IFRS 9 Financial Instruments (IFRS 9) introduced major accounting changes for financial assets that significantly impacted the financial statements of all types of lending organizations, such as banks, financial cooperations, and leasing companies. Here the focus is on classification and measurement – including impairment loss provisions – of smaller lending organizations’ financial assets. Other significant changes that may impact smaller lending organizations (such as the simplification of hedge accounting) are not covered here.
Classification of loan to members, term deposit investment, derivative and equity investments
Under IFRS 9 there is a single classification and measurement approach for all financial assets. A smaller lending organization classifies financial assets as subsequently measured at amortized cost, fair value through other comprehensive income (FVTOCI) or fair value through profit or loss (FVTPL) on the basis of both:
- the entity’s business model for managing the financial assets, and Classification, measurement and impairment of financial
- the contractual cash flow characteristics of the financial asset. Classification, measurement and impairment of financial
Smaller lending organizations need to perform an analysis of both tests to determine how they account for financial assets using the basis currently used (for example loans to members at amortized cost). In general, lending by smaller lending organizations meets the contractual cash flows test, which looks at whether the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal or interest (SPPI test). The cash flows received would generally be in the form of principal and interest repayments.
The business model test looks at whether the business objectives are to hold in order to collect contractual cash flows only or to hold in order to collect and sell. If they are held to collect only, a smaller lending organization classifies member loans and other investments at amortized cost. If they are held to collect and for sale, a smaller lending organization classifies financial assets using FVTOCI. In certain situations, IFRS 9 also permits an election to classify as FVTPL. Classification, measurement and impairment of financial
Derivatives (futures, options, etc.) and equity instruments always fail the SPPI test. As a result, all derivatives are classified as FVTPL. However, for equity investments, a smaller lending organization also needs to consider the business model for managing the investment. If the equity investments are held for trading, the instruments are classified and presented as FVTPL, the same as they were under IAS 39. However, if they are not held for trading, the entity has an option to use FVTPL or to elect FVTOCI. This is an irrevocable election.
Note that the accounting for instruments at FVTOCI is not the same as accounting for available sale investments (AFS) under IAS 39. FVTOCI classification does not permit recycling into P&L of any unrealized or realized gains and losses. In addition, IFRS 9 also removed the exemption to recognize equity instruments that do not have a quoted market price in an active market at cost. Smaller lending organizations with equity investments that were carried at cost under IAS 39 need to consider how to classify and measure these equity investments.
IFRS 9 introduced a forward-looking expected credit loss impairment model. This was a change from the incurred loss model under IAS 39. For example, under IAS 39, a smaller lending organization was looking at the probability that a counterparty had defaulted. In applying IFRS 9, a smaller lending organization is looking at the probability that a counterparty will default.
There are three stages to consider (excluding purchased or originated credit impaired instruments):
Stage 1 – If a financial asset is subject to low credit risk at the reporting date, an amount equal to 12 month expected losses would be recognized.
Stage 2 – If the credit risk increases significantly from initial recognition, an amount equal to lifetime expected credit losses would be recognized. Interest revenue would be on the gross basis.
Stage 3 – If the financial asset meets the credit impaired definition, an amount equal to lifetime expected credit losses would be recognized and interest revenue would be on the net basis, rather than on the gross amount.
Smaller lending organizations face challenges in implementing this new impairment model. These include, but are not limited to:
- How to measure or estimate expected credit losses
- The best available information (historical or forecasts). Classification, measurement and impairment of financial
- Probability-weighted estimate of cash flows based on a range of possible outcomes from the possibility that a credit loss occurs to the possibility that no credit loss occurs.
- How to define a “significant increase in credit risk”
Smaller lending organizations may look to apply a default definition that is consistent with internal credit risk management purposes and takes into account qualitative indicators of default when appropriate. Regardless of the way in which a smaller lending organization assesses significant increases in credit risk, there is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due, causing the financial asset to transfer into stage 2 of the impairment model. However, a smaller lending organization can rebut this presumption if it has reasonable and supportable information available, without undue cost or effort, that demonstrates that the credit risk has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due.
- What is the impact, if any, of credit enhancements such as credit insurance on credit risk and expected loss measurement?
- Are systems in place to track movements in credit risk? Classification, measurement and impairment of financial
- How are changes in forward looking information determined/managed?
IFRS 9 is effective for annual periods beginning on or after January 1, 2018.