Accounting for financial liabilities is not substantially impacted by the adoption of IFRS 9 but will need to account for ‘own credit risk’ in OCI for some financial liabilities

In recent editions of Accounting News we have examined the impact that the adoption of IFRS 9 Financial Instruments will have on accounting for financial assets:

  • In the May 2018 and June 2018 editions we examined the classification and measurement of financial assets, and
  • In the August 2018 edition we examined the impairment of financial assets.

As explored in those articles, the manner in which financial assets are accounted for under IFRS 9 will differ substantially from the accounting treatment applied under IAS 39 Financial Instruments: Recognition and Measurement, with new classification categories for financial assets, and a different impairment approach that may lead to the recognition of earlier and greater amounts of impairment losses.

Classification of financial liabilities

Although IFRS 9 will herald major changes in the accounting for financial assets, the accounting for financial liabilities will remain largely consistent with that applied under IAS 39.  Under IFRS 9, there will be the same two financial liability classification categories as existed under IAS 39, i.e.:

  • Financial liabilities at fair value through profit or loss
  • Financial liabilities at amortised cost.

Financial liabilities are generally classified and measured at amortised cost unless they meet the criteria for ‘fair value through profit or loss’.

Fair value through profit or loss

A financial liability is classified as a financial liability at fair value through profit or loss (FVTPL) if it meets one of the following conditions:

  • It is held for trading, or
  • It is designated by the entity as being at FVTPL (note that such a designation is only permitted if specified conditions are met).

A financial liability is held for trading if it meets one of the following conditions:

  • It is incurred principally for the purpose of repurchasing it in the near term
  • On initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking, or
  • It is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).

Examples of financial instruments that fall under this category include interest rate swaps, commodity swaps and foreign currency forwards and options.

Like IAS 39, IFRS 9 contains a ‘fair value’ option where entities may designate a financial liability at FVTPL is when doing so results in more relevant information, because either:

  • It eliminates, or significantly reduces, a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities, or recognising the gains and losses on them, on different bases, or
  • A group of financial liabilities, or financial assets and financial liabilities, is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

Where an entity issues a hybrid financial instrument that contains a financial liability host and an embedded derivative that are not closely related (e.g. a convertible note where the conversion feature fails the ‘fixed-for-fixed’ criteria), the entity also has an option to designate the entire hybrid financial instrument at FVTPL.

Measurement of financial liabilities

Financial liabilities at FVTPL are initially recognised at fair value and are thereafter carried at fair value.

Financial liabilities at amortised cost are initially recognised at fair value less transaction costs and are thereafter carried at amortised cost using the effective interest method. 

FVTPL Amortised cost
Initial recognition Fair value Fair value less transaction costs
Subsequently Fair value Amortised cost using the effective interest method

‘Own credit risk’

For all financial liabilities at FVTPL, IFRS 13 Fair Value Measurement requires that when measuring fair value of a financial liability, an entity shall take into account the effect of its own credit risk and any other factors that might influence the likelihood that the obligation will or will not be fulfilled.

The one major change for financial liabilities designated at FVTPL relates to the manner in which changes in ‘own credit risk’ are accounted for. Under IAS 39, all changes in the fair value of financial liabilities at FVTPL are recognised in profit or loss.  However, under IFRS 9, where a financial liability has been designated at FVTPL, fair value changes related to changes in the entity’s ‘own credit risk’ are recognised in other comprehensive income (OCI), while all other fair value changes are recognised in profit or loss.

This requirement to recognise changes in fair value related to the entity’s own credit risk in OCI does not apply to all financial liabilities measured at FVTPL, but rather only to financial liabilities designated at FVTPL. Therefore changes in fair value due to own credit risk for interest rate swaps and other derivatives are recognised in profit or loss.

 

IFRS 9 IAS 39
Subsequent recognition of financial liabilities designated at FVTPL Fair value
  • Changes due to 'own credit risk’ recognised in other comprehensive income (OCI)
  • Other fair value changes recognised in profit or loss
FVTPL

The requirement to recognise fair value changes due to an entity’s own credit risk in OCI is to eliminate the counter intuitive effect that would otherwise arise, i.e. that the poorer the financial condition of an entity, the higher the discount rate that applies when measuring fair value, resulting in a higher associated gain in profit or loss.

Two-step approach

The requirement to recognise changes in fair value due to an entity’s own credit risk separately in OCI means that typically a two-step approach is needed:

Step 1       Step 2
Determine changes in fair value of the financial liability as a whole     Perform a separate calculation to determine the change in fair value due to changes in the entity’s own credit status

The difference between the amounts calculated in steps 1 and 2 above will be recognised in profit or loss.

It should be noted that amounts recognised in OCI for fair value movements as a result in changes in own credit risk are never recycled to profit or loss when the financial liability is derecognised, but a transfer may be made to another account within equity.

Example – Own credit risk

An entity has a financial liability designated at FVTPL.

The fair value of the liability decreases by $10,000, with $2,000 of that decrease due to a change in the entity’s own credit risk.

Under IAS 39, the journal entry would be:

  Dr Cr
Financial liability at FVTPL $10,000  
Profit or loss   $10,000

However, under IFRS 9 the journal entry would be:

  Dr Cr
Financial liability at FVTPL $10,000  
Other comprehensive income   $2,000
Profit or loss   $8,000

Concluding thoughts

In preparing for their adoption of IFRS 9, finance teams will need to ensure that they have mechanisms in place to identify any financial liabilities designated at FVTPL and ensure that changes in own credit risk are accounted for correctly in OCI.