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ANALYSIS: If the shoe fits …

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This article is the second of a three-part series looking at the requirements of the final IFRS 9 Financial Instruments. In this part we take a look at the new requirements of classification and measurement of financial assets. In part 3 we will discuss the new impairment model

Spring is in the air. Time to clean out the closet, out with the old shoes and make space for the new ones.

In time for spring, the International Accounting Standards Board (IASB) released the complete and final version of the IFRS 9 Financial Instruments standard in July 2014 which will replace the current IAS 39 Financial Instruments: Recognition and Measurement standard. With the change in season, now is the best time for South African preparers, many of whom waited for the final version, to start thinking about how the new standard would affect their businesses. The final version includes the new impairment model for financial assets and includes a new measurement category for debt instruments held as financial assets.

WHICH PAIR TO WEAR

Similar to IAS 39, financial assets are initially recognised at fair value. The subsequent measurement depends on the measurement category of the financial asset, which the entity determines on initial recognition. IFRS 9 includes the following possible categories:

  • Amortised cost
  • Debt instruments at fair value through other comprehensive income
  • Equity instruments for which the entity elects to present fair value changes in other   comprehensive income, and
  • Fair value through profit or loss

THE TRIED AND TESTED PAIR: AMORTISED COST

Debt instruments (such as trade receivables and loans receivable) can only be measured at amortised cost if they meet both the following conditions:

  • The financial asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows, and
  • The contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding (the SPPI criterion)

The business model is determined by the way the business is managed. To put it simply, entities “slip on the shoe that fits”. A single entity can have more than one business model to manage its financial assets.

Many preparers may wonder whether incidental sales of financial assets will result in the requirement “to hold to collect contractual cash flows” not being met. The answer is “not necessarily”. Sales do not automatically disqualify assets from the business model “to hold to collect contractual cash flows”. The frequency, timing, volume of sales and the reasons for these sales in prior periods will however need to be considered as part of the assessment of the business model.

The final version of IFRS 9 provides clearer guidance on payments which solely comprise payment of principal and interest. Below is a summary of what principal and interest involves:

PrincipalInterest
Principal is the fair value on initial recognition and can change over time as the entity pays back the principal amountsIFRS 9 requires entities to consider basic lending arrangements. In a basic lending arrangement, interest compensates the lender for:

  • Time value of money ( compensation that money is paid back over time)
  • Credit risk (risk that counterparty might not pay)
  • Other risks, for example liquidity, and
  • Costs, for example administrative costs

THE TAILORED PAIR: FAIR VALUE THROUGH OTHER COMPREHENSIVE INCOME

Debt instruments that meet the SPPI criterion and are managed in a business model both to collect contractual cash flows and for sale (that is, a dual business model) are measured at fair value through other comprehensive income. When these debt instruments are derecognised, amounts accumulated in other comprehensive income are reclassified to profit or loss. To simplify the accounting, the standard requires that information about interest, credit risk and forex on these debt instruments be presented in profit or loss (the same as for amortised cost instruments). Other gains or losses will be presented in other comprehensive income.

For equity instruments that are not held for trading, entities can irrevocably elect an accounting policy, on an instrument-by-instrument basis, to measure them at fair value through other comprehensive income. Dividends on these equity instruments continue to be recognised in profit or loss. Amounts accumulated in other comprehensive income are not reclassified to profit or loss, even on derecognition.

THE LATEST FASHION TREND PAIR: FAIR VALUE THROUGH PROFIT OR LOSS

All equity instruments, apart from the ones discussed earlier, will automatically be measured at fair value through profit or loss. The exemption in IAS 39 to measure certain equity instruments at cost will no longer apply.

Entities should also think carefully about the fair value measurement. A simple net asset value calculation does not achieve the objectives of IFRS 13 Fair Value Measurement. In determining the fair value, an entity considers the price that would be received to sell the asset in the principal (or most advantageous) market considering current market conditions. Entities would therefore need improved valuation techniques to fairly represent the fair value.

Debt instruments that do not meet the business model and SPPI criteria will also be measured at fair value through profit or loss.

Similar to IAS 39, all derivatives are measured at fair value through profit or loss.

Finally, entities can also choose to designate any financial assets at fair value through profit or loss if the designation reduces an accounting mismatch, that is, where the pair of shoes don’t match.

A PAIR OF SHOES THAT MATCH

IFRS 9 prohibits the separation of embedded derivatives from the financial asset host contract. Instead, in determining the measurement category for the financial asset, an entity considers the financial asset in its entirety.

This change is a significant step to simplified accounting, but could result in unexpected outcomes. Embedded derivatives (such as early redemption options, conversion features and linked-interest rates) create leverage by increasing the variability of the contractual cash flows. This leverage may result in the financial asset not having economic characteristics of interest.

Certain features would reflect economic characteristics of interest. An example of this would be a pre-payment option that requires that the amortised value be settled on exercise of the option. Other features however would not reflect economic characteristics of interest. Consider for example a loan that is convertible into equity instruments of the borrower.

When the economic characteristics are not that of interest, the financial assets should be measured at fair value rather than amortised cost.

CHANGING YOUR MIND ABOUT WHICH PAIR TO WEAR

IFRS 9 requires entities to apply judgement in considering their business model. Once the business model is identified, it is not set in stone. Business is dynamic, business models can change over time. Reclassifications of financial assets between the different categories may only occur if the entity’s business model changes. Considering the impact that a change in the business model will have on all the other financial instruments of an entity, this decision should not be taken lightly.

FITTING OUT THE NEW SHOE CLOSET

With the effective date of IFRS 9 set for 1 January 2018, entities need to be fully aware of the impacts that IFRS 9 will have on their business to avoid any unintended consequences. These range from fair value measurements, volatility in profit or loss and system changes for larger business. To prevent sore feet down the line, it is worthwhile to start opening the closet and make some space. ❐

Author:

Mametse Kgatle CA(SA), Manager within the Department of Professional Practice at KPMG

Giel Pieterse CA(SA), Senior Manager within the Department of Professional Practice at KPMG

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