The IASB has published the complete version of IFRS 9 'Financial Instruments', which replaces the current standard IAS 39. This final version includes requirements on the classification and measurement of financial assets and liabilities and an expected credit losses model that replaces the incurred loss impairment model that is used today. The new standard is effective for accounting periods beginning on or after 1 January 2018, subject to EU endorsement, with early application permitted. A summary of the new standard can be found on the IASB website.
This accounting standard has been in development since the financial crisis and it has taken a long time to reach consensus on some of its more controversial proposals. One main aim has had to be abandoned, which was to align the IFRS rules with US accounting standards. The US standard setter has taken a different approach to many of the major issues in this area. Although financial institutions will find their reporting most affected by the new standard, normal corporates will also be impacted, particularly if they have major treasury functions, but also in the area of hedge accounting.
1. Classification and measurement
IFRS 9 has three classification categories for debt instruments: amortised cost, fair value through other comprehensive income (‘FVOCI’) and fair value through profit or loss (‘FVPL’). Classification under IFRS 9 is driven by the company's business model for managing its financial assets and whether the contractual cash flows represent solely payments of principal and interest (‘SPPI’). A company’s business model is how a company manages its financial assets in order to generate cash flows and create value. Thus, a company's business model determines whether the cash that flows to it will result from collecting contractual cash flows, selling financial assets or both.
2. Expected credit losses
IFRS 9 introduces a new model for the recognition of impairment losses, namely the expected credit losses (ECL) model. The ECL model is a significant change from the approach in IAS 39 and seeks to address the criticisms of the incurred loss model following the economic crisis where commentators believed that banks had overstated profits through failure to recognise all the losses they expected to incur on financial assets. The new rules will require companies to record a "day 1 loss" equal to the 12-month ECL on initial recognition of financial assets that are not credit impaired (or lifetime ECL for trade receivables). IFRS 9 promulgates a three stage approach which is based on the change in credit quality of financial assets since initial recognition. Assets move through the three stages as credit quality changes and the stages dictate how a company measures impairment losses. Where there has been a significant increase in credit risk, impairment is measured using lifetime ECL rather than 12-month ECL. The model includes operational simplifications for lease and trade receivables, which will be helpful to non-financial corporates. An implementation group has been set up by the IASB in order to deal with the most challenging aspects of implementation of the new ECL model as this is an area in which significant judgement will be required.
3. Hedge accounting
The objective of hedge accounting is to represent in the financial statements the effect of a company's risk management activities when they use financial instruments to manage exposures arising from particular risks and those risks could affect their profits. The new hedge accounting model enables companies to better reflect their risk management activities in the financial statements, to help investors to understand the effect of hedging activities on the financial statements and on future cash flows. Importantly, the IASB has said it will deal with "macro-hedging", which mainly affects financial institutions, as a separate project, and a discussion paper on this subject is currently out for comment.
4. Effective date and transition
IFRS 9 is effective for annual periods beginning on or after 1 January 2018. Earlier application is permitted. The standard will be applied retrospectively but comparatives are not required to be restated. If a company elects to apply IFRS 9 early, it must apply all of the requirements at the same time. Companies applying the standard before 1 February 2015 continue to have the option to apply the standard in phases. However, IFRS 9 is still subject to the endorsement process in Europe and until it passes through that, no EU company will be able to apply it.