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A Point of View

An Overview of the Final Version of IFRS 9


Financial Instruments
Abstract
IASB published the final version of IFRS 9- Financial Instruments, on July 24, 2014, marking the completion of the project to replace IAS 39
Financial Instruments: Recognition and Measurement. This paper discusses the changes introduced in this new version, and gives an overview
of IFRS 9 requirements with respect to classification, measurement, impairment, and hedge accounting of financial instruments.
IFRS 9 will impact both the financial and non-financial services sector, because all balance sheets contain one or the other financial
instrument. Its implementation would pose significant challenges to financial firms, especially banks, because the new classification and
measurement requirements will need a thorough assessment of financial assets classification, considering the business model requirements
that are substantially different from IAS 39.
Further, assessing business models is a highly subjective area because it depends on facts and circumstances. Banks will also need to
document the reasons behind their assessment. In fact, the new impairment model is touted to significantly impact banks because they
generally hold large volumes of loans in their balance sheets. They will now have to bear the cost of updating their systems and processes to
move from calculating incurred loss to expected loss.

How Did IFRS 9 Come Into Being?


IAS 39 Financial Instruments: Recognition and Measurement establishes the principles for recognizing and measuring financial assets,
financial liabilities, and some contracts to buy or sell nonfinancial items. It also deals with the classification of financial instruments, their
ongoing measurement (including detailing when impairment is required), their recognition or de-recognition, and hedge accounting
requirements.
At the 2009 G20 summit, world leaders declared that the financial reporting process needed IFRS 9 brings together the
improvements. IAS 39, which came into effect in January 2001, has been widely considered an classification and measurement,
unfriendly standard due to its complexities and internal inconsistencies. Thus, the impairment, and hedge accounting
International Accounting Standards Board (IASB) decided to significantly accelerate its project phases of the IASBs project to replace
to replace this standard. However, replacing IAS 39 has not been an easy task. IAS 39 Financial Instruments:
The IASB divided this project into phases and published various versions of IFRS 9, introducing Recognition and Measurement. The
new classification and measurement requirements in 2009 and 2010, and a new hedge final version of IFRS 9 Financial
accounting model in 2013. IASBs publication on July 24, 2014, announces the final version of Instruments comes into force on 1
IFRS 9 and marks the completion of the project to replace IAS 39. January 2018.

How Is IFRS 9 Different from IAS 39?


Classification, Measurement, and Reclassification of Financial Assets
Classification determines how financial assets are accounted for and measured on an ongoing basis. Classification and measurement
requirements are the foundation for financial instruments accounting as they provide a basis for impairment and hedge accounting.
IFRS 9 removes the 'held to maturity' category and related 'tainting' rules, as well as the 'available for sale' and 'loans and receivables'
categories. It requires all financial assets to be classified into one of three measurement categories (listed below), based on two teststhe
Business Model test and the Contractual Cash Flow Characteristics test.
n Amortized cost
n Fair Value through Other Comprehensive Income (FVOCI)
n Residual category Fair Value through Profit or Loss (FVTPL)
The Business Model test refers to how financial assets are managed to generate cash flow, i.e. by collecting
contractual cash flows or selling financial assets, or both. The Contractual Cash Flow Characteristics test IFRS 9 prohibits
assesses whether the contractual cash flows are solely payments of principal and interest. Only financial reclassification after
assets with such cash flows are eligible for amortized cost or fair value through other comprehensive initial recognition
income measurement dependent on the business model in which the asset is held. unless there is a
fundamental change in
Financial Assets Classification the business model for
managing the financial
Business Model Type Objective Classification
assets, in which case
1 Holds financial assets in order to collect contractual cash flows Amortized cost reclassification is
required with
Holds financial assets for collecting contractual cash flows and
2 for selling them FVOCI exhaustive disclosures
as mentioned in IFRS 7
FVTPL Financial Instruments-
3 Does not meet objectives of models 1 and 2
(Residual category)
Disclosures.

Financial assets such as loans or debt instruments, which were previously classified as loans and
receivables, or were categorized as 'held to maturity' under IAS 39, will now be classified as amortized cost under IFRS 9. The assets that used
to be classified as FVTPL or AFS, such as financial assets held for trading, derivatives, and so on, will now be classified as FVTPL or FVOCI, as
the case may be, on the basis of the two tests mentioned earlier.

