Brace for impact: The first two of the new triple threat IFRS are now in effect

There has been a lot of discussion over the last few years about the three new International Financial Reporting Standards (IFRS) that have recently come into effect, or that will soon come into effect.  These standards are:

  • IFRS 9 Financial Instruments (IFRS 9), which came into effect for financial reporting periods beginning on or after 1 January 2018
  • IFRS 15 Revenue from Contracts with Customers (IFRS 15), which came into effect for financial reporting periods beginning on or after 1 January 2018
  • IFRS 16 Leases (IFRS 16), which comes into effect for financial reporting periods beginning on or after 1 January 2019.

The table below outlines what this means for you, based on your reporting date:

If your reporting date is: IFRS 9 is effective for the first time in your: IFRS 15 is effective for the first time in your: IFRS 16 is effective for the first time in your:
31 December 31 December 2018 financial statements 31 December 2018 financial statements 31 December 2019 financial statements
31 March 31 March 2019 financial statements 31 March 2019 financial statements 31 March 2020 financial statements
30 June 30 June 2019 financial statements 30 June 2019 financial statements 30 June 2020 financial statements
30 September 30 September 2019 financial statements 30 September 2019 financial statements 30 September 2020 financial statements

As the table shows:

  • No matter what your reporting date, you are already in the comparative period for the adoption of IFRS 9 and IFRS 15 or the comparative period is complete
  • If your reporting date is 31 December or 31 March, you are now in the first financial reporting period in which IFRS 9 and IFRS 15 must be applied
  • Entities with interim reporting obligations such as producing quarterly or half-yearly reports, may already have, or will soon need to, issue interim reports applying IFRS 9 and IFRS 15, and
  • If your balance date is 31 December or 31 March, you are already in the comparative period for the adoption of IFRS 16. 

All three of these new standards are complex and have the potential to significantly impact reported financial performance, financial position, or both. 

If you have not already started the process for adopting these new standards, it is important that you do so. 

In future editions of Accounting News, we will examine some issues we have seen in practice that you may encounter when adopting IFRS 9, IFRS 15 and IFRS 16.  Before we do that, however, we remind you of the scale of change that each of these three new standards will introduce.  

Financial instruments

The accounting for financial instruments under IFRS 9 is complex.  Depending on the number and type of financial instruments held by your company, changing the manner in which financial instruments are accounted for could result in considerable impacts to both your reported financial performance, and your reported financial position.  

IFRS 9, which comes into effect for financial reporting periods beginning on or after 1 January 2018, will replace IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) and IFRIC 9 Reassessment of Embedded Derivatives.

The primary differences between IFRS 9 and IAS 39 relate to:

  • The classification and measurement of financial assets
  • The impairment of financial assets
  • Hedge accounting.

Classification and measurement of financial assets

IAS 39 classifies financial assets into the following four categories:

Category of financial instrument How measured?
Financial assets at fair value through profit or loss Fair value, with value changes recognised in profit or loss
Loans and receivables Amortised cost
Held to maturity Amortised cost
Available for sale Fair value, with value changes recognised in other comprehensive income (OCI)

Classification is dependent on the characteristics of an instrument and management’s intentions in relation to the instrument.  The default classification is ‘available for sale’, which means that the default approach to accounting for financial assets is to recognise them at fair value, and to recognise changes in their fair value in other comprehensive income.

  Default category Fair value changes measured in:
IAS 39 Available for sale Other comprehensive income
IFRS 9 Fair value through profit or loss Profit or loss

In contrast, the default position in IFRS 9 is to carry financial assets at ‘fair value through profit or loss’.  Some financial assets are permitted to be carried at fair value through other comprehensive income, or at amortised cost, but only if specific criteria are met, which relate to:

  • The cash flow characteristics of the financial asset (and specifically whether those cash flows constitute solely payments of principal and interest), and
  • The business model under which the financial asset is held. 
The adoption of IFRS 9 may result in more financial assets being carried at fair value through profit or loss, which would increase profit or loss volatility. 

Impairment of financial assets

Under IAS 39, impairment is determined using an ‘incurred loss’ model.  Under this model, impairment losses are recognised only if there is objective evidence of impairment as a result of a past event that occurred subsequent to initial recognition. Expected losses as a result of future events, no matter how likely, are not recognised. 

In contrast, IFRS 9 determines impairment using an ‘expected loss’ model, which is a three stage model that recognises impairment on the basis of expectations about future loss events. 

The change from the IAS 39 ‘incurred loss’ model to the IFRS 9 ‘expected loss’ model will result in earlier impairment recognition and, in many instances, the recognition of greater levels of impairment. 

Hedge accounting

Under both IAS 39 and IFRS 9, hedge accounting is optional and can only be entered into when specified criteria are met.  The criteria are somewhat less complex under IFRS 9 than under IAS 39, which may result in increased levels of hedge accounting under IFRS 9.

Revenue

Revenue is the top line figure when reporting financial performance, and is usually one of the financial measures of most interest to shareholders, potential investors, market analysts and other interested parties.

IFRS 15, which comes into effect for financial reporting periods beginning on or after 1 January 2018, replaces:

  • IAS 18 Revenue (IAS 18)
  • IAS 11 Construction Contracts (IAS 11)
  • IFRIC 13 Customer Loyalty Programmes
  • IFRIC 15 Agreements for the Construction of Real Estate
  • IFRIC 18 Transfers of Assets from Customers
  • IFRIC SIC-31 Revenue – Barter Transactions Involving Advertising Services.

