Accounting for financial instruments: IFRS 9 and IAS 39

Introduction to Accounting for Financial InstrumentsIFRS 9 and IAS 39 are two most important
accounting standards for corporate treasurers because they address how to account for financial
instruments, or how they are measured on an ongoing basis.IFRS 9 Financial Instruments is the more
recent Standard released on 24 July 2014 that will replace most of the guidance in IAS 39 Financial
Instruments: Recognition and Measurement.Treasurers should examine these standards closely to
understand their implications on risk management, tax, internal controls and processes.Under IAS 39,
many preparers, auditors and users of financial statements had given feedback that the requirements for
reporting financial instruments were too complex and difficult to apply.There were too many exceptions
in the application of IAS 39, and companies struggled to apply the Standard correctly and consistently.
Therefore, after the Global Financial Crisis (GFC), with strong interest from the G20, the Financial
Advisory Group and other groups, the IASB decided to accelerate the project for IFRS 9 to supersede IAS
39.After about a decade of consultations and outreaches with different constituents and stakeholders,
the IASB finally issued the complete version of IFRS 9 Financial Instruments on 24 July 2014, to replace
the notoriously cumbersome IAS 39 Financial Instruments: Recognition and Measurement. This new
Standard IFRS 9 will be effective for annual periods on or after 1 January 2018.There are 3 main sections
of IFRS 9, which will be explained in greater detail in the sections below:(a) Classification and
measurement. This explains how financial instruments, assets or liabilities, are classified and should be
recorded in financial statements. Should financial assets be measured and recorded as fair value or
amortized cost? Should the gains or losses on financial instruments be recorded in the income statement
or are they recorded directly to equity?(b) Impairment. After we have classified and recorded the
financial instruments in part (a), how do we determine record any potential impairment of the financial
instruments? What is the difference between the ‘incurred loss’ model in IAS 39 and ‘expected loss’
impairment model in IFRS 9?(c) Hedge accounting. Financial instruments for hedging may result in large
fluctuations in profit and loss due to fair value accounting. How do we properly implement hedge
accounting, and how will the income statement be affected if we opt to apply hedge accounting to our
hedging instruments? Classification and Measurement of Financial Instruments (under IAS 39)Previously,
under IAS 39, financial assets are classified into 4 broad categories:

Financial asset at fair value through profit or loss (FVTPL): These are financial assets that are held for
trading. These financial instruments are measured at fair value. Gains and losses are passed into the
income statement.

Held to maturity financial investments (HTM): These are non-derivative financial assets with fixed or
determinable payments that an entity has intention to hold to maturity. These are measured at
amortized cost using the effective interest method. Gains and losses are passed into the income
statement.

Loans and receivables: These are non-derivative financial assets with fixed or determinable payments
that are not quoted in active market. Like HTM instruments, these are measured at amortized cost using
the effective interest method. Gains and losses are passed into the income statement.
Available for sale financial assets (AFS): These are non-derivative financial assets not classified under the
above three categories. These instruments are measured at fair value. Gains and losses are passed into
Other Comprehensive Income (OCI).

Financial liabilities under IAS 39 are classified into two main categories.

Financial liabilities at fair value through profit or loss: These are financial liabilities that are held for
trading. They are measured at fair value. Gains and losses are passed into the income statement.

Other financial liabilities: These are measured at amortized cost using the effective interest method.
Gains and losses are passed into the income statement.

Regardless of the initial classification of the financial assets, IAS 39 allows entities to initially designate
them at FVTPL, if fair value can be reliably measured. Classification and Measurement of Financial
Instruments (under IFRS 9)The new Standard, IFRS 9 is more principles-based, and therefore requires
more judgment in its application. In contrast with IAS 39, it applies a two-step approach to classify all
types of financial assets, which are either measured at fair value or amortized cost.Under IFRS 9, the
classification of financial assets are dependent on the ‘business model’ test and ‘contractual cash flow’
test to determine whether they are measured at fair value or amortized cost.1) Business Model Test:
Financial asset is held in order to collect contractual cash flows. 2) Contractual Cash Flow Test:
Contractual cash flows represent solely payments of principal and interest (SPPI).In the examples below,
we will use both tests to illustrate when financial assets should be measured at amortized cost, fair value
(recorded in OCI), or fair value (recorded in P&L)

Financial Asset Measured at Amortized Cost. Gains and losses passed into income statement.

