Many companies sell goods or services on credit to customers resulting in the recognition of trade receivables in their financial records. This type of financial asset is currently measured by most companies in terms of the International Accounting Standard 39 Financial Instruments: Recognition and Measurement (IAS 39). However, the International Accounting Standards Board (IASB) is in the process of replacing IAS 39 with International Financial Reporting Standard 9: Financial Instruments (IFRS 9). So what are the differences between the two standards when looking at trade receivables?
IFRS 9 PROJECT
The IASB intends ultimately to replace IAS 39 in its entirety. For this reason, IFRS 9 is currently being drafted in several phases. The IFRS 9 chapters dealing with the recognition and measurement of financial assets and liabilities as well as hedge accounting, have been issued. The final phase will deal with the impairment of financial assets (expected credit losses) and is expected to be completed during 2014. The effective date has been postponed numerous times and is now expected to be 1 January 2017.
CLASSIFICATION AND MEASUREMENT OF TRADE RECEIVABLES: IAS 39 vs IFRS 9
According to IAS 32 Financial Instruments: Recognition, trade receivables are classified as a financial asset, namely an asset that is a contractual right to receive cash or another financial asset from another entity. In terms of IAS 39, such financial assets are measured at amortised cost as they fall in the category ‘loans and receivables’.
IFRS 9 paragraph 4.1.1 states that a financial asset shall be measured at fair value unless it is measured at amortised cost in accordance with paragraph 4.1.2, which reads as follows:
… a financial asset shall be measured at amortised cost if both of the following conditions are met:
The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.
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.
Interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.
Most businesses’ purpose with trade receivables is to collect the cash flows associated therewith. These cash flows are usually only the repayment of the principal amount (amount of goods or services sold on credit) as well as interest levied on outstanding amounts (if payment is made after the normal credit period). Therefore most trade receivables will fall within the ‘at amortised cost’ category of IFRS 9. Consequentially, the classification and measurement of trade receivables is not expected to differ substantially between the two standards.
IMPAIRMENT OF TRADE RECEIVABLES
During July 2013, the IASB issued an exposure draft on Financial Instruments: Expected Credit Losses which addressed the impairment of financial assets (as a part of the IFRS 9 project). The IASB aims to develop a forward-looking model, which recognises expected credit losses on a more timely basis compared to the existing model in IAS 39 (an “incurred loss” model which delays the recognition of credit losses until there is evidence of a credit loss event). This would bring about a significant change in the subsequent measurement of trade receivables.
Currently, however, the principles in IAS 39 are still followed when evaluating financial assets held at amortised cost for impairment. For this reason, trade receivables (whether classified and measured in terms of IAS 39 or IFRS 9) would be subject to impairment using the IAS 39 rules. IAS 39 paragraph 58 states: “An entity shall assess at the end of each reporting period whether there is any objective evidence that a financial asset or group of financial assets measured at amortised cost is impaired. If any such evidence exists, the entity shall apply paragraph 63 to determine the amount of any impairment loss.” Paragraph 63 indicates that if there is objective evidence that an impairment loss has been incurred, the carrying amount of the financial asset shall be reduced either directly or through the use of an allowance account.
Most accountants are familiar with the naming convention ‘Provision for doubtful debt’ as the allowance account used to account for bad debt allowances on trade receivables. This account is used to reduce the carrying amount of trade receivables in the Statement of Financial Position, if there is doubt regarding its collectability. However, this naming convention might not be technically accurate, as it does not meet die definition of the provision in terms of IAS 37: Provisions, Contingent Liabilities and Contingent Assets. IAS 37 defines a provision as a liability of uncertain timing or amount. A liability is, in turn, a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of resources. With regard to the doubtful debts on trade receivables, a company has no present obligation to settle anything and there is no expected outflow of resources. Rather the entity is experiencing an impairment on its trade receivables.
IFRS 7 Financial Instruments: Disclosures deals with disclosures relating to financial instruments. Paragraph 16 of IFRS 7 is applied when an allowance (separate) account is used to account for an impairment of financial assets (due to credit losses). Credit losses are losses due to the effect of credit risk (the risk that the counterparty, who should pay an amount to you, fails to discharge its obligations). The credit loss stems from a so-called credit event (such as a payment default). The allowance account (in IFRS 7 paragraph 16) is referred to as an ‘allowance account for credit losses’ for which the entity shall disclose a reconciliation of the changes during the period, per class of financial assets. Scholars already make use of this name convention and therefore it is suggested that it should be used in practice as well. It will hopefully be applied in the near future, together with the new chapters in IFRS 9 on the measurement of the impairment of financial assets.
The new IFRS 9 developments are aimed at providing more useful information to the users of financial statements (also regarding an entity’s trade receivables). Taking into account the constant changes in economic conditions and the effect thereof on a company’s clients, it is suggested that accountants make themselves familiar with IFRS 9. For more information on IFRS 9, visit www.ifrs.org. ❐
Author: Danielle van Wyk CA(SA) and Gretha Steenkamp CA(SA) are lecturers in the School of Accounting at the University of Stellenbosch