IFRS 9 Financial instruments

IFRS 9 Best long-read SPPI Test

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The SPPI Test

If an asset is in a hold-to-collect or hold-to-collect or sell business model, an entity assesses whether the cash flows from the financial asset meet the ‘solely payments of principal and interest’ (SPPI Test) benchmark – i.e. whether the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest.

  • ‘Principal’ is the fair value of the financial asset on initial recognition. The principal may change over time – e.g. if there are repayments of principal.
  • ‘Interest’ is consideration for the time value of money and credit risk. Interest can also include consideration for other basic lending risks and costs, and a profit margin.

A financial asset that does not meet the SPPI Test is always measured at FVPL, unless it is a non-trading equity instrument and the entity makes an irrevocable election to measure it at FVOCI. Here is the decision tree to put the narrative in context:

SPPI Test

Contractual cash flows that meet the SPPI Test are consistent with a basic lending arrangement in the banking industry.

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Low credit risk operational simplification

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Low credit risk operational simplification

IFRS 9 contains an important simplification that, if a financial instrument has low credit risk, then an entity is allowed to assume at the reporting date that no significant increases in credit risk have occurred. The low credit risk concept was intended, by the IASB, to provide relief for entities from tracking changes in the credit risk of high quality financial instruments. Therefore, this simplification is only optional and the low credit risk simplification can be elected on an instrument-by-instrument basis.

This is a change from the 2013 ED, in which a low risk exposure was deemed not to have suffered significant deterioration in credit risk. The amendment to make the simplification optional was made in response to requests from constituents, including regulators. It is expected that the Basel Committee SCRAVL consultation document will propose that sophisticated banks should only use this simplification rarely for their loan portfolios.

For low risk instruments, the entity would recognise an allowance based on 12-month ECLs. However, if a financial instrument is not considered to have low credit risk at the reporting date, it does not follow that the entity is required to recognise lifetime ECLs. In such instances, the entity has to assess whether there has been a significant increase in credit risk since initial recognition that requires the recognition of lifetime ECLs.

The standard states that a financial instrument is considered to have low credit risk if: [IFRS 9.B5.22]

  • The financial instrument has a low risk of default
  • The borrower has a strong capacity to meet its contractual cash flow obligations in the near term
  • Adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations Low credit risk operational simplification

A financial instrument is not considered to have low credit risk simply because it has a low risk of loss (e.g., for a collateralised loan, if the value of the collateral is more than the amount lent (see collateral) or it has lower risk of default compared with the entity’s other financial instruments or relative to the credit risk of the jurisdiction within which the entity operates.

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Payment holidays on loans

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Payment holidays on loans under IFRS 9

Governments and banks have introduced payment deferral programs to support borrowers affected by Covid-19. But deferred payments are not forgiven and must be repaid in the future, raising prospective risks to the banking system. Thus, they should be designed to balance near-term economic relief benefits with longer-term financial stability considerations.

The Basel Committee on Banking Supervision (BCBS) and several prudential authorities have issued statements clarifying how payment deferrals should be considered in assessing credit risk under applicable accounting frameworks. These measures aim to encourage banks to continue lending, to avert an even deeper recession.

Prudential authorities are caught “between a rock and a hard place” as they encourage banks – through various relief measures – to provide credit to solvent, but cash-strapped borrowers, while keeping in mind the longer-term implications of these measures for the health of banks and national banking systems.

In navigating these tensions, banks and supervisors face a daunting task as borrowers that may be granted payment holidays have varying risk profiles. Distinguishing between illiquid and insolvent borrowers – amidst an uncertain outlook – should help guide banks’ efforts to support viable borrowers, while preserving the integrity of their reported financial metrics.

What is this all about?

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Amortised cost and the effective interest method

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Amortised cost and the effective interest method

This narrative explores the factors that an entity needs to consider in calculating the amortised cost of a financial asset or financial liability and recognising interest revenue and expense based on the effective interest rate (EIR).

Calculating amortised cost

The amortised cost of a financial asset or financial liability is calculated in the same way as under IAS 39, although IFRS 9 introduces the concept of ‘gross carrying amount’ for financial assets. The gross carrying amount is the amortised cost grossed up for the impairment allowance. The elements of amortised cost are illustrated below.

Financial assets

Financial liabilities

Fair value at initial recognition

At recognition a loan receivable or payable is recognised at fair value measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (currency, term, etc.) with a similar credit rating.

