ifrs 9: financial instruments

OVERVIEW


IFRS 9 sets the requirements for the accounting treatment and disclosures of the financial assets and financial liabilities in the financial statements so that the users of the financial statements understand and evaluate the timing, uncertainty of the expected future cash flows of an entity.


SCOPE


IFRS 9 applies to all the financial assets and liabilities of an entity. The requirements of the IFRS 9 are almost the same as that of the previous standard IAS 39 – Financial Instruments: Recognition and Measurement with the only difference of the accounting treatment of the loan received. IAS 39 requires the receipt of the loan to be treated as per the IAS 37: Provisions, Contingent liabilities, and contingent assets. However, IFRS 9 requires that loan receipt shall be treated as a financial liability and to be recognized and measured under IFRS 9.

Key Takeaway Points


=> IFRS 9 sets the requirements for the accounting treatment and disclosures of the financial assets and financial liabilities in the financial statements so that the users of the financial statements understand and evaluate the timing, uncertainty of the expected future cash flows of an entity.


=> IFRS 9 applies to all the financial assets and liabilities of an entity. The requirements of the IFRS 9 are almost the same as that of the previous standard IAS 39 – Financial Instruments: Recognition and Measurement with the only difference of the accounting treatment of the loan received. IAS 39 requires the receipt of the loan to be treated as per the IAS 37: Provisions, Contingent liabilities, and contingent assets.


=> Financial assets shall be recognized by an entity when it became the party to the contractual provisions of the agreement or contract.


=> There are three choices available to an entity for the classification of the financial assets which are the following:


Measuring of the financial assets at amortized cost

Measuring the financial assets through profit or loss

Measuring the financial assets through other comprehensive income

 

=> The financial assets are measured at the fair value when initially acquired plus any incidental direct cost incurred on it plus any transaction costs are included in the value of the financial assets unless it is measured through profit or loss.


=> The financial liabilities shall be recognized initially at fair value. This is usually the net proceeds of the cash received less any cost of issuing the liability.


=> Financial assets will be measured and carried out at the amortized cost. Amortized cost shall be calculated as the initial value plus the effective interest incurred over it less any interest paid on the financial liabilities.


=> A compound instrument is an instrument with the characteristics of both financial assets and financial liability. An example of a compound instrument is a convertible loan.

 


RECOGNITION AND MEASUREMENT


Financial instruments could be either financial assets or financial liabilities. We have to discuss here the recognition and measurement of the financial assets and financial liabilities separately so firstly let’s have a look at the recognition and measurement criteria of the financial assets.


FINANCIAL ASSETS


Financial assets shall be recognized by an entity when it became the party to the contractual provisions of the agreement or contract.


CLASSIFICATION


There are three choices available to an entity for the classification of the financial assets which are the following:


Measuring of the financial assets at amortized cost


The financial assets shall be measured at the amortized cost if an entity complies with the following condition as laid out in the IFRS 9:


=> The business holds such assets with an objective to earn contractual cash flows from it.

=> The contractual terms of the financial asset lead to generating the cash flows that are the sole payments of principal and interest on the principal amount outstanding.


Measuring the financial assets through profit or loss


The financial assets shall be measured through profit or loss if an entity complies with the following condition as laid out in the IFRS 9:


=> The entity business model is of the nature which is managing the financial assets

=> The business satisfies the contractual cash flow characteristic model test regarding the financial assets


Measuring the financial assets through other comprehensive income


The financial assets shall be measured through other comprehensive income if an entity complies with the following condition as laid out in the IFRS 9:


=> The financial assets are held with an objective to generate the contractual cash flows from it and sell the financial assets.

=> The contractual terms of the financial assets give rise to the sole payments of principal amount and interest amount on the principal amount outstanding.


MEASUREMENT OF FINANCIAL ASSETS


The financial assets are measured at the fair value when initially acquired plus any incidental direct cost incurred on it plus any transaction costs are included in the value of the financial assets unless it is measured through profit or loss.


RECLASSIFICATION OF THE FINANCIAL ASSETS


When an entity changes its business model for managing the financial assets then it also needs to reclassify the affected financial assets.


