1 Best Complete Read – Financial Instruments

Financial Instruments is a summary of the current (Financial Statements preparation for 2020 on wards) IFRS reporting requirements relating to the combination of IAS 32 Financial Instruments: Presentation, IFRS 7 Financial instruments: Disclosure and IFRS 9 Financial Instruments, into one overall narrative.

IFRS standards for Financial Instruments have a complicated history. It was originally intended that IFRS 9 would replace IAS 39 in its entirety. However, in response to requests from interested parties that the accounting for financial instruments be improved quickly, the project to replace IAS 39 was divided into three main phases.

The three main phases of the project to replace IAS 39 were:

  1. Phase 1: classification and measurement of financial assets and financial liabilities.
  2. Phase
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The best 1 in overview – IFRS 9 Impairment requirements

IFRS 9 Impairment requirements

forward-looking information to recognise expected credit losses for all debt-type financial assets

 

Under IFRS 9 Impairment requirements, recognition of impairment no longer depends on a reporting entity first identifying a credit loss event.

IFRS 9 instead uses more forward-looking information to recognise expected credit losses for all debt-type financial assets that are not measured at fair value through profit or loss.

IFRS 9 requires an entity to recognise a loss allowance for expected credit losses on:

  • debt instruments measured at amortised cost
  • debt instruments measured at fair value through other comprehensive income
  • lease receivables
  • contract assets (as defined in IFRS 15 ‘Revenue from Contracts with Customers’)
  • loan commitments that are not measured at fair value through profit or loss
  • financial guarantee contracts (except those accounted for as insurance contracts).

IFRS 9 requires an expected loss allowance to be estimated for each of these types of asset or exposure. However, the Standard specifies three different approaches depending on the type of asset or exposure:

IFRS 9 Impairment requirements

* optional application to trade receivables and contract assets with a significant financing component, and to lease receivables

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Low credit risk operational simplification

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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Basel Committee IFRS 9 Guidance

Basel Committee IFRS 9 Guidance

Expected credit losses continuously in focus

In December 2015, the Basel Committee on Banking Supervision (‘the Committee’) issued its Guidance on credit risk and accounting for expected credit losses (‘Basel Committee IFRS 9 Guidance’). The Guidance sets out supervisory guidance on sound credit risk practices associated with the implementation and ongoing application of expected credit loss (ECL) accounting frameworks, such as that introduced in IFRS 9, Financial Instruments.

The Committee expects a disciplined, high-quality approach to assessing and measuring ECL by banks. The Basel Committee IFRS 9 Guidance emphasises the inclusion of a wide range of relevant, reasonable and supportable forward looking information, including macroeconomic data, in a bank’s accounting measure of ECL. In particular, banks should not ignore future events simply because they have a low probability of occurring or on the grounds of increased cost or subjectivity.

In addition, the Basel Committee IFRS 9 Guidance notes the Committee’s view that that the use of the practical expedients in IFRS 9 should be limited for internationally active banks. This includes the use of the ‘low credit risk’ exemption and the ‘more than 30 days past due’ rebuttable presumption in relation to assessing significant increases in credit risk.

Obviously, banks keep in continued talks to their local regulator about the extent to which their regulator expects the (below) Banking IFRS 9 Guidance to apply to them.

Principles underlying the Banking IFRS 9 Guidance – in Summary

Supervisory guidance for credit risk and accounting for expected credit losses

Basel Committee IFRS 9 Guidance Basel Committee IFRS 9 Guidance Basel Committee IFRS 9 Guidance Basel Committee IFRS 9 Guidance Basel Committee IFRS 9 Guidance

Principle 1

Responsibility

A bank’s board of directors and senior management are responsible for ensuring appropriate credit risk practices, including an effective system of internal control, to consistently determine adequate allowances.

Principle 2

Methodology

The measurement of allowances should build upon robust methodologies to address policies, procedures and controls for assessing and measuring credit risk

Banks should clearly document the definition of key terms and criteria to duly consider the impact of forward-looking information including macro-economic factors, different potential scenarios and define accounting policies for restructurings

Principle 3

Credit Risk Rating

A bank should have a credit risk rating process in place to appropriately group lending exposures on the basis of shared credit risk characteristics

Principle 4

Allowances adequacy

A bank’s aggregate amount of allowances should be adequate and consistent with the objectives of the applicable accounting framework

Banks must ensure that the assessment approach (individual or collective) does not result in delayed recognition of ECL, e.g. by incorporating forward-looking information incl. macroeconomic factors on collective basis for individually assessed loans

Principle 5

Validation of models

A bank should have policies and procedures in place to appropriately validate models used to assess and measure expected credit losses

Principle 6

Experienced credit judgment

Experienced credit judgment in particular with regards to forward looking information and macroeconomic factors is essential

Consideration of forward looking information should not be avoided on the basis that banks consider costs as excessive or information too uncertain if this information contributes to a high quality implementation

Principle 7

Common systems

A bank should have a sound credit risk assessment and measurement process that provides it with a strong basis for common systems, tools and data

Principle 8

Disclosure

A bank’s public disclosures should promote transparency and comparability by providing timely, relevant, and decision-useful information

Principle 9

Assessment of Credit Risk Management

Banking supervisors should periodically evaluate the effectiveness of a bank’s credit risk practices

Principle 10

Approval of Models

Supervisors should be satisfied that the methods employed by a bank to determine accounting allowances lead to an appropriate measurement of expected credit losses

Principle 11

Assessment of Capital Adequacy

Banking supervisors should consider a bank’s credit risk practices when assessing a bank’s capital adequacy

Principles underlying the Banking IFRS 9 Guidance

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IFRS 16 Good Important Read – Lease payments

Lease payments – Lessee perspective

or what does a lessee include in its lease liability?

