Numerous articles have been published on IFRS 9, the new standard dealing with financial instruments, and it would be presumptuous of me to think that I could go into its many facets in any detail in just one article. The scope of this article is therefore intended to give you a taste of what IFRS 9 is about and share with you some of my personal views on the topic.
Many righteous fingers pointed to IAS 39 as one of the main culprits leading to the 2008 financial crisis. While I think that there were a number of more culpable factors, the incurred loss model, whereby losses could only be recognised once the loss event occurred, surely exacerbated the situation. The need to revise the notorious standard was immediately felt and the IASB embarked on a comprehensive project on financial instruments to replace IAS 39. This project, or IFRS 9, comprised three phases. The first phase, dealing with the classification and measurement requirements of the standard was issued as early as 2009. The phase focusing on a new general hedge accounting model was published in 2013, while the last phase, a forward looking impairment model, was completed in July 2014. The 2014 publication represents the final version of the standard and completes IASB’s IFRS 9 project, replacing IAS 39.
In November 2016 the new standard was endorsed by the EU1 and the effective date for the application of IFRS 9 is for accounting periods beginning on or after 1 January 2018.
Phase 1: Classification and Measurement
The objective of this first phase of the new standard is to improve the usefulness of financial statements for users by simplifying the classification and measurement requirements. IFRS 9 proposes a logical and principle based approach towards the classification and measurement of financial instruments and the main differences between the old and the new standards are listed below2.
|IAS 39 Classification||IFRS 9 Classification|
|Rule based||Principle based|
|Complex and applied at instrument level||Business model + cashflow characteristics|
|Multiple impairment models||One forward looking impairment model|
|Own credit gains/losses on FV liabilities recognised in P&L||Own credit gains/losses on FV liabilities presented in OCI|
|Complicated reclassification rules||Reclassification driven by business model|
Whereas IAS 39 allowed for the classification and measurement at instrument level, IFRS 9 introduces the concept of the Business Model as well as a simplified process to determine the accounting for all types of financial assets, including those containing embedded derivative features.
The 2 criteria applied to determine how to classify a financial instrument are:
- What is the entity’s business model for managing financial assets?
- What do the contractual cash flow characteristics of the instrument represent?
In substance, if the asset is a simple debt instrument and the objective of the entity when investing in such instrument is to collect the principal and interest, or contractual cash flows, then the asset is measured at amortised cost. If, on the other hand, the business model is to collect the cash flows and also to sell it, the asset is measured at fair value in the balance sheet with the fair value changes recorded in reserves (through OCI). Should the business model be neither of these, then fair value information is important and is to be reflected in both the balance sheet and the profit or loss account.
In practical terms, an entity would have to determine at what level(s) is the business model(s) to be defined. This depends on the complexity of the entity and would take into consideration the existing structure, such as subsidiaries.
The second criterion used to determine the classification of a financial asset is whether the contractual cash flows represent solely payment of principal and interest – the SPPI test. Extensive guidance has been provided on this and it has been clarified that the interest portion covers not only the time value of money but can include other components such as margins for credit and liquidity risks. However, if the returns are not consistent with a basic lending arrangement, the SPPI criterion is not met and the asset cannot be measured at amortised cost.
The classification and measurement principles prescribed in IFRS 9 retain the fair value option for accounting mismatches. IAS 39 was revolutionary when it required recognition of derivative instruments at fair value. IFRS 9 retains this and all derivatives are to be measured at fair value through profit or loss. Indeed, it goes further and allows for fair value through P&L for those debt instruments which give rise to an accounting mismatch – i.e. where the underlying or related derivative impact the income statement.
The treatment of own credit gains and losses on liabilities measured at fair value was a thorny issue under IAS 39, as these were accounted for in profit or loss. This gave rise to the anomaly that where the market value of issued debt of an entity decreased, the reduction in this liability was treated as a credit to the P&L. In fact when the EU endorsed IAS 39, these provisions were carved out. IFRS 9 addressed this matter by requiring that such gains and losses are to be accounted for in reserves.
Phase 2: Impairment
The objective of this phase is to improve the decision-usefulness of financial statements for users by improving the amortised cost measurement, in particular the transparency of provisions for losses on loans and for the credit quality of financial assets.
The heavy criticism levied at IAS 39 arose because under its incurred loss model the provisions that could be made were considered to be ‘too little and too late’. The delayed recognition of credit losses was compounded by the multiple impairment catered for in this standard.