MINUS

Principal redemptions/repayments

ADD

Periodical interest income based on the effective interest method

Periodical interest expense based on the effective interest method

MINUS

Gross carrying amount

N/A

Loss allowance

= Amortised costs

= Amortised costs

(no adjustment for loss allowance)

Calculating the EIR

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Blockchain – Best 2 accounting for IFRS

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Blockchain accounting for IFRS

Holdings of cryptocurrencies allow individuals and businesses to transact directly with each other without an intermediary such as a bank or other financial institution. These cryptocurrency transactions rely on a key technology called blockchain technology.

Digital assets or so-called cryptoassets are becoming increasingly common but what are they and how might you record them in your financial statements?

Holding cryptocurrencies – e.g. Bitcoin, Ether etc

What are the characteristics?

  • Cryptocurrencies – e.g. Bitcoin and Ether – typically exhibit some similarities to traditional currencies in that they can be traded for goods or services. They can also be held as a longer-term investment or for trading or speculation. But IFRIC and other commentators do not consider current cryptocurrencies to be cash or currency because:

    • they are a poor store of value, because their value is based on demand and supply and is highly volatile;

    • they are not sufficiently widely accepted as a medium of exchange; and

    • they are not issued by a central bank.

  • With cryptocurrencies also failing to meet the definition of a financial asset, the question is, what type of asset are they?

How might they impact your financial statements?

  • Because of their high volatility in value, many believe that cryptocurrencies are akin to derivatives and should be measured at fair value through profit or loss (FVTPL). However, IFRIC’s tentative conclusions on accounting for cryptocurrencies do not support this approach.

  • IFRIC proposes that cryptocurrencies are generally intangible assets under IAS 38 Intangible Assets – i.e. non-monetary items with no physical substance that convey economic benefits to the holder.

  • Measurement would be at cost – or potentially at fair value with movements through other comprehensive income (OCI) if, and only if, there is an active market.

  • If the cryptocurrency is held for sale in the normal course of business – e.g. if you are a broker-trader (see below) – then IAS 38 does not apply and, instead, IFRIC proposes that the cryptocurrency would be accounted for as inventory under IAS 2 Inventory.

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Impairment of financial assets

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Impairment of financial assets

The following table summarises how the key concepts of the model are explained throughout this narrative.

1. Scope of the impairment requirements

3. General approach

Special cases

3.1 Expected credit loss model

6. Assets that are credit impaired at initial recognition

7. Simplified approach for trade and lease receivables and contract assets

3.2.1 12-month ECL

3.2.2 Lifetime ECL

3.4.6 Modifications

4 Measurement

5 Write-offs

1 Scope of the impairment requirements

1.1 General requirements

The following table sets out instruments that are in and out of the scope of IFRS 9’s impairment requirements. (IFRS 9.2, IFRS 9.4.2.1, IFRS 9.5.5.1)

In scope

Out of scope
  • Financial assets that are debt instruments measured at amortised cost or at FVOCI (see Classification of financial assets) – these include loans, trade receivables and debt securities
  • Loan commitments issued that are not measured at FVTPL
  • Financial guarantee contracts issued that are in the scope of IFRS 9 and are not measured at FVTPL
  • Lease receivables in the scope of IFRS 16
  • Contract assets in the scope of IFRS 15
  • Equity investments (see 1.2)
  • Loan commitments issued that are measured at FVTPL
  • Other financial instruments measured at FVTPL

IFRS 9 has a single impairment model that applies to all financial instruments in its scope.

Food for thought – Scope of the impairment requirements

(IAS 39.2(h), IAS 39.63-70, IAS 39.AG4(a), IFRS 9.BC5.259)

The existence of several impairment models under IAS 39 creates complexity. Under IAS 39, there were different models for:

  • assets at amortised cost;
  • available-for-sale assets – debt instruments; and
  • available-for-sale assets – equity instruments.

In addition, losses relating to loan commitments and financial guarantees issued by banks were generally accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. This has created a practical issue for banks, because they often manage credit risk on financial guarantees and loan commitments in the same way as credit risk on loans and other debt instruments, whereas for accounting purposes they are treated differently.

In addition, for revolving credit facilities (see 4.3.2) banks often manage the amount receivable and the undrawn amount of the commitment together for risk management purposes – i.e. on a facility level.