At the commencement date, a lessee measures the lease liability as the present value of lease payments that have not been paid at that date. In a simple lease that includes only fixed lease payments, this can be a simple calculation (IFRS 16.26).

Lease payments

Worked example – Fixed lease payments are included in lease liabilities
Lessee B enters into a five year lease of a photocopier. The lease payments are 10,000 per annum, paid at the end of each year.

Because the annual lease payments are fixed amounts, B includes the present value of the five annual payments in the initial measurement of the lease liability.

Using a discount rate (determined as B’s incremental borrowing rate) of 5%, the lease liability at the commencement date is calculated as follows:

Year

Lease payments

Discounted

1

10,000

9,524

2

10,000

9,070

3

10,000

8,638

4

10,000

8,227

5

10,000

7,835

Lease liability at commencement date

43,294

 

Categories of lease payment

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Need for accounting measurement the big 1

Need for accounting measurement

Need for accounting measurement provides a summary of the measurement bases in use in Financial Reporting
and the concepts behind these measurement bases.
The measurement bases that will be considered here are

All these bases are forms of accrual accounting – that is, they are intended to measure income as it is earned and costs as they are incurred, as opposed to simply recording cash flows. The last four are all forms of current value measurement.

In forming a judgment on the appropriateness of measurement bases, in literature, the overriding tests has been identified to be their cost-effectiveness and fitness for purpose. However, in the absence of direct evidence on these matters, it is usual to argue in terms of various secondary characteristics that ought to be relevant in assessing the quality of information (see the key indicators in What is useful information?).

The most important of these characteristics are generally considered to be relevance and faithful representation / reliability (older term).

For each basis, an outline is given of how it works and the relevance and faithful representation of the resulting measurements. The question of measurement costs is also considered briefly. In reading the analyses that follow, the following comments should be borne in mind.

Bases of measurement in financial reporting are not carved in stone. Different people have different views on how each basis should work, and meanings evolve as practice changes. Some readers may therefore find that the way a particular basis is described does not match how they understand it.

This does not mean either that their understanding is wrong or that the description in the report is wrong; views on these things simply differ.

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IAS 36 How Impairment test

IAS 36 How Impairment test is all about this – When looking at the step-by-step IAS 36 impairment approach it comes down to the following broadly organised steps: IAS 36 How Impairment test

  • What?? – Determining the scope and structure of the impairment review, explained here,
  • If and when? – Determining if and when a quantitative impairment test is necessary, explained here,
  • IAS 36 How Impairment test or understanding the mechanics of the impairment test and how to recognise or reverse any impairment loss, if necessary. Which is explained in this section…

The objective of IAS 36 Impairment of assets is to outline the procedures that an entity applies to ensure that its assets’ carrying values are not … Read more

IFRS 2 Shares to the value of a fixed amount

Variable number of equity instruments or variable exercise price or IFRS 2 Shares to the value of a fixed amount

Shares to the value of of if a variable number of equity instruments to the value of a fixed amount is granted, commonly known as ‘shares to the value of’, then such an arrangement is recorded as an equity-settled share-based payment. IFRS 2 Shares to the value of a fixed amount

A question arises about the measurement of such a grant if the date of delivery of the shares is in the future because there is a service requirement. In general, there are two acceptable approaches in respect of measurement:

  • as a fixed amount of cash that will be
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IFRS 2 Fair value of equity instruments granted

IFRS 2 Fair value of equity instruments granted – Share-based payment transactions with employees are measured with reference to the fair value of the equity instruments granted (IFRS 2.11).

The fair value of a equity instrument granted is determined as follows (IFRS 2.16-17):

  • If market prices are available for the actual equity instruments granted – i.e. shares or share options with the same terms and conditions – then the estimate of fair value is based on these market prices. IFRS 2 Fair value of equity instruments granted
  • If market prices are not available for the equity instruments granted, then the fair value of equity instruments granted is estimated using a valuation technique.

IFRS 2 (IFRS Read more

IFRS 2 Employee equity-settled share-based payment

IFRS 2 Employee equity-settled share-based payment – Headlines

Employee services are recognised as expenses, unless they qualify for recognition as assets, with a corresponding increase in equity.

  • Employee service costs are recognised over the vesting period from the service commencement date until vesting date.
  • Employee services are measured indirectly with reference to the fair value of the equity instruments granted; this is done by applying the modified grant-date method. If, in rare circumstances, the fair value of the equity instruments granted cannot be measured reliably, then the intrinsic value method is applied.
  • Under the modified grant-date method, the grant-date fair value of the equity instruments granted is determined once at grant date, which may be after the service commencement date.
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