Practical guide to IFRS

Practical guide to IFRS

Practical guide to IFRS: The IASB completed part of the first phase of this project on financial assets and issued IFRS 9.

‘Financial instruments’, in November 2009. IFRS 9 was updated in November 2010 to include guidance on financial liabilities and recognising financial instruments. IFRS 9 replaces the multiple classification and measurement models for financial assets in IAS 39,

‘Financial Instruments: Recognition and measurement’, with a model that has only two classification categories: amortised cost and fair value. Classification under IFRS 9 is driven by the entity’s business model for managing the financial assets and the contractual cash flow characteristics of the financial assets.

The accounting and presentation for financial liabilities and for derecognising financial instruments has been relocated from IAS 39 without change except for financial liabilities that are designated at fair value through profit or loss. IFRS 9 is effective for annual periods beginning on or after 1 January 2013. Early application is permitted, although IFRS 9 has not yet been endorsed for use in the EU.

Practical guide to IFRS

Practical guide to IFRS: 

Background : The IASB has been reviewing accounting issues that have emerged as a result of the recent global financial crisis, including those identified by the

G20 and other international bodies such as the Financial Stability Board. The IASB is working with the FASB to produce a globally consistent response to the crisis. As part of this, the IASB has accelerated its project to replace IAS 39 and sub-divided it into three main phases: classification and measurement, impairment and hedging. The IASB completed part of the first phase of this project (classification and measurement) for financial assets in November 2009; it completed financial liabilities in November 2010.

The IASB also considered changes to the guidance that addresses when financial instruments are derecognised, (this was in response to concerns over whether off-balance-sheet structures were appropriately treated during the financial crisis). No changes were made to the accounting, but improved disclosures are now required. IFRS 9 now contains guidance for: recognising and derecognising financial instruments; classifying and measuring financial assets; and classifying and measuring financial liabilities. This ‘practical guide’ explains the requirements in IFRS 9 for accounting for financial assets and financial liabilities. The other phases of the project cover impairment and hedge accounting. A final standard on these is expected by June 2011.

Practical guide to IFRS

Objective and scope

  • No change from IAS 39
  • Initial recognition and derecognition No change from IAS 39
  • Classification and measurement – assets Substantial change from IAS 39
  • Classification and measurement – liabilities Limited change from IAS 39
  • Presentation and disclosure Some change from IAS 39/IFRS 7
  • Effective date and transition Substantial change from IAS 39

Practical guide to IFRS

Objective IFRS 9’s

objective is to establish principles for the financial reporting of financial instruments that will present relevant and useful information to users of financial statements for their assessment of amounts, timing and uncertainty of the entity’s future cash

Practical guide to IFRS

Scope IFRS 9 generally has to be applied by all entities preparing their financial statements in accordance with IFRS and to all types of financial instruments within the scope of IAS 39, including derivatives. Any financial instruments that are currently accounted for under IAS 39 will fall within the IFRS 9’s scope.

Practical guide to IFRS

Recognition and derecognition

Initial recognition Consistent with IAS 39, all financial instruments in IFRS 9 are to be initially recognised at fair value, plus or minus – in the case of a financial instrument that is not at fair value through profit or loss – transaction costs that are directly attributable to the acquisition or issue of the financial instrument. Derecognition The guidance (including associated application and implementation guidance) on derecognising financial assets and financial liabilities in IAS 39 has been relocated unchanged to IFRS 9.

Practical guide to IFRS

Classification and measurement – financial assets Classification model If the financial asset is a debt instrument (or does not meet the definition of an equity instrument in its entirety from an IAS 32 perspective), management should consider whether both the following tests are met: The objective of the entity’s business model is to hold the asset to collect the contractual cash flows.

The asset’s contractual cash flows represent only payments of principal and interest. Interest is consideration for the time value of money and the credit risk associated with the principal amount outstanding during a particular period of time. If both these tests are met, the financial asset falls into the amortised cost measurement category. If the financial asset does not pass both tests, it is measured at fair value through profit or loss. Even if both tests are met, management also has the ability to designate a financial asset as at fair value through profit or loss if doing so reduces or eliminates a measurement or recognition inconsistency (‘accounting mismatch’).

Practical guide to IFRS

Business model test Financial assets are subsequently measured at amortised cost or fair value based on the entity’s business model for managing the financial assets. An entity assesses whether its financial assets meet this condition based on its business model as determined by the entity’s key management personnel (as defined in IAS 24, ‘Related party disclosures’). Management will need to apply judgement to determine at what level the business model condition is applied. That determination is made on the basis of how an entity manages its business; it is not made at the level of an individual asset.

The entity’s business model is not therefore a choice and does not depend on management’s intentions for an individual instrument; it is a matter of fact that can be observed by the way an entity is managed and information is provided to its management. Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, some sales or transfers of financial instruments before maturity may not be inconsistent with such a business model. The following are examples of sales before maturity that would not be inconsistent with a business model of

holding financial assets to collect contractual cash flows: an entity may sell a financial asset if it no longer meets the entity’s investment policy, because its credit rating has declined below that required by that policy; when an insurer adjusts its investment portfolio to reflect a change in the expected duration (that is, the timing of payout) for its insurance policies; or when an entity needs to fund unexpected capital expenditure. However, if more than an infrequent number of sales are made out of a portfolio, management should assess whether and how such sales are consistent with an objective of collecting contractual cash flows.

There is no rule for how many sales constitutes ‘infrequent’; management will need to use judgement based on the facts and circumstances to make its assessment. An entity’s business model is not to hold instruments to collect the contractual cash flows − for example, where an entity manages the portfolio of financial assets with the objective of realising cash flows through sale of the assets. Another example is when an entity actively manages a portfolio of assets in order to realise fair value changes arising from changes in credit spreads and yield curves, which results in active buying and selling of the portfolio.

Practical guide to IFRS

Re-classifications An instrument’s classification is made at initial recognition and is not changed subsequently, with one exception. Re-classifications between fair value and amortised cost (and vice versa) are required only when the entity changes how it manages its financial instruments (that is, it changes its business model). Such changes are expected to be infrequent. The reclassification must be significant to the entity’s operations and demonstrable to external parties. Any reclassification should be accounted for prospectively. Entities are not therefore allowed to restate any previously recognised gains or losses.

The asset should be re-measured at fair value at the date of a reclassification of a financial asset from amortised cost to fair value; this value will be the new carrying amount. Any difference between the previous carrying amount and the fair value is recognised in a separate line item in the income statement. At the date of a reclassification of a financial asset from fair value to amortised cost, its fair value at that reclassification date becomes its new carrying amount. An example of a change in the business model that requires reclassification would be an entity that has a portfolio of commercial loans that it holds to sell in the short term.

Following an acquisition of an entity whose business model is to hold commercial loans to collect the contractual cash flows, that portfolio is managed together with the acquired portfolio to collect the contractual cash flow.

Practical guide to IFRS

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IFRS training material

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