by John Hughes

Well, the final version of IFRS 9 Financial Instruments has finally been issued, effective for financial years beginning on or after January 1, 2018. These are some of the Standard’s headline achievements, as summed up in the IASB’s press release:

• Impairment During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identified as a weakness in existing accounting standards. As part of IFRS 9, the IASB has introduced a new, expected-loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new Standard requires entities to account for expected credit losses from when financial instruments are first recognized and to recognize full lifetime expected losses on a more timely basis.  The IASB has already announced its intention to create a transition resource group to support stakeholders in the transition to the new impairment requirements.
• Hedge accounting IFRS 9 introduces a substantially-reformed model for hedge accounting, with enhanced disclosures about risk management activity.  The new model represents a significant overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements.  In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
• Own credit IFRS 9 also removes the volatility in profit or loss that was caused by changes in the credit risk of liabilities elected to be measured at fair value.  This change in accounting means that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognized in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted by IFRS 9.

For many smaller companies though, the only potentially relevant aspect of the standard is the content on classification and measurement. In their recent disclosures about future accounting pronouncements, a lot of companies have been saying something along these lines: “IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the multiple rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments in the context of its business model and the contractual cash flow characteristics of the financial assets.” It’s not necessarily an inaccurate summary. But I don’t know that everyone would pick up IFRS 9 and say, wow, isn’t this great – a single approach! In some ways, the layout of the standard seems to me just as tortuous as that of IAS 39. And although at its core it may have a “single approach” to the matters described, by the time it gets through explaining the multi-pronged application of that single approach, it sounds awfully like a bunch of multiple rules.

The notion is that a financial asset is measured at amortized cost if it’s held within a business model with the objective of holding assets in order to collect contractual cash flows and if its contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding; otherwise it’s measured at fair value. The first part of that clearly encompasses a straightforward debt instrument which will only ever be held to maturity, although the standard allows some latitude on selling such an instrument as a response to (say) an increase in its credit risk, or to other infrequent events. On the other hand, the standard emphasizes that “sales in themselves do not determine the business model and therefore cannot be considered in isolation” (one must look at how the performance of the business model is measured and evaluated, how its managers are compensated, and so forth). And IFRS 9 now contains an additional category of financial assets “held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets” (a situation, for instance, where the entity makes ongoing decisions about whether collecting contractual cash flows or selling financial assets will maximize the return on the portfolio until the need arises for the invested cash); these are measured at fair value, but through other comprehensive income rather than through profit and loss. It’s hard to imagine these lines and concepts won’t often get murky.

Regarding the contractual terms of the instrument, IFRS 9 sets out various terms and scenarios that fall inside or outside the concept of “contractual cash flows that are solely payments of principal and interest on the principal amount outstanding” – for this purpose, interest is “consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as a profit margin” (i.e. and nothing else). For example, it’s OK to link the payments to an inflation index, because that resets the time value of money to a current level, but if they’re linked to some other kind of variable – a measure of the borrower’s performance or of an equity index – then the standard regards that as bringing in something other than a consideration of credit risk and of the time value of money. Perhaps you could argue it just reflects a different way of having negotiated an interest rate, but that’s not how IFRS 9 looks at it. In contrast, a bond with a variable market interest rate that’s capped falls within the concept. If the terms of an instrument allow deferring interest in defined situations, but without accruing additional interest on the deferred amounts, then that falls outside the concept because the interest ceases to reflect consideration for the time value of money on the principal amount. True enough, but you might ask why the fact of a lender having made such a (possibly modest) concession should change so completely the accounting treatment available to the borrower.

So I don’t know, is that a “single approach” or is it still an example of what Alex Milburn once called “the inconsistent and unintegrated mix of measurement theories and pragmatics that underlie existing accounting standards and practice”…?

The opinions expressed are solely those of the author