IFRS 9 - Financial Instruments (detailed review)

Objective

This standard prescribes the guidelines to be followed by an entity for the recognition and measurement of financial asset and financial liability in the financial statements, which will produce the relevant and reliable information for the users of financial statements, to evaluate the cash flows and uncertainties attached to those cash flows relating to financial instruments along with the impact of such financial instruments upon the financial performance of the entity.

Scope

The requirements of this standard are applicable to deal with the accounting treatment of all types of financial instruments except for the following:

• Investment in subsidiary, associate or joint venture which are measured at cost in the separate financial statements of the acquirer. However, the requirements of this standard will be applicable to such investments if the holder chooses to the measure such investments as per the requirements of this standard in its separate financial statements as permitted by IAS 27 Separate Financial Statements

• The rights and obligations under share based payment arrangements to which IFRS 2 Share Based Payment is applicable

• The rights and obligations relating to employee benefit plans to which IAS 19 Employees Benefits is applicable

• The rights and obligations relating to insurance contracts to which IFRS 4 Insurance Contracts is applicable

Financial Assets

Initial Recognition

The entity will recognize the financial assets right on the date when entity becomes the party to the contract.
However, the regular way purchase or sale of financial asset will be accounted for either using ‘Trade date Accounting’ or ‘Settlement date Accounting’ as follows:

Trade Date Accounting

The trade date is the date when the entity agrees to purchase or sell a financial asset. Trade date accounting involves the application of the following:

• The entity will recognize the financial asset to be received and the relating liability to pay for it on the trade date, and
• The entity will de-recognize the financial asset which is sold and relating receivable from the buyer including the recognition of any gain or loss on disposal on the trade date

Settlement Date:

The settlement date is the date when a financial asset is delivered by or to an entity. Settlement date accounting involves the application of the following:

• The entity will recognize the financial asset on the day when it is received by the entity, and
• The entity will derecognize the financial asset and any resulting gain or loss on disposal on the day when it is delivered by the entity.

If the entity has opted settlement date accounting, it will incorporate any changes in the
fair value of financial asset to be received relating to the period between the trade date to the settlement date in the similar manner as for an acquired asset i.e. the change in value will be recognized in statement of profit or loss, or other comprehensive income as per the classification of financial asset. However change in fair value will not be recognized for an asset measured at amortized cost.

Classification of Financial Assets

This standard classifies financial assets on the basis of business objective model of the entity in to following categories:

1. At Fair Value through Profit or Loss:

The financial assets held by the entity in the form of investment in debt or equity instrument which are held for the purpose of trading or short term profit taking will be classified under this category.

This category also includes:

• The derivative contracts which are held by the entity for the purpose of trading
• An instrument designated by the management at fair value through profit or loss to eliminate an accounting mismatch.
• The investment in debt instruments which fails the amortized cost criteria

Accounting Treatment

The financial assets which are measured at fair value through profit or loss will be measure as follows:

• These are initially measured at purchase price (fair value)
• Any related transaction cost (such as commission or brokerage) will be charged to the statement of profit or loss.
• At each reporting date, these are re-measured at their fair value on reporting date and any change in fair value (fair value increase or decrease) will be charged to the statement of profit or loss
• Any interest or dividend income received relating to these financial assets will be charged to the statement of profit or loss
• The disposal gain or loss upon the disposal of these investments will be charged to the statement of profit or loss

2. At Fair Value through Other Comprehensive Income

This standard provides an option to the entity to make an election, in respect of financial assets which are measured at fair value, to recognize the changes in fair value at each reporting date in the other comprehensive income relating to the investment in equity instruments which is held by the entity for long term.

However, this election is only available for investment in equity instruments at their initial recognition and is irrevocable once opted.

Accounting Treatment

The financial assets in the form of investment in equity instruments for which entity has taken an election to recognize the relating changes in fair value in the other comprehensive income, will be measured as follows:

• These are initially measured at purchase price including transaction cost.

• At each reporting date, these are re-measured at their fair value on reporting date and change in fair value (fair value increase or decrease) will be reported to other comprehensive income, and it will be accumulated in statement of changes in equity in a separate column; it will remain there till the disposal of related investment. When such investment will be sold in future, any previous fair value gain or loss held in the separate column in the statement of changes in equity may be transferred to other reserves or alternatively it may retain in the equity

• However, any dividend income received and disposal gain or loss upon disposal relating to these investments will be charged to statement of profit or loss

3. At Amortized Cost

Financial assets held by the entity in the form of investment in debt instruments will be classified under this category, if these satisfy the following two conditions:

• The financial asset is held by the entity to collect its contractual cash flows over the life of the instrument (i.e. it will be held to maturity)
• The contractual cash flows of the financial asset are only the payments of interest and principal.

