IFRS 9 Financial Instruments is a complex standard. IFRS 9 replaced IAS 39 Financial Instruments: Recognition and Measurement. It establishes accounting principles for recognising, measuring and disclosing information about financial assets and financial liabilities. The objective of this chapter is to summarise the key aspects of financial instrument recognition under IFRS 9.
IFRS 9 is remarkably wide in scope and interacts with several other standards (see Figure 1.1). When addressing hedging there are, in addition to IFRS 9, primarily three standards that have an impact on the way a hedge is structured: IAS 21 The Effects of Changes in Foreign Exchange Rates, IAS 32 Financial Instruments: Disclosure and Presentation and IFRS 13 Fair Value Measurement.
Whilst the International Accounting Standards Board (IASB) is responsible for setting the IFRS standards, jurisdictions may incorporate their own version. For example, entities in the European Union must apply the version of IFRS 9 endorsed by the EU, which might differ from the IASB's IFRS 9 standard.
Under IFRS 9, a financial instrument is any contract that gives rise to both a financial asset in one entity and a financial liability or equity instrument in another entity.
IFRS 9 does not cover the accounting treatment of some financial instruments – for example, own equity instruments, insurance contracts, leasing contracts, some financial guarantee contracts, weather derivatives, loans not settled in cash (or in any other financial instrument), interests in subsidiaries/associates/joint ventures, employee benefit plans, share-based payment transactions, contracts to buy/sell an acquiree in a business combination, contracts for contingent consideration in a business combination, and some commodity contracts are outside the scope of IFRS 9.
A financial asset is any asset that is cash, a contractual right to receive cash or some other financial asset, a contractual right to exchange financial instruments with another entity under conditions that are potentially favourable, or an equity instrument of another entity. Financial assets include derivatives with a fair value favourable to the entity.
IFRS 9 considers three categories of financial assets (see Figures 1.2 and 1.3):
The classification of an instrument is determined on initial recognition. Reclassifications are made only upon a change in an entity's business model, and are expected to be very infrequent. No other reclassifications are permitted.
A financial asset qualifies for amortised cost measurement only if it meets both of the following criteria:
This is a mandatory classification, unless the fair value option is applied. Financial assets in the amortised cost category include non-callable debt (i.e. loans, bonds and most trade receivables), callable debt (provided that if it is called the holder would recover substantially all of debt's carrying amount) and senior tranches of pass-through asset-backed securities.
If a financial asset does not meet any of the two conditions above it is measured at FVTPL. If both conditions are met but the sale of the financial asset is also integral to the business model, it is recognised at FVOCI.
Even if an asset is eligible for classification at amortised cost or at FVOCI, management also has the option – the FVO – to designate a financial asset at FVTPL if doing so reduces or eliminates a measurement or recognition inconsistency (commonly referred to as “accounting mismatch”).
If the entity's objective is to hold the asset to collect the contractual cash flows, then it will meet the first criterion to qualify for amortised cost. The entity's business model does not depend on management's intentions for the individual asset, but rather on the basis of how an entity manages the portfolio of debt instruments. Examples of factors to consider when assessing the business model for a portfolio are:
IFRS 9 indicates that sales due to deterioration of the credit quality of the financial assets so that they no longer meet the entity's documented investment policy would be consistent with the amortised cost business model. Sales that occur for other reasons may also be consistent with the amortised cost business model if they are infrequent (even if significant) or insignificant (even if frequent), or if the sales take place close to the maturity of the financial asset and the proceeds from the sale approximate the collection of the remaining contractual cash flows. For example, an entity could sell one financial asset that results in a large gain and this would not necessarily fail the business model test due to its significant effect on profit or loss unless it was the entity's business model to sell financial assets to maximise returns.
If an entity is unsure of the business model for the debt investments, the default category would be at FVTPL.
