12/27/24, 10:34 PM IFRS 9, Financial Instruments – part 1 | ACCA Global

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IFRS 9, Financial Instruments – part 1

IFRS 9, Financial
Instruments – part 1
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This is the first of two articles

IFRS 9, Financial
on the topic of financial Instruments – part 2
instruments.

This article covers:

recognition
measurement of financial assets
measurement of financial liabilities
derecognition
reclassification
impairment

Recognition of financial assets

and liabilities

In accordance with IFRS 9, Financial

Instruments, a company recognises a financial
asset or a financial liability when the company

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becomes party to the contractual provisions of

the instrument. For example, if a company
receives a firm order for goods from a
customer, it should delay recognition of the
trade receivable until at least one of the
parties has performed under the agreement.
This would normally be when the goods are
shipped or delivered. In contrast, however, a
forward contract or option is recognised on the
commitment date if it falls within the scope of
IFRS 9.

Except for trade receivables, a company

measures a financial asset or financial liability
on initial recognition at its fair value. The
treatment of transaction costs directly
attributable to the acquisition or issue
depends on the instrument’s measurement
category.

Measurement of financial assets

A financial asset is measured at fair value

through profit or loss (FVTPL) unless it is
measured at amortised cost or at fair value
through other comprehensive income
(FVTOCI). Classification depends on both the
company’s business model for managing the
financial assets and the contractual cash flow
characteristics of the financial asset.

Question 1
In accordance with IFRS 9, what is meant by a
company’s ‘business model’?

Answer
According to IFRS 9, a company’s business
model refers to how an entity manages its
financial assets in order to generate cash flows.
It determines whether cash flows will result from
collecting contractual cash flows, selling

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financial assets or both. An entity’s business

model is a matter of fact.

A financial asset is measured at amortised

cost if:

(i) the financial asset is held within a business

model whose objective is to hold financial
assets in order to collect contractual cash
flows; and

(ii) the contractual terms of the financial asset

give rise on specified dates to cash flows that
are solely payments of principal and interest
on the principal amount outstanding.

A financial asset is measured at FVOCI if:

(i) the financial asset is held within a business

model whose objective is achieved by both
collecting contractual cash flows and selling
financial assets; and

(ii) the contractual terms of the financial asset

give rise on specified dates to cash flows that
are solely payments of principal and interest
on the principal amount outstanding.

A company can make an irrevocable election

at initial recognition for investments in equity
instruments to be measured at FVOCI if they
are not held for trading.

IFRS 9 contains an option to designate, at

initial recognition, a financial asset as
measured at FVTPL if it would eliminate or
significantly reduce an ‘accounting mismatch’.
This can arise when measuring assets or
liabilities, or recognising the gains and losses
on them, on different bases.

Question 2
On 1 June 20X7, Design Co loaned $9 million

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to a subsidiary. There was no loan agreement

or repayment date or interest charged.
However, there was an expectation that the
amount would be repaid on demand. This type
of event has previously occurred, and the loan
repaid. At 31 December 20X7, the subsidiary
could not repay the loan but it was probable
that repayment would occur by February 20X8.

Does the inter-company loan meet the

conditions in IFRS 9 to be measured at
amortised cost?

Answer
To classify a financial asset at amortised cost,
IFRS 9 states that its contractual terms must
give rise to cash flows on specified dates that
are solely payments of principal and interest on
the principal amount outstanding. These cash
flows must be consistent with normal lending
arrangements.

As the inter-company loan can be called at any

time, there is an argument that a financial
institution would charge low interest for such a
loan as it could be called in at any time. Thus, it
could be argued that there is nothing different to
a normal lending arrangement with the current
terms. Therefore, the intercompany loan meets
the contractual cash flow characteristics test in
IFRS 9.

To be measured at amortised cost, the

instrument must be held within a business
model that has the objective to hold financial
assets to collect contractual cash flows. The
loan is not held to sell; therefore, the inter-
company loan meets both the IFRS 9 tests to
be measured at amortised cost.

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Measurement of financial
liabilities

Measurement of financial liabilities is easier

than financial assets. Almost all financial
liabilities are measured at amortised cost,
meaning that a finance cost is reported in
profit or loss based on the effective rate of
interest. Financial liabilities held for trading,
including derivative liabilities, are measured at
FVTPL.

As with financial assets, a company can

designate, at initial recognition, a financial
liability to be measured at FVTPL if it would
eliminate or significantly reduce an
‘accounting mismatch’.

