This is the first of two articles on the topic of financial instruments. This article covers:
- recognition
- measurement of financial assets
- measurement of financial liabilities
- derecognition
- reclassification
- impairment
Recognition of financial assets and liabilities
In accordance with IFRS 9,Financial Instruments, a company recognises a financial asset or a financial liability when the company becomes party to the contractual provisions of the instrument. For example, if a company receives a firm order for goods from a customer, it should delay recognition of the trade receivable until at least one of the parties has performed under the agreement. This would normally be when the goods are shipped or delivered. In contrast, however, a forward contract or option is recognised on the commitment date if it falls within the scope of IFRS 9.
Except for trade receivables, a company measures a financial asset or financial liability on initial recognition at its fair value. The treatment of transaction costs directly attributable to the acquisition or issue depends on the instrument’s measurement category.
Measurement of financial assets
A financial asset is measured at fair value through profit or loss (FVTPL) unless it is measured at amortised cost or at fair value through other comprehensive income (FVTOCI). Classification depends on both the company’s business model for managing the financial assets and the contractual cash flow characteristics of the financial asset.
In accordance with IFRS 9, what is meant by a company’s ‘business model’?
Answer
According to IFRS 9, a company’s business model refers to how an entity manages its financial assets in order to generate cash flows. It determines whether cash flows will result from collecting contractual cash flows, selling financial assets or both. An entity’s business model is a matter of fact.
A financial asset is measured at amortised cost if:
(i) the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows, and
(ii) 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 financial asset is measured at FVOCI if:
(i) the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, and
(ii) 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 company can make an irrevocable election at initial recognition for investments in equity instruments to be measured at FVOCI if they are not held for trading.
IFRS 9 contains an option to designate, at initial recognition, a financial asset as measured at FVTPL if it would eliminate or significantly reduce an ‘accounting mismatch’. This can arise when measuring assets or liabilities, or recognising the gains and losses on them, on different bases.
On 1 June 20X7, Design Co loaned $9 million to a subsidiary. There was no loan agreement or repayment date or interest charged. However, there was an expectation that the amount would be repaid on demand. This type of event has previously occurred, and the loan repaid. At 31 December 20X7, the subsidiary could not repay the loan but it was probable that repayment would occur by February 20X8.
Does the inter-company loan meet the conditions in IFRS 9 to be measured at amortised cost?
Answer
To classify a financial asset at amortised cost, IFRS 9 states that its contractual terms must give rise to cash flows on specified dates that are solely payments of principal and interest on the principal amount outstanding. These cash flows must be consistent with normal lending arrangements.
As the inter-company loan can be called at any time, there is an argument that a financial institution would charge low interest for such a loan as it could be called in at any time. Thus, it could be argued that there is nothing different to a normal lending arrangement with the current terms. Therefore, the intercompany loan meets the contractual cash flow characteristics test in IFRS 9.
To be measured at amortised cost, the instrument must be held within a business model that has the objective to hold financial assets to collect contractual cash flows. The loan is not held to sell; therefore, the inter-company loan meets both the IFRS 9 tests to be measured at amortised cost.
Measurement of financial liabilities
Measurement of financial liabilities is easier than financial assets. Almost all financial liabilities are measured at amortised cost, meaning that a finance cost is reported in profit or loss based on the effective rate of interest. Financial liabilities held for trading, including derivative liabilities, are measured at FVTPL.
As with financial assets, a company can designate, at initial recognition, a financial liability to be measured at FVTPL if it would eliminate or significantly reduce an ‘accounting mismatch’.
Where a company has a financial liability that is measured at FVTPL, the fair value of the liability can depend on the credit worthiness of the company. As a result, where the credit worthiness of a company deteriorates the fair value of the liability will typically reduce, resulting in a fair value gain. And where the credit worthiness of a company improves the fair value of the liability will typically increase, resulting in a fair value loss. IFRS 9 requires the fair value movements in a financial liability designated to be measured at FVPL that are attributable to changes in the credit risk of that liability should be presented in other comprehensive income, as opposed to being presented in profit or loss. This does not apply where this treatment would create or would enlarge an accounting mismatch.
Insert Co has applied the fair value option in IFRS 9 in order that the recognition of gains and losses on its investment properties and the related borrowings (financial liability) which financed the purchase of the investment property would be consistent. The investment property was measured at fair value in accordance with IAS 40 Investment Property using a discounted cash flow technique.
Can Insert Co apply the fair value option rule in IFRS 9 to the measurement of its financial liability?
Answer
IFRS 9 allows companies to designate a financial liability as measured at FVTPL if it would eliminate or significantly reduce a measurement or recognition inconsistency (an 'accounting mismatch') which would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases. This is an accounting policy choice.
If the fair value option was not used, then the financial liability would be measured at amortised cost and the investment property at fair value. However, there is significant correlation between the measurement of the fair value of the investment property and the related financial liability, in that both elements will use current interest rates. Therefore, the fair value option can be used to avoid inconsistency.
Derecognition
Derecognition is the removal of all or part of an asset or liability from the statement of financial position.
Derecognition of financial assets
A company derecognises a financial asset when the contractual rights to the cash flows from the financial asset have expired, or it transfers the financial asset such that it qualifies for derecognition. A company transfers a financial asset where it transfers the contractual rights to receive the cash flows of the financial asset, or where it retains the contractual rights to receive the cash flows of the financial asset but assumes a contractual obligation to pay the cash flows to a third party. The company also evaluates the extent to which it retains the risks and rewards of ownership of the financial asset.
