IFRS 9
IFRS 9, or International Financial Reporting Standard 9, is a comprehensive accounting standard issued by the International Accounting Standards Board (IASB) that addresses the accounting for financial instruments. It falls under the broader category of financial reporting standards, aiming to provide a more consistent and robust framework for how entities classify, measure, impair, and hedge financial assets and financial liabilities. IFRS 9 introduced significant changes, particularly regarding the recognition of expected credit losses (ECL), moving away from an incurred loss model.
History and Origin
The development of IFRS 9 was a direct response to criticisms of its predecessor, IAS 39 Financial Instruments: Recognition and Measurement, which was perceived as being "too little, too late" in recognizing credit losses during the 2008 global financial crisis. The IASB embarked on a project to replace IAS 39 in phases, aiming to improve and simplify accounting for financial instruments. The first phase, covering the classification and measurement of financial assets, was issued in November 2009. Subsequent phases addressed financial liabilities (October 2010) and hedge accounting (November 2013). The final version of IFRS 9, incorporating a new expected loss impairment model, was issued on July 24, 2014, with a mandatory effective date for annual periods beginning on or after January 1, 2018.25,24, This phased approach allowed the IASB to respond quickly to urgent issues highlighted by the financial crisis while developing a more complete standard.
Key Takeaways
- IFRS 9 replaced IAS 39, aiming to enhance financial reporting for financial instruments.
- It introduces a new, forward-looking expected credit loss (ECL) model for impairment.
- IFRS 9 streamlines the classification and measurement of financial assets based on business model and contractual cash flow characteristics.
- The standard includes a revised model for hedge accounting to better align with risk management activities.
- IFRS 9 impacts various sectors, with significant implications for banks and other financial institutions.
Formula and Calculation
While IFRS 9 itself does not present a single overarching formula, its core impairment model for expected credit losses (ECL) involves calculating a probability-weighted amount. The general concept for Expected Credit Losses (ECL) can be expressed as:
Where:
- ( PD ) = Probability of Default: The likelihood that a borrower will fail to meet its contractual obligations.23
- ( LGD ) = Loss Given Default: The proportion of the exposure that is expected to be lost if a default occurs.
- ( EAD ) = Exposure at Default: The total exposure to a financial instrument at the time of default.
This calculation is applied considering forward-looking information, including macroeconomic factors, rather than only historical data.22
Interpreting IFRS 9
IFRS 9 significantly changes how entities account for financial instruments, particularly regarding credit risk. Under IFRS 9, companies must recognize potential losses much earlier than under IAS 39. For financial assets, the standard categorizes them primarily into those measured at amortized cost, fair value through other comprehensive income (FVOCI), or fair value through profit or loss (FVTPL). The classification depends on two criteria: the entity’s business model for managing the assets and the contractual cash flow characteristics of the assets (specifically, whether cash flows are solely payments of principal and interest, or SPPI). If the cash flows are not SPPI, the asset is generally measured at FVTPL. T21his forward-looking approach for impairment aims to provide more timely and relevant information to users of financial statements about an entity's financial health and exposure to credit risk.
Hypothetical Example
Consider a bank that issues a loan to a small business. Under IAS 39, the bank would only recognize an impairment loss if there was objective evidence of a loss event, such as the business missing a payment or showing signs of significant financial difficulty.
With the implementation of IFRS 9, the bank must now assess the expected credit losses from the moment the loan is issued. Even if the small business has a good payment history, the bank would perform a forward-looking assessment considering factors like the economic outlook, industry trends, and the business's specific circumstances. If the assessment suggests a low, but non-zero, probability of default over the next 12 months, a provision for expected credit losses would be recognized immediately. If the business's credit risk significantly increases in the future but before an actual default occurs, the bank would be required to recognize lifetime expected credit losses, meaning the estimated losses over the entire remaining life of the loan. This contrasts sharply with the "incurred loss" model of IAS 39, which waited for an actual loss event. This proactive approach aims to provide more transparent and timely reporting of potential loan losses.
Practical Applications
IFRS 9 has widespread practical applications across various sectors, especially financial services. Banks are significantly affected by the new expected credit loss model, which requires them to make more accurate and forward-looking assessments of their loan portfolios and associated risks. This has led to substantial changes in their risk management and internal control practices.