Where a company has a financial liability that

is measured at FVTPL, the fair value of the
liability can depend on the credit worthiness of
the company. As a result, where the credit
worthiness of a company deteriorates the fair
value of the liability will typically reduce,
resulting in a fair value gain. And where the
credit worthiness of a company improves the
fair value of the liability will typically increase,
resulting in a fair value loss. IFRS 9 requires
the fair value movements in a financial liability
designated to be measured at FVPL that are
attributable to changes in the credit risk of that
liability should be presented in other
comprehensive income, as opposed to being
presented in profit or loss. This does not apply
where this treatment would create or would
enlarge an accounting mismatch.

Question 3
Insert Co has applied the fair value option in
IFRS 9 in order that the recognition of gains
and losses on its investment properties and the
related financial liability would be consistent.

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The investment property was measured at fair

value in accordance with IAS 40 Investment
Property using a discounted cash flow
technique.

Can Insert Co apply the fair value option

rule in IFRS 9 to the measurement of its
financial liability?

Answer
IFRS 9 allows companies to designate a
financial liability as measured at FVTPL if it
would eliminate or significantly reduce a
measurement or recognition inconsistency (an
'accounting mismatch') which would otherwise
arise from measuring assets or liabilities or
recognising the gains and losses on them on
different bases. This is an accounting policy
choice.

If the fair value option was not used, then the

financial liability would be measured at
amortised cost and the investment property at
fair value. However, there is significant
correlation between the measurement of the fair
value of the investment property and the related
financial liability, in that both elements will use
current interest rates. Therefore, the fair value
option can be used to avoid inconsistency.

Derecognition

Derecognition is the removal of all or part of

an asset or liability from the statement of
financial position.

Derecognition of financial assets

A company derecognises a financial asset
when the contractual rights to the cash flows
from the financial asset have expired, or it
transfers the financial asset such that it
qualifies for derecognition. A company
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transfers a financial asset where it transfers

the contractual rights to receive the cash flows
of the financial asset, or where it retains the
contractual rights to receive the cash flows of
the financial asset but assumes a contractual
obligation to pay the cash flows to a third
party. The company also evaluates the extent
to which it retains the risks and rewards of
ownership of the financial asset.

On derecognition of a financial asset, the

difference between the carrying amount and
the consideration received is recognised in
profit or loss. If a company neither transfers
nor retains substantially all the risks and
rewards of ownership of a transferred asset,
and retains control of the transferred asset,
the company continues to recognise the
transferred asset to the extent of its continuing
involvement.

Derecognition of financial liabilities

A company should derecognise a financial
liability from its statement of financial position
when the obligation is discharged, cancelled
or has expired.

An exchange between an existing borrower

and lender of debt instruments with
substantially different terms is accounted for
as extinguishing the original financial liability
and recognition of a new financial liability.
Similarly, a substantial modification of the
terms of the existing financial liability is
accounted for by extinguishing the original
financial liability and recognising a new
financial liability. The terms are substantially
different if the present value of the cash flows
under the new terms (including any fees paid
net of any fees received) when discounted
using the original effective interest rate is at
least 10 per cent different from the present
value of the remaining cash flows of the
original financial liability. The difference
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between the carrying amount of a financial

liability extinguished or transferred to another
party and the consideration paid is recognised
in profit or loss.

Where the terms are not substantially different

the original liability is not derecognised. The
liability is restated to the present value of the
revised cash flows. Any increase or decrease
in carrying amount is presented in the
statement of profit or loss.

Question 4
On 31 December 20X7, View Co modified the
terms of its long-term loans (financial liabilities)
such that the effective interest rate changed by
3%. As a result, the present value of the
remaining outstanding loans was reduced by
25%.

What is the correct accounting treatment of

the above?

Answer
The interest rate is substantially different from
the original borrowing agreements and the
discounted present value of the cash flows
under the new terms is more than 10% different
from the original financial loans. This means
there has been a substantial modification of the
terms of the existing financial liabilities. The
original financial liabilities should be
derecognised and new financial liabilities
recognised instead. The difference between the
carrying amount of the original liabilities that
were extinguished and the fair value of the new
liabilities should be shown in profit or loss. The
new borrowings will be initially measured at fair
value on the statement of financial position and
subsequently measured at amortised cost using
the new effective interest (unless the fair value
option is applied).

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Reclassification

When, and only when, a company changes its

business model for managing financial assets,
it should reclassify all affected financial
assets. Reclassification should be applied
prospectively from the reclassification date.
The company should not restate any
previously recognised gains, losses or interest
already recognised.

Financial assets designated at FVTPL and

investments in equity measured at FVOCI are
not subject to the reclassification requirements
of IFRS 9.

