Planned reform of financial instruments reporting (Third of four parts)

KPMG CORNER - Armin M. Rau and Reinhard Klemmer () - December 7, 2010 - 12:00am

Classification and measurement under IFRS 9

Classification refers to the basis on which financial assets are presented in the financial statements. It is important because it drives how they are measured or valued, how any value changes are reflected in income and the way in which they are displayed in the financial statements.

In order to assess the new classification and measurement model in IFRS 9, it is important to understand the model currently required by IAS 39.

Currently IAS 39 requires that financial assets are measured on an on-going basis, according to the following classifications:

Fair value through profit or loss: Financial assets are measured at fair value on the balance sheet with changes in fair value reported immediately in profit or loss.

Held to maturity: Financial assets are measured at amortized cost.

Loans and receivables: Financial assets are measured at amortized cost.

Available-for-sale: Financial assets are measured at fair value on the face of the balance sheet with changes in fair value recorded in other comprehensive income (part of equity). Gains and losses are recognized in profit or loss when realized, i.e. on derecognition, impairment, dividend payments or accrual of interest.

Unlike IAS 39, IFRS 9 requires that financial assets are classified into one of only two categories: at fair value through profit and loss or amortized cost.

However, IFRS 9 requires that two test need to be satisfied to classify financial assets at amortized cost:

The Business Model Test: The objective of an entity’s business model has to be to hold financial assets to collect contractual cash flows; and

The Characteristic of the Instrument Test: The contractual terms of the financial asset give rise on specified dates to cash flows that are only payments of principal and interest on the principal outstanding.

Where either of these tests is not satisfied, financial assets are classified at fair value. With this two-measurement-category approach the existing categories under IAS 39 of “held to maturity”, loans and receivable” and “available for sale” are eliminated.

The Business Model Test

The business model test is a fundamental building block of the new standard and aims to align the accounting with the way that management deploys assets in its business, while also considering the characteristics of the assets. The IASB expects a business model to be a factual criteria, independent of management intent, and changes to business models to be rare.

The business model test differentiates between the objective of holding financial assets to collect contractual cash flows from the objective of realizing fair value changes, however it accepts that some asset sales may occur without compromising the objective of holding financial assets to collect contractual cash flows. For example, it would be acceptable to sell some financial assets to meet investment policy criteria (e.g. due to credit downgrades) or to fund capital expenditures.

Within one entity different business models could exist, for example could a bank have two distinct businesses, one investment banking and one retail banking business. Similar financial instruments could then be classified differently depending which business entered into them.

The Characteristic of the Instrument Test

The characteristics of the instrument test requires that all contractual cash flows arising on a financial asset must be solely payments of interest and principal on the principal outstanding to be eligible for amortized cost accounting. Interest paid must only reflect consideration for the time value of money and credit risk associated with the instrument over the life of the instrument.

Equity instruments do not have characteristics of interest and principal and therefore are not eligible for the amortized cost category.

Classification and measurement of financial liabilities

With regard to financial liabilities the IASB decided to maintain the existing amortized cost measurement for most liabilities, limiting change to that required to address the own credit problem.

With the new requirements (published on 28 October 2010), an entity choosing to measure a liability at fair value (so called “Fair Value Option”) will present the portion of the change in its fair value due to changes in the entity’s own credit risk in the other comprehensive income (OCI) section of the income statement, rather than within profit or loss. The new requirements address the counter-intuitive way a company in severe financial trouble can book a large profit based on its theoretical ability to buy back its own debt a reduced cost.

4) Accounting for hybrid contracts

A hybrid contract is a contract that contains a non derivative host contract and an embedded derivative. IAS 39 often requires components of a hybrid contract to be separated. IAS 39 has different accounting requirements for the host contract and the embedded derivative.

IFRS 9 has removed the requirement in IAS 39 to split-out and separately account (bifurcate) derivatives embedded in (non derivative) host financial assets. Instead the embedded instrument with financial host that are financial assets should be classified in their entirety in accordance with the classification criteria used for all other financial assets. As a result a single classification approach will be used on how financial assets are accounted for after initial recognition. This will result in quite a number of hybrid instruments being accounted for at fair value in their entirety compared to split accounting under the current IAS 39.

To be concluded

(Armin M. Rau is a Senior Manager for Audit and Reinhard Klemmer is a Seconded Partner from KPMG Germany to Manabat Sanagustin & Co., CPAs, a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of Manabat Sanagustin & Co., CPAs. For comments or inquiries, please email manila@kpmg.com or mquizon @kpmg.com)

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