Both Business Model Test and Contractual Cash Flow Test need to pass for the financial asset to be
measured at amortized cost. Take for example, entities may hold some debt financial investments for
their contractual cash flows.The entities may decide to sell their financial assets when assets’ credit risk
is high. Selling the financial assets for this reason may not be inconsistent with a business model whose
objective is to collect contractual cash flows because a lower credit quality can impact the entity’s ability
to collect contractual cash flows.Therefore, selling financial assets to manage credit concentration risk
may also be consistent with a business model whose objective is to collect contractual cash flows.
Entities will need to examine factors like frequency of sales of financial assets, timings and reasons for
those sales to demonstrate that the sales do not reflect a change in the entity’s business model.

Financial Asset Measured at Fair Value. Gains and losses passed into Other Comprehensive Income (OCI).

If business model test fails, e.g. the business model of holding the financial asset is achieved by both
collecting contractual cash flows and selling the financial asset, the financial asset is measured at
FVOCI.Entities may invest in debt instruments for yield, but might also sell its financial assets to reinvest
in better yielding financial assets or to rebalance its portfolio’s risk or duration of its liabilities.In this
case, the business objective of the entity is to maximize the return on portfolio and is therefore more
aligned with the FVOCI category.
All other financial assets that cannot be classified under amortized cost or FVOCI have to be measured at
fair value, with gains and losses passing through profit and loss (FVTPL). This means all financial assets
that fail the ‘business model’ test and ‘contractual cash flow’ test will be classified as FVTPL.

Regardless of the ‘business model’ test and ‘contractual cash flow’ test, an entity may designate a
financial asset as FVTPL if doing so results in more relevant information and reduces recognition
inconsistency or an accounting mismatch. The classification of financial liabilities under IFRS 9 remain
broadly the same as in IAS 39.

Financial liabilities that are held for trading are measured at FVTPL.

Other financial liabilities are classified as FVOCI.

The only change in the classification of financial liabilities is that fair value gains or losses that are related
to changes in the entity’s own credit risk should be recognised in OCI, with the remainder recognized in
profit or loss. Amounts in OCI related to its own credit are not recycled to profit or loss, when the
financial liability is derecognized and amounts are realized. Impairment of Financial
InstrumentsPreviously under IAS 39, impairment or credit losses are only recognised when a credit loss
event occurs (‘incurred loss model’). Under IFRS 9, the new impairment requirements are based on
expected credit losses (‘expected credit loss model’). Expected credit losses (ECLs) are an estimate of
credit losses over the life of a financial instrument, and are recognised as a loss allowance or provision.
The amount of ECLs to be recognised depends on the extent of credit deterioration since initial
recognition, and an entity will need to take into account:

probability-weighted outcomes;

the time value of money; and

reasonable and supportable information that is available without undue cost or effort.

The main difference between the two accounting standards is that the new standard (IFRS 9) requires a
recognition of credit loss allowances on initial recognition of financial assets, whereas previously under
IAS 39, impairment is recognized at a later stage, when a credit loss event has occurred.While this
change will result in credit losses being recognized more evenly over the lives of financial assets, it will
require more judgment by preparers to estimate the amount of ECL provision for financial assets.
‘General’ approach for impairmentThis new model is a ‘three-stage’ model, also known as ‘three-bucket’
approach or ‘general’ approach. It should be applied to investments in debt instruments (e.g. loans, debt
securities) measured at amortized cost and FVOCI, loan commitments not measured at FVTPL, financial
guarantee contracts not accounted for at FVTPL and lease receivables under IAS 17. Stage 1: If credit risk
on a financial instrument has not increased significantly since the initial recognition, a 12-month ECL
shall be recognized at reporting date. 12-month ECL are the expected credit losses that result from
default events that are possible within 12 months after the reporting date.Stage 2: If credit risk on a
financial instrument has increased significantly since the initial recognition, a lifetime ECL shall be
recognized. Lifetime ECL are the expected credit losses that result from all possible default events over
the expected life of the financial instrument. Interest revenue is calculated on the gross carrying amount
of the financial assets. Stage 3: If the financial instrument is credit-impaired, i.e. non-performing or there
is objective evidence of impairment, a lifetime ECL is recognized. Interest revenue is calculated on the
net carrying amount (gross carrying amount less loss allowance). Alternatives to the ‘general’ approach
for impairmentAlternative #1: Simplified ApproachThe simplified approach can be applied for trade
receivables, contract assets and lease receivables that do not have significant financing component
(normally held by entities that do not have sophisticated credit risk management systems like financial
institutions).Under the simplified approach, there is no need to calculate a 12-month ECL and assess
whether a significant increase in credit risk has occurred. A loss allowance should be measured at initial
recognition and throughout the life of the receivable at an amount equal to lifetime ECLs for the assets.
Alternative #2: Purchased or Originated Credit-impaired AssetsPurchased or originated credit-impaired
assets refer to assets that have observable evidence of impairment at the point of initial recognition (for
example, the financial asset was purchased at a deep discount, or the borrower had significant financial
difficulty at initial recognition of asset).In such a scenario, the initial 12-month ECLs would have already
been reflected in the fair values at which they were initially recognized. Recording a 12 month-ECL
allowance over the discounted financial assets would be double counting the credit losses for these
assets with high credit risk.For such assets, there is therefore no need to account for an additional 12-
month ECL allowance on initial recognition. For subsequent reporting periods, the entity would need to
recognize changes in lifetime ECLs, either as an impairment gain or loss, in P&L. Hedge AccountingMost
businesses implement some risk management strategies to manage their exposures to different risks like
interest rate, exchange rate or commodity price risks. Applying hedge accounting to its financial
instruments for hedging is a matter of choice for companies.To apply hedge accounting, entities will first
need to maintain proper hedge documentation set out in IFRS 9 or IAS 39. Hedge accounting affects the
timing of recognition of hedging gains and losses. By applying hedge accounting, entities can better
match the gains or losses of the hedging instrument with gains or losses of their corresponding hedged
items.If an entity chooses not to apply hedge accounting, hedging instruments will need to be classified
and measured like any other financial instruments, as required by IFRS 9. Gains and losses on the
hedging instruments may not be recognized in P&L or OCI in the same accounting period as the gains
and losses on their corresponding hedged items.With hedge accounting, the hedging instrument will be
matched with its corresponding hedged item, so that gains and losses on both the hedging instrument
and hedged item are recognized in the same accounting period. Hedge accounting is thus based on the
fundamental ‘matching’ concept, and helps to reduce the volatility in the income statement caused by
the accounting mismatch between the hedging instrument and hedged item.There are 3 main types of
hedge relationships:

Fair value hedge: a hedge of exposure to changes in fair value of a recognized asset, liability or an
unrecognized firm commitment. Change in fair value could be due to a change in interest rates for fixed
rate loans, foreign currency, equity and commodity prices. Gains or losses on both hedging instrument
and hedged item shall be recognized in P&L in each accounting period (matching concept).
 [However, if the hedged item is an equity instrument accounted for at FVOCI, changes in fair value of
hedging instrument should also be recorded in OCI without recycling to P&L. This is a new change under
IFRS 9.]

Cash flow hedge: a hedge of the exposure to variable cash flows that is attributable to a recognized
asset, liability or a highly probable forecast transaction that could affect profit or loss. The variable cash
flows could be due to change in interest rates, foreign currency, equity or commodity prices.

Gains or losses on the hedging instrument to be recognized in OCI (cash flow hedge reserve) should be
the lower of:

Cumulative gain or loss on the hedging instrument from inception of hedge

Cumulative change in the fair value of expected cash flows on hedged item from inception of hedge

In other words, if the amount in (i) exceeds the amount in (ii), i.e. ‘over-hedge’ situation, an
ineffectiveness of (ii) – (i) will be recognized in P&L. In an ‘under-hedge’ situation, the amount in (ii) will
exceed the amount in (i), no ineffectiveness is recognized and all gains and losses on the hedging
instrument can be recognized in OCI.For forecast transactions that result in recognition of a non-financial
asset or liability (e.g. inventory or fixed asset), the cash flow hedge reserve will be removed from OCI and
included directly in the carrying amount of the non-financial asset or liability.For forecast transactions
that result in future cash flows affecting P&L (e.g. interest income, expense or forecast sales), the cash
flow hedge reserve will need to be transferred from OCI to P&L in the same period or periods during
which the hedged expected future cash flows affect P&L.

Net investment hedge: a hedge in an entity’s interest in the net assets of its foreign operations, i.e.
overseas subsidiaries, associates, joint ventures or branches, including any recognized goodwill.

The accounting for net investment hedges is similar to that of cash flow hedges. The effective portion of
the hedge is recognized in OCI, while the ineffective portion is recognized in P&L. As exchange
differences arising from consolidation of net assets (hedged item) are recognized as foreign currency
translation reserve in OCI, gains or losses on the hedging instrument are also recognized in OCI, to the
extent that the hedge is effective.When the foreign operations are disposed, the foreign currency
translation reserve from consolidation will be reclassified from equity to P&L. Previous gains or losses on
hedging instrument should therefore also be transferred from OCI to P&L to match the foreign currency
gains or losses from foreign currency translation reserve.Hope this gives you a good understanding of the
main points covered in IFRS 9 and IAS 39, and you can better appreciate how financial instruments are
recorded in the financial statements!