For amortised cost measurement, the cash flows from financial asset should represent solely payments of principal and interest on the principal amount outstanding on specified dates. Interest here means the consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.
Leverage is not consistent with the ‘solely payments of principal and interest’ criterion. Leverage is described as increasing the variability of the contractual cash flows such that they do not have the economic characteristics of interest. The standard lists
freestanding swaps, options and forwards as instruments that contain leverage.
Examples
The following are examples when both the above conditions are met and hence the financial asset is subsequently remeasured at amortised cost:
A bond with variable interest rate and an interest cap;
A fixed interest rate loan;
Zero coupon bond;
Variable interest loans including an element of fixed credit spread which is determined at inception e.g. LIBOR + 300 bps;
Purchase of impaired / discounted loans which are then held to collect the contractual cash flows.
On the other hand, an investment in a convertible loan note would not qualify for amortised cost measurement because of the inclusion of the conversion option which is not deemed to represent payment of principal and interest. Similarly, an inverse floating interest loan which has an inverse relationship to market rates does not represent consideration for the time value of money and credit risk.
4.5. Impact of sale of financial assets on business model
Under IAS 39, subject to certain exemptions, if the entity sells / reclassifies held-to-maturity assets before maturity, tainting provisions under paragraph 9 to IAS 39 shall apply. Under IFRS 9, not all of the assets in a portfolio have to be held to maturity in order for the objective of the business model to qualify as holding assets to collect contractual cash flows. A sale of financial asset may not preclude subse-quent measurement at amortised cost if, for example, a financial asset is sold as per entity’s investment policy when the credit rating of the financial asset declined below certain threshold or a financial asset is sold to fund capital expenditures. The standard does not give any bright line or indicator as to what frequency of anticipated sales would preclude an amortised cost classification.
IAS 39 prescribed very limited circumstances under which sale of financial assets within HTM category were permitted without attracting tainting provisions. Under IFRS 9, portfolio of financial assets continue to be measured at amortised cost as long as the sale of financial assets is infrequent in number. Thus the scope for permitted sales of financial assets is much wider for the reporting entities.
4.6. Contractually linked instruments especially for securitisation transactions
An entity may have prioritised payments to holders of multiple ‘contractually linked’ instruments that create concentrations of risk e.g. the tranches of securitised debt. The complexity arises because the junior tranches provide credit protection to the more senior tranches and the characteristics of the tranches depend on the underlying instruments held. The holder should ‘look through’ the structure until the underlying pool of instruments that are creating (rather than passing through) the cash flows are identified for assessment for solely pay-ments of principal and interest, instruments which reduce cash flow variability and exposure to credit risk. Determining whether a tranche has a lower credit risk than that of the underlying instruments should, in many cases, be straightforward. The most senior tranches will qualify, while the most junior tranches will not. For the tranches in between, the entity may have to evalu-ate on a quantitative basis. E.g. Tranches with underlying instruments where the interest rate is linked to a commodity index would not have contractual cash flows that are solely payments of principal and interest.
When it is impracticable to assess the underlying pool of instruments, the test is deemed to fail and the tranche must be measured at FVTPL.
In practice, significant management judgement shall be required for classifying a financial asset where sale of some of these assets is anticipated. In such cases, management needs to determine whether the particular activity involves one business model with some infrequent sale of assets, or whether there are two business models where one is held for collecting contractual cash flows while the other could be sold in future. However, an entity that actively manages a portfolio in order to realise fair value changes, or a portfolio that is managed and whose performance is evaluated on a fair value basis, does not hold the asset under a business model to collect contrac-tual cash flows. Such instruments would not qualify for amortised cost measurement; hence the portfolio would be subsequently remeasured at fair value every reporting date.
5. Option to designate financial asset at FVTPL
Like IAS 39, an entity can choose to designate a financial asset which otherwise would qualify for amortised cost accounting as measured at FVTPL only if it eliminates or significantly reduces a recognition or measurement inconsistency that otherwise would arise from measuring financial assets or liabilities, or recognising gains or losses on them, on a different basis. The election is available only on initial recognition of the asset and is irrevocable.