The reclassification of the financial assets shall be applied prospectively and not retrospectively. Therefore, any previous gains or losses on the financial assets shall not be restated.


If the financial assets are classified at the fair value at the date of the reclassification then the gain or loss due to the fair value measurement shall be recognized in the statement of the profit or loss.


EQUITY INSTRUMENTS


The equity instruments purchased like the shares of other company is a financial asset for the purchasing company and is measured at either:


=> Fair value through profit or loss

=> Fair value through other comprehensive income


Fair value through profit or loss


This is the default category for the measurement of the equity instruments. Any transaction costs associated with the purchase of the equity instruments shall be expense out in the statement of profit or loss and should not be included in the cost of the equity instruments.


The investments shall be measured and revalued at the end of each year and any gain or loss to be recorded and reflected in the statement of profit or loss.


Fair value through other comprehensive income


Entities are allowed under the IFRS 9 to measure and classify the equity investments through other comprehensive income. The investment can be classified through other comprehensive income if the investment is intended to hold for a long time. However, once the investment is classified through other comprehensive income then it cannot be reclassified to the profit or loss.


When the investment is classified through other comprehensive income then transaction costs related to the investment shall be capitalized and investment shall be revalued at the end of each year and any gain or loss in the value of the investment shall be reflected in the statement of profit or loss.


The revaluation concept for the equity investments is the same as the revaluation concept given in the IAS 16 with the only difference that revaluation reserve can be negative on the investments under the IFRS 9.


When the investments are recognized through other comprehensive income then the revaluation reserve shall be transferred to the retained earnings once sold.


DEBT INSTRUMENTS


Debt instruments and redeemable preference shares are the financial assets and shall be categorized in one of the following three ways as per IFRS 9:


=> Fair value through profit or loss

=> Fair value through other comprehensive income

=> Amortized cost


The default category to measure and classify the debt instruments are the fair value through profit or loss. However, business entities shall measure the financial assets through other comprehensive income or at amortized cost when the following conditions are fulfilled:


The business model test means that the business entity holds the financial asset for the long term with the purpose to generate future cash flows.


The contractual cash flow characteristics test means that the business entity will receive cash due to the holding of the investments and considers what it comprises.


Amortized Cost


For financial instruments to be measured at the amortized cost the following two conditions shall be fulfilled:


The business model test means that the business entity holds the financial asset for the long term with the purpose to generate future cash flows.


The contractual cash flow characteristics test means that the business entity will receive cash due to the holding of the investments and comprises of the principal amount and the interest over such instrument.


If the debt instrument is classified and held at the amortized cost then any interest income received over it shall be calculated using the effective interest rate and shall be recorded in the statement of the profit or loss.


Fair value through other comprehensive income


For financial instruments to be measured through other comprehensive income when the following two conditions shall be fulfilled:


The business model test means that the business entity holds the financial asset for the long term with the purpose to generate future cash flows.


The contractual cash flow characteristics test means that the business entity will receive cash due to the holding of the investments and comprises of the principal amount and the interest over such instrument just like in the case of the financial instruments held at the amortized cost.


If financial assets are held through other comprehensive income then the transaction cost associated with the purchase of the asset shall be capitalized and added to the value of the asset. The interest income over the financial asset shall be calculated using the effective interest rate and shall be recorded in the statement of profit or loss.


The financial assets measured through other comprehensive income shall be revalued at the end of each accounting period and any gain or loss shall be recorded in the statement of the profit or loss.


RECEIVABLES FACTORING


Factoring of receivables means that one company say company A transfers its receivables to another company say company B for the management and collection of receivables and the first company, company A that transfers the receivables to another company receives advance money against the transfer of the receivables.


The important point to consider in the factoring of receivables is who will bear the risk of bad debts. Following two situations decide who will bear the risk of the bad debt in case of the factoring of receivables.


In case of sale of receivables with recourse, the transferor company of receivables will bear the risk of the bad debts, not the transferee company. In this case, the receivables shall not be removed from the statement of the financial position of the transferor company.