20Beyond banking, corporations also face challenges, particularly in determining the appropriate measurement approach for their financial assets, which may now require ongoing fair value measurement. For trade receivables and contract assets, IFRS 9 allows a simplified approach, measuring lifetime expected credit losses, potentially simplifying the assessment for short-term assets.
19The standard influences how entities account for hedging activities, aiming for a better link between the economics of risk management and its accounting treatment. F18or example, under IFRS 9, hedge accounting rules are more aligned with an entity's actual risk management strategies, enabling broader participation for organizations that implement hedge accounting. T17he standard's implementation requires robust data collection and sophisticated models for forecasting economic conditions and borrower creditworthiness. Details on how IFRS 9 impacts financial institutions can be found in resources provided by organizations like EY.
16## Limitations and Criticisms
While IFRS 9 was introduced to address deficiencies in IAS 39, particularly the delayed recognition of credit losses, it has faced certain criticisms and presented implementation challenges. One significant impact observed, especially in the banking sector, is an increase in the volatility of loan-loss allowances and credit-loss charges, which can reduce reported net profits and potentially require higher levels of equity capital.,
15
14The shift to an expected credit loss model requires significant judgment in assessing future economic conditions and specific borrower circumstances, which can be complex and subject to variability. S13ome critics argue that while IFRS 9 improves the transparency of financial reporting by requiring earlier recognition of losses, it might not be superior in all respects compared to IAS 39 for all financial instruments. For instance, the accounting for financial instruments other than basic lending instruments might provide different information than under IAS 39, which may or may not be seen as an improvement by all users. A12dditionally, the standard's effectiveness has not yet been fully tested under severe economic downturns since its mandatory adoption, leading some analysts to suggest improvements in the granularity of information related to the different stages of credit risk.
11## IFRS 9 vs. IAS 39
IFRS 9 replaced IAS 39 as the accounting standard for financial instruments, driven by the need for more timely and accurate recognition of credit losses. The key differences are:
| Feature | IAS 39 | IFRS 9 |
|---|---|---|
| Impairment Model | Incurred Loss Model | Expected Credit Loss (ECL) Model (forward-looking) |
| Loss Recognition | "Too little, too late"; losses recognized only upon objective evidence of a loss event. | 10 Timely recognition of losses; provisions made for expected future losses. |
| Asset Classification | Rule-based, based on specific definitions for categories like "held-to-maturity" or "available-for-sale." | 9 Principle-based, based on the entity's business model and contractual cash flow characteristics (SPPI test)., 8 |
| Embedded Derivatives | Often required separate accounting (bifurcation). | 6 Generally not separated if the host contract is a financial asset within scope; the entire hybrid contract is assessed. |
| Hedge Accounting | More rigid, with a strict 80-125% effectiveness range. | More flexible, aligning better with risk management strategies. 4 |
The primary aim of IFRS 9 was to resolve the "too little, too late" problem of IAS 39 by accelerating the recognition of credit losses, thereby providing a more faithful representation of an entity's financial position. W3hile IAS 39 was often criticized for its complexity, IFRS 9 attempts to simplify aspects like classification while introducing new complexities in estimating expected credit losses.
2## FAQs
What is the main purpose of IFRS 9?
The main purpose of IFRS 9 is to establish principles for the financial reporting of financial instruments, replacing IAS 39. It aims to improve the relevance and faithful representation of information about financial instruments in an entity's financial statements, especially by introducing a forward-looking model for recognizing expected credit losses.
When did IFRS 9 become effective?
IFRS 9 became mandatorily effective for annual periods beginning on or after January 1, 2018. H1owever, early adoption was permitted.
How does IFRS 9 affect banks?
IFRS 9 significantly impacts banks by requiring them to forecast and recognize expected credit losses on their loans and other financial assets much earlier than under the previous standard. This necessitates more robust internal models and data to assess credit risk considering future economic conditions, potentially leading to higher loan loss provisions and impacts on regulatory capital.
Does IFRS 9 apply to all companies?
Yes, IFRS 9 applies to all entities that prepare financial statements under International Financial Reporting Standards (IFRS) and have financial instruments within its scope. This includes companies across all sectors, not just financial institutions, although the impact can vary depending on the nature and volume of an entity's financial instruments.