IFRS 9 addresses this critical matter through its forward looking expected credit loss (ECL) model. Rather than waiting for a loss event to occur in order to recognise a provision, or loan loss allowance, IFRS 9 requires the recognition of all expected credit losses on all financial instruments measured at amortised cost. An entity is required to update its ECL at each reporting date to reflect changes in the credit risk of the financial instruments held. In measuring expected credit losses, an entity is to make use of reasonable and supportable information – historical, current and forecasts – that is available ‘without undue cost and effort’.
The impairment model of IFRS 9 envisages 3 stages, namely Performing, Underperforming and Non Performing. The transition between stages depends on significant changes in credit risk – SICR. (Also refer to the table below)
All financial assets, except for purchased or originated credit impaired assets, are recognised in Stage 1 – Performing, and require recognition of 12 month expected credit losses. These are the expected credit losses that are will result from possible default events during the 12 month period after the reporting date.Rather than the expected shortfall in cash flows, the 12 month ECL is the total expected credit losses adjusted to reflect the probability that this loss will happen within 12 months of the reporting date. From a practical perspective, this implies that life time ECLs have to be calculated, even for those financial assets in the Performing (Stage 1) category. More importantly, the ECL is not calculated as the loss on those assets expected to default over the coming 12 months as this may indicate a significant increase in credit risk thereby requiring moving the asset to Stage 2 and recognising life time ECL.
Financial assets in Stages 2 and 3 require recognition of life time expected credit losses. This represents the present value of expected losses over the life of the asset. From a practical point of view, the volatility in provisions, or the ‘cliff effect’ experienced under IAS 39, will remain under the new standard due to the substantial difference between 12 month and life time ECL.
In order to calculate life time ECL, three key inputs are needed, namely:
- the exposure at default (EAD)
- the probability of default (PD)
- the loss given default (LDG).
The new standard adopts a wider view of the EAD as it includes not only the current outstanding balance but also off balance sheet, or committed amounts. The probability of early repayments also needs to be factored in when estimating the EAD. The PD is a measure of credit rating and estimates the likelihood that the borrower will not honour the repayment obligation – the loan will not be repaid and the borrower will default. In arriving at the PDs, various sources, entity specific and/or external, may be used. An entity may use its own historical data as well as other reasonable and supportable information that is available at the reporting date and can be obtained ‘without undue cost or effort’. While the standard is forward looking and focuses on ‘expected’ credit losses, historical data may prove to be a sound base to measure PDs, provided such data is adjusted to factor in both current and forecast conditions. The LGD is that part of the EAD that is not expected to be recovered, even after the realisation of collateral in the case of secured exposures, and includes the costs associated with the recovery process. In calculating the LGD, due consideration needs to be given to any haircuts that may be required on collateral values, the time to realise and the discounting of expected future inflows.
It is clear that a substantial level of judgement must be applied both in estimating ECL and in applying the staging or transition criteria. IFRS 9 has significant disclosure requirements. The objective of this new standard is to enhance the information on financial instruments contained in the financial statements and to improve the ability of users to understand this information. Time will tell the extent to which this objective will be reached.
Phase 3: Hedge Accounting
The comprehensive project on financial instruments originally included macro hedging. This was however hived off to a separate IASB project, possibly not to further extend the finalisation of the IFRS 9 project. The hedge accounting considered under IFRS 9 is limited to general hedge accounting.
IAS 39 was criticised about its rule based approach towards hedge accounting. It was considered to be just an accounting tool disjointed from the risk management activities engaged by an entity to effectively manage its risks. Also, its disclosure requirements were not deemed to not provide sufficient information about an entity’s risk management practices.
IFRS 9, in its rather limited scope as it focuses only on general hedge accounting, seeks to align hedge accounting to the risk management activities of an entity. Being principle based, IFRS 9 eligibility criteria are determined using risk management data rather than the accounting metrics of IAS 39. The new standard no longer applies the effectiveness ‘bright lines’ imposed by its predecessor and also requires clearer information disclosure on the use of hedge accounting within the financial statements.
In conclusion, IFRS 9 is expected to have a material impact on entities, and in particular on banks. As such, its implementation is very much a top priority not only for the banks themselves but also for the regulators who are keeping close tabs on the progress being made. The European Banking Authority is also very keen to have visibility on how IFRS 9 will impact banks’ capital and has already carried out two detailed surveys amongst a number of banks to assess this.