For instance, an entity may have issued foreign currency convertible bonds (FCCB) that is measured at fair value in entirety. These funds were utilised in investment of fixed rate bonds and met the amortised cost criteria in accordance with IFRS 9. This would lead to accounting mismatch as the liability is mea-sured at fair value while the asset is measured at amortised cost. This accounting mismatch can be significantly reduced by designating the financial asset at fair value through profit or loss as per IFRS 9.
IAS 39 also permitted an entity to designate a financial asset at FVTPL in two other scenarios.
IAS 39 permitted designating financial asset at FVTPL if the portfolio consists assets managed on a fair value basis. For instance, an entity may hold a portfolio of debt securities. The entity manages the portfolio to maximise its returns (i.e. interest and fair value changes) and evaluates its performance on that basis. In such a case, IAS 39 permitted the entity to designate the portfolio as FVTPL.
As discussed above, these assets cannot qualify for amortised cost measurement under IFRS 9 and therefore are required to be measured at fair value.
a) IAS 39 permitted hybrid instruments (containing an embedded derivative and the host contract) to be designated as FVTPL. Under IFRS 9, hybrid instrument as a whole is assessed for classification as amortised cost or FVTPL. If not classified as at amortised cost, entire instrument is measured at fair value through profit or loss. Point 9.4 below explains the difference in the accounting treatment under IAS 39 and IFRS 9 with an example.
Option to designate investment in equity shares at fair value through other comprehensive income (FVOCI)
6.1. Initial designation
The standard allows an entity, at initial recognition only, to elect to present changes in fair value of an investment in an equity instrument (not held for trading) in ‘Other comprehensive income’ (‘OCI’). The election is irrevocable and can be made on an instrument-by-instrument basis. However, investments in associates and joint ventures for venture capital organizations, mutual funds, unit trusts are not permitted such an option on account of equity accounting or proportional consolidation.
6.2. Subsequent measurement of equity instruments
IFRS 9 requires all investments in equity instruments (including unquoted equity instruments) to be measured at fair value. IFRS 9 permits cost to be an appropriate estimate of fair value of unquoted equity instruments in very limited circumstances.
6.3. Accounting implications on profit or loss
The amounts recognised in OCI are not recycled to profit or loss on disposal of the investment. However, dividend income on these investments continues to be recogn-ised in profit or loss, unless the dividend clearly represents a repayment of part of cost of the investment. Under IFRS 9, no separate impairment loss is to be recognised in profit or loss even if the equity invest-ment is designated as FVOCI.
7. Reclassifications
7.1. Change in business model
Classification of financial instruments is determined on initial recognition. Subsequent reclassification is prohibited. However, when an entity changes its business model in a way that is significant to its operations, a re-assessment is required of whether the initial classification remains appropriate. The standard expects such changes to be very infrequent and demonstrable to external parties.
7.2. New carrying value
If a financial asset is reclassified from fair value measurement to amortised cost measurement, then the fair value at the reclassification date becomes the new carrying amount. Conversely, if a financial asset is reclassified from amortised cost measurement to fair value measurement, then the fair value at the reclassification date becomes the new carrying amount and the difference between amortised cost and fair value is recognised in profit or loss.
7.3. Reclassification date
The reclassification date is the first day of the next reporting period. The reason that the reclassification date is different from the actual date of change in business model is that the IASB did not want to allow entities to choose a reclassification date to achieve an accounting result. Thus, from the date of change in business model until the reclassification date, financial assets continue to be accounted as if the business model has not changed.
