International financial reporting standards ifrs 9

What Is International Financial Reporting Standard 9 (IFRS 9)?

International Financial Reporting Standard 9 (IFRS 9) is a global accounting standard that governs how entities classify, measure, and account for financial instruments. It falls under the broader category of Financial Accounting Standards and was issued by the International Accounting Standards Board (IASB) as part of a project to replace its predecessor, International Accounting Standard 39 (IAS 39). The primary goal of IFRS 9 is to improve the reporting of financial assets and financial liabilities by providing more timely and relevant information, especially concerning credit losses³³. This standard significantly impacts how banks and other financial institutions recognize and provision for potential credit losses.

History and Origin

The development of IFRS 9 was a direct response to criticisms leveled against IAS 39, particularly during the 2007-2008 global financial crisis. IAS 39's "incurred loss" model was widely criticized for delaying the recognition of credit losses until a loss event had actually occurred, which was seen as contributing to the procyclicality of financial reporting and potentially overstating the financial health of institutions³².

In response to calls for a quicker improvement in financial instrument accounting, the IASB divided its project to replace IAS 39 into phases³¹. The first phase, dealing with the classification and measurement of financial assets, was issued in November 2009. Requirements for the classification and measurement of financial liabilities followed in October 2010. A new hedge accounting chapter was added in November 2013, and the completed version of IFRS 9, including a new expected credit loss impairment model, was issued in July 2014³⁰. The mandatory effective date for IFRS 9 was for annual periods beginning on or after January 1, 2018²⁹.

Key Takeaways

• IFRS 9 changes how financial instruments are classified and measured, moving from a rules-based approach to a principles-based approach driven by an entity's business model and the contractual cash flow characteristics of the instrument²⁸.
• A core change introduced by IFRS 9 is the new "expected credit loss" (ECL) model for impairment, which requires entities to recognize provisions for anticipated losses earlier than under IAS 39²⁷.
• IFRS 9 categorizes financial assets into three main measurement categories: amortized cost, fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL)²⁶.
• The standard aims to enhance the relevance and comparability of financial statements by providing more forward-looking information on credit risk²⁵.
• While IFRS 9 brought significant improvements, its implementation has presented challenges related to data requirements, modeling complexity, and operational processes²⁴.

Formula and Calculation

IFRS 9 introduces an expected credit loss (ECL) model, which differs significantly from the incurred loss model of IAS 39. The ECL model requires entities to estimate and recognize credit losses based on forward-looking information. The calculation of expected credit losses typically involves three stages for a financial instrument:

• Stage 1: 12-Month ECL. For financial instruments where credit risk has not significantly increased since initial recognition, a loss allowance is recognized for expected credit losses (ECL) that are expected to result from default events possible within the next 12 months.
• Stage 2: Lifetime ECL (Non-Credit-Impaired). If the credit risk has significantly increased since initial recognition but the financial instrument is not yet credit-impaired, a loss allowance for full lifetime expected credit losses is recognized. This considers all possible default events over the instrument's expected life²³.
• Stage 3: Lifetime ECL (Credit-Impaired). For financial instruments that are credit-impaired, lifetime expected credit losses are also recognized, and interest revenue is calculated on the net carrying amount (gross carrying amount less loss allowance)²².

The basic conceptual formula for an expected credit loss can be expressed as:

Where:

• (PD) = Probability of Default, representing the likelihood of a borrower defaulting over a specific period.
• (LGD) = Loss Given Default, representing the proportion of the exposure that an entity expects to lose if a default occurs.
• (EAD) = Exposure At Default, representing the total exposure an entity expects to have at the time of default.

The application of this formula varies based on the stage of the financial instrument and requires sophisticated impairment models, often drawing on historical data, current conditions, and forward-looking economic forecasts.

Interpreting IFRS 9

Interpreting IFRS 9 involves understanding its core principles, particularly regarding the classification of financial assets and the recognition of expected credit losses. The standard's emphasis on the entity's business model for managing financial assets and the characteristics of their contractual cash flows is central to determining whether an asset is measured at amortized cost, FVOCI, or FVTPL²¹.

For financial assets, a key interpretation point is the "solely payments of principal and interest" (SPPI) test, which assesses whether the contractual cash flows of a financial instrument represent only principal and interest on the principal amount outstanding. Assets that pass this test and are held within a "hold to collect" business model are typically measured at amortized cost. Those held in a "hold to collect and sell" business model are measured at FVOCI. Any other financial assets, or those that fail the SPPI test (e.g., most derivatives), are measured at FVTPL²⁰. This framework requires judgment and careful assessment by financial institutions.

Hypothetical Example

Consider a hypothetical bank, "Diversified Lending Inc.," that issues a new business loan to "Growth Ventures Ltd." on January 1, 2025. The loan has a principal of $1,000,000 and a five-year term.

1. Initial Recognition (Stage 1): On January 1, 2025, Diversified Lending Inc. assesses the loan to Growth Ventures. As a newly originated loan with low credit risk, it is classified into Stage 1. Diversified Lending calculates the 12-month expected credit loss. Based on historical data for similar loans and current economic forecasts, the bank estimates a 0.5% probability of default within the next 12 months, a 40% loss given default, and an exposure at default equal to the principal.

   • 12-Month ECL = 0.005 (PD) * 0.40 (LGD) * $1,000,000 (EAD) = $2,000.
   • Diversified Lending Inc. recognizes a loss allowance of $2,000 in its financial statements.

