Tapping into IFRS 9 – Financial Instruments

This article is an overview of “IFRS 9 – Financial Instruments”, one the most complex reporting standards. All the important areas will be explained in separate posts. We’ll try to explain the requirements of this standard in a simple way along with useful examples so that this complex standard becomes easy for you.

So here’s an outline of the Standard.

Introduction and Effective Date

IFRS 9, Financial Instruments, was issued initially in November 2009 by the International Accounting Standards Board (IASB) as a replacement of IAS 39, Financial Instruments: Recognition and Measurement. The initial chapters of the Standard related to classification and measurement of financial assets.

Subsequently, requirements pertaining to classification and measurement of financial liabilities, embedded derivatives and hedge accounting were included and a complete version of Standard was issued with a mandatory effective date of January 01, 2018.

Financial Instrument Standards

IFRS 9 is read in conjunction with other accounting standards as reflected below. These accounting standards encapsulate the reporting of financial instruments.

Why issued?

IFRS 9 was introduced by IASB to improve the reporting and accounting of financial assets and liabilities. While there was already an accounting standard in place to deal with financial instruments i.e., IAS 39, it had its own share of criticisms. IAS 39 laid down a rule-based approach to deal with financial instruments especially with respect to classification and measurement. It recognised credit losses of financial assets as per “incurred loss” that did not address risk and uncertainty. The complexity of the standard and its share of issues in application propelled the IASB to address these criticisms in the form of a new standard – IFRS 9.

Scope of IFRS 9

IFRS 9 establishes principles to recognise financial assets and financial liabilities in the financial statements i.e., when the entity becomes a party to the contract. It spells out the principles for recognition, measurement and derecognition of financial instruments and hedge accounting.  

Classification of financial instruments

Financial assets

Financial assets can be classified into the following categories:

  1. Amortised cost;
  2. Fair value through other comprehensive income (FVTOCI); and
  3. Fair value through profit and loss (FVTPL).

This classification is done on the basis of:

  • Business Model Assessment: The entity’s business model for managing the financial assets; and
  • Contractual Cash Flow Characteristics Test: The assessment if the financial asset gives rise on specified dates to cashflows that are solely payments of principal and interest.

Financial liabilities

IFRS 9 classifies financial liabilities into the following categories:

  1. Amortised cost; and
  2. Fair value through profit and loss.

Measurement of financial instruments

Initial measurement

  • Financial assets or financial liabilities shall be measured at their fair value.
  • In case of financial instruments held at amortised cost or FVOCI, transaction costs shall be adjusted i.e., for financial assets (fair value + transactions costs) and for liabilities (fair value – transaction costs).

Subsequent measurement

The Standard sets down requirements for recognition of a loss allowance for expected credit losses on a financial asset that is measured at amortised cost or fair value through other comprehensive income. It offers two stages for measurement of impairment loss: General approach and Simplified approach.

Derecognition of financial instruments

IFRS 9 states that an entity may derecognise a financial asset when:

  • the contractual rights to the cash flows from the financial asset expire; or
  • the entity transfers the financial asset and the transfer qualifies for derecognition.

An entity shall derecognise a financial liability when it is extinguished.

Embedded Derivative

IFRS 9 defines embedded derivative as a component of hybrid contract with a non-derivative host—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

The measurement of embedded derivatives is contingent upon the classification of host contract i.e. if the contract is a financial asset within the scope of IFRS 9 or a contract outside the scope of the Standard.

In case the embedded derivative cannot be separated from the host contract under the criteria set by IFRS 9, the whole contract shall be accounted for at fair value through profit or loss.

Hedge Accounting

IFRS 9 also includes significant new hedging requirements, that are less complex than IAS 39 and are aligned with the entity’s risk management strategy.

The Standard specifies qualifying criteria for hedging instruments and hedged items.

It specifies the following types of hedging relationships for hedge accounting:

  • Fair value hedge;
  • Cash flow hedge; and
  • Hedge of a net investment in a foreign operation.