IFRS 9 – Financial Instruments

Overview

IFRS 9 provides principles for measurement, classification, and impairment of financial instruments namely:

• Financial liabilities,
• Financial assets and
• A few contracts for the sale and buy of non-financial items.

It also provides for the rues of hedge accounting and expected loss.

Effective Date and Adaptation

The standard was issued on 24^th July 2014. IFRS 9 gave new requirements for the measurement and classification of financial assets, together with a replacement expected loss impairment model.

IFRS 9 is mandatorily effective for all the entities’ annual period beginning on or after 1^st January 2018. It also permits early application.  It replaces IAS 39 Financial Instrument – Recognition and measurement.

Scope

Financial liabilities and financial assets scoped out of IFRS 9 are as under:

• Share-based payments – under IFRS 2
• Interest in subsidiaries – under IFRS 10/IAS 27
• Interest in associates and joint ventures – IAS 27/IAS 28
• Employees rights and obligations – under IAS 19
• Lease rights and obligations – under IFRS 16
• Insurance contracts – under IFRS 4
• Entity’s own equity instruments – under IAS 32

The main changes introduced through IFRS 9 were:

• Hedge Accounting: The IAS 39 rule based, and complicated approach was replaced with new hedge accounting requirements of IFRS 9, which are simpler to apply and gave better link to treasury operations and risk management.
• Impairment: The IAS 39 incurred loss model was replaced with a brand new forward looking ‘expected loss model’.

Important Definitions:

Financial Instrument: Contract between two organizations that give rise to the delivery of financial/economic asset from one organization and equity instrument/financial liability of another organization.

Financial Asset: It’s defined as:

• A contractual right to receive financial asset or cash,
• Contractual right to exchange financial liabilities of financial assets with the other entity,
• Cash,
• Another entity’s equity instrument,
• Contract which will or are going to be settled within the equity instrument of an entity itself.

Financial Liability: It will be defined as:

• Contractual obligation of an entity to deliver a financial asset or cash,
• Contractual obligation of an entity to exchange financial liabilities or financial assets with some other entity,
• Contract that may or will be settled through equity instrument of an entity.

Equity Instrument: It is the remaining interest (net of all liabilities) in the assets of an entity.

Embedded Derivative: these are components of Hybrid contracts (contracts including non-derivative host). These components result in the modification of contractual cash flow, depending upon specified variable (e.g. foreign exchange rate, commodity price, interest rate etc.)

Following are not embedded derivatives:

• Variables that are non-financial and specific to a contractual party,
• Derivatives attached to a specific financial instrument that by contract is either:

> having different counterparty from that particular instrument, or

> transfer does not depend on or is independent from the instrument

Fair Value: In an orderly transaction between participants of the market, it is the price at the measurement date that would be paid to transfer a liability or received in the event of sale of an asset.

Directly Attributable Transaction Costs: directly attributable incremental or additional costs in relation to issue, acquisition or disposal of financial liability or financial asset.

IFRS 9: In a Nutshell

a) Initial Recognition

On the event of an entity becoming party to the contractual provisions of a certain contract.

b) Initial Measurement

• Financial assets and liabilities classified at fair value through profit and loss – AT FAIR VALUE
• Financial assets and liabilities NOT classified at fair value through profit and loss – AT DIRECTLY ATTRIBUTABLE TRANSACTION COSTS.

c) Subsequent Measurement

Financial assets that are within the scope of IFRS 9 are subsequently measured at:

• Fair value through profit and loss (FVTPL),
• Fair value through other comprehensive income (FVTOCI),
• Amortized cost.

Accounting requirements for Financial Instruments under IFRS 9

Financial Assets

Financial assets are classified as one of the following:

Amortized Costs	Fair value through profit and loss	Fair value through other comprehensive income
Classification Criteria: Below both conditions MUST be met: i. Characteristics of contractual cash flow: solely principal payments and interest on principal outstanding. ii. Business model objective: objective to collect contractual cash flow from financial assets.	Classification Criteria: i. Designation of financial assets at initial recognition. Only if doing so will significantly reduce/eliminate an accounting mismatch (this option to designate is irrevocable), ii. Financial assets that don’t meet the criteria for amortized costs, iii. Held for trading financial assets.	Classification Criteria: Equity Instruments Only for equity instruments that are not held for trading. At initial recognition this designation is irrevocable and optional. Debt Instruments Meets the sole payment of principal and interest contractual cash flow criteria. The entity aims at the collection of the contractual cash flows and financial assets sale.
Subsequent Measurement: At amortized cost with method of effective interest rate.	Subsequent Measurement: At fair value. All relating losses/gains are recognised in profit and loss statement.	Subsequent Measurement: Equity Instrument i. At fair value, ii. Gains/losses recognised in Other Comprehensive Income, iii. No recycling of fair value changes to P&L, iv. Recognition of dividends in P&L.Debt Instruments i. At fair value, ii. Gains/losses recognized in Other Comprehensive Income (relating to impairment in P&L), iii. On reclassification or derecognition, changes in fair value are recycled from OCI to P&L.

Financial Liability

Financial Liabilities are classified as one of the following:

Amortized Costs	Fair value through profit and loss
Classification Criteria: All financial liabilities except: i. Commitment to providing loan at an interest rate that is below the market, ii. Financial guarantee contracts.	Classification Criteria: i. Held for trading financial liabilities, ii. Derivative financial liabilities, iii. Designated at initial recognition (subject to further criteria).
Subsequent Measurement: Amortized cost at method of effective interest rate.	Subsequent Measurement: Fair value with gains/losses recognized in P&L.

