New IFRS 9 for Financial Instruments Adopted, EFRAG Delays Endorsement Advice to European Commission

The International Accounting Standards Board has adopted new IFRS 9 for the accounting for financial instruments, as part of its project to replace IAS 39. The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity. IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how a firm manages its financial instruments, its business model, and the contractual cash flow characteristics of the financial assets. The Board also decided not to bifurcate hybrids containing embedded derivatives.

The new standard requires a single impairment method to be used, replacing the many different impairment methods in IAS 39. Thus, IFRS 9 improves comparability and makes financial statements easier to understand for investors and other users. Firms must apply IFRS 9 for annual periods beginning on or after 1 January 2013. But early adoption is permitted. To facilitate early adoption, a firm that applies IFRS 9 before financial reporting periods beginning before the first of January 2012 is not required to restate comparatives. Commenting on IFRS 9, IASB Chair David Tweedie said that the Board delivered on its commitment to the G-20 and stakeholders internationally to provide an improved financial instrument standard for the classification and measurement of financial assets for use in 2009.

The Board decided to consider the classification and measurement of financial liabilities separately. IFRS 9 therefore prescribes the classification and measurement of financial assets only.

In adopting IFRS 9, the Board’s goal is neither to increase nor decrease the application of fair value accounting to financial instruments, but rather to ensure that financial assets are measured in a way that provides useful information to investors. Whether firms will have more or fewer financial assets measured at fair value as a result of applying IFRS 9 will depend on the nature of their business and the nature of the instruments they hold.

Generally, the IASB noted that the more risky financial assets a firm holds the more likely it is that those financial assets will be measured at fair value. For example, the IASB will not require that the loan book of banks be held at fair value. As a result, the final standard will likely result in financial institutions that undertake traditional banking activities applying less fair value accounting rather than more.

The category into which the asset is classified determines whether it is measured on an ongoing basis at amortized cost or fair value. The business model test is applied first in determining whether a financial asset is eligible for amortized cost measurement. The Board confirmed that to be eligible for amortized cost measurement an asset must have contractual cash flow characteristics representing principal and interest. IFRS 9 includes examples of the application of that principle to particular financial assets. All equity investments must be measured at fair value.

Unquoted equity instruments, and derivatives over such instruments, must be measured at fair value, however, in limited circumstances, cost may be an appropriate estimate of fair value. IFRS 9 contains guidance on when cost may be an appropriate estimate of fair value. However, measurement of fair value will be subsequently addressed as part of the fair value measurement project.

A firm is required to reclassify affected financial assets only if its business model changes. The exposure draft had proposed prohibiting reclassification. The Board removed the prohibition on reclassification of financial instruments in response to comments that a change in business model should result in reclassification. Thus, companies would be able to reclassify financial instruments out of the fair value option when making their new designations. To ensure full transparency, the Board would require appropriate disclosures and presentation of any reclassifications

If a financial asset is eligible for amortized cost measurement, a firm can elect to measure it at fair value if it eliminates or significantly reduces an accounting mismatch.

If a firm holds a tranche in a structure it must determine the classification of that tranche by looking through to the assets ultimately underlying that portfolio and assess the credit quality of that tranche compared with the underlying portfolio. If an entity is unable to look through, then the tranche must be measured at fair value.

The Board concluded that there will be no bifurcation of an embedded derivative where the host is a financial asset. Thus, a hybrid non-derivative host contract with an embedded derivative with a host that is a financial asset is not separated. Such contracts are classified in accordance with the classification criteria in their entirety. There is no change to the accounting for hybrid contracts if the host contract is a financial liability or a non-financial item.

IAS 39 had split the instrument, with the embedded derivative being measured at fair value and the non-derivative host being measured at amortized cost or as an executory contract using accrual accounting. While recognizing that separating an embedded derivative from its host contract can provide useful information for users of financial statements, the Board was also cognizant of the important goal of simplifying the accounting for financial instruments. The Board concluded that the additional information gained from separating the components of the contract did not justify the significant additional costs and complexity that separation entails.

EFGAG Endorsement Advice

A key advisory panel has urged the European Commission to delay the endorsement of the new international financial instrument accounting standard, IFRS 9. The European Financial Reporting Advisory Group (EFRAG) decided that more time should be taken to consider the output from the IASB project to improve accounting for financial instruments. Therefore, at this stage, EFRAG would not finalize its endorsement advice to the Commission on IFRS 9.

On November 2, EFRAG issued draft endorsement advice seeking input from constituents. EFRAG provides advice to the European Commission on the endorsement of new or amended IFRSs and comments on proposed IFRSs and IASB discussion papers and consultative documents. EFRAG also attends various IASB Working Group meetings as an observer.

The IASB adopted new IFRS 9 for the accounting for financial instruments, as part of its project to replace IAS 39. The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity. IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how a firm manages its financial instruments, its business model, and the contractual cash flow characteristics of the financial assets.

In its draft endorsement advice, EFRAG sought comment on a number of issues involving the application of IFRS 9. EFRAG’s initial assessment of IFRS 9 is that it meets the technical criteria for endorsement. In other words, it is not contrary to the true and fair principle and it meets the criteria of understandability, relevance, reliability and comparability.

EFRAG is assessing the costs for both preparers and users on implementation of IFRS 9 in the EU, both on initial adoption and in subsequent years. Some initial work has been carried out, and comments will be used to complete that assessment. EFRAG’s initial assessment is that preparers could incur significant year-one costs arising from the initial adoption of IFRS 9, and moderate ongoing costs. For users, application of IFRS 9 is likely to involve significant additional costs in year-one and, for some users, moderate ongoing incremental costs. But EFRAG added that IFRS 9 would reduce complexity in the classification and measurement aspect of reporting financial instruments; and the benefits to be derived from that are likely to exceed the costs involved.

Since IFRS 9 requires firms to determine the fair value for unquoted equity instruments, there is concern that requiring such instruments to be measured at fair value might result in measures that are not sufficiently reliable. While IFRS 9 may cause some reliability concerns, the majority of EFRAG members concluded that those concerns would be mitigated by existing disclosures requirements in IFRS 7.

Similarly, EFRAG noted that IFRS 9 will not be free from some significant comparability concerns, such as with the treatment of tranched securities. Nevertheless, the majority of EFRAG members believe that most significant issues of comparability are partially mitigated by disclosure requirements. While some comparability concerns may remain thereafter, EFRAG does not consider those concerns significant.

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