International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

by International GAAP 2019 (pdf)

  comprehensive income, without recycling); or

  • financial liabilities either at fair value through profit or loss or at amortised cost.

  Following the initial recognition of financial assets and financial liabilities, their subsequent

  accounting treatment depends principally on the classification of the instrument, although

  there are a small number of exceptions. These requirements are summarised in Figure 46.1

  below and are considered in more detail in the remainder of this section.

  Figure 46.1 Classification and subsequent measurement of financial assets and

  financial liabilities

  Classification

  Instrument type Statement of Fair value gains

  Interest and

  Impairment Foreign

  financial

  and losses

  dividends

  exchange

  position

  Financial assets and

  Debt Amortised – Profit

  or

  loss:

  Profit or loss

  Profit or loss

  liabilities at

  cost

  using an

  (financial

  amortised cost

  effective

  assets)

  interest rate

  Debt financial assets

  Debt Fair

  value Other Profit or loss:

  Profit or loss

  Profit or loss

  at fair value through

  comprehensive

  using an

  other comprehensive

  income and

  effective

  income

  recycled to

  interest rate

  profit or loss

  when

  derecognised

  Fair value through

  Debt, equity

  Fair value Profit or loss (see

  Profit or loss

  – Profit

  or

  loss

  profit or loss

  or derivative

  Chapter 50

  (see Chapter 50

  (including

  at 7.1.1 on

  at 7.1.1 on

  derivatives not

  presentation

  presentation

  designated in

  requirements)

  requirements)

  effective hedges)

  and other

  comprehensive

  income for

  changes in own

  credit risk

  (see 2.4.1 below)

  Equity investments at

  Equity Fair

  value Other Profit or loss:

  – Other

  fair value through

  comprehensive

  dividends

  comprehensive

  other comprehensive

  income

  receivable

  income

  income

  (no recycling

  (no recycling

  to profit or

  to profit or

  loss when

  loss when

  derecognised)

  derecognised)

  Financial instruments: Subsequent measurement 3687

  In addition, IFRS 9 sets out the accounting treatment for certain financial guarantee

  contracts (see Chapter 41 at 3.4) and commitments to provide a loan at a below market

  interest rate (see Chapter 41 at 3.5).

  2.1

  Debt financial assets measured at amortised cost

  Financial assets that are measured at amortised cost require the use of the effective

  interest method and are subject to the IFRS 9 impairment rules. [IFRS 9.5.2.1, 5.2.2]. Gains

  and losses are recognised in profit or loss when the instrument is derecognised or

  impaired, as well as through the amortisation process. [IFRS 9.5.7.2]. The effective interest

  method of accounting is dealt with at 3 below, foreign currency retranslation is

  discussed at 4 below, modification of financial assets is covered at 3.8 below and

  impairment is addressed in Chapter 47.

  2.2

  Financial liabilities measured at amortised cost

  Liabilities that are measured at amortised cost require the use of the effective interest

  method with gains or losses recognised in profit or loss when the instrument is

  derecognised as well as through the amortisation process. [IFRS 9.5.3.1, 5.7.2]. The

  effective interest method of accounting is dealt with at 3 below, foreign currency

  retranslation is discussed at 4 below and modification of financial liabilities is covered

  at 3.8 below.

  2.3

  Debt financial assets measured at fair value through other

  comprehensive income

  For financial assets that are debt instruments measured at fair value through other

  comprehensive income (see Chapter 44 at 2.1), the IASB decided that both amortised

  cost and fair value information are relevant because debt instruments held by entities in

  this measurement category are held for both the collection of contractual cash flows

  and the realisation of fair values. [IFRS 9.4.1.2A, BC4.150].

  After initial recognition, investments in debt instruments that are classified as measured

  at fair value through other comprehensive income are measured at fair value in the

  statement of financial position (with no deduction for sale or disposal costs) and

  amortised cost information is presented in profit or loss. [IFRS 9.5.7.10, 5.7.11].

  Subsequent measurement of debt instruments at fair value through other

  comprehensive income involves the following: [IFRS 9.5.7.1(d), 5.7.10, B5.7.1A]

  • impairment gains and losses (see Chapter 47) are derived using the same

  methodology that is applied to financial assets measured at amortised cost and are

  recognised in profit or loss; [IFRS 9.5.2.2, 5.5.2]

  • foreign exchange gains and losses (see 4 below) are calculated based on the

  amortised cost of the debt instruments and are recognised in profit or loss;

  [IFRS 9.B5.7.2, B5.7.2A]

  • interest revenue is calculated using the effective interest method (see 3 below) and

  is recognised in profit or loss; [IFRS 9.5.4.1]

  • other fair value gains and losses are recognised in other comprehensive income;

  [IFRS 9.5.7.10, B5.7.1A]

  3688 Chapter 46

  • when debt instruments are modified (see 3.8 below and Chapter 47 at 8), the

  modification gains or losses are recognised in profit or loss;1 [IFRS 9.5.7.10, 5.7.11, 5.4.3] and

  • when the debt instruments are derecognised, the cumulative gains or losses

  previously recognised in other comprehensive income are reclassified (i.e. recycled)

  from equity to profit or loss as a reclassification adjustment. [IFRS 9.5.7.10, B5.7.1A].

