 39.
IFRS 9 uses forward looking information to recognise expected credit losses for all debt-type financial assets that are not measured at fair value through the income and expenditure account of the business.
The first significant consequence of this is that a credit loss arises as soon as a company originates a loan or a receivable (a day one loss).
Recognising an Impairment Loss
Businesses are expected to always estimate an “expected loss” considering a broad range of information. This includes:
- Past events, such as the businesses experience of historical losses for similar instruments.
- Current conditions.
- Reasonable and supportable forecasts that affect the expected collectability of future cash flows from the instrument.
What do we mean by Instrument?
IFRS 9 applies to the following class of instruments:
- Debt instruments measured at amortised cost.
- Debt instruments measured at fair value through other comprehensive income.
- Lease receivables
- Contract assets as defined by IFRS 15 Revenue from Contracts with Customers.
- Loan commitments that are not measured at fair value through the income and expenditure account,
- Financial guarantee contracts (except those accounted for as insurance contracts).
IFRS 9 and Equity Instruments
Under IFRS 9, investments in equity instruments are measured at fair value through the income and expenditure account, either at fair value through the profit and loss or at fair value through comprehensive income.
Impairment of equity instruments is – because of the accounting treatment specified above -unnecessary as they are already measured at fair value. Accordingly, equity instruments are outside the scope of IFRS 9. Readers should note that it is not possible under IFRS 9 to measure investments in equity instruments at cost (as is currently allowed under IAS 39) where they do not have a quoted market price and their fair value cannot be reliably measured.
Some of the new Definitions
Before moving further, we must understand some of the new definitions included in IFRS 9.
Credit losses
Credit losses are the difference between the contractual cash flows that are due to a business and the cash flows that it expects to receive. The difference between the two is referred to as the “cash shortfall”.
The cash shortfall is discounted at the original effective interest rate for the instrument that is expected to incur the loss.
Lifetime Expected Credit Losses
Lifetime expected credit losses are the expected shortfalls in contractual cash flows considering the potential for default at any point during the total life of the financial instrument.
12 Months Expected Credit Losses
12 months expected credit losses are a portion of the lifetime expected credit losses. This is not the expected cash shortfall for the next 12 months, but is calculated by multiplying the probability of default occurring on the instrument in the next 12 months by the total lifetime expected credit losses that would result from the default. We include an example of this calculation in the second blog entry in this series.
An Overview of the General Approach under IFRS 9
While reading the following keep in mind that IFRS 9 requires you to measure and recognise an impairment loss at the time a new financial instrument is originated.
Beyond this – IFRS 9 draws a distinction between financial instruments that have not deteriorated significantly in credit quality since initial recognition and those that have.
If a financial instrument has not deteriorated significantly in credit quality 12 months expected credit losses are recognised. This is the same recognition criteria for a new financial instrument, although the amount recognised are likely to change over the life of the instrument.
If a financial instrument has deteriorated significantly in quality, lifetime expected credit losses are recognised. Measurement of the expected credit losses is determined by a probability-weighted estimate of credit losses over the expected life of the financial instrument.
The important point to note here is that a financial instrument would move from recognising 12 months expected credit losses to lifetime expected credit losses when there has been a significant deterioration in credit quality.
There is one “get out of jail” card allowed by IFRS 9. Businesses can stay in the 12-month expected credit loss category if the absolute level of credit risk is low. This “get out of jail” card applies even if the level of credit risk has increased significantly.
The Third Stage – Objective Evidence of Impairment
The third stage applies to assets that have objective evidence to suggest that they are impaired (this is the same evidence test for impairment contained in IAS 39).
Under the third stage approach, the credit loss is still based on lifetime expected losses, but the calculation of interest income is different. In the periods subsequent to the initial recognition of the assets, interest is calculated based on the amortised cost net of the loss provision, whereas under the first and second stage, the calculation is based on the gross carrying value.
We begin to look at these stages in our next blog entry in this series.
Closing thoughts – a time to chill and a time to invest?
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