2. Subsequent Reporting Period (Stage 2): By December 31, 2025, economic conditions have worsened, and Growth Ventures Ltd. reports a decline in revenue, though it continues to make timely payments. Diversified Lending reassesses the credit risk. While Growth Ventures is not yet in default, its credit risk has significantly increased since initial recognition. The loan moves to Stage 2.

   • Diversified Lending Inc. now calculates the lifetime expected credit loss. Using updated models and forecasts for the remaining four years of the loan, the estimated lifetime PD is 8%, and LGD remains 40%.
   • Lifetime ECL = 0.08 (PD) * 0.40 (LGD) * $1,000,000 (EAD) = $32,000.
   • The bank adjusts its loss allowance from $2,000 to $32,000, recognizing an additional $30,000 in its profit or loss statement.

This example illustrates how IFRS 9's forward-looking approach leads to earlier recognition of potential losses compared to an incurred loss model, which would typically wait for an actual default event.

Practical Applications

IFRS 9 profoundly impacts financial institutions, including banks, insurance companies, and investment firms, particularly in how they manage risk and prepare financial reports.

• Lending and Provisioning: Banks apply IFRS 9 to their loan portfolios, recognizing expected credit losses on loans and other financial instruments from the moment they are originated or acquired¹⁹. This leads to potentially higher and more volatile provisions than under previous standards¹⁸.
• Treasury Management: The classification and measurement requirements of IFRS 9 influence how financial assets held in treasury portfolios (e.g., government bonds, corporate bonds) are accounted for, affecting reported earnings volatility depending on whether they are measured at amortized cost, FVOCI, or FVTPL¹⁷.
• Hedge Accounting: IFRS 9's revised hedge accounting provisions aim to better align accounting with risk management strategies, allowing entities to apply hedge accounting more flexibly for various risks¹⁶. For example, entities can choose to apply the hedge accounting requirements of IFRS 9 or continue to apply those from IAS 39¹⁵.
• Capital Management: The increased loan loss provisions under IFRS 9 can directly impact a bank's capital ratios by reducing retained earnings¹⁴. This necessitates careful capital planning and scenario analysis.
• Regulatory Compliance: Regulators in jurisdictions adopting IFRS closely monitor the implementation of IFRS 9 to ensure proper application and to assess its impact on the stability and transparency of financial reporting¹³. The standard requires significant data collection and robust IT infrastructure to support the complex calculations¹².

Limitations and Criticisms

Despite its aims to improve financial reporting, IFRS 9 has faced several limitations and criticisms:

• Complexity: The standard is considered highly complex, particularly the expected credit loss model, which requires sophisticated models, significant estimations, and considerable judgment¹¹. This complexity can be challenging for non-financial firms and even smaller financial institutions to implement effectively¹⁰.
• Data and IT Infrastructure: Implementing IFRS 9 requires extensive data and robust IT infrastructure to support the detailed calculations for expected credit losses across large portfolios of financial instruments⁹. Many institutions have had to invest heavily in upgrading their systems and processes to comply⁸.
• Procyclicality: While IFRS 9 aimed to reduce procyclicality compared to IAS 39, concerns remain that the forward-looking nature of ECL provisioning could still exacerbate economic downturns. During a recession, expected losses would increase, leading to higher provisions and a reduction in capital, potentially pressuring banks to curtail lending⁷. Some research indicates that while IFRS 9 is less procyclical than IAS 39, it remains more procyclical than US GAAP's CECL⁶.
• Comparability: Despite the goal of enhanced comparability, there have been observed inconsistencies in how firms, particularly non-financial firms, reclassify equity instruments and estimate impairment under the new model, potentially hindering direct comparisons between entities⁵. Additionally, the comparability of financial statements can be reduced due to the significant judgment required in applying the standard⁴.

International Financial Reporting Standard 9 (IFRS 9) vs. International Accounting Standard 39 (IAS 39)

IFRS 9 replaced IAS 39 as the accounting standard for financial instruments, marking a significant shift in financial reporting. The key differences lie in classification, measurement, and especially impairment.

The main confusion often arises from the shift from a retrospective "incurred loss" approach to a prospective "expected loss" approach, which fundamentally changes how provisions are made for potential defaults.

FAQs

What is the main purpose of IFRS 9?

The main purpose of IFRS 9 is to improve the financial reporting of financial instruments by providing more timely and useful information, particularly by moving from an incurred loss model to a forward-looking expected credit loss model for impairment recognition.

When did IFRS 9 become effective?

IFRS 9 became mandatory for annual periods beginning on or after January 1, 2018, although early adoption was permitted³.

How does IFRS 9 affect banks?

IFRS 9 significantly impacts banks by requiring them to provision for expected credit losses on loans and other financial assets much earlier than under previous standards. This affects their profitability, capital ratios, and risk management processes.

What are the three stages of impairment under IFRS 9?

The three stages of impairment under IFRS 9 are:

1. Stage 1: 12-month expected credit losses for financial instruments with no significant increase in credit risk since initial recognition.
2. Stage 2: Lifetime expected credit losses for financial instruments with a significant increase in credit risk since initial recognition but not yet credit-impaired.
3. Stage 3: Lifetime expected credit losses for credit-impaired financial instruments, where interest revenue is also recognized on the net carrying amount.

Can entities still use IAS 39 for anything?

While IFRS 9 superseded most of IAS 39, entities have the option to continue applying the hedge accounting requirements of IAS 39 instead of the IFRS 9 hedge accounting model². Additionally, for issues not explicitly covered by IFRS 9, IAS 39 requirements may still apply¹.