Under IFRS 9, a single set of impairment requirements applies to all instruments in the scope of IFRS 9 that are not accounted for at FVTPL. This may simplify the requirements and align them more closely with the way banks manage their credit risk. However, differences may arise in practice between the way banks perform the calculations for internal risk management purposes and the specific requirements of IFRS 9. These are discussed further in 4.2.2 in respect of loan commitments.

The new model may also have an impact on corporates that apply IAS 39 to issued financial guarantee contracts, and therefore recognise a provision on such contracts only when it is probable that an outflow will occur. For discussion of the IFRS 9 impairment model’s impact on financial guarantee contracts issued, see 4.9.1.

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IFRS 9 Modified financial assets

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IFRS 9 Modified financial assets

If the contractual cash flows on a financial asset are renegotiated or modified, the holder needs to assess whether the financial asset should be derecognised. While IAS 39 contains guidance on when financial liabilities that have been renegotiated or modified should be derecognised, it does not do so for financial assets.

Similarly, as the derecognition literature in IAS 39 has been carried forward to IFRS 9, the IASB has still not established criteria for analysing when a modification of a financial asset constitutes a derecognition event. However, an entity may refer to the decision made by the IFRS Interpretations Committee in May 2012.

The Interpretations Committee was asked to consider the accounting treatment of Greek government bonds (GGBs). The principal issue raised was whether the portion of the old GGBs to be exchanged for new bonds with different maturities and interest rates should result in derecognition of the whole asset, or only part of it, in accordance with IAS 39 or, conversely, be accounted for as a modification that would not require derecognition. IFRS 9 Modified financial assets

The IFRS Interpretations Committee concluded that this assessment can be made, either on the basis of: IFRS 9 Modified financial assets

  • The extinguishment of the contractual rights to the cash flows from the assets (IFRS 9 3.2.3)
    Or IFRS 9 Modified financial assets IFRS 9 Modified financial assets
  • By analogising to the notion of a substantial change of the terms of financial liabilities to these assets (IFRS 9 3.3.2)

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Purchased and originated credit-impaired financial assets – IFRS 9 Best Read

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Purchased and originated credit-impaired financial assets

Purchased and originated credit-impaired financial assets are those for which one or more events that have a detrimental impact on the estimated future cash flows have already occurred. If these financial assets had been originated or purchased before becoming credit impaired, they would be in Stage 3 and lifetime expected losses would be recognised.

Purchased and originated credit-impaired financial assetsIndicators that an asset is credit-impaired would include observable data about the following events:

  • Significant financial difficulty of the issuer or the borrower
  • Breach of contract,
  • The lender has granted concessions as a result of the borrower’s financial difficulty which the lender would not otherwise consider,
  • It is becoming probable that the borrower will enter bankruptcy or other financial reorganisation,
  • The disappearance of an active market for that financial asset because of financial difficulties,
  • The financial asset is purchased or originated at a deep discount that reflects the incurred credit losses.

It may not be possible to identify a single discrete event. It could be the combined effect of several events may have caused financial assets to become credit-impaired.

Food for thought – Interaction between definitions of ‘credit-impaired’ and ‘default’
The definition of ‘credit-impaired’ under IFRS 9 may differ from the entity’s definition of ‘default’ (see explanation here). However, an entity’s definition of default should be consistent with its credit risk management, and should consider qualitative factors. For example, many financial institutions apply regulatory definitions of default for accounting and regulatory purposes – e.g. those issued by the Basel Committee on Banking Supervision under which a default is considered to have occurred when it is unlikely that the obligor will be able to repay its obligation. The assessment of whether such a definition is met may be based on similar criteria to those used for assessing whether an asset is credit-impaired. In these cases, the asset would be considered to be in default when it is credit-impaired. (IFRS 9.5.5.37)

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Reclassification of financial assets

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Reclassification of financial assets

This narrative looks at the circumstances in which financial assets are reclassified, and their measurement on reclassification. Financial liabilities cannot be reclassified (IFRS 9.4.4.2).

Conditions for reclassification of financial assets

Under IFRS 9, reclassification of financial assets is required if, and only if, the objective of the entity’s business model Reclassification of financial assetsfor managing those financial assets changes (IFRS 9.4.4.1).

Such changes are expected to be very infrequent, and are determined by the entity’s senior management as a result of external or internal changes. These changes have to be significant to the entity’s operations and demonstrable to external parties. Accordingly, a change in the objective of an entity’s business model will occur only when an entity either begins or ceases to carry out an activity that is significant to its operations – e.g. when the entity has acquired, disposed of or terminated a business line (IFRS 9.B.4.4.1).

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