On derecognition of a financial asset, the difference between the carrying amount and the consideration received is recognised in profit or loss. If a company neither transfers nor retains substantially all the risks and rewards of ownership of a transferred asset, and retains control of the transferred asset, the company continues to recognise the transferred asset to the extent of its continuing involvement.
Derecognition of financial liabilities
A company should derecognise a financial liability from its statement of financial position when the obligation is discharged, cancelled or has expired.
An exchange between an existing borrower and lender of debt instruments with substantially different terms is accounted for as extinguishing the original financial liability and recognition of a new financial liability. Similarly, a substantial modification of the terms of the existing financial liability is accounted for by extinguishing the original financial liability and recognising a new financial liability.
Reclassification
When, and only when, a company changes its business model for managing financial assets, it should reclassify all affected financial assets. Reclassification should be applied prospectively from the reclassification date. The company should not restate any previously recognised gains, losses or interest already recognised.
Financial assets designated at FVTPL and investments in equity measured at FVOCI are not subject to the reclassification requirements of IFRS 9.
Financial liabilities are never reclassified.
Impairment
Except for investments in equity instruments, financial assets classified as amortised cost or FVTOCI must be tested for impairment at the end of each reporting period.
IFRS 9 has a general approach for impairment that distinguishes between ‘12-month expected credit losses’ and ‘lifetime expected credit losses’. Expected credit losses are the present value of all cash shortfalls (the difference between the cash flows that are due to an entity and the cash flows that the entity expects to receive) over the expected life of the financial instrument. Expected credit losses should be measured in a way that reflects an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes, the time value of money and reasonable and supportable information.
The decision as to whether the loss allowance is based upon 12-month expected credit losses or lifetime expected credit losses depends on whether there has been a significant increase in credit risk since initial recognition. An increase in credit risk is reflected by a change in the risk of a default occurring over the expected life of the financial asset. When making the assessment the company must consider reasonable and supportable information, that is available without undue cost or effort that is indicative of significant increases in credit risk since initial recognition. If the financial instrument has low credit risk at the reporting date, then the company can assume that the credit risk has not increased significantly since initial recognition. Low credit risk is based on a company’s internal credit risk ratings, or other acceptable methods
If a financial asset’s credit risk has not increased significantly since initial recognition, a company calculates 12-month expected credit losses. This means that expected credit losses are calculated based on default events that are possible within 12 months from the reporting date. Where the credit risk has increased significantly since initial recognition, a company calculates lifetime expected credit losses. This means that expected credit losses are calculated based on all possible default events over the expected life of the financial instrument. A company assesses at each reporting date whether the credit risk associated with a financial asset has increased significantly since initial recognition. For trade receivables, contract assets and lease receivables, a simplified approach may be applied. This approach allows a company to always calculate expected credit losses as equal to the lifetime expected credit losses.
If an actual default event occurs and the financial asset becomes credit-impaired, lifetime expected credit losses are calculated as the difference between the asset’s gross carrying amount and the present value of the expected future cash flows.
For financial assets measured at amortised cost, a loss allowance is recognised for the expected credit losses. This reduces the net carrying amount of the financial asset. Movements in the allowance year-on-year are charged (or credited) to profit or loss.
For financial assets measured at FVOCI, no adjustment is made to the net carrying amount of the financial asset in respect of expected credit losses. This is because the financial asset must be measured at fair value. Instead, an increase (or decrease) in expected credit losses is charged (or credited) to profit or loss, with a corresponding adjustment to other comprehensive income.
The rules are different for purchased or originated credit-impaired financial assets. These are financial assets that are already credit impaired at initial recognition. At each reporting date, a company recognises the amount of the change in lifetime expected credit losses as an impairment gain or loss in profit or loss.
On 1 January 20X7, Sparrow Co purchased quoted bonds issued by Pippit Co for $10 million and measured them at amortised cost. The coupon rate of interest on the bonds was 5%, which was the same as the effective rate. Credit risk associated with the bonds on 1 January 20X7 was deemed to be low. No loss allowance was recognised on this date.
At 31 December 20X7, Sparrow Co received $0.5 million interest from the bonds. However, newspapers have reported that Pippit Co is in financial difficulties. The price of Pippit Co’s bonds declined significantly despite an overall increase in the bonds market.
At 31 December 20X7, 12-month expected credit losses were calculated to be $1.6 million and lifetime expected credit losses were calculated to be $4.5 million.
Discuss how the above information should be accounted for by Sparrow Co in the year ended 31 December 20X7.
Answer
At the reporting date, the gross carrying amount of the financial asset is $10 million.
At the reporting date, a loss allowance must be recognised because the financial asset is measured at amortised cost.
The loss allowance should be equal to lifetime-expected credit losses if credit risk has increased significantly. This would seem to be the case because of Pippit Co’s widely reported financial difficulties. Moreover, the decline in the price of Pippit Co’s bonds suggests that the bonds are becoming riskier and that investors are less inclined to purchase them.
As such a loss allowance should be recognised for $4.5 million, with a corresponding charge to profit or loss. This will reduce the net carrying amount of the financial asset presented on the statement of financial position to $5.5 million.
Written by a member of the DipIFR examining team