The revenue recognition requirements in IAS 18 vary depending on the source of the revenue:

Source of revenue

Revenue recognised:

Sale of goods

When significant risks and rewards of ownership have been transferred to the purchaser (which usually coincides with the transfer of legal title and/or the passing of legal possession) and there is no continuing managerial involvement in, or control over, the goods.

Sale of services

On a percentage of completion basis (unless the stage of completion cannot be reliably measured, in which case revenue is recognised only to the extent of the expenses recognised that are recoverable).

The requirements in IAS 11 for the recognition of revenue from construction contracts mirror those in IAS 18 for the recognition of revenue from the provision of services, with revenue required to be recognised on a percentage of completion basis (unless the stage of completion cannot be reliably measured, in which case revenue is only recognised to the extent of contract costs incurred that it is probable will be recoverable).  

In contrast, IFRS 15 introduces a five step model for the recognition of all revenue:

Step 1 Identify the contract(s) with the customer
Step 2 Identify the performance obligations in the contract
Step 3 Determine the transaction price
Step 4 Allocate the transaction price to the performance obligations
Step 5 Recognise revenue when a performance obligation is satisfied

The IFRS 15 five step model is based on the new concept of a ‘performance obligation’, which is essentially a promise to a customer to do something, such as provide a product or deliver a service.  Revenue is recognised when, or in some circumstances as, a performance obligation is satisfied. 

Under IFRS 15, revenue recognition over the course of time is only permissible when specified criteria are met, which are stricter than those that apply under IAS 18 and IAS 11. 

The key impact that the adoption of IFRS 15 will have is on the timing of revenue recognition, which will impact the amount of revenue reported in individual financial years.  For some industries, such as construction, manufacturing and software development, it is likely that this impact will be substantial.  Any impact on revenue will flow through to net profit and, through retained earnings, to financial position. 

In addition to introducing a new model for the recognition of revenue, IFRS 15 provides considerably expanded guidance on the measurement of revenue and requires substantially increased disclosures. 

Leases

IFRS 16, which comes into effect for financial reporting periods beginning on or after 1 January 2019, replaces IAS 17 Leases (IAS 17), IFRIC 4 Determining whether an Arrangement contains a Lease, SIC-15 Operating Leases – Incentives and SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease

IFRS 16 retains the IAS 17 accounting treatment for lessors.  However, it fundamentally changes the manner in which lessees account for leases by:

  • At inception of the lease - requiring the recognition of a liability for the obligation to make lease payments and an asset for the right to use the leased asset
  • Subsequent to initial recognition - requiring the depreciation of the right-of-use asset and the recognition of a finance charge in a pattern that produces a constant periodic rate of interest on the remaining balance of the liability. 
IFRS 16 could potentially have significant adverse impacts on a lessee’s net current assets, working capital and debt ratios, but it could also have a favourable impact on EBITDA and operating cash flows.

This new treatment will have a substantial impact on lessees:

  • Statement of financial position ratios will change due to the recognition of right-of-use assets and lease liabilities
  • The current year portion of the lease liability will be a current liability, which will impact working capital and associated ratios
  • The straight-line operating lease expense recognised under IAS 17 will be replaced by interest expense (which will decrease over time) and depreciation – this will mean a larger impact on profit or loss at the beginning of a lease than at later stages of a lease
  • Earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA) will increase due to an operating expense being replaced by depreciation and interest expense  
  • An operating cash flow (for lease payments) will be replaced by a financing cash flow (for the reduction in the lease liability) and an operating or financing cash flow for the interest expense.

In addition to fundamentally changing the manner in which lessees account for leases, IFRS 16 also requires substantially increased disclosures.

The adoption process

An in-depth understanding of contract terms and business practices is vital in the adoption process.

As outlined above, adoption of the three new standards has the potential to substantially impact reported financial performance and position.  However, one aspect of the adoption of these three new standards that is often overlooked is the in-depth knowledge of underlying business arrangements that is required to adopt the standards.  For instance, revenue recognition under IFRS 15 will need to be considered on a contract-by-contract basis, with the possibility that the specific clauses of individual contracts will result in different timing for revenue recognition even if, on the surface, the contracts appear similar.  Similarly, financial asset classification and measurement under IFRS 9 will be based on the cash flows generated by the asset and the business model under which the asset is held, while calculation of a lessee’s right-of-use assets and lease liabilities under IFRS 16 will be dependent on the specific terms of each lease that the lessee has entered into.

The in-depth understanding of underlying business practices and contracts that is required to adopt IFRS 9, IFRS 15 and IFRS 16 will make the adoption process time consuming and will require substantial input from senior members of a company’s finance team.  This, in conjunction with the significant financial impact that could be created by the adoption of these three new standards, means that companies that have not yet commenced the process of adoption need to now do so with some urgency.

Future articles

In the work that we have done to date to assist clients with their adoption of IFRS 9, IFRS 15 and IFRS 16, we have noticed a number of complexities with the application of the standards.  As mentioned above, we will look at some of these issues in future editions of Accounting News.