Example includes the purchase of debentures, loan notes, bonds and trade or loan receivables.

Accounting Treatment

The financial assets which are classified under the amortized cost category are measured as follows:

• These are initially measured at purchase price
• Any related transaction cost (such as commission or brokerage) will be included in the value of instrument
• At each reporting date, these are measured at amortized cost using effective interest rate and change in value will be charged to the statement of profit or loss
• Any interest income received relating to these investments will be charged to the statement of profit or loss

Application of Business Model and Contractual Cash Flow Test

To classify the financial assets under amortized cost category, they must be held by the entity under the business objective model to collect contractual cash flows of the instrument over their life as in the following:

Example

A financial institute engaged in financial services lends loan and sells the resulting loan receivables to its 100% owned securitization vehicle. The securitization vehicle then issues debt instruments on the basis of these loan receivable as a backing reserve and the cash collected by the securitization vehicle is passed on to its parent i.e. the originating entity.

The loan receivable will not qualify as held to contractual cash flows in the individual financial statements of originating entity as the entity sells these loan receivable to the
securitization vehicle to generate cash flows. However, these loan receivables will qualify as held to collect contractual cash flows in the consolidated financial statements from the group perspective.

• The business model test should be applied upon portfolio level

• The financial asset should also meet the contractual cash flow characteristics condition i.e. the contractual cash flows of financial asset are only the payment of interest and principal, where interest is the compensation for the time value and associated credit risk. The equity instruments do not satisfy the contractual cash flow characteristics as their cash flows are not the compensation for the time value. Similarly convertible instrument also does not satisfy the contractual cash flow characteristics as it contains an equity option which does not reflect the payments of interest and principal.

Reclassification of Financial Assets

IFRS 9 classifies financial asset on the basis of business objective model of the entity therefore reclassification of financial assets from one category to another is allowed only when there is change in business objective model of the entity.

For example, if a financial institute which was engaged in lending loans and managing those till maturity to collect contractual cash flows, chooses to close its operations and classified it’s all loan receivable as held for sale reflects the change in the business objective model of the entity.

The reclassifications which are permitted by IFRS 9 in the circumstances when there is change in the business objective model of the entity are as follows:

• In case of transfer from At Fair Value through Profit or Loss to Amortized Cost, No gain or loss will arise on the date of reclassification as fair value of financial asset on this date will become amortized cost for subsequent accounting

• In case of transfer from Amortized Cost to At Fair Value through Profit or Loss, the difference between amortized cost of financial asset on the date of the reclassification and its fair value on the same date will be charged to the statement of profit or loss and subsequently it will be measured at fair value through profit or loss

However, it is applied prospectively from the date of reclassification therefore; the entity does not need to restate the gains and losses previously recognized

Transfer into and out of at fair value through OCI category is not permitted.

Circumstances which do not reflect the Change in Business Model

Reclassification is not permitted if there is no change in the business objective model of the entity. These circumstances include the following:

a) Sale of financial asset out of the portfolio which is held to maturity in order to:

• To meet a capital expenditure requirement
• To meet the company’s credit rating policy
• To avoid the credit deterioration risk

b) Change in intention relating to particular financial asset because of change in market conditions

c) Transfer of financial asset from one portfolio to another to balance out the return on another portfolio

However, these circumstances should be infrequent in number.

Impairment of Financial Asset (IAS 39)

For the financial assets measured at amortized cost, the entity is required to review whether a financial asset is impaired. If an indication exists (such as financial difficulty of investee, default on interest payments by investee, disappearance of market relating to financial asset, liquidation of investee) the entity is required to apply the impairment test upon such financial asset as follows:

Carrying Value of financial asset (I.e. Amortized Cost on the date of impairment)	x
Recoverable Value (Present Value of Revised Cash Flows using Original Effective Interest Rate)	x
Impairment Loss	(x)

• The entity will charge the resulting impairment loss to the statement of profit or loss.

• No impairment test is required for the financial assets measured at fair value through profit or loss or at fair value through other comprehensive income as these are already measured at fair value

De-recognition of Financial Asset

A financial asset is derecognized from the financial statements when following conditions are met:

a) When substantial risks and rewards relating to financial asset have been transferred

b) When right to receive cash flows relating to financial asset has been transferred

c) Entity retains no control over financial asset after transfer

Any gain or loss on de-recognition of financial asset will be charged to the statement of profit or loss.