If the financial asset's contractual terms give rise on specified dates to cash flows that are “solely payments of principal and interest on the principal amount outstanding” (SPPI), then it will meet the second criterion to qualify for amortised cost.
Interest is defined as “consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time”. The assessment as to whether cash flows meet this test is made in the currency of denomination of the financial asset.
IFRS 9 also refers to the case of “modified economic relationships”. For example, a financial asset may contain leverage or an interest rate that is resettable, but the frequency of the reset does not match the tenor of the interest rate (an “interest rate mismatch”). In such cases, the entity is required to assess the modification to determine whether the contractual cash flows represent solely payments of principal and interest on the principal amount outstanding. To do this, an entity considers cash flows on a comparable or benchmark financial asset that does not contain the modification. The benchmark asset is a contract of the same credit quality and with the same contractual terms (including, when relevant, the same reset periods), except for the contractual term under evaluation (i.e., the underlying rate).
If the modification results in cash flows that are more than insignificantly different from the benchmark cash flows, or if the entity is unable to reach a conclusion, then the financial asset does not satisfy the SPPI test (see Figure 1.3).
In making this assessment the entity only considers reasonable possible scenarios rather than every possible scenario. If it is clear with little or no analysis whether the cash flows on the financial asset could or could not be more than insignificantly different from the benchmark cash flows, then an entity does not need to perform a detailed assessment.
This category consists of debt investments that meet the contractual cash flows test, for which their business model is held to collect and for sale. This is a mandatory classification, unless the FVO is applied. This category is intended to acknowledge the practical reality that an entity may invest in debt instruments to capture yield but may also sell if, for example, the price is considered advantageous or it is necessary to periodically adjust or rebalance the entity's net risk, duration or liquidity position.
This category also consists of equity investments which are not held for trading. An entity can choose to classify non-trading equity investments in this category on an instrument-by-instrument basis. This is an irrevocable election.
The FVTPL category is in effect the “residual category” for instruments that do not qualify for the amortised cost or FVOCI categories. The following financial assets would be included in the FVTPL category:
Derivatives are recognised at FVTPL unless they are a hedging instrument in cash flow hedge or net investment in foreign operation. Therefore, derivatives undesignated or being hedging instruments in fair value hedging relationships are classified at FVTPL. Recognition of derivatives is covered in detail in Chapter 2.
An entity recognises a financial asset when and only when the entity becomes a party to the contractual provisions of a financial instrument. The initial measurement of the financial asset is its fair value, which normally is the consideration given, including directly related transaction costs.
Debt instruments classified at amortised cost are subsequently recognised at amortised cost less impairment in the statement of financial position. Interest income and impairment are recognised in profit or loss. Interest income is recognised using the effective interest rate method. Impairment charges can be reversed through profit or loss. Foreign exchange gains and losses are recognised in profit or loss.
A debt instrument classified at FVOCI is presented in the statement of financial position at fair value. The entity also keeps an amortised cost calculation (i.e., an effective interest rate) to recognise interest income in profit or loss.
Interest income and impairment are recognised in profit or loss, using the same methodology as for amortised cost. Interest income is recognised using the effective interest rate method. Impairment charges can be reversed through profit or loss. Likewise, foreign exchange gains and losses are recognised in profit or loss as if the instrument were carried at amortised cost. The difference between amortised cost (in the currency of denomination) and fair value (in the currency of denomination) is recognised in OCI and recycled when the instrument is sold.
Gains and losses on equity investments in this category are recognised in OCI with no recycling of gains and losses into profit or loss. If an equity investment is so designated, then dividend income generally is recognised in profit or loss. No impairment is recognised.
Gains and losses on instruments in this category are recognised in profit or loss. No impairment is recognised.
