Post-Implementation Review of IFRS 9 Financial Instruments (Phase 1) begins

The international Accounting Standards Board (IASB) has published a Request for Information for the post-implementation review of IFRS 9 Financial Instruments on classification and measurement. This relates to the first phase of the PIR on IFRS 9, which focuses on the classification and measurement section of the standard. The PIR phases relating to impairment and hedge accounting requirements will be carried out at a later date.

Background

IFRS 9 on financial instruments came into force in 2018, after a development process in three successive phases, the first being classification and measurement and the second and third addressing the provisioning of assets and hedge accounting respectively.

In accordance with the governance process, the IASB is required to conduct a Post-Implementation Review (PIR) after a standard has been implemented for at least two years, hence the issuance of this Request For Information (RFI).

This process allows the IASB to assess the impact of the implementation of a recently issued standard on the various stakeholders, such as preparers, users, auditors, regulators,  and to determine whether:

• the objectives of the standard‑setting project have been met;
• information provided by the standard is useful to users of financial statements;
• the costs associated with applying the standard are as expected by the various stakeholders; and
• the standard can be applied consistently by entities.

This process is also an opportunity to draw lessons that could result in future amendments to IFRS 9.

The IFRS 9 RFI represents a first step. Subsequent steps will consist of:

• an analysis of the feedback (leading to the publication of a summary of findings in a ‘Report and Feedback Statement); and
• proposals, where applicable, for amendments to the standard, or for educational materials to be issued to make the standard easier to apply.

Abbreviations used in this review

In this review, we use the following abbreviations:

• SPPI: Solely Payments of Principal and Interest. This is the criterion that characterises a basic lending instrument whose contractual flows correspond solely to payments of principal and interest.
• HTC: Held to Collect and HTCS: Held to Collect and Sell, representing the two main business models described by the standard for debt assets, corresponding respectively to a strategy of holding the assets on over the life of the instrument for the purpose of collecting contractual flows, and a combined strategy of holding and selling these assets.
• CLI: Contractually Linked Instruments. This is a category of financial assets defined by the standard (IFRS 9.B4.1.20). These are instruments usually issued by a special purpose vehicle and backed by financial assets held by the vehicle. The operation of the vehicle is based on the principle of allocating payments to the various liability tranches in an order of priority according to their respective subordination rankings.

IFRS 9 approach to the measurement of financial assets

As a reminder, IFRS 9 articulates its measurement model for financial assets on two building blocks:

• the contractual cash flows of the financial instrument, leading to its classification as an equity instrument, SPPI debt instrument or non-SPPI debt instrument; and
• the business model: HTC, HTCS, or “other”.

This results in four categories: amortised cost, fair value through equity with recycling to P&L (FV-OCI), fair value through profit or loss (FV-PL) and fair value through equity without recycling to P&L (FV-OCI/NR), as summarised in the following decision tree diagram:

https://blogs.mazars.com/mindthegaap/files/2021/11/Financial-asset-measurement_Decision-tree-diagram.pdf

What questions does the RFI ask?

After consultation with stakeholders, the RFI identifies seven topics for analysis by respondents (questions 2-8):

1. The business model for managing financial assets.
2. The contractual cash flow characteristics of debt instruments (SPPI test).
3. The accounting treatment of equity instruments.
4. Accounting for own credit risk on financial liabilities designated at fair value by option.
5. Accounting for modifications to contractual cash flows of debt instruments.
6. Practical implementation of the effective interest method.
7. Transitional reliefs available when first applying the standard.

Other questions relate to the relevance of the overall approach to the classification of financial assets (question 1) and whether there are other matters of interest deserving comment that have not been identified by the RFI (question 9).

Without attempting to be exhaustive, here we consider each of these seven topics in more detail, together with the main issues raised by the Board.

1. The business model for managing financial assets

Background: The standard identifies three potential business models for management of cash flows: HTC, HTCS and “other”, which is the default category covering trading activities. The identification of each of these models is based on an objective assessment of the activity, carried out at a sufficiently high level of aggregation and not dependent on any management intention. The objective criteria for determining the business model includes how the entity’s risks and performance are evaluated and reported to management (e.g. on a fair value basis), and how managers of the business are compensated. Consequently, changes in the business model are rare, and can only be justified by the occurrence of a significant event, such as the sale or acquisition of a business.

Issue raised: The Board would like to understand in which situations and how frequently the business model has changed, and more generally if the requirements for changing a business model have been correctly calibrated in terms of how they affect the relevance of financial reporting and its comparability over time.

2. The contractual cash flow characteristics of debt instruments

Background: If a debt instrument has SPPI cash flows, how it is classified between the different accounting categories will depend on the business model under which it is held. The debt instruments eligible as SPPI under the standard are “basic” instruments, i.e. those whose cash flows essentially remunerate the issuer’s credit risk and the time value of money, to which may be added liquidity risk, compensation for administrative management costs, or a pure margin component.