Classification and Measurement of Financial Liabilities and Own Credit


The fair value of an entitys own
Financial Liabilities: IFRS 9 continues IAS 39s treatment of financial liabilities. This means that debt is affected by changes in
most financial liabilities will continue to be measured at amortized cost. IFRS 9, just like IAS 39, the entitys own credit risk
permits entities to measure financial liabilities at fair value through profit or loss, on the (own credit).
fulfillment of specific criteria.
This means that when an entitys
Own Credit: Changes in the credit risk of financial liabilities that an entity has elected to credit quality declines, the value
measure at fair value causes volatility in profit or loss. This has been a major concern for IASB. of its liabilities fall, and if those
IFRS 9 addresses the so-called own credit issue by introducing new requirements for liabilities are measured at fair
accounting and presentation of changes in the fair value of an entitys own debt when the value, a gain is recognized in
entity has chosen to measure that debt at fair value under the FVO. profit or loss (and vice versa).

IFRS 9 requires changes in the fair value of an entitys own credit risk to be recognized in other Many investors find this concept
comprehensive income rather than in profit or loss. Such liabilities will continue to be measured confusing.
in the balance sheet at fair value.

Impairment and Interest Income Calculation


IFRS 9 adopts a single forward-looking expected credit loss model that is applicable to all types of financial instruments subject to
impairment accounting, as opposed to the incurred loss model mentioned in IAS 39.
A comparison of the approaches and the methodologies of IAS 39 and IFRS 9 in calculating impairment provision or loss is shown in Table 1.
It shows that the new model will result in more prudent and timely recognition of loan losses.

Model Incurred Loss ( IAS 39) Expected Loss (IFRS 9)

Approach n Classify assets into individually Assess financial asset at portfolio level or individually, using a three stage approach
significant and individually not (refer Figure 1), based on level of credit quality at reporting date:
significant (portfolio) to assess
n Stage 1 Estimate expected credit loss over the next 12 months, using Probability of Default
impairment
(PD) and Loss Given Default (LGD), if there is no significant deterioration in credit quality.
n Use objective indicators to Assets falling under this bucket/stage are called performing assets.
determine if the asset has
n Stage 2 Estimate life time expected credit loss if there is significant credit loss, but no
suffered impairment
objective evidence. Assets falling under this bucket/stage are called underperforming assets.
n Stage 3 - Calculate lifetime impairment loss using discounting of revised cash flows @EIR if
there is a significant deterioration in credit quality and presence of objective evidence. Assets
falling under this bucket/stage are called non-performing assets.

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Model Incurred Loss ( IAS 39) Expected Loss (IFRS 9)

Impairment n Carry out collective impairment Estimate impairment loss based on:
calculation provisioning for an individually n Past events
insignificant asset n Current economic outlook of the borrower
n Recognise impairment loss if the n Reasonable, relevant, and supporting information that allows for a forward looking
carrying value of an individually estimation
significant asset is less than the n Range of possible outcomes and their likelihood and - PDs and LGD
discounted future estimated cash
flows, else group it for collective n Discount estimated future cash flows at a rate between effective interest rate (EIR) and risk
impairment provisioning based free rate (both limits inclusive)
on a roll rate

Table 1: A comparison of the impairment approach as under IAS 39 and IFRS 9

New Impairment Model

Deterioration in credit quality since initial recognition

Stage 1 Stage 2 Stage 3


(Performing asset) (Under-performing asset) (Non-performing asset)
Recognition of
12-month expected Lifetime expected Life-time expected
expected
credit losses credit losses credit losses
credit losses