The table below gives an overview of the accounting treatment of each category of financial assets:
Asset category | Measurement | Fair value changes |
At amortised cost | Initial recognition at fair value Subsequent recognition at amortised cost less impairment. Any premium or discount is amortised to profit or loss |
Not relevant unless impaired Interest income, impairment and foreign exchange gains/losses recognised in profit or loss. Impairment can be reversed through profit or loss |
At FVTPL | Fair value | Changes in fair value recorded in profit or loss No impairment recorded |
At FVOCI | Fair value | Changes in fair value recorded in OCI For debt instruments: interest revenue, credit impairment and foreign exchange gains or losses recognised in profit or loss. On derecognition any cumulative gains and losses in OCI reclassified to profit or loss For equity investments: no impairment is recorded. Dividends recorded in profit or loss |
In order to meet the contractual cash flows criterion, there should be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows, with the result that they do not have the economic characteristics of interest.
IFRS 9 contains specific guidance on classifying non-recourse (or limited recourse) financial assets. These assets represent an investment in which the investor's claims are limited to specified assets, which may be financial or non-financial assets. IFRS 9 states that the fact that a financial asset is non-recourse does not mean in itself that the SPPI criterion is not met.
IFRS 9 contains specific guidance on classifying contractually linked instruments that create concentrations of credit risk (e.g., securitisation tranches). The right to payments on more junior tranches depends on the issuer's generation of sufficient cash flows to pay more senior tranches. The standard requires a look-through approach to determine whether the SPPI criterion is met. Otherwise, the tranche would be recognised at fair value.
A tranche meets the SPPI criterion only if all the following conditions are met:
The look-through approach is carried through to the underlying pool of instruments that create, rather than pass through, the cash flows. For example, if an entity invests in a tranched note issued by SPE 2 whose only asset is an investment in another tranched note issued by SPE 1, the entity looks through to the assets of SPE 1 in performing the assessment.
When the tranche held by the investor is prepayable contingent upon a prepayment occurring in the pool of underlying assets, it may meet SPPI even if the following features exist in the structure (assuming the three primary conditions for the tranche as a whole are met):
IFRS 9 requires an entity to reclassify financial assets if and only if the objective of the entity's business model for managing those assets changes. Such changes are expected to be infrequent, and need to be determined by the entity's senior management as a result of internal or external modifications. These modifications have to be significant to the entity's operations and demonstrable to external parties. Reclassification is applied prospectively from the start of the first reporting period following the change in business model.
Both the amortised cost and FVOCI categories require the effective interest rate to be determined at initial recognition. Therefore, when reclassifying a financial asset between the amortised cost and the FVOCI categories, the recognition of interest income would not change and the entity would continue to use the effective interest rate determined at initial recognition. A financial asset reclassified out of the FVOCI category to the amortised cost category would be measured at amortised cost as if it had always been so classified. This will be effected by transferring the cumulative gain or loss previously recognised in OCI out of equity, with an offsetting entry against the fair value carrying amount at the reclassification date.
However, for financial assets at FVTPL, and entity is not required to separately recognise interest income. When reclassifying a financial asset out of the FVTPL category, the effective interest rate would be determined based on the fair value carrying amount at the reclassification date.
Reclassification to | |||
Asset category | Amortised cost | FVOCI | FVTPL |
From: At amortised cost | N/A | Remeasure at fair value with any difference in OCI The effective interest rate determined at initial recognition remains unchanged |
New carrying amount is the fair value on reclassification date Any difference between amortised cost and fair value is recognised in profit or loss |
From: At FVOCI | Accumulated OCI recycled out of equity, with offsetting entry against fair value carrying amount Adjusted carrying amount is existing amortised cost The effective interest rate determined at initial recognition remains unchanged |
N/A | Accumulated OCI amount recycled to profit or loss Asset continues to be measured at fair value Subsequent changes in fair value recognised in profit or loss |
From: At FVTPL | New amortised cost is the fair value on reclassification date The effective interest rate is calculated |
Asset continues to be measured at fair value Subsequent changes in fair value recognised in OCI The effective interest rate is calculated |
N/A |
It was mentioned earlier that some assets and liabilities are measured at amortised cost. The amortisation is calculated using the effective interest rate (EIR). This rate is applied to the carrying amount at each reporting date to determine the interest expense for the period. The EIR is the rate that exactly discounts the stream of principal and interest cash flows to the initial net outlay (in the case of assets) or proceeds (in the case of a liability). In this way, the contractual interest expense in each period is adjusted to amortise any premium, discount or transaction costs over the life of the instrument.
