Sir David Tweedie, the former chairman of the International Accounting Standards Board (IASB) said that those who have read IAS 39 (the previous standard on financial instruments) and have understood it have not read it properly.
The global financial crisis of 2008 expedited the development of IFRS 9 Financial Instruments which replaced IAS 39 for periods beginning on or after 1 January 2018. There are three key topics in IFRS 9:
- Principles-based approach to classification of financial assets and financial liabilities which drives subsequent measurement;
- Forward looking expected credit loss model for impairment on financial assets; and
- Principles-based hedge accounting which is aligned to common risk management practices.
The global lockdown has affected almost all companies and this effect will be reflected in the financial statements. If you would like to read about the impact of COVID-19 on the financial statements, please see our blog on the topic.
Here we will analyse the impact of COVID-19 on specific IFRS 9 topics.
Modification of financial assets/financial liabilities
Due to the adverse business impact of the global lockdown, the borrowers may approach the lenders for modification of the terms of the loan, for example, concessions such as reduction in interest rates or changes to repayment schedule. These concessions result in gains to the borrower and losses for the lender.
If a concession results in a significant (say >10% based on best practice) change in the present value of the cash flows, then the existing financial instrument must be derecognised and a new financial instrument must be recognised. Any difference is recognised in the income statement.
The lending and borrowing transactions where there have been modifications may need to be assessed to see if derecognition is required.
Expected Credit Losses (ECL)
The ECL model is a forward-looking approach to recognition of impairment losses. It requires us to consider borrower specific factors, internal/external factors and macro-economic forecasts to determine the loss provision. There are two approaches – Three-stage General Approach and Simplified Approach (for receivables).
The three-stage General Approach requires recognition of the ECL as follows:
ECL = Exposure at default x Loss given default x Probability of default
We must consider the time value of money.
Have you evaluated the impact of COVID-19 on the staging of the financial assets where the General Approach is applied?
- Stage 1: All assets are classified in Stage 1 on initial recognition and subsequently until there is a significant increase in credit risk since purchase or origination. 12-month ECL provision is required on assets in Stage 1.
- Stage 2: Assets are transferred to Stage 2 if there has been a significant increase in credit risk since purchase or origination. A full lifetime ECL provision is required though there is no default.
- Stage 3: Credit-impaired financial assets are transferred to Stage 3 on which lifetime ECL provision is required.
What proportion of your financial assets have suffered a significant increase in credit risk which requires recognition of lifetime ECL?
This will have an impact on the profit and loss, and hence the earnings per share.
The IASB has published guidance on IFRS 9 and COVID-19. It states that as preparers, we need to adjust the existing ECL methodology, in particular the macroeconomic scenarios and their weightings for ECL. It requires us to consider all reasonable and supportable information that is available without undue cost or effort, including the impact of government support measures.
If you are using a provision matrix for your receivables (simplified method), there will be an impact due to COVID-19. The customers may take longer to pay and some of them may even default. It is necessary to adjust the default rates for the different time buckets based on the current circumstances and this may require regular revisions in the light of changes to uncertainties in the future.
It may be useful to review whether further customer segmentation is required. For example, in the pre COVID-19 world, you may have put all receivables due from customers in a particular country in one segment. In the COVID-19 world, this may need to be split between receivables due from customers in an industry which has been adversely affected, for example, airlines and those due from customers in an industry which has had relatively less impact, for example pharmaceuticals.
You may also need to review the financial guarantee contracts to ensure liability is measured appropriately in current environment.
Lastly, the impact of COVID-19 will affect the interim financial reporting. There will be adjustments to the measurement of assets and liabilities and additional disclosures will be required. The focus should be on providing relevant and useful information to the users to enable them to understand the impact of COVID-19 on the financial position, financial performance and cash flows.
About the Author
Saket Modi is an IASeminars instructor on IFRS and IPSAS based in London. He has designed and facilitated courses on IFRS, in particular financial instruments, for delegates from over 50 countries in UK, Europe, Africa, Middle East and Asia. He is a qualified accountant and CFA® charterholder.