  It follows that the amount recognised in other comprehensive income is the difference

  between the total change in fair value and the amounts recognised in profit or loss

  (excluding any amounts received in cash, e.g. the coupon on a bond).

  2.4

  Financial assets and financial liabilities measured at fair value

  through profit or loss

  After initial recognition, financial assets and financial liabilities that are classified as

  measured at fair value through profit or loss (including derivatives that are not

  designated in effective hedging relationships) are measured at fair value, with no

  deduction for sale or disposal costs (see Chapter

  44 at

  2, 4, 5.4 and

  7).

  [IFRS 9.5.2.1, 5.3.1, 5.7.1].

/>   The standard helpfully points out that if the fair value of a financial asset falls below

  zero it becomes a financial liability (assuming it is measured at fair value). [IFRS 9.B5.2.1].

  The standard does not explain what happens if the fair value of a financial liability

  becomes positive, but it is safe to assume that it becomes a financial asset and not a

  negative liability.

  Gains and losses arising from remeasuring a financial asset or financial liability at fair

  value should normally be recognised in profit or loss. [IFRS 9.5.7.1]. However, there is an

  exception for most non-derivative financial liabilities that are designated as measured

  at fair value through profit or loss. For these liabilities the element of the gain or loss

  attributable to changes in credit risk (see 2.4.1 below) should normally be recognised in

  other comprehensive income (with the remainder recognised in profit or loss).

  [IFRS 9.5.7.7, B5.7.8]. These amounts presented in other comprehensive income should not

  be subsequently transferred to profit or loss. However, the cumulative gain or loss may

  be transferred within equity. [IFRS 9.B5.7.9].

  This exception does not apply to loan commitments or financial guarantee contracts,

  nor does it apply if it would create or enlarge an accounting mismatch in profit or loss

  (see 2.4.2 below). [IFRS 9.5.7.8, 5.7.9]. In these cases, all changes in the fair value of the

  liability (including the effects of changes in the credit risk) should be recognised in profit

  or loss. [IFRS 9.B5.7.8].

  2.4.1

  Liabilities at fair value through profit or loss: calculating the gain or

  loss attributable to changes in credit risk

  IFRS 7 – Financial Instruments: Disclosures – defines credit risk as ‘the risk that one

  party to a financial instrument will cause a financial loss for the other party by failing to

  discharge an obligation’, which is also part of non-performance risk as defined in

  IFRS 13 (see Chapter 14 at 11.3). [IFRS 7 Appendix A]. The change in fair value of a financial

  liability that is attributable to credit risk relates to the risk that the issuer will fail to pay

  Financial instruments: Subsequent measurement 3689

  that particular liability. It may not solely relate to the creditworthiness of the issuer but

  may be influenced by other factors, such as collateral.

  For example, if an entity issues a collateralised liability and a non-collateralised liability

  that are otherwise identical, the credit risk of those two liabilities will be different, even

  though they are issued by the same entity. The credit risk on the collateralised liability

  will be less than the credit risk of the non-collateralised liability. In fact, the credit risk

  for a collateralised liability may be close to zero. [IFRS 9.B5.7.13]. It is important to

  distinguish between the terms ‘credit risk’ and ‘the risk of default’ as referred to in the

  impairment requirements of the standard (see Chapter 47 at 6.1), since the latter does

  not include the benefit of collateral.

  For these purposes, credit risk is different from asset-specific performance risk. Asset-

  specific performance risk is not related to the risk that an entity will fail to discharge a

  particular obligation but rather it is related to the risk that a single asset or a group of

  assets will perform poorly (or not at all). [IFRS 9.B5.7.14]. For example, consider:

  [IFRS 9.B5.7.15]

  (a) a liability with a unit-linking feature whereby the amount due to investors is

  contractually determined on the basis of the performance of specified assets. The

  effect of that unit-linking feature on the fair value of the liability is asset-specific

  performance risk, not credit risk;

  (b) a liability issued by a structured entity with the following characteristics:

  • the structured entity is legally isolated so the assets in the structured

  entity are ring-fenced solely for the benefit of its investors, even in the

  event of bankruptcy;

  • the structured entity enters into no other transactions and the assets in the

  SPE cannot be hypothecated; and

  • amounts are due to the structured entity’s investors only if the ring-fenced

  assets generate cash flows.