The carrying amount of an instrument accounted for at amortised cost is computed as:
Transaction costs include fees, commissions and taxes paid to other parties. Transaction costs do not include internal administrative costs.
Suppose that an entity issues a bond with the following terms:
Nominal amount: | EUR 1,250 |
Maturity: | 5 years |
Issue proceeds: | EUR 1,250 |
Coupons: | First year: 6% (75) |
Second year: 8% (100) | |
Third year: 10% (125) | |
Fourth year: 12% (150) | |
Fifth year: 16% (200) |
The EIR is computed as the rate that exactly discounts estimated future cash payments through the expected life of the financial instrument:
Solving this equation, we get EIR = 9.96%. The amortised cost of the liability at each accounting date is computed as follows:
Year | Amortised cost at beginning of year (a) | Interest (b) = (a) × 9.96% |
Cash flow (c) | Amortised cost at end of year (d) = (a) + (b) – (c) |
1 | 1,250 | 125 | 75 | 1,300 |
2 | 1,300 | 129 | 100 | 1,329 |
3 | 1,329 | 132 | 125 | 1,336 |
4 | 1,336 | 133 | 150 | 1,319 |
5 | 1,319 | 131 | 200 | 1,250 |
IFRS 9 does not specify how the EIR is calculated for floating rate debt instruments. The EIR of a floating rate instrument changes as a result of periodic re-estimation of determinable cash flows to reflect movements in market interest rates. Two approaches can be used to calculate the EIR in a floating rate debt instrument:
When the floating rate instrument is recognised at an amount equal to the principal receivable or payable on maturity, this periodic re-estimation does not have a significant effect on its carrying amount. Therefore, for practical reasons the first approach is used, and in such cases the carrying amount is usually not adjusted at each repricing date, because the impact is generally insignificant. According to this method, the interest income for the period is calculated as follows:
Similarly, for floating rate debt liabilities, the following method is used to calculate interest expense for the period:
The treatment of an acquisition discount or premium on a floating rate instrument depends on the reason for that discount or premium. For example:
IFRS 9 does not prescribe any specific methodology for how transaction costs should be amortised for a floating rate instrument. Any consistent methodology that would establish a reasonable basis for amortisation of the transaction costs may be used. For example, it would be reasonable to determine an amortisation schedule of the transaction costs based on the interest rate in effect at inception. In my view, this approach also could be applied for a floating rate instrument recognised at amortised cost with an embedded derivative that is not separated (e.g., a floating rate bond with a cap). Another reasonable approach would be to linearly amortise the transaction costs over the life of the instrument.
Suppose that an investor bought, at a discount, a fixed rate bond with the following terms:
Bond terms | |
Purchase price | EUR 98 million |
Purchase date | 1-Jan-X0 |
Notional | EUR 100 million |
Maturity | Three years (31-Dec-X2) |
Notional | USD 100 million |
Coupon | 5% annually, 30/360 basis |
Let us assume that the bond was recognised at amortised cost, and that no impairments were recognised. The calculation of the effective interest rate was performed as follows (in EUR millions):
EIR was 5.7447%.
