IFRS 9 - Financial Instruments

IFRS 9: Financial Instruments

IFRS 9 Financial Instruments sets out the requirements for recognising and measuring financial assets, financial liabilities, and some contracts to buy or sell non-financial items.

Initial measurement of financial instruments

At initial recognition, an entity measures a financial asset or a financial liability (other than a financial asset or a financial liability at fair value through profit or loss), at its fair value plus or minus transaction costs that are directly attributable to the acquisition or issue of the financial asset or the financial liability.

An entity will recognise a financial asset or financial liability on its statement of financial position when it becomes a party to the contractual provisions of the instrument rather than when the contract is settled. An important consequence of this is that all derivatives should be recognised in the statement of financial position. This is because even if there is no initial investment or the initial investment is relatively low, derivative contracts expose the entity to risks and rewards due to changes in value of the underlying. In most cases, the date on which an entity becomes a party to a financial instrument’s contractual obligations is fairly obvious. For example, option contracts are recognised as assets or liabilities when the holder or writer becomes a party to the contract.

Financial assets

When an entity first recognises a financial asset, it classifies it based on the entity’s business model for managing the asset and the asset’s contractual cash flow characteristics, as follows:

• Amortised cost— a financial asset is measured at amortised cost if both of the following conditions are met:
  • The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows; and
  • 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.

• Fair value through other comprehensive income — financial assets are classified and measured at fair value through other comprehensive income if they are held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.

• Fair value through profit or loss — any financial assets that are not held in one of the two business models mentioned are measured at fair value through profit or loss.

The classification of a financial asset is made at the time it is initially recognised, namely when the entity becomes a party to the contractual provisions of the instrument. If certain conditions are met, the classification of an asset may subsequently need to be reclassified.

Financial assets are cash, a contractual right to receive cash or another financial asset (such as shares) or to exchange financial assets or liabilities on favourable terms, or holdings of equity instruments (such as shares).

Debt instruments

A debt instrument that meets the following two conditions must be measured at amortised cost (net of any write down for impairment) unless the asset is designated at FVTPL under the fair value option:

• Business model test: The objective of the entity’s business model is to hold the financial asset to collect the contractual cash flows (rather than to sell the instrument prior to its contractual maturity to realise its fair value changes).
• Cash flow characteristics test: 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.

A debt instrument that meets the following two conditions must be measured at FVTOCI unless the asset is designated at FVTPL under the fair value option:

• Business model test: The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets
• Cash flow characteristics test: 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.

All other debt instruments must be measured at fair value through profit or loss (FVTPL).

Fair value option

Even if an instrument meets the two requirements to be measured at amortised cost or FVTOCI, IFRS 9 contains an option to designate, at initial recognition, a financial asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases.

Equity instruments

All equity investments in scope of IFRS 9 are to be measured at fair value in the statement of financial position, with value changes recognised in profit or loss, except for those equity investments for which the entity has elected to present value changes in ‘other comprehensive income’. There is no ‘cost exception’ for unquoted equities.

‘Other comprehensive income’ option

If an equity investment is not held for trading, an entity can make an irrevocable election at initial recognition to measure it at FVTOCI with only dividend income recognised in profit or loss.

Measurement guidance

Despite the fair value requirement for all equity investments, IFRS 9 contains guidance on when cost may be the best estimate of fair value and also when it might not be representative of fair value.

Financial liabilities

IFRS 9 doesn’t change the basic accounting model for financial liabilities under IAS 39. Two measurement categories continue to exist: FVTPL and amortised cost. Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are measured at amortised cost unless the fair value option is applied.

If a financial liability should be measured at fair value (e.g. FVTPL), but the fair value is not capable of reliable measurement, they should be measured at cost.

Derivatives are always measured at fair value through profit or loss.

Liabilities can include derivatives (other than derivatives that are financial guarantee contracts or are designated as effective hedging instruments), other liabilities held for trading, and liabilities that an entity designates to be measured at fair value through profit or loss.

After initial recognition, an entity cannot reclassify any financial liability.

Fair value option

IFRS 9 contains an option to designate a financial liability as measured at FVTPL if:

• Doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases, or
• The liability is part or a group of financial liabilities or financial assets and financial liabilities that is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

A financial liability which does not meet any of these criteria may still be designated as measured at FVTPL when it contains one or more embedded derivatives that sufficiently modify the cash flows of the liability and are not clearly closely related.

