What’s New with IFRS 9?
Completion of Long-Anticipated Financial Instrument Classification Standard Drifts Closer
By: Georgie Patten, UK Client Services Team Lead, Clearwater Analytics
This article was originally published in the 1st Quarter 2014 issue of Let’s Talk from Swift Print Communications.
Work continues to progress on International Financial Reporting Standards (IFRS) 9, Financial Instruments, the long-anticipated International Accounting Standards Board (IASB) accounting standard that replaces International Accounting Standards (IAS) 39 Financial Instruments: Recognition and Measurement and provides guidance on the classification and measurement of financial assets.
So What’s Really New with IFRS 9?
Broadly speaking, IFRS 9 provides guidance on how entities should recognize, measure, and classify financial instruments within an insurer’s investment portfolio. The goal is to replace IAS 39 with a simplified standard that corresponds to how an entity manages its financial assets (also known as its business model) and the contractual cash flow characteristics of those assets. Due to the complexity of its classification and measurement protocol, IAS 39 has been revised several times since it was originally adopted. Updating to IFRS 9 will simplify how insurers classify securities in their portfolios.
Where Things Stand Now
Since November 2008, the IASB has been working on IFRS 9, splitting its development into three phases:
At the February meeting, the IASB announced several new Phase 2 requirements for Impairment Methodology and several limited amendments to Phase 1 requirements for Classification and Measurement.
While IFRS 9 is an extensive standard on financial instruments, for the purposes of this article we will focus on the classification and measurement of financial assets and the impairment methodology.
Differences Between IAS 39 and IFRS 9
|IAS 39||IFRS 9|
|OCI as the residual FV category||FVTPL as the residual FV category|
|Reclassification into the FVTPL category after initial recognition is prohibited. Reclassifications out of FVTPL are permitted, subject to meeting certain criteria.||Reclassifications are required when there is a change in business model.|
|Incurred Loss model for impairment||Expected Loss model for impairment|
IFRS 9 splits all financial assets currently within the scope of IAS 39 into two classifications: Those measured at amortized cost and those measured at fair value. Fair value measurements include Fair Value through Other Comprehensive Income (FVOCI), or Fair Value through Profit & Loss (FVTPL). The decision is made at the time of initial recognition and any reclassifications are done prospectively from reclassification date. Restatement of any previously recognized gains, losses, or interest is not required.
It’s important to note that all financial instruments are initially measured at fair value, and adjusted for any incremental transaction costs that are directly attributable to the acquisition of the instrument. Debt Instruments
In order for a debt security to be recognized at amortized cost, it must satisfy the requirements of both the Business Model Test and the Cash Flow Test:
- Business Model Test: The entity’s objectives must be to hold the asset in order to collect the contractual cash flows rather than to sell the instrument prior to its contractual maturity date to realize fair value changes.
- Cash Flow Test: The contractual terms of the asset must give rise on specified dates to cash flows that consist solely of payments of principal and interest on the outstanding principal.
If an asset does not qualify for amortized cost, it will be measured at FVOCI only if it passes the cash flow test and if the assets are managed to achieve the business model objectives through both the collection of contractual cash flows and sales. Interest income (using the effective interest rate method) and impairment losses (and reversals) would be recognized in profit and loss, and the net cumulative fair value gain or loss would be recognized in OCI.
All other debt instruments will be measured at FVTPL, effectively making FVTPL the residual category. There is also an irrevocable option to designate an asset as FVTPL, only if the result eliminates or significantly reduces a measurement or recognition inconsistency.
Although the standard does not mandate the level at which the business model should be assessed, it is not an “instrument-by-instrument” approach and should rather be determined at a higher aggregation level. A single entity may have more than one business model, thus the assessment does not need to be determined at the reporting entity level either.
All equity securities should be measured at fair value, with changes recognized in profit or loss. If an equity investment is not held for trading at initial recognition an entity may choose to measure the investment at FVOCI, with only dividend income recognized in profit or loss. The associated OCI gains and losses should not be subsequently transferred to profit or loss, although the cumulative gain or loss may be transferred within equity.
Reclassifications between fair value and amortized cost are required only when an entity changes how it manages its financial instruments. Such changes are expected to be infrequent. If reclassification is appropriate, it must be done prospectively from the reclassification date with no restatement of any previously recognized gains, losses, or interest.
IAS 39 uses an incurred loss model for impairment while IFRS 9 uses a three-bucket, expected-credit-loss approach, which reflects the deterioration in the assets’ credit quality. This will apply to debt instruments held at amortized cost or FVOCI and means that it will no longer be necessary for a loss event to occur before an impairment allowance is recognized. The three-bucket method is set up as follows:
- Bucket One: Consists of financial assets where there has been no identified credit deterioration since initial recognition. All financial assets, except for purchased credit-impaired assets, will start in this bucket, regardless of credit quality level. Assets in this category will have a credit allowance for 12-months of “expected” losses. The 12-month expected credit losses are the expected shortfalls in contractual cash flows over the life of an asset that will result if a default occurs within 12 months after the reporting date, weighted by the probability of that default occurring.
When there has been a significant deterioration in credit quality since initial recognition, then assets will be transferred from Bucket One to Bucket Two or Three.
- Buckets Two and Three: Consists of assets with an allowance measured as the lifetime expected credit losses. Transfers from Bucket One to Bucket Two will be at the portfolio level, while transfers to Bucket Three will be at the individual instrument level.
Write-Offs and Disclosures
The gross carrying amount of an asset must be directly reduced when the entity has no reasonable expectation of recovery. This can relate to the asset in its entirety, or to a portion of it. Reversals of impairment losses (or gains) should be presented as a separate line item in profit and loss or OCI. IFRS 9 amends some of the requirements of IFRS 7: Financial Instruments: Disclosures, including added disclosures about investments in equity instruments designated at FVOCI.
Stay Tuned for Future Developments
The impacts of the IFRS 9 are far-reaching. Insurers that are affected by the change should continue to track progress of IFRS 9—it’s important for investment professionals trying to stay ahead of any regulatory changes that might impact their investment portfolios.