Interest Effective interest on Effective interest on Effective interest on


Revenue gross carrying amount gross carrying amount net carrying amount

Figure 1: New Impairment Model

Financial assets such as loans will move between these stages depending on changes in credit loss expectations. So, for example, a loan might
be transferred to the second stage if there is a significant increase in credit risk, and to the third stage if there is objective evidence of
impairment. A loan loss provision will be made against all loans in all the categories, but each category will have its own measurement process.
Further, IFRS 9 requires interest revenue from financial assets to be calculated using the effective interest method on its gross carrying
amount, except when there is objective evidence of impairment at a reporting date. In such a case, it is required that the interest revenue be
calculated on its net carrying value. In addition, if there is objective evidence that the financial asset is credit-impaired at initial recognition
(purchased or originated credit-impaired financial asset), the interest revenue will have to be calculated by applying the credit-adjusted
effective interest rate to the amortized cost of the asset.
This new model requires extra and detailed disclosures about the expected credit losses recognized, and the impact of changes in credit risk
of financial instruments. The new impairment requirement would require an entity to:
n Assess data availability to capture the historical data and trend information needed to build a forward-looking view of impairment, such
as historical probability of defaults, ratings, and product features. It is possible that many portfolios will lack such data or simply present
estimates. Entities may need to install a new system or upgrade systems to store, manipulate, and report all of this information.
n Develop new models and processes, or upgrade existing models to identify increase in credit risks and measure lifetime expected losses.

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Improved Hedge Accounting Process
IFRS 9 introduces an improved hedge accounting model to better link the To improve financial reporting and better reflect
economics of risk management with its accounting treatment. Hedge accounting risk management activities, the IASB has divided
represents the effect of an entitys risk management activities in the financial the hedge accounting phase into two work
statements. An entity uses hedging to manage its exposure to risks such as foreign streams due to the complexity of the topic:
exchange risk, interest rate risk, and the price of a commodity. n General hedge accounting for one-to-one
or static hedge relationships
Under IFRS 9, the general hedge accounting model applies to static or closed
hedging relationships, where the designated volumes of the hedged item and the n Macro hedge accounting model for
hedging instrument do not change frequently once the hedge is set up and dynamic hedge relationships of portfolios of
documented. financial assets and financial liabilities where
the hedged position changes constantly
Table 2 shows the major changes introduced by IFRS 9, as compared to IAS 39, with
respect to hedge accounting.

Area IAS 39 IFRS 9


Hedge effectiveness Quantitative retrospective and prospective Retrospective effectiveness testing is not permitted. Hedge relationship must meet
testing hedge effectiveness assessment within the three criteria to qualify for hedge accounting:
80-125 percent threshold to qualify for n Existence of an economic relationship between hedge item and hedging
hedge accounting instrument
n Effect of credit risk does not dominate fair value changes
n Hedge ratio is designated based on actual quantities of hedge item and hedging
instruments
Rebalancing On change in hedge ratio, terminate the On change in hedge ratio, continue current hedge relationship. However, the hedge
current hedge relationship and start a new ratio for hedge accounting purposes must change to align with the new hedge ratio
hedge relationship for risk management purposes; i.e. the hedge ratio for accounting purposes should be
adjusted if it is adjusted for risk management purposes.
Risk components for Not an eligible hedged item Eligible hedged item if the risk component is separately identifiable and reliably
non-financial items measurable

Aggregated exposures Derivatives, or any exposure containing Designates an exposure that combines a derivative and a non-derivative (known as
derivatives, cannot be designated as a an aggregated exposure) as a hedged item, provided that aggregated exposure is
hedged item managed as one exposure
Discontinuation Can discontinue hedge accounting at any Voluntary discontinuation not permitted; can only discontinue where the qualifying
time criteria are no longer met.

Inflation risk Inflation risk is not an eligible risk Rebuttable presumption that non contractually specified inflation risk will not usually
component unless it is contractually qualify as an eligible hedged item
specified
Own use contracts Contracts for sale or purchase of a non- Option to account for 'own use' contracts at fair value through profit or loss if it
financial item that are for own use are eliminates an accounting mismatch
outside the scope of IAS 39
Hedges of groups Groups permitted only if the fair value of Restriction removed
the items in the group move
approximately proportionally to the fair
value of the group as a whole
Fair value hedge of a Not allowed Permitted
group with offsetting
positions
Cash flow hedge of a Not allowed Permitted for foreign exchange risk (FX). Hedge documentation at inception must
group with offsetting specify the nature and amount.
/net positions

Hedges of credit risk General criteria for risk component apply, Can elect to account for a loan or loan commitment at FVTPL at any time and for a
using credit derivatives with no specific exceptions proportion of the instrument. The election can also be revoked.