  Thus, changes in the fair value of the liability primarily reflect changes in the fair

  value of the assets. The effect of the performance of the assets on the fair value of

  the liability is asset-specific performance risk, not credit risk.

  Unless an alternative method more faithfully represents the change in fair value of a

  financial liability that is attributable to credit risk, the standard states that this amount

  should be determined as the amount of change in the fair value of the liability that is

  not attributable to changes in market conditions that give rise to what it defines as

  ‘market risk’. [IFRS 9.B5.7.16]. Changes in market conditions that give rise to market risk

  include changes in a benchmark interest rate, the price of another entity’s financial

  instrument, a commodity price, foreign exchange rate or index of prices or rates.

  [IFRS 9.B5.7.17].

  The standard says that if the only significant relevant changes in market conditions for

  a financial liability are changes in ‘an observed (benchmark) interest rate’, the amount

  to be recognised in other comprehensive income can be estimated as follows:

  [IFRS 9.B5.7.18]

  3690 Chapter 46

  (a) first, the liability’s internal rate of return at the start of the period is computed using

  the fair value and contractual cash flows at that time and the observed (benchmark)

  interest rate at the start of the period is deducted from this, to arrive at an

  instrument-specific component of the internal rate of return;

  (b) next, the present value of the cash flows associated with the liability is calculated

  using the liability’s contractual cash flows at the end of the period and a discount

  rate equal to the sum of the observed (benchmark) interest rate at the end of the

  period and the instrument-specific component of the internal rate of return at the

  start of the period as determined in (a); and

  (c) the difference between the fair value of the liability at the end of the period and

  the amount determined in (b) is the change in fair value that is not attributable to

  changes in the observed (benchmark) interest rate and this is the amount to be

  presented in other comprehensive income.

  It should be noted that ‘market risk’ is defined to include movements in ‘a benchmark

  rate’. The latter term is not itself defined but typically it would encompass both ‘risk

  free’ rates, such as AAA rated government bond rates or overnight rates, and rates such

  as 3 month LIBOR or EURIBOR, which include an element of credit risk. It would

  therefore appear that the standard is ambivalent as to whether the amount of change in

  fair value that is attributable to changes in credit risk of a liability is measured by

  reference to risk free rates, or by comparison to the credit risk already present in LIBOR.

  Using the former, the amount will reflect any changes in credit risk of the liability,

  whereas using the latter it will only reflect changes in credit risk specific to the liability.

  Further, the change in credit risk will differ depending on whether the selected
r />   benchmark is 3 month LIBOR, 6 month LIBOR or 12 month LIBOR. It should also be

  noted that regulators are encouraging benchmark rates such as LIBOR to be

  discontinued over the next three years, in favour of risk free benchmarks based on

  overnight rates. It would follow that the change in the amount attributable to credit risk

  will in future reflect all changes in credit risk.

  This method is illustrated in the following example, adapted from that provided in the

  Illustrative Examples attached to the standard. [IFRS 9.IE1-IE5].

  Example 46.1: Estimating the change in fair value of an instrument attributable

  to its credit risk

  On 1 January 2019, Company J issues a 10-year bond with a par value of €150,000 and an annual fixed

  coupon rate of 8%, which is consistent with market rates for bonds with similar characteristics. J uses 3 month

  Euro LIBOR as its observable (benchmark) interest rate. At the date of inception of the bond, 3 month Euro

  LIBOR is 5%. At the end of the first year:

  • 3 month Euro LIBOR has decreased to 4.75%; and

  • the fair value of the bond is €153,811 which is consistent with an interest rate of 7.6% (i.e. the remaining

  cash flows on the bond, €12,000 per year for nine years and €150,000 at the end of nine years, discounted

  at 7.6% equals €153,811).

  For simplicity, this example assumes a flat yield curve, that all changes in interest rates result from a parallel

  shift in the yield curve, and that the changes in 3 month Euro LIBOR are assumed to be the only relevant

  changes in market conditions.

  The amount of change in the fair value of the bond that is not attributable to changes in market conditions

  that give rise to market risk is estimated as follows:

  Financial instruments: Subsequent measurement 3691

  Step (a)

  The bond’s internal rate of return at the start of the period is 8%. Because the observed (benchmark) interest rate

  (3 month Euro LIBOR) is 5%, the instrument-specific component of the internal rate of return is deemed to be 3%.

  Step (b)

  The contractual cash flows of the instrument at the end of the period are:

  • interest: €12,000 [€150,000 × 8%] per year for each of years 2020 (year 2) to 2028 (year 10).

  • principal: €150,000 in 2028 (year 10).

  The discount rate to be used to calculate the present value of the bond is thus 7.75%, which is the 4.75% end

  of period 3 month LIBOR rate, plus the 3% instrument-specific component calculated as at the start of the