Overview of the IFRS 9

IFRS 9 generally is effective for years beginning on or after January 1, 2018, with earlier adoption permitted. However, in late 2016 the IASB agreed to provide entities whose predominate activities are insurance related the option of delaying implementation until 2021.

Why we need IFRS 9 when there is

already IAS 39 Financial Instruments – Recognition and Measurement

IAS 39 is too complex, inconsistent with the way entities manage their businesses and risks and defers the recognition of credit losses on loans and receivables until too late in the credit cycle. IFRS 9 dealing separately with the classification and measurement of financial assets, impairment and hedging.

Let us first understand what Financial Instrument is

Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world's investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity.

Some of the most common examples of financial instruments include the following:

1. Exchanges of money for future interest payments and repayment of principal.

• Loans and Bonds. A lender gives money to a borrower in exchange for regular payments of interest and principal.
• Asset-Backed Securities. Lenders pool their loans together and sell them to investors. The lenders receive an immediate lump-sum payment and the investors receive the payments of interest and principal from the underlying loan pool.

2. Exchanges of money for possible capital gains or interest.

• Stocks. A company sells ownership interests in the form of stock to buyers of the stock.
• Funds. Includes mutual funds, exchange-traded funds, real estate investment trusts, hedge funds, and many other funds. The fund buys other securities earning interest and capital gains which increases the share price of the fund. Investors of the fund may also receive interest payments.

There are two types of Financial instruments

1. Cash Instruments

• The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
• Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.

2. Derivative Instruments

• The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
• These can be over-the-counter (OTC) derivatives or exchange-traded derivatives.

Hope we all understood what financial instruments is, now let’s move ahead and understand what is type of asset classes of financial instruments;

Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.

1. Debt-Based Financial Instruments

• Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs).
• Exchange-traded derivatives under short-term, debt-based financial instruments can be short- term interest rate futures. OTC derivatives are forward rate agreements.
• Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives.

2. Equity-Based Financial Instruments

• Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.

Special Considerations

There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards, and foreign exchange swaps.

So, let’s start when to recognise or derecognise a financial instrument

1. Recognition of Financial instrument

Financial asset or a financial liability is recognised in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument

2. Derecognition of Financial instrument

First, let’s understand how to derecognise financial assets:

While it’s very easy to recognize a financial asset, it’s very difficult and complicated to derecognize it in some cases. IFRS 9 is very “sticky” and the reason is to prevent companies from hiding toxic assets out of their balance sheets.

Before you decide whether to derecognize or not, you need to determine WHAT you’re dealing with:

• A financial asset (or a group of similar financial assets) in its entirety, or

• A part of a financial asset (or a part of a group of similar financial assets) meeting specified conditions.

After you determine WHAT you derecognize, then you need derecognize the asset when:

• The contractual rights to the cash flows from the financial asset expire – that’s an easy and clear option; or

• An entity transfers the financial asset and the transfer qualifies for the derecognition – that’s more complicated.

Transfers of financial assets are discussed in more details and to sum it up, you need to go through the following steps:

1. Decide whether the asset (or its part) was transferred or not,

2. Determine whether also risks and rewards from the financial asset were transferred.

3. If you have neither retained nor transferred substantially all of the risks and rewards of the asset, then you need to assess whether you have retained control of the asset or not.

The next is derecognition of a financial liability

• An entity shall derecognize a financial liability when it is extinguished.
• It happens when the obligation specified in the contract is discharged, cancelled or expires

After recognition of financial asset or liability know now we understand how should we classify the financial assets?

1. Business model test

What is the objective of holding financial assets? Collecting the contractual cash flows? Selling?

2. Contractual cash flows’ characteristics test

Are the cash flows from the financial assets on the specified dates solely payments of principal and interest on the principal outstanding? Or, is there something else?

Based on these two tests, the financial assets can be classified in the following categories:

1. At amortized cost

A financial asset falls into this category if BOTH of the following conditions are met:

• Business model test is met, i.e. you hold the financial assets only to collect contractual cash flows (not to sell them), and
• Contractual cash flows’ characteristics test is met, i.e. the cash flows from the asset are only the payments of principal and interest.

Examples: debt securities, receivables, loans.

2. At fair value through other comprehensive income (FVOCI) Here, there are 2 subcategories:

• If a financial asset meets contractual cash flows characteristics test (i.e. debt assets only) and the business model is to collect contractual cash flows AND SELL financial assets, then such an asset mandatorily falls into this category (unless FVTPL option is chosen; see below)
• You can voluntarily choose to measure some equity instruments at FVOCI. This is an irrevocable election at initial recognition.