8. Embedded derivatives
8.1. Embedded derivatives on financial asset host
Under IAS 39, embedded derivatives on financial assets hosts are assessed whether they need to be accounted separately. If the embedded derivative is separated from the host contract, the embedded derivative is measured at fair value while the host could be measured at amortised cost. IFRS 9 requires an entity to assess whether the hybrid instrument (i.e. host with embedded derivative) being a financial asset within the scope of the standard meets the criteria provided in the standard for amortised cost measurement. If the amortised cost measurement criteria are fulfilled, the entire hybrid instrument is measured at amortised cost (Refer 9.4 below). Else, the entire hybrid instrument is measured at fair value (Refer 9.3 below). However, in both cases, the embedded derivative is not separated.
8.2. Embedded derivatives on non-financial asset host
IFRS 9 does not change the accounting prescribed under IAS 39 for embedded derivatives with host contracts that are not financial assets within the scope of the standard. E.g. rights under leases, insurance contacts, financial liabilities and other non-financial assets
9. Examples for classification under IFRS 9 and IAS 39
9.1. Investment in quoted as well as unquoted equity instruments
Under IAS 39, the investments shall be classified as Available-for-sale (AFS), unless held for trading, and measured at fair value every reporting date. The fair value changes shall be recognised in OCI. The entity may also have recorded the unquoted equity instrument at cost based on the exemption given in IAS 39.
Under IFRS 9, the investment does not meet the criteria for amortised cost measurement. Hence they will be measured at fair value at every reporting date. The fair value changes shall be recognised in profit or loss, unless the entity elects to recognise the same in OCI.
9.2. Investment in quoted debt securities
Under IAS 39, an investment in a debt instrument quoted in active market is not permitted to be classified as loans and receivable category. Hence, these investments shall be classified as Available for sale unless there is a stated intent and ability to hold the instrument to maturity (in which case, the instrument would be classified as Held to Maturity and measured at amortised cost)
Under IFRS 9, if the objective of the business model is to collect solely principal and interest on the principal, then the instrument shall be subsequently measured at amortised cost. Thus, the fact that the debt instrument is quoted in active market has no impact on classification of financial asset.
9.3. Investment in Convertible bonds (at the option of investor)
Under IAS 39, the presence of the con-version feature that is exercisable by the investor precludes classification as HTM category. Such convertible bonds are clas-sified as AFS by the investor. Further, the embedded conversion option shall have to be separately accounted for.
Under IFRS 9, the conversion option shall preclude the amortised cost measurement as the investment shall not be considered to collect solely principal and interest. The entire instrument shall be classified at fair value through profit or loss (FVTPL) with fair value changes reported in income state-ment.
9.4. Prepayment options with reasonable additional compensation for early termination
Under IAS 39, if a debt instrument has a prepayment option that permits the holder to redeem the debt instrument for an amount that is approximately equal on each exercise date to the amortised cost of the debt instrument, such option is deemed to be closely related to the host and does not require separation.
IFRS 9 does not preclude amortised cost classification for a financial asset with a prepayment option when the prepayment amount substantially represents unpaid amounts of principal and interest, including reasonable additional compensation for early termination. Thus, in some cases, amortised cost accounting may be possible for the entire hybrid contract under IFRS 9, while separation of prepayment option may be required under IAS 39.
9.5. Term extending options
Under IAS 39, term extending option is an embedded derivative. The embedded derivative does not require separation if the rate of interest for the extended period approximates to the market rate of interest at the time of obtaining extension. Else, the derivative would require separation.
Under IFRS 9, amortised cost classification
for a term extension option is not precluded if the instrument is held under a business model whose objective is to collect contractual cash flows. Thus in such cases, the entire hybrid instrument shall be carried at amortised cost.
Summary of key differences between IAS 39 and IFRS 9
The standard is effective for annual periods beginning on or after 1 January 2013. Early application is permitted.
The standard has given certain transitionary provisions which provide guidance on how companies who are currently following IAS 39 principles can transition to IFRS 9 within the period when the standard is issued and the effective date of application referred above.
The transitionary provision also provides guidance on classification and measurement of financial as-sets existing on the date of initial application of IFRS 9.