In case of sale of receivables without recourse, the transferee company of receivables will bear the risk of the bad debts, not the transferor company. In this case, the receivables shall be removed from the statement of the financial position of the transferor company.


EMBEDDED DERIVATIVES


As per IFRS 9, the Embedded derivative is a component of the hybrid contract or an agreement that also includes the non-derivative host element with the effect that some of the cash flows of the combined instruments may vary in a way that is similar to the stand-alone derivatives.


If a hybrid contract also contains a host and such host is an asset, falls within the scope of IFRS 9 then the above classification requirements would apply.


If a hybrid contract contains a host that is not an asset and does not fall within the scope of the IFRS 9 then the embedded derivatives shall be separated from the host and to be accounted as the derivatives only when the following conditions shall met:


=> The economic characteristics and the risks of the embedded derivatives are not closely related to the economic characteristics and risks of the host.

=> The hybrid contract is not measured at the fair and the changes in the fair value are reflected in the statement of the profit loss.

=> If an entity is required to separate the embedded derivative from its host under the IFRS 9 but is unable to do so and the separation is not possible then the embedded derivative shall be measured at the fair value through profit or loss.


FINANCIAL LIABILITIES


The financial liabilities shall be recognized initially at fair value. This is usually the net proceeds of the cash received less any cost of issuing the liability.


SUBSEQUENT MEASUREMENT OF THE FINANCIAL LIABILITIES


Financial assets will be measured and carried out at the amortized cost. Amortized cost shall be calculated as the initial value plus the effective interest incurred over it less any interest paid on the financial liabilities.


PREFERENCE SHARES


The preference shares of an entity purchased by another entity constitute its financial liabilities. However, if shares are issued as irredeemable preference shares and it contains no obligations to make any payment, either of the capital or dividend then it shall be classified as equity.


INTEREST AND DIVIDEND


The accounting treatment of the interest and dividends depends upon the accounting treatment of the underlying instrument itself:


=> The equity dividend declared are reported directly in the equity.

=> The dividends on the instruments that are classified as liability are treated as a finance cost in the statement of profit or loss.


COMPOUND INSTRUMENTS


A compound instrument is an instrument with the characteristics of both financial assets and financial liability. An example of a compound instrument is a convertible loan. A convertible loan has the following characteristics:


=> It is repayable at the lender option and it is repayable in the shares of the issuing company rather than repayable in cash.

  1. => The number of shares that are issued is fixed at the inception of the loan.

=> The lender will accept the rate of interest which is below the market rate for non-convertible instruments.

=> The convertible loan is accounted in the financial statements using the split method of accounting which means that its liability and equity component shall be measured and classified separately in the financial statements.


The accounting treatment of the convertible loan falls within the following two categories which are as follows:


INITIAL RECOGNITION OF THE CONVERTIBLE LOAN


The convertible loan is recognized at fair value when initially recognized. The fair value is the present value of the future cash flows which is calculated using the discount market rate of interest while the equity element is equal to the loan proceeds less liability element.


SUBSEQUENT MEASUREMENT


The convertible loan measured at the amortized cost shall be measured subsequently as the initial value of the liability plus the market rate of interest less any interest paid on the loan.


The equity shall not be re-measured and remains at the same value on the statement of financial position until the debt is redeemed.


DERECOGNITION


Financial instruments shall be derecognized when the following conditions are fulfilled:


=> Financial assets are derecognized when the contractual rights to the cash flows from the financial assets become expires.

=> Financial liabilities are derecognized when the obligations in the contract are fully discharged.

=> On the de-recognition, the differential amount on the amount received on the financial assets or amount paid on the financial liability shall be recorded in the statement of profit or loss.


DISCLOSURES


IFRS 9 requires the following disclosures at minimum regarding the financial instruments:


=> The carrying amount of each category of the financial instrument.

=> The item of income and expenses and gains or loss incurred on the financial asset or financial liability.

=> The risks and uncertainty faced by an entity regarding the financial assets and financial liabilities shall be disclosed.