IFRS 9: Financial Instruments

IFRS 9: Financial Instruments
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IFRS 9: Financial Instruments
Introduction
IFRS 9 officially came into effect in January 2018 to replace IAS 39, deemed too complex and inconsistent with management of risks and business (PWC, 2017). Therefore, the standard aimed to simplify and improve how financial assets and liabilities are measured and classified. According to PWC (2017), IFRS 9 replaced IAS 39's assortment of random bright-line tests, abuse prevention methods, and accommodations for the measurement and classification of financial with a model containing less number of exceptions. With the new IFRS 9, it obligatory that financial assets are measured and classified at fair value. While the new standard is simpler than IAS 39, it comes at a price in the form of volatility risk in gains and losses. Under the former IAS 39, non-trading assets were measured by default as Fair Value through Other Comprehensive Income (FVTOCI); however, for IFRS 9, it is measured by default as Fair Value through Profit and Loss (FVTPL) [PWC, 2017]. How embedded derivatives in financial assets are treated also contributes to the volatility risk. With IAS 39, the embedded derivatives' measurement not associated closely with non-trading host contract must be done at FVTPL; however, the measurement can still be done at an amortized cost. On the other hand, the IFRS9 requires that for the whole contract, save for a few cases, the measurement must be done at FVPL. As a result, any change in both the embedded derivative and the host contract's fair value has an immediate impact on profit and loss.
There are also other changes related to classification and measurement that came with IFRS 9. For trade receivables without a major financing component, the standard allows for their measurement at undiscounted invoice price rather than fair value. A new criterion for reclassification and financial liabilities and assets was also set with the new standard. Regarding accounting for impairments, the new standard eliminated the requirements for impairment assessments for equity instruments. For receivables and loans, it established a new approach. IFRS 9 also brought changes to hedging as it allowed for hedging of more exposures and established a simplified hedge accounting criteria (PWC, 2017). The introduction of IFRS 9 brought some major changes in the measurement and classification of financial instruments.
Financial Assets Classification under IFRS 9
When an entity recognizes a financial asset, the classification is done depending on the business model the entity uses for handling the asset and related cash flow elements as per the contract in place (IFRS Foundation, 2017). As such, IFRS 9 takes into account three categories of financial assets: at amortized cost, at FVOCI, and FVTPL. For a financial asset to be accounted for at amortized cost, it must satisfy two criteria: the business model test and the contractual cash flow test (Ramirez, 2015). A financial asset passes the business model test if it is covered by a business model that seeks to hold assets to collect cash flows as per the contract in place. The contractual cash flow test is met only if the associated cash flows are exclusively matched to the interest and principal payments. If a financial asset fails to meet these criteria, measurement is done at FVTPL. The recognition is done at FVOCI if both criteria are met, but the sale is significant to the business model.
The second category, at FVOCI, applies to financial assets held by an entity within a business model that seeks to collect cash flows from the contract in place and sell financial assets. Ramirez (2015) noted that FVOCI is a compulsory classification unless the fair value option (FVO) is taken into account. It is important to recognize that this category considers the practical reality where an investment in a debt instrument may be made to capture yield, and there is a chance that it may be sold. The third category, at FVTPL, covers instruments that fail to qualify for the other two categories.
It is imperative to note that recognizing a financial asset is done when and only an entity agrees to terms of the contract of a financial instrument. The initial measurement of the instrument is thus done at fair value. For the debt instruments classified at amortized cost, subsequent recognition is done at amortized cost minus impairment (Ramirez, 2015). The recognition for impairment and interest income is done in profit and loss.
Below is a flowchart summarizing the classification of financial assets:
666753168015Source: Ramirez (2015)Source: Ramirez (2015)
Financial Liabilities Classification under IFRS 9
Under IFRS 9, financial liabilities are accounted for either at FVTPL or amortized cost. Financial liabilities accounted for at FVTPL cover the liabilities that an entity incurs for trading reasons, as well as derivatives that do not make up a hedging arrangement (Sweetman, n.d.). The financial liabilities that are not measured under FVTPL are accounted for at amortized cost. Sweetman (n.d.) noted that IFRS 9 also allows the option for some liabilities, which are usually accounted for at amortized cost, to be accounted for at FVTPL if doing so reduces or eradicates an ac...