Exeptions to the FVTPL treatment include, if a financial liability:

• Is part of a hedging arrangement, or
• Is designated as at fair value through profit or loss and the entity is required to present the effects of changes in the liability’s credit risk in other comprehensive income

Credit Risk

IFRS 9 requires gains and losses on financial liabilities designated as at FVTPL to be split into the amount of change in fair value attributable to changes in credit risk of the liability, presented in other comprehensive income, and the remaining amount presented in profit or loss. The new guidance allows the recognition of the full amount of change in the fair value in profit or loss only if the presentation of changes in the liability’s credit risk in other comprehensive income would create or enlarge an accounting mismatch in profit or loss. That determination is made at initial recognition and is not reassessed.

Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss, the entity may only transfer the cumulative gain or loss within equity.

Derivatives

All derivatives in scope of IFRS 9, including those linked to unquoted equity investments, are measured at fair value. Value changes are recognised in profit or loss unless the entity has elected to apply hedge accounting by designating the derivative as a hedging instrument in an eligible hedging relationship.

Embedded derivatives

An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

The embedded derivative concept that existed in IAS 39 has been included in IFRS 9 to apply only to hosts that are not financial assets within the scope of the Standard. Consequently, embedded derivatives that under IAS 39 would have been separately accounted for at FVTPL because they were not closely related to the host financial asset will no longer be separated. Instead, the contractual cash flows of the financial asset are assessed in their entirety, and the asset as a whole is measured at FVTPL if the contractual cash flow characteristics test is not passed.

The embedded derivative guidance that existed in IAS 39 is included in IFRS 9 to help preparers identify when an embedded derivative is closely related to a financial liability host contract or a host contract not within the scope of the Standard (e.g. leasing contracts, insurance contracts, contracts for the purchase or sale of a non-financial items).

Derecognition

Financial assets

The basic premise for the derecognition model in IFRS 9 (carried over from IAS 39) is to determine whether the asset under consideration for derecognition is:

• An asset in its entirety, or
• Specifically identified cash flows from an asset (or a group of similar financial assets), or
• A fully proportionate (pro rata) share of the cash flows from an asset (or a group of similar financial assets), or
• A fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets)

Once the asset under consideration for derecognition has been determined, an assessment is made as to whether the asset has been transferred, and if so, whether the transfer of that asset is subsequently eligible for derecognition.

An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or the entity has retained the contractual rights to receive the cash flows from the asset, but has assumed a contractual obligation to pass those cash flows on under an arrangement that meets the following three conditions:

• The entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the original asset
• The entity is prohibited from selling or pledging the original asset (other than as security to the eventual recipient),
• The entity has an obligation to remit those cash flows without material delay

Once an entity has determined that the asset has been transferred, it then determines whether or not it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded.

If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity must assess whether it has relinquished control of the asset or not. If the entity does not control the asset then derecognition is appropriate; however if the entity has retained control of the asset, then the entity continues to recognise the asset to the extent to which it has a continuing involvement in the asset.

The following flowchart summarises the evaluation of whether, and to what extent, a financial asset should be derecognised.

Financial liabilities

A financial liability should be removed from the balance sheet when, and only when, it is extinguished, that is, when the obligation specified in the contract is either discharged or cancelled or expires.

Where there has been an exchange between an existing borrower and lender of debt instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

A gain or loss from extinguishment of the original financial liability is recognised in profit or loss.

Reclassification

For financial assets, reclassification is required between FVTPL, FVTOCI and amortised cost, if and only if the entity’s business model objective for its financial assets changes so its previous model assessment would no longer apply.

If reclassification is appropriate, it must be done prospectively from the reclassification date which is defined as the first day of the first reporting period following the change in business model. An entity does not restate any previously recognised gains, losses, or interest

IFRS 9 does not allow reclassification:

• For equity investments measured at FVTOCI, or
• Where the fair value option has been exercised in any circumstance for a financial assets or financial liability.

Disclosures

IFRS 9 amends some of the requirements of IFRS 7 Financial Instruments: Disclosures including adding disclosures about investments in equity instruments designated as at FVTOCI, disclosures on risk management activities and hedge accounting and disclosures on credit risk management and impairment.

Further Information