Derecognition of Financial Instruments

Financial Assets	Financial Liabilities
Financial assets are derecognised if:   The rights to cash flow from the assets expire or The rights to receive cash flows from the asset have been transferred or An obligation has been assumed by the entity to pay cash flows arising from the asset under the IFRS 9 conditions in para 3.2.5, and If all substantial risks and rewards have been transferred, or If the control has been transferred.	Financial liabilities are derecognized if: Extinguished, Cancelled, Expired, Discharged.

Impairment of Financial Assets

Scope:

The requirements of impairment are applied to the following:

• Lease receivables,
• Financial assets measured at fair value through OCI and amortized costs,
• Below market rate loan commitments,
• Financial guarantee contracts other than those under IFRS 4 Insurance Contracts.

Initial Recognition:

At initial recognition, a loss allowance is recognized that is equal to 12 months expected credit losses, consisting of default event expected credit losses that are possible within a 12 month period from the entity’s reporting date.

Subsequent Recognition:

A three-stage approach based on expected credit loss changes is followed by the impairment model for the determination of:

• Impairment recognition,
• Interest revenue recognition.

Three-Stage Approach:

Stage 1	Stage 2	Stage 3
12 Months Expected Credit Losses Gross Interest	Lifetime Expected Credit Losses Gross Interest	Lifetime Expected Credit Losses Net Interest
Where increase in credit risk is NOT significant, Continued 12 months expected loss recognition, Update at each reporting date, Interest is presented on gross basis.	Where increase in credit risk IS significant, Lifetime expected loss is recognized, Interest is presented on gross basis.	Applicable when asset is credit impaired, Lifetime expected loss is recognized Interest is presented on net basis.

Reclassification of Financial Assets

(Financial liabilities are not reclassified)

Reclassification of financial assets is required between amortized cost, FVTPL and FVTOCI only if:

• There is change in the objective of an entity’s business model,
• Reclassification is done prospectively,
• Previously recognized gains/losses or interest are not restated.

Following rules are applied for reclassification:

1. Amortized cost to FVTPL

• Fair value is measured at the reclassification date,
• Loss/gain arising from difference between fair value and previously recognised amortized cost is recognized in P&L.

2. Amortized cost to FVTOCI

• Fair value is measured at the reclassification date,
• Loss/gain arising from difference between fair value and previously recognised amortized cost is recognized in OCI,
• Expected credit losses and effective interest rate is NOT adjusted.

3. FVTPL to Amortized Cost

• Fair value at reclassification date becomes new gross carrying amount,
• Loss allowance and effective interest rate are determined at the reclassification date.

4. FVTOCI to Amortized Cost

• Reclassified at fair value at reclassification date,
• Previously recognized cumulative gains and losses in OCI are removed from equity and adjusted against financial asset’s fair value,
• Expected credit losses and effective interest rate are NOT adjusted.

5. FVTPL to FVTOCI

• Financial asset is continued to be measured at fair value,
• Loss allowance and effective interest rate are determined at the reclassification date.

6. FVTOCI to FVTPL

• Financial asset is continued to be measured at fair value,
• Cumulative gains/losses previously in OCI are reclassified to P&L from equity as a reclassification adjustment.

Other Useful Implementation Guidance in Relation to IFRS 9

Hedging:

All the following criteria must be met to apply hedge accounting:

1. Hedging relationship,
2. Documentation and designation,
3. All the three hedge accounting requirements in IFRS 9 are met.

The following types of hedge accounting are applied to eligible hedged item:

a) Cash Flow Hedge:

Exposure to the variability of cash flow.

RECOGNITION:

• Hedge effectiveness – in OCI
• Hedge ineffectiveness – in P&L
• Lower of fair value in hedged item or cumulative gain/loss in hedging instrument – in equity separately (cash flow hedge reserve)

b) Fair Value Hedge:

Exposure to the variability of fair value.

RECOGNITION:

• Loss/gain on hedging instrument/hedged item – in P&L
• Loss/gain on equity hedging instrument/hedged item measured at fair value through OCI – in OCI

c) Hedges of net investment in Foreign Operations:

Exposure of the entity’s interest in a foreign operation’s net assets.

RECOGNITION:

• Hedge effectiveness – in OCI
• Hedge ineffectiveness – in P&L
• Disposal of foreign operation – reclassification of accumulated amounts from equity to P&L

Financial Guarantee Contracts:

Subsequently measured at higher of:

1. Initially recognized amount net of cumulative amortization,
2. Amount determined as per IAS 37

Financial Liability as a Result of Financial Asset Transfer:

Net carrying amount of the associated liability and transferred asset is measured at either of the following:

1. If transferred asset at amortized cost – Retained rights and obligation’s amortized cost,
2. If transferred asset is at fair value – Retained rights and obligation’s fair value.

Embedded Derivatives:

These are accounted for depending upon the host contract:

a) Within a financial asset host contract:

• Not separated from the host,
• Accounted as a single instrument with the application of IFRS 9 requirements.

b) Within a financial liability host contract:

Subject to further criteria defined in IFRS 9:

• Separated from host contract,
• Accounted for within the requirements of IFRS 9.

Disclosure Requirements:

IFRS 9 gives some amendments to IFRS 7 Financial Instrument: Disclosure requirements. The following additional disclosures have been introduced:

• About equity investments designated at FVTOCI,
• Relating to risk management activities,
• About hedge accounting,
• About impairment,
• On credit risk management.