An optimist sees the opportunity in every difficulty: is IFRS 9 an opportunity or a difficulty?

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Magasine du Trésorier
December 2010

An optimist sees the opportunity in every difficulty: is IFRS 9 an opportunity or a difficulty? The financial crisis was the start of a period during which intense political pressure was again brought to bear on the IASB. As a result, a number of changes to the accounting of financial instruments have been proposed. Over the last 18 months, the IASB have issued phase 1 of IFRS 9, amended it, and published exposure drafts which address the recognition and measurement of financial instruments. Phase 1 of IFRS 9 is the first step in a three phase project to replace IAS 39.

The phase 1 of IFRS 9 deals with the classification and measurement of financial assets within the scope of IAS 39. The new standard defines three categories of financial assets, for which each has its own measurement principles: derivatives, debt instruments and equity investments.

Similarly to the existing IAS 39, all derivatives are measured at fair value through profit or loss, unless they qualify and are designated for hedge accounting.

Also similarly to the existing IAS 39, debt instruments are measured normally measured at amortised cost or at fair value. Nevertheless, the new standard contains more detailed criteria when using amortised cost. Debt instruments may be measured at amortised cost if the asset is held within a ‘business model’ whose objective is to hold the assets to collect the 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 outstanding. This concept of ‘business model’ is new to IFRS and the application guidance to IFRS 9 provides detailed examples to understand how to apply it in practice. An important change is that whether or not the instrument is quoted in an active market is no longer relevant.

Equity investments that are held for trading must still be measured at fair value through profit or loss. A major change is that companies must measure other equity investments at fair value through profit or loss or irrevocably opt upon initial recognition to measure them at fair value through other comprehensive income (with no recycling of the change in fair value to profit or loss if the investment is subsequently derecognized). As a result of this change, the IASB has withdrawn the concept of impairment of equity investment classified as available for sale.

Graphic of Classification and measurement of financial assets
Source: Implementing Phase 1 of IFRS 9 (pdf, 2mb) 

Where do these changes bring us? Winston Churchill said: “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.” No doubt that we have good reasons to be optimistic:

  • It is a unique opportunity to revoke the fair value option (FVO) and reclassify instruments previously designated at fair value though profit or loss, or to re-apply the FVO for instruments where there is an accounting mismatch
  • The recognition of the full fair value decline as impairment on available-for-sale debt investments can be avoided by reclassifying them to amortised cost (and so, instead, applying the amortised cost impairment model), as long as they meet the business model and characteristics of financial assets tests.
  • The recognition of impairment on available for sale equity investments as a result of a significant or prolonged decline in fair value can be avoided by electing to record them at fair value though OCI.
  • Previously recorded impairment on available for sale equity investments whose fair values have increased can be reversed by reclassifying them to fair value though profit or loss
  • The restatement of comparative figures can be avoided (if adopting by 2011)

Even though we are optimistic, we remain conscious that the preparers will face challenges:

  • In order to qualify for amortised cost, entities need to be able to demonstrate that financial assets are held and managed as part of a ‘business model with the objective to hold the financial assets in order to collect the contractual cash flows’ (i.e., management intent for individual instruments is not sufficient).
  • Entities need to assess the instruments impacted due to the new measurement criteria and make appropriate changes to accounting systems
  • A number of areas will require judgment and interpretation by preparers and auditors (for example, whether a business model is actively managed in order to realise fair value changes)
  • Depending on the choices exercised, there could also be a change in the financial statement captions where certain gains and losses are recognized in the statement of comprehensive income
  • Entities would need to determine regulatory and tax consequences –adopting IFRS 9 would mean changes to the measurement model, with a consequential impact on the net profit or loss for the reporting period
  • As hedge accounting have been scoped out of the first phase, entities could face difficulties in understanding the overall implications for their portfolios
  • The EU has not yet endorsed the standard and may ‘carve out’ some principles similarly to what it did with IAS 39.

As previously mentioned, these principles on the recognition and measurement of financial assets are the first step in a three phase project to replace IAS 39

What shall we expect in the future?

The IASB recently amended phase 1 of IFRS 9 to address financial liabilities. The amendment retains most of the existing IAS 39 classification, measurement and de-recognition principles for financial liabilities. The main change relates to the option to measure financial liabilities at fair value. As such we anticipate only limited impact as rare are the entities (other than financial institutions) in Luxembourg which opted for the fair value measurement.

Graphic of the Financial Liabilities
Source: EY Supplement to IFRS Outlook – Issue 89/October 2010