Year | Amortised cost beginning of year (a) | Interest (b) = (a) × EIR | Cash Flow (c) | Amortised cost end of year (d) = (a) + (b) – (c) |
1 | 98,000,000 | 5,630,000 | 5,000,000 | 98,630,000 |
2 | 98,630,000 | 5,666,000 | 5,000,000 | 99,296,000 |
3 | 99,296,000 | 5,704,000 | 5,000,000 | 100,000,000 |
The related accounting entries were as follows:
Let us assume that the bond was recognised at FVOCI, and that no impairments were recognised. Let us assume further that the fair value of the bond on 31 December 20X0 and 31 December 20X1 was EUR 97 million and EUR 101 million, respectively. The change in the bond's clean fair at each reporting date was:
Year | Clean fair value (a) | Previous clean fair value (b) | Change (c) = (a) – (b) |
1 | 97,000,000 | 98,000,000 | <1,000,000> |
2 | 101,000,000 | 97,000,000 | 4,000,000 |
3 | 100,000,000 | 101,000,000 | <1,000,000> |
In order to account for the bond the investor had to keep track of both the bond's amortised cost and its fair value. The bond's amortised cost profile, which was identical to that in the previous example, determined the interest expense to be recognised at each period.
Any difference between the bond's clean fair value (i.e., excluding accrued interest) and its amortised cost was recognised in the FVOCI reserve in OCI.
Year | Clean fair value (a) | Amortised cost end of year (b) | FVOCI reserve (c) = (a) – (b) | Previous FVOCI reserve (d) | New FVOCI entry (c) – (d) |
1 | 97,000,000 | 98,630,000 | <1,630,000> | -0- | <1,630,000> |
2 | 101,000,000 | 99,296,000 | 1,704,000 | <1,630,000> | 3,334,000 |
3 | 100,000,000 | 100,000,000 | -0- | 1,704,000 | <1,704,000> |
The related accounting entries were as follows:
A financial liability is any liability that is a contractual obligation to deliver cash or some other financial asset to another entity or to exchange financial instruments with another entity under conditions that are potentially unfavourable.
Under IFRS 9 there are only two categories of financial liabilities (see Figure 1.5): at amortised cost and at FVTPL. The following table summarises the accounting treatment of each category of financial liabilities:
Liability category | Measurement | Fair value changes |
At amortised cost | Amortised cost. Any premium or discount is amortised to profit or loss | Not relevant by virtue of not being fair valued |
At FVTPL | Fair value | Changes in fair value attributable to changes in credit risk presented in OCI (unless it creates or increases accounting mismatch) Remaining changes in fair value recorded in profit or loss |
The category of financial liabilities at FVTPL has two sub-categories: liabilities held for trading and those designated to this category at their inception using the FVO. Financial liabilities classified as held for trading include:
The following instruments are measured under specific guidance in IFRS 9:
When an entity repurchases own financial liabilities, the repurchased part is derecognised. According to IFRS 9, “if an entity repurchases a part of a financial liability, the entity shall allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised based on the relative fair values of those parts on the date of the repurchase. The difference between (a) the carrying amount allocated to the part derecognised and (b) the consideration paid, including any non-cash assets transferred or liabilities assumed, for the part derecognised shall be recognised in profit or loss.”
The amount of change in the fair value of a liability designated at FVTPL under the FVO that is attributable to changes in credit risk must be presented in other comprehensive income (OCI), unless:
The remainder of the change in fair value is presented in profit or loss.
To determine whether the treatment would create or enlarge an accounting mismatch, the entity must assess whether it expects the effect of the change in the liability's credit risk to be offset in profit or loss by a change in fair value of another financial instrument. In reality, such instances are expected to be rare, unless an entity, for example, holds an asset whose fair value is linked to the fair value of the liability.
The changes in credit risk recognised in OCI are not recycled to profit or loss on settlement of the liability.
The following instruments, when recognised at FVTPL, are not required to isolate the change in fair value attributable to credit risk (i.e., all gains and losses are presented in profit or loss):
IFRS 9 largely carries forward guidance from IFRS 7 on how to determine the effect of changes in credit risk. An entity determines the amount of the fair value change that is attributable to changes in its credit risk either:
IFRS 9 clarifies that this would include any liquidity premium associated with the liability.
