IFRS-9: Classification and Measurement of Financial Assets and Liabilities

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Effective 01 January 2018, IFRS-9 accounting standards will be implemented across banks and financial institutions regarding classification and measurement of financial assets and liabilities. The Accounting standards of IAS-39 that proceeded IFRS-9 had a framework of incurred losses which resulted into huge financial losses in 2008 due to delayed loss recognition.

The new standard contains substantial changes from the current financial instruments standard (IAS 39) with regards to the classification, measurement, impairment and hedge accounting requirements which will impact many entities across various industries.

The three main sections or pillars of IFRS-9 are:

  1. Classification and measurement: As per IFRS-9 accounting standards, classification and measurements of financial assets or liabilities are based on both the entity’s business model for managing the financial assets and the contractual cash flow characteristics of a financial asset.
  2. Impairment: The IASB has sought to address a key concern that arose as a result of the financial crisis that the incurred loss model in IAS 39 contributed to the delayed recognition of credit losses. As such, it has introduced a forward-looking expected credit loss model.
  3. Hedge accounting: The aim of the new hedge accounting model is to provide useful information about risk management activities that an entity undertakes using financial instruments.

Let us briefly look into classification and measurement of assets and liabilities.

Classification and measurement of financial assets: As per IFRS-9 financial assets are recognized in entirety rather than being subject to complex bifurcation requirements. As per IAS-39, embedded options or derivatives were bifurcated and treated separately.

As per IAS-39 Financial assets were classified into 4 categories.

  1. Held to maturity (HTM)
  2. Loans and receivables (LAR)
  3. Fair value through profit or loss (FVTPL)
  4. Available for sale (AFS).

IFRS-9 introduces more principal based approach to classify financial assets into 4 categories. The first three categories are for Debt instruments and the last one applies to Equity.

  1. Amortized cost: The Amortized cost standard applies to financial instruments for which an entity has a business model to hold the financial asset to collect the contractual cash flows. The characteristics of the contractual cash flows are that of solely payments of the principal amount and interest (referred to as “SPPI”). Principal is the fair value of the instrument at initial recognition and Interest is the return within a basic lending arrangement and typically consists of consideration for the time value of money, and credit risk.
  2. Fair value through profit or loss (FVTPL): This classification applies to the financial instruments that are held for trading or for which the entity’s business model is to manage the financial asset on a fair value basis i.e. to realize the asset through sales as opposed to holding the asset to collect contractual cash flows. This category represents the ‘default’ or ‘residual’ category if the requirements to be classified as amortized cost or FVOCI are not met. All derivatives would be classified as at FVTPL.
  3. Fair value through other comprehensive income (FVTOCI) for debt: Fair value through other comprehensive income is the classification for instruments for which an entity has a dual business model, i.e. the business model is achieved by both holding the financial asset to collect the contractual cash flows and through the sale of the financial assets.
  4. FVTOCI for equity: Equity instruments are normally measured at FVTPL. On initial recognition, an entity may make an irrevocable election (on an instrument-by-instrument basis) to designate an equity instrument at FVOCI. This option only applies to instruments that are not held for trading and are not derivatives.

Classification and measurement of financial liabilities: The classification of financial liabilities under IFRS9 does not follow the approach for the classification of financial assets; rather it remains broadly the same as under IAS 39. Financial liabilities are measured at amortized cost or fair value through profit or loss (when they are held for trading). Financial liabilities can be designated at FVTPL if managed on a fair value basis or eliminates or reduces an accounting mismatch- refer to above on financial assets.

Reclassification: In certain rare circumstances an entity may change its business model for managing financial assets. When and only when this happens, it shall prospectively reclassify all affected financial assets, unless irrevocably designated at initial recognition.

Impairment: During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identified as a weakness in existing accounting standards. As part of IFRS 9, the IASB has introduced a new, expected-loss impairment model that will require more timely recognition of expected credit losses.

Impairment of loans is recognized – on an individual or collective basis – in three stages under IFRS 9:

Stage 1: Low Risk

Stage 2 – Loan’s credit risk has increased significantly since initial recognition.

Stage 3 – If the loan’s credit risk increases to the point where it is considered credit-impaired.

  • 12-month ECLs (Stage 1): Applies to all items (from initial recognition) as long as there is no significant deterioration in credit quality •
  • Lifetime ECLs (Stages 2 and 3): Applies when a significant increase in credit risk has occurred on an individual or collective basis

Measurement of ECL: Lifetime ECL would be estimated based on the present value of all cash shortfalls over the remaining life of the financial instrument. The 12-month ECL is a portion of the lifetime ECL that is associated with the probability of default events occurring within the 12 months after the reporting date.

Hedge Accounting: Hedge accounting in IFRS-9 follows the standards of IAS-39 and consists of three categories.

  1. Cash flow hedge
  2. Fair value hedge
  3. Hedge of a net investment in a foreign operation.

Above is the brief summary of Classification and measurement financial assets and liabilities. Following sections would cover 12 month ECL (Expected Credit Loss) and Lifetime ECL in detail.

Next Section: 12 Month PD-IFRS-9

To better understand IFRS-9 it is advised to start from the first section (Introduction IFRS-9).

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