Anticipated challenges in implementing the completed IFRS 9

SUITS THE C-SUITE By Francisco Roque A. Lumbres and Jeramael P. Villaber

Business World (09/22/2014 – p.S1/5)

(First of two parts)

A FEW weeks ago, the International Accounting Standards Board (IASB) issued the complete version of International Financial Reporting Standard (IFRS) 9 Financial Instruments. IFRS 9 is the culmination of the IASB’s project to replace International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement.

IAS 39 was widely criticized as complex and difficult to apply. Looking back, the 2008 global financial crisis highlighted in particular the weakness of the impairment model in IAS 39 (the “incurred loss” approach), which recognizes credit losses on financial instruments only when there is a “loss event trigger.” During the crisis, banks’ loan loss provisioning following the “incurred loss” model was seen to be “too little, too late.”

IFRS 9 was issued to address these concerns and also to provide a better accounting standard for financial instruments. It is a principles-based accounting standard for financial instruments, and introduces a new approach to the classification and measurement of financial assets, a forward-looking impairment model (“expected loss” approach) and improved hedge accounting guidelines, which better link risk management activities with accounting treatment.

The new issuance promises improvements, although challenges in implementation are also expected.


IFRS 9 provides three measurement categories for financial assets: amortized cost; fair value through other comprehensive income (FVOCI); and fair value through profit or loss (FVPL).

The classification and measurement of financial assets is now based on two criteria, namely:

a) The contractual cash flow characteristics of the financial asset; and,
b) The entity’s business model for managing the financial assets.

The focus of the first criterion is to assess whether the nature of the contractual cash flows from the financial asset solely represents principal and interest, while the second evaluates how the entity plans to realize those cash flows.

The characteristics of the contractual cash flow criterion generally permits only debt financial assets (depending on the business model) with contractual cash flows that are solely payments of principal and interest to qualify under amortized cost or FVOCI. If it fails this test, the debt financial asset would be classified and measured under FVPL.

The business model assessment determines whether debt financial assets held in a portfolio must be measured at amortized cost, FVOCI or FVPL. The business model refers to how an entity manages its financial assets in order to generate cash flows.

Debt financial assets held in a business model whose objective is to hold the assets in order to collect contractual cash flows can be classified and measured at amortized cost.

On the other hand, debt financial assets classified and measured at FVOCI are held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. Examples of this type of business model are a portfolio of financial assets to manage liquidity, to maintain a particular interest yield profile or to match the duration of financial assets and liabilities. Accordingly, fair value changes for debt financial assets at FVOCI are recognized in other comprehensive income (OCI). Interest income, foreign exchange revaluation and expected credit losses (ECL) are recognized in profit or loss in a treatment similar to that for amortized cost assets. Upon de-recognition or sale, the net cumulative fair value gains or losses recognized in OCI are recycled to profit or loss.

At the entity’s option, a debt financial asset that already qualifies for either amortized cost or FVOCI accounting could still be accounted for at FVPL to address an accounting mismatch (for example, if the financial asset is hedged by a derivative that is measured at FVPL). This fair value option, however, has to be applied at initial recognition.

Meanwhile, equity financial assets are measured at FVPL unless the entity chooses, on initial recognition, to present fair value changes in OCI. This option is irrevocable and applies only to equity instruments that are not held for trading. Unlike debt instruments, gains and losses in OCI are not recycled to profit or loss upon sale. Equity financial assets at FVOCI are also not subject to impairment testing.

Derivatives continue to be measured at FVPL. Embedded derivatives are no longer separated from the host financial assets; however, bifurcation rules for derivatives embedded in financial liabilities and non-financial hosts still apply. Instead, the entire hybrid instrument’s characteristic of contractual cash flow is assessed as a whole in determining the classification and measurement category — whether at amortized cost, FVOCI or FVPL.

IFRS 9 retains practically all the classification and measurement principles for financial liabilities from IAS 39. The only amendment is on the gain or loss on a financial liability designated at FVPL using the fair value option (FVO) that is attributable to changes in the entity’s “own credit risk,” which is now presented in OCI. Any other changes in fair value, other than “own credit risk,” is presented in profit or loss.


IFRS 9 replaces the “incurred loss” model in IAS 39 with a forward-looking “expected loss” model. Therefore, a “loss event trigger” is no longer required to occur before credit losses are recognized. The standard aims to improve financial information about an entity’s ECL on financial instruments and address the “too little, too late” concern especially for banks’ loan loss provisioning. It is expected that this new guideline will “speed up” the recognition of credit losses.

This new impairment model applies to debt financial assets at amortized cost or at FVOCI, including certain loan commitments and financial guarantees that are not measured at FVPL.

In general, entities must recognize ECL in three stages:

• Stage 1 (requires 12-month ECL) — Upon initial recognition and as long as the credit risk of a financial asset has not increased significantly since initial recognition (i.e., good exposures), the entity is required to provide for credit losses equivalent to 12-month ECL. Interest income is recognized by applying the effective interest rate (EIR) on the gross carrying amount of the financial asset.

• Stage 2 (requires lifetime ECL) — If the credit risk has increased significantly since initial recognition, an allowance will be provided equivalent to lifetime ECL. Interest income recognition is the same as in Stage 1.

• Stage 3 (requires lifetime ECL) — If the financial asset shows objective evidence of impairment following similar criteria as in IAS 39, an allowance will be provided equal to lifetime ECL. Additionally, interest revenue would be calculated applying the EIR to the amortized cost net of loss allowance.

When credit risk has increased significantly from Stage 1 to Stages 2 and 3 above, the amount of impairment recognized (i.e., lifetime ECL) will correspondingly increase.

In next week’s column, we will discuss some simplifications to this forward-looking impairment model for certain financial assets, along with hedge accounting, effective date and early application, and well as next steps for businesses.

Francisco Roque A. Lumbres, CFA, PRM is a Partner, and Jeramael P. Villaber is an Associate Director, of SGV & Co.