If the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, under IFRS 9 the amount of fair value changes that is attributable to changes in credit risk may be estimated using the so-called default method as follows:
This default method is appropriate only if the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate and that, when other factors are significant, an alternative measure that more faithfully measures the effects of changes in the liability's credit risk should be used. For example, if the liability contains an embedded derivative, the change in fair value of the derivative would be excluded in calculating the fair value change amount attributable to changes in credit risk.
The fair value option is an option to designate financial assets or financial liabilities at FVTPL. The election is available only on initial recognition and is irrevocable. In the case of financial assets, the FVO is available for instruments that would otherwise be mandatorily recognised at amortised cost or at FVOCI, being permitted only if:
In the case of financial liabilities, the FVO is available for instruments that would otherwise be mandatorily recognised at amortised cost, being permitted only if:
The FVO is only available on initial recognition of the financial asset or liability. This requirement may create a problem if the entity enters into offsetting contracts on different dates. A first financial instrument may be acquired in the anticipation that it will provide a natural offset to another instrument that has yet to be acquired. If the natural hedge is not in place at the outset, IFRS 9 would not allow the first financial instrument to be recorded at FVTPL, as it would not eliminate or significantly reduce a measurement or recognition inconsistency. Additionally, to impose discipline, an entity is precluded from reclassifying financial instruments in or out of the fair value category, unless (in the case of financial assets) the business model for those assets changes.
Sometimes a particular market risk that affects a financial asset or a financial liability is hedged with another financial instrument that behaves in an opposite way to movements in such market risk (i.e., an increase in the market variable would increase the fair value of one of the two items while decreasing that of the other item). In this case, the entity would be interested in measuring the financial asset or financial liability at FVTPL to benefit from their natural offsetting. The entity could apply the FVO because it will eliminate or significantly reduce the measurement or recognition inconsistency that would otherwise arise from measuring these assets or liabilities, or recognising the gains and losses on them, on different bases.
Sometimes, a derivative is “embedded” in an instrument – called a hybrid instrument or hybrid contract – in combination with a host contract. The embedded derivative causes some or all of the contractual cash flows to be modified based on a specified interest rate, a security price, a commodity price, a foreign exchange rate, index of prices or rates, or other variables. The accounting treatment depends on whether the host is a financial asset or a financial liability (see Figure 1.6).
A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument (e.g., an equity warrant attached to a bond), or has a different counterparty, is not an embedded derivative, but a separate financial instrument.
When the host contract is a financial asset within the scope of IFRS 9, the hybrid financial instrument is not bifurcated; instead it is assessed in its entirety for classification under the standard.
Existence of a derivative feature in a hybrid instrument might not preclude amortised cost. This may be the case when the economic risks and characteristics of the instrument are closely related to the host contract.
When the host contract is either (i) a financial liability within the scope of IFRS 9 or (ii) an instrument not within the scope of IFRS 9, an assessment is performed to determine whether the embedded derivative must be separated from the host (i.e., whether the embedded derivative should be accounted for separately).
IFRS 9 does not require the separation of the embedded derivative (see Figure 1.7):
Contracts with embedded derivatives to be separated include:
Examples of contracts not requiring separation include:
The concept of compound instruments is similar to that of hybrid instruments (see Figure 1.8). A hybrid instrument is comprised of a liability component (the host contract) and an embedded derivative, while a compound instrument is comprised of a liability component (the host contract) and an equity component. An example of a compound instrument is a bond issued by the entity that is convertible into a fixed number of shares of the entity, which can be split between:
Compound instruments are defined in IAS 32. The liability and equity components of a compound instrument are required to be accounted for separately, upon initial recognition, and the separation is not subsequently revised. The split between the two components is implemented in two steps:
I have included several cases that cover the accounting of convertible bonds in Chapter 9.