Issue raised: The Board would like to understand the fact patterns encountered and the analysis applied to two areas, as well as any complexities in terms of practical application, in order to determine whether it is necessary to supplement or amend the standard. These two areas are:

• Green finance instruments, or economically responsible finance (in conjunction with environmental, social and governance targets (ESG)). The Board distinguishes three categories of green finance:
• loans or bonds which finance ESG projects, but which do not give rise to variability in the contractual cash flows which may be linked to these factors;
• structured instruments whose performance is linked to an ESG index that is not specific to a party to the contract; and
• financial instruments whose contractual cash flows may vary reflecting performance criteria linked to ESG targets specific to the borrower. For this category, the Board hopes to obtain more information on the various types of clauses encountered and on the SPPI analysis conducted by stakeholders, particularly in terms of their correlation with credit risk, profit margin or the remuneration of another risk specific to the borrower.
• CLI: the standard allows a contractually linked instrument with a basic cash flow profile to qualify as SPPI if the underlying assets are themselves SPPI or similar and the credit risk associated with the instrument is equivalent to or better than the average credit risk of the underlying portfolio.

3. The accounting treatment of equity instruments

Background: The standard requires equity instruments to be measured at fair value and, by default, remeasured through profit or loss (JV-PL), but entities may make an irrevocable election, on an individual basis and at initial recognition, to present in OCI changes in the value of an equity instrument not held for trading (JV-OCI/NR).

Issue raised: The Board would like to identify the type of instruments that entities have presented in JV-OCI/NR, and to better understand how the requirements for this new accounting category, including the absence of recycling in P&L of  accumulated performance in OCI, have been taken into account by entities when deciding whether to use this category, or may even have influenced investment decisions.

4. Accounting for own credit risk on financial liabilities designated at fair value by option

Background: The standard requires these financial liabilities to be remeasured:

• in profit or loss for all components except the own credit risk component; and
• in other comprehensive income/OCI without recycling for the own credit risk component, in order to limit the counterintuitive effects of remeasuring changes in the entity’s own credit risk through profit or loss. However, this measurement method does not apply to financial liabilities that are remeasured through profit or loss due to a held-for-trading business model.

Issue raised: The Board would like to determine whether this mechanism captures the appropriate population of financial liabilities and if the disclosures on this subject are appropriate.

5. Accounting for modifications to contractual cash flows of debt instruments

Background: The standard  requires that when there is a modification in the contractual cash flows of a debt instrument held or issued that does not lead to derecognition, its value is adjusted in profit or loss by discounting the new post-modification cash flows at the instrument’s original effective interest rate. In the specific case of financial liabilities, the standard includes additional qualitative and quantitative criteria to determine whether the modification in contractual cash flows is sufficiently substantial to result in derecognition of the instrument. When considering the effects of interest rate benchmark reform, the Board also had to examine the notion of modification in a situation where, without any modification of the contractual terms of the instrument, the bases for calculating an index used to determine the contractual flows had changed.

Issue raised: The Board would like to understand how the provisions on the modification of financial assets (absent from the pre-existing standard IAS 39) and those on the modification of financial liabilities have been applied. The IASB also hopes to determine whether these provisions can be applied consistently and result in useful information for users of financial statements.

6. Practical implementation of effective interest method (EIR)

Background: This method is used to calculate the amortised cost of a debt instrument issued or held, and in the allocation of the interest income or interest expense in profit or loss over time, based on the estimated cash flows of the instrument over its expected life. If the estimated cash flows are revised, the standard requires either:

• a ‘catch-up adjustment’ to the balance sheet value through profit or loss; or
• a prospective adjustment of the EIR, without immediate impact in profit or loss.

Issue raised: The Board would like to better understand how the scope of each of these two accounting treatments for revised estimates is determined in practice, particularly when those revisions are related to changes in the likelihood of meeting the conditions of the original estimates. This question arose recently concerning:

• compliance with the conditions under which banks grant loans as required by the European Central Bank (ECB) through the TLTRO III refinancing program; and
• the fulfilment of ESG criteria included when determining the level of the amounts due on certain banking arrangements.

7. Transitional reliefs available when first applying the standard

Background: IFRS 9 allowed entities to use some reliefs transitional to address difficulties in retrospective application of the standard, including:

• waiving the requirement to present restated comparative information on initial application; and
• allowing entities to use the effective date of the standard, rather than the initial recognition date of the instruments, for the application of some of the new provisions introduced by the standard, such as the determination of business model, or assessing whether an instrument met the criteria for designation under the fair value through profit or loss option.

At the same time, the standard required entities to disclose sufficient information in the notes to the financial statements to estimate the impact of the transition from the pre-existing IAS 39 to the new standard.

Issue raised: In order to draw lessons for the development of future standards, the Board would like to ensure that the transitional arrangements have indeed simplified the task of preparers, while preserving the quality of information for users.

The deadline for submitting replies to the RFI is 28 January 2022.