Equity investments at N/A Eligible hedged item. Ineffectiveness recorded in OCI


FVTOCI

Table 2: A comparison of hedge accounting requirements as under IFRS9 and IAS 39

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The new hedge accounting requirements may have significant impact on systems and processes, due to:
n Linking of accounting and economics of derivative and hedging transactions
n Forward looking effectiveness testing with no arbitrary effectiveness range
n Rebalancing of a fair value hedge relationship that involves changing the volume of a hedged item that is a financial instrument
n Tracking of the component of the separate line item in the statement of financial position related to individual hedged items in fair value
hedging relationship
n Hedging on a net position basis

Conclusion
Upon a comparative analysis with IAS 39, we observe that IFRS 9 has adopted:
n A logical principle-based approach towards financial instruments classification and measurement, and removed the restrictive
reclassification rules that were mentioned in IAS 39.
n A single forward-looking expected credit loss model applicable to all types of financial instruments that are subject to impairment accounting.
n An improved hedge accounting model to better link the economics of risk management with its accounting treatment
The new impairment model will have a high impact on banks and financial institutions.
n Now, financial organizations will be required to recognize not only credit losses that have already occurred, but also the ones that are
expected in the future, in order to ensure they are appropriately capitalized for the loans they have written. Based on our understanding
of provisioning for non-performing assets, with our banking customers, we believe that the implementation of the expected loss model
would increase the loan loss provision by almost up to 50 percent for banks and financial institutions.
n The new model may introduce a greater degree of subjectivity because it is more forward looking. Banks and financial institutions could
have different valuations of collateral and treat trigger events that result in an expected loss differently. This indicates that provisions for
bad debts may increase, and will likely be more volatile.
When compared to the restrictive hedge accounting requirements under IAS 39, the new IFRS 9 hedge accounting model will allow entities
to better reflect their risk management activities in their financial statements. This model will also enable investors and other stakeholders
understand the risks that an entity faces, the action that the management takes to manage those risks, and the effectiveness of those risk
management strategies.
IASBs macro hedge accounting project, which aims to explore a better approach for having organizations reflect their dynamic risk
management activities in financial statements, is currently at an early stage of development. A paper titled Discussion Paper Accounting for
Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging was published in April 2014. Thus, for general hedge
accounting, entities will have to comply by requirements of IFRS 9, but for macro hedging activities they can, for the time being, continue to
function as per the specific IAS 39 accounting for macro hedges.
Since IFRS 9 is mandatorily effective from January 01, 2018, an entity must have IFRS capability in place by the end of 2016, assuming that a
parallel run of one year is enough to iron out issues with the new processes and systems. This will give entities sufficient time to understand
assumptions, judgments, and sensitivities. Further, an entitys management will also need to invest time to fully understand the interaction
between IFRS 9 and the complex regulatory capital requirements.
IFRS 9 is perhaps the most important part of IASBs response to the financial crisis. Banks and financial institutions need to nail it down at the earliest.
Please note: This paper is based on the material pertaining to IFRS 9 and IAS 39 as available on IFRS official website (www.ifrs.org). The analysis presented is the authors own
assessment of the regulatory standard and how the shift will impact the financial services organizations.

For further reading


[1] IASB, April 2014, Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging, accessed July 26, 2014,
http://www.ifrs.org/Alerts/ProjectUpdate/Pages/IASB-publishes-Discussion-Paper-on-accounting-for-macro-hedging-April-2014.aspx
[2] IFRS, July 2014, IFRS 9 Project Summary, accessed July 26, 2014,
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Documents/IFRS-9-Project-Summary-July-2014.pdf

About the Author


Dinesh Darak
Dinesh Darak is a qualified chartered accountant and is certified in International Financial Reporting Standards (IFRS). He has over 12 years of
experience, and is a functional consultant with the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). In
his current role, Dinesh consults on IFRS and FATCA requirements, and helps TCS' customers write functional specifications for designing IFRS
compliant solutions and processes.

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