IFRS 9 creates challenges for corporates

From the IFRS Institute - February 28, 2019

IFRS 9 isn’t just for banks. As many corporates close their first annual financial statements applying IFRS 9, two main challenges emerge. (1) Determining the appropriate measurement approach requires new judgments. Certain financial assets now need to be measured at fair value on an ongoing basis and fair value is not always directly observable. (2) Impairment testing has shifted from an incurred to an expected credit loss model. This means bad debt reserves on receivables and contract assets could require a more extensive forecasting exercise.

Effective for calendar-year companies as of January 1, 2018¹, IFRS 9 applies across all sectors. IFRS 9 introduces major changes for most companies and while the impact on financial institutions has been highly publicized, the impact on corporates has not received as much attention. In our article, IFRS and US GAAP long awaited changes to hedge accounting, we took a fresh look at the impacts of the new hedging requirements. In this article, we focus on classification, measurement and impairment-related issues for corporates.

IFRS 9 is a comprehensive accounting standard that requires a combination of management judgment and detailed calculations that may require comprehensive modeling for mission-critical business processes that cut across multiple functions within the organization. As part of the process of developing the accounting positions for classification, measurement and impairment of financial assets, corporates also should consider additional requirements for data collection, disclosures and other financial processes at the date of initial application and on a go-forward basis. This generally also requires an update of the supporting systems. Corporates need to consider the following (not exhaustive):

• business requirements of both accounting and non-accounting stakeholders;
• adequacy of current disclosure process and related internal controls to support new disclosures requirements;
• data collection, retention and migration strategy;
• systems architecture and constraints;
• internal control over financial reporting; and
• tax calculations and reporting implications.

Classification and measurement

The new standard changes the way financial assets are classified on the balance sheet under IFRS and establishes the following categories:

• financial assets measured at amortized cost;
• financial assets measured at fair value through other comprehensive income (FVOCI); and
• financial assets measured at fair value through profit or loss (FVTPL).

The previous IAS 39² categories of held-to-maturity, loans and receivables, and available-for-sale have been eliminated.

For investments in equity instruments that are neither consolidated nor accounted for under the equity method, IFRS 9 changes their classification and measurement. Under IAS 39, investments in equity instruments were generally classified as available-for-sale and measured at FVOCI or as trading and measured at FVTPL. There was also an exemption that allowed companies to measure equity instruments at cost under very limited circumstances.

IFRS 9 requires companies to measure investments in equity instruments at FVTPL, but provides the option to measure them at FVOCI, if they are not held for trading. This means that cost is no longer an acceptable measure. The FVOCI option for equity instruments may appeal to corporates looking to avoid income statement volatility. However, it comes with some disadvantages – e.g. the gain or loss on the sale of the investment is recorded through other comprehensive income (OCI). 

For investments in debt instruments, IFRS 9 introduces a two-step analysis to determine which category is appropriate for their classification and measurement.

The application of the SPPI criterion and business model assessment requires management judgment, and therefore new processes, controls and robust documentation to support classification conclusions. 

Previous conclusions on embedded derivatives within financial assets also have to be reopened. Under IAS 39, an embedded derivative was separated from the host contract when the economic characteristics and risks of the embedded derivative was not closely related to that of the host contract. Unlike IAS 39, embedded derivatives within a host contract that is a financial asset are not separated from the host contract under IFRS 9. Instead, the combined host contract and embedded derivatives are evaluated as a single unit of account; in most cases, this will mean that it does not meet the SPPI criterion and therefore is measured at FVTPL.

The classification and measurement changes also impact how financial assets are presented on the balance sheet. The IAS 39 terminology is now obsolete and the new IFRS 9 language needs to be incorporated into companies’ financial reporting practices. IFRS 9 also amended IFRS 7⁴ to introduce new disclosure requirements.

Expected credit losses

IFRS 9 has a single expected credit loss (ECL) impairment model applicable to all financial assets measured at amortized cost and debt instruments measured at FVOCI, with some simplifications for trade receivables, contract assets and lease receivables.

The ECL model differs significantly from the IAS 39 incurred loss model in that a loss event does not need to occur before an impairment loss is recognized. In other words, there is no longer a recognition threshold, and it is no longer appropriate to wait for a customer to default or other evidence of an incurred loss such as a receivable that has aged beyond normal payment terms to record a bad debt reserve. Under the ECL model, companies may have sooner, larger and more volatile bad debt reserves recognized than before.

Corporates might have many financial assets impacted by IFRS 9.

General approach

Under the general approach, the loss allowance for a financial instrument is initially measured based on 12-month expected credit losses. However, if as of the reporting date, the credit risk on the financial instrument has increased significantly since its initial recognition, the loss allowance is based on lifetime expected credit losses. If, in a subsequent reporting period, the credit risk is determined to not have significantly increased since initial recognition, the loss allowance is measured based on 12-month expected credit losses in that subsequent reporting period.

Simplified approach

For trade receivables and contract assets, the ECL model replaces the traditional approach of measuring bad debt reserves. For trade receivables and contract assets with no significant financing component, IFRS 9 allows a simplified approach using a lifetime ECL measurement regardless of whether a significant increase in credit risk has been observed. IFRS 9 requires discounting of expected credit losses, but for trade receivables and contract assets without a significant financing component that are short term, it may be possible to conclude that discounting is not material.

For trade receivables or contract assets with a significant financing component and for lease receivables, companies can elect to apply the ECL simplified approach or the ECL general approach. The simplified approach is less complex, but could result in a higher ECL value under most circumstances. Furthermore, the ECL of such assets should be discounted using the original effective interest rate.

Provision matrix

IFRS 9 provides a credit risk measurement practical expedient in the form of a provision matrix⁵ that may be appropriate. The provision matrix approach takes historical trade receivable balances over a period of time, disaggregated based on credit risk characteristics, and divides them into delinquency categories – e.g. current, up to 30 days past due, between 31-60 days past due, and so on.

Using the historical data, it is possible to determine the rate at which debtors move into a worse delinquency category as time passes and then determine, using matrix multiplication, a loss rate for each delinquency category.

The loss rate must be adjusted for current conditions and also for 'reasonable and supportable’ forecasts of future economic conditions over the remaining life of the trade receivables. These loss rates are then applied to the reporting date outstanding receivables balance by delinquency category to determine the ECL allowance.

This approach may seem similar to how many corporates historically measured their bad debt provisions. However, because IFRS 9 requires that loss rates reflect relevant, reasonable and supportable information about future expectations, bad debt provisions under IFRS 9 will likely be higher than under the previous incurred loss approach.

Here is an illustrative example of a provision matrix (source: KPMG