Financial liabilities are never reclassified.

Impairment

Except for investments in equity instruments,

financial assets classified as amortised cost or
FVTOCI must be tested for impairment at the
end of each reporting period.

IFRS 9 has a general approach for impairment

that distinguishes between ‘12-month
expected credit losses’ and ‘lifetime expected
credit losses’. Expected credit losses are the
present value of all cash shortfalls (the
difference between the cash flows that are
due to an entity and the cash flows that the
entity expects to receive) over the expected
life of the financial instrument. Expected credit
losses should be measured in a way that
reflects an unbiased and probability-weighted
amount that is determined by evaluating a
range of possible outcomes, the time value of
money and reasonable and supportable
information.

The decision as to whether the loss allowance

is based upon 12-month expected credit
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losses or lifetime expected credit losses

depends on whether there has been a
significant increase in credit risk since initial
recognition. An increase in credit risk is
reflected by a change in the risk of a default
occurring over the expected life of the
financial asset. When making the assessment
the company must consider reasonable and
supportable information, that is available
without undue cost or effort that is indicative of
significant increases in credit risk since initial
recognition. If the financial instrument has low
credit risk at the reporting date, then the
company can assume that the credit risk has
not increased significantly since initial
recognition. Low credit risk is based on a
company’s internal credit risk ratings, or other
acceptable methods

If a financial asset’s credit risk has not

increased significantly since initial recognition,
a company calculates 12-month expected
credit losses. This means that expected credit
losses are calculated based on default events
that are possible within 12 months from the
reporting date. Where the credit risk has
increased significantly since initial recognition,
a company calculates lifetime expected credit
losses. This means that expected credit
losses are calculated based on all possible
default events over the expected life of the
financial instrument. A company assesses at
each reporting date whether the credit risk
associated with a financial asset has
increased significantly since initial recognition.
For trade receivables, contract assets and
lease receivables, a simplified approach may
be applied. This approach allows a company
to always calculate expected credit losses as
equal to the lifetime expected credit losses.

If an actual default event occurs and the

financial asset becomes credit-impaired,
lifetime expected credit losses are calculated
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as the difference between the asset’s gross

carrying amount and the present value of the
expected future cash flows.

For financial assets measured at amortised

cost, a loss allowance is recognised for the
expected credit losses. This reduces the net
carrying amount of the financial asset.
Movements in the allowance year-on-year are
charged (or credited) to profit or loss.

For financial assets measured at FVOCI, no

adjustment is made to the net carrying amount
of the financial asset in respect of expected
credit losses. This is because the financial
asset must be measured at fair value. Instead,
an increase (or decrease) in expected credit
losses is charged (or credited) to profit or loss,
with a corresponding adjustment to other
comprehensive income.

The rules are different for purchased or

originated credit-impaired financial assets.
These are financial assets that are already
credit impaired at initial recognition. At each
reporting date, a company recognises the
amount of the change in lifetime expected
credit losses as an impairment gain or loss in
profit or loss.

Question 5
On 1 January 20X7, Sparrow Co purchased
quoted bonds issued by Pippit Co for $10
million and measured them at amortised cost.
The coupon rate of interest on the bonds was
5%, which was the same as the effective rate.
Credit risk associated with the bonds on 1
January 20X7 was deemed to be low. No loss
allowance was recognised on this date.

At 31 December 20X7, Sparrow Co received

$0.5 million interest from the bonds. However,
newspapers have reported that Pippit Co is in

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financial difficulties. The price of Pippit Co’s

bonds declined significantly despite an overall
increase in the bonds market.

At 31 December 20X7, 12-month expected

credit losses were calculated to be $1.6 million
and lifetime expected credit losses were
calculated to be $4.5 million.

Discuss how the above information should

be accounted for by Sparrow Co in the year
ended 31 December 20X7.

Answer
At the reporting date, the gross carrying amount
of the financial asset is $10 million.

At the reporting date, a loss allowance must be

recognised because the financial asset is
measured at amortised cost.

The loss allowance should be equal to lifetime-

expected credit losses if credit risk has
increased significantly. This would seem to be
the case because of Pippit Co’s widely reported
financial difficulties. Moreover, the decline in the
price of Pippit Co’s bonds suggests that the
bonds are becoming riskier and that investors
are less inclined to purchase them.

As such a loss allowance should be recognised

for $4.5 million, with a corresponding charge to
profit or loss. This will reduce the net carrying
amount of the financial asset presented on the
statement of financial position to $5.5 million.

Written by a member of the SBR examining

team

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