Impairment of Financial Instruments

Previously under IAS 39, impairment or credit losses are only recognised when a credit loss event occurs
(‘incurred loss model’).

Under IFRS 9, the new impairment requirements are based on expected credit losses(‘expected credit
loss model’). Expected credit losses (ECLs) are an estimate of credit losses over the life of a financial
instrument, and are recognised as a loss allowance or provision. The amount of ECLs to be recognised
depends on the extent of credit deterioration since initial recognition, and an entity will need to take into
account:

 probability-weighted outcomes;

 the time value of money; and

 reasonable and supportable information that is available without undue cost or effort.

The main difference between the two accounting standards is that the new standard (IFRS 9) requires a
recognition of credit loss allowances on initial recognition of financial assets, whereas previously under
IAS 39, impairment is recognized at a later stage, when a credit loss event has occurred.

While this change will result in credit losses being recognized more evenly over the lives of financial assets,
it will require more judgment by preparers to estimate the amount of ECL provision for financial assets.

‘General’ approach for impairment

This new model is a ‘three-stage’ model, also known as ‘three-bucket’ approach or ‘general’ approach. It
should be applied to investments in debt instruments (e.g. loans, debt securities) measured at amortized
cost and FVOCI, loan commitments not measured at FVTPL, financial guarantee contracts not accounted
for at FVTPL and lease receivables under IAS 17.

Stage 1: If credit risk on a financial instrument has not increased significantly since the initial recognition,
a 12-month ECL shall be recognized at reporting date. 12-month ECL are the expected credit losses that
result from default events that are possible within 12 months after the reporting date.

Stage 2: If credit risk on a financial instrument has increased significantly since the initial recognition,
a lifetime ECL shall be recognized. Lifetime ECL are the expected credit losses that result from all possible
default events over the expected life of the financial instrument. Interest revenue is calculated on the gross
carrying amount of the financial assets.

Stage 3: If the financial instrument is credit-impaired, i.e. non-performing or there is objective

evidence of impairment, a lifetime ECL is recognized. Interest revenue is calculated on the net carrying
amount (gross carrying amount less loss allowance).

Alternatives to the ‘general’ approach for impairment

Alternative #1: Simplified Approach

The simplified approach can be applied for trade receivables, contract assets and lease receivables that do
not have significant financing component (normally held by entities that do not have sophisticated credit
risk management systems like financial institutions).

Under the simplified approach, there is no need to calculate a 12-month ECL and assess whether a
significant increase in credit risk has occurred. A loss allowance should be measured at initial recognition
and throughout the life of the receivable at an amount equal to lifetime ECLs for the assets.

Alternative #2: Purchased or Originated Credit-impaired Assets

Purchased or originated credit-impaired assets refer to assets that have observable evidence of impairment
at the point of initial recognition (for example, the financial asset was purchased at a deep discount, or the
borrower had significant financial difficulty at initial recognition of asset).

In such a scenario, the initial 12-month ECLs would have already been reflected in the fair values at which
they were initially recognized. Recording a 12 month-ECL allowance over the discounted financial assets
would be double counting the credit losses for these assets with high credit risk.

For such assets, there is therefore no need to account for an additional 12-month ECL allowance on initial
recognition. For subsequent reporting periods, the entity would need to recognize changes in lifetime ECLs,
either as an impairment gain or loss, in P&L.

Hedge Accounting

Most businesses implement some risk management strategies to manage their exposures to different risks
like interest rate, exchange rate or commodity price risks. Applying hedge accounting to its financial
instruments for hedging is a matter of choice for companies.
 To apply hedge accounting, entities will first need to maintain proper hedge documentationset out in
IFRS 9 or IAS 39. Hedge accounting affects the timing of recognition of hedging gains and losses. By
applying hedge accounting, entities can better match the gains or losses of the hedging instrument with
gains or losses of their corresponding hedged items.

If an entity chooses not to apply hedge accounting, hedging instruments will need to be classified and
measured like any other financial instruments, as required by IFRS 9. Gains and losses on the hedging
instruments may not be recognized in P&L or OCI in the same accounting period as the gains and losses on
their corresponding hedged items.

With hedge accounting, the hedging instrument will be matched with its corresponding hedged item, so that
gains and losses on both the hedging instrument and hedged item are recognized in the same accounting
period. Hedge accounting is thus based on the fundamental ‘matching’ concept, and helps to reduce the
volatility in the income statement caused by the accounting mismatch between the hedging instrument and
hedged item.

There are 3 main types of hedge relationships:

 Fair value hedge: a hedge of exposure to changes in fair value of a recognized asset, liability or an
unrecognized firm commitment. Change in fair value could be due to a change in interest rates for fixed rate
loans, foreign currency, equity and commodity prices. Gains or losses on both hedging instrument and
hedged item shall be recognized in P&L in each accounting period (matching concept).

[However, if the hedged item is an equity instrument accounted for at FVOCI, changes in fair value of
hedging instrument should also be recorded in OCI without recycling to P&L. This is a new change under
IFRS 9.]

 Cash flow hedge: a hedge of the exposure to variable cash flows that is attributable to a recognized asset,
liability or a highly probable forecast transaction that could affect profit or loss. The variable cash flows
could be due to change in interest rates, foreign currency, equity or commodity prices.

Gains or losses on the hedging instrument to be recognized in OCI (cash flow hedge reserve) sho uld be the
lower of:

 Cumulative gain or loss on the hedging instrument from inception of hedge

 Cumulative change in the fair value of expected cash flows on hedged item from inception of hedge

In other words, if the amount in (i) exceeds the amount in (ii), i.e. ‘over-hedge’ situation, an ineffectiveness
of (ii) – (i) will be recognized in P&L. In an ‘under-hedge’ situation, the amount in (ii) will exceed the
 amount in (i), no ineffectiveness is recognized and all gains and losses on the hedging instrument can be
recognized in OCI.

For forecast transactions that result in recognition of a non-financial asset or liability (e.g. inventory or
fixed asset), the cash flow hedge reserve will be removed from OCI and included directly in the carrying
amount of the non-financial asset or liability.

For forecast transactions that result in future cash flows affecting P&L (e.g. interest income, expense or
forecast sales), the cash flow hedge reserve will need to be transferred from OCI to P&L in the same period
or periods during which the hedged expected future cash flows affect P&L.

 Net investment hedge: a hedge in an entity’s interest in the net assets of its foreign operations, i.e.
overseas subsidiaries, associates, joint ventures or branches, including any recognized goodwill.

The accounting for net investment hedges is similar to that of cash flow hedges. The effective portion of the
hedge is recognized in OCI, while the ineffective portion is recognized in P&L. As exchange differences
arising from consolidation of net assets (hedged item) are recognized as foreign currency translation reserve
in OCI, gains or losses on the hedging instrument are also recognized in OCI, to the extent that the hedge is
effective.

When the foreign operations are disposed, the foreign currency translation reserve from consolidation will
be reclassified from equity to P&L. Previous gains or losses on hedging instrument should therefore also be
transferred from OCI to P&L to match the foreign currency gains or losses from foreign currenc y translation
reserve.

Source:

http://tfageeks.com/accounting-for-financial-instruments-ifrs-9-and-ias-39/