The same conditions as mentioned above will be applicable whether a financial asset in its entirety or a part of financial asset is derecognized. A part of financial asset includes the following:

• The specific identifiable cash flows of a financial asset such as when the entity enters into an arrangement in which it grants counter party the right to the interest element of a debt instrument
• The pro rata share of entire financial asset such as when entity enters into arrangements in which entity grants counter party the right to the pro rata share of all cash flows of entire financials asset
• The pro rata share of specific identifiable cash flows of financial asset such as when the entity enters into an arrangement in which it grants counter party the right to pro rata share of interest element of a debt instrument

When a part of financial asset qualifies for de-recognition, the carrying value of entire financial asset will be allocated to the part retained and part being de-recognized on the basis of fair value of each respective component, and the difference between (a) and (b) below will be charge to statement of profit or loss as:

• Consideration received for part being de-recognized
• The carrying value of part being de-recognized

When an entity transfers a financial asset retaining the right to collect the cash flows relating to the financial asset but entity has contractual obligation to remit those cash flows to the ultimate recipient, such financial asset will be de-recognized if:

• The entity is under no obligation to pay cash flows relating to financial asset unless those are collected
• The entity cannot use cash flows of financial asset in any way such as pledge
• The entity is under contractual obligation to transfer cash flows relating to financial asset to its ultimate recipient without any material delay

In particular circumstances, when the entity transfer the financial asset which is eligible to be de-recognized, if the entity has the right to service the cash flows relating to financial asset the entity will recognize the servicing fee receivable as servicing asset or liability if servicing fee is not sufficient to perform the services

When an entity transfers the financial asset, it should also assess that which party owns the risks and rewards relating to the financial asset as follows:

• If it has transferred substantial risks and rewards relating to financial asset, the financial asset will be de-recognized
• If it has retained substantial risks and rewards relating to the financial asset even after transfer, the financial asset will not be de-recognized
• If the entity identifies that it has neither transferred nor retained the risks and rewards relating to financial asset, it will account for such situation as follows:

  i) If the entity has no control over financial asset after transfer, it will de-recognize the financial asset
  ii) If the entity has control over financial asset, it will continue to recognize the financial asset up to the extent of continuing involvement

Examples, when financial asset is derecognized

• Unconditional sale of financial asset
• Sale of financial asset with a contract to buy back on some certain future date at its current fair value
• Non-re-coursable factoring (i.e. when receivables are sold along with related risks and rewards)

 

Examples, when financial asset is not derecognized

• Sale of financial asset with a contract to buy back on some certain future date at a fair value plus interest
• Re-coursable factoring (i.e. when receivables are sold without the related risks of bad debts)
• Sale of financial asset with a total return swap

Classification of Financial Liability

This standard classifies financial assets on the basis of business objective model of the entity in to following categories:

a) Amortized Cost

The liabilities which are held by the entity to maturity date will be classified under this category such as:

• Trade payables
• Bank loan payable
• Issue of debt instruments (loan notes, debentures and redeemable preference shares)

Accounting treatment

• These are initially measured at net cash inflow
• Any transaction cost relating the liability will be deducted from the value of liability.
• At reporting date these are measured at amortized cost using effective interest rate and change in value will be charged to the statement of profit or loss
• Any interest expense will be charged to the statement of profit or loss

b) At Fair Value through Profit or Loss Account

The financial liabilities (derivatives) which are held by the entity for trading purposes will be classified under this category. However, the entity can also designate a financial liability under this category to eliminate an accounting mismatch but it will be an irrevocable election.

Accounting Treatment

• These are initially measured at fair value
• At each reporting date, these will be re-measured at fair value and change in fair value will be charged to the statement of profit and loss
• However, in case of designated financial liability, the change in value at reporting date will be analyzed into two portions as follows:

  a) The change in fair value due to entity’s own credit risk (deterioration in the financial position of the entity) will be reported to other comprehensive income and
  b) The change in fair value due to other factors (market factors) is charged to profit and loss account.

De-recognition of Financial Liability

The entity will de-recognize the financial liability when it is extinguished i.e.:

• When it is paid or settled or if it expires
• Exchanged

Exchange

Sometimes, the lender of finance re-terms or modifies the terms of original liability. This will be accounted for as follows:

• If the reduction in the value of original liability is material i.e. more than 10% of original liability, it will be treated as exchange of original liability for a new liability i.e. the entity will de-recognize the old liability and recognize new liability and the difference is charged to the statement of profit or loss

• If the reduction in the value original liability is immaterial i.e. less than 10% of original liability, the entity will continue to recognize the old liability and treat it as simple reduction in the value of original liability and such reduction in the value of original liability will be charged to the statement of profit or loss

The entity will determine the reduction as the difference between the present value of liability considering original cash out flow using original effective interest rate and the present value of liability considering revised cash out flow using original effective interest rate

Derivatives

These are secondary financial instruments and it is a contract which is:

• Settled on future date
• It requires no investment or very nominal investment at the time of contract
• Its value changes in response to some other variables

Examples: Forward, Future, Option, Swap, Cap

Accounting Treatment

These are recognized right on the date when an entity becomes the party to a contract.
If these are held for trading or net in cash settlement or other financial instruments, these will be accounted for as follows:

• These are initially measured at the value which is required to be paid to enter into the contract
• At each reporting date, these are re-measured at fair value and change in value (increase or decrease) will be charged to the statement of profit or loss

However, if derivative contracts are held for hedging purpose then these will be accounted for as per the hedge accounting requirements.

Embedded Derivatives

When a derivative contract is incorporated into a simple (non-derivative) contract, it is called Embedded Derivative. The simple (non-derivative) contract in which derivative is embedded is called Host contract and the contract as whole is called Host Contract.

Examples

• Convertible bond attaching an equity option
• Operating lease contract involving the settlement of lease rentals in foreign currency
• Contract of sale and purchase involving the settlement of receipts in foreign currency

Accounting Treatment

If the host contract is a contract which is covered under this standard then the combined contract will be measured as per the requirements of this standard.

However, this standard requires that the embedded derivative should be separated from the host contract, if the host contract is not a contract which is covered under this standard all of the following conditions are met:

• The embedded derivative meets the definition of derivative.
• The combined contract is not measured at fair value through profit or loss account.
• The economic characteristics of the embedded derivative are different from those of the host contract.

The embedded derivative will be separated from the host contract as follows:

• The fair value of embedded derivative will be deducted from the from the fair value of combined contract, the residual will be allocated to the host contract
• If the fair value of embedded derivative is not reliably measureable, then the fair value of host contract will be deducted from the fair value of combined contract, the residual will be allocated to the embedded derivative

When the embedded derivative is separated from the host contract, the embedded derivative will be covered by this IFRS and the host contract will be covered by the relevant standard

If the entity is unable to determine the separate the embedded derivative as per the requirements of this standard then the combined contract as whole will be measured at fair value through profit or loss

Hedge Accounting (IAS 39)

Hedging is a technique to minimize the risk of change in fair value or cash flows of the hedge items, by designated one or more hedging instrument.

• Hedge item exposes the risk and hedging instrument will mitigate such risk
• Hedge accounting is allowed only if the hedging relationship between the hedge items and hedge instrument in highly effective i.e. between 80%-125%

Hedge Item

It is any asset or liability due to which entity is exposed to risk of change in fair value or cash flow.

Hedge Instrument

These are normally derivatives whose change in value will offset the risk of change in fair value or cash flow of the hedge item.

1. Fair Value Hedging

When an entity designates one or more hedging instrument to minimize the exposure to risk of change in fair value of hedge item, such an arrangement is termed as fair value hedging.

Conditions for Fair Value Hedge Accounting

• There should be proper and formal documentation at the inception of the hedge identifying hedged item, hedging instrument and nature of risk involved
• The hedging relationship between the hedged item and hedging instrument is expected to be highly effective
• The hedging relationship is expected to be highly effective prospectively and retrospectively
• The hedge effectiveness is reliably measureable.

Accounting Treatment

Under the fair value hedge accounting the hedge item and hedging instrument both will be measured at fair value and change in fair value at reporting date will be charged to the statement of profit or loss

2. Cash Flow Hedging

When an entity designates one or more hedging instrument to minimize the exposure to risk of change in cash flows of hedge item, such an arrangement is termed as cash flow hedging.

Conditions for Cash Flow Hedge Accounting

• There should be proper and formal documentation at the inception of the hedge identifying hedged item, hedging instrument and nature of risk involved
• The hedging relationship between the hedged item and hedging instrument is expected to be highly effective
• The hedging relationship is expected to be highly effective prospectively and retrospectively
• The hedge effectiveness is reliably measureable
• The transaction giving rise to cash flow risk is highly probable and it is expected that it will ultimately affect profitability

Accounting Treatment

Under cash flow hedging the hedged item will have no treatment.
However, the hedging instrument will be measured at fair value and its change in fair value at reporting date will be analyzed into two portions effective portion and ineffective portion.
The effective portion will be initially reported to other comprehensive income and ineffective portion is charged to the statement of profit or loss
The effective portion held initially in the other comprehensive income will be reclassified to the statement of profit or loss in future when hedge item will affect the statement of profit or loss.

Effective Portion

The gain or loss on the hedge instrument up to the extent of gain or loss on the hedged item will be effective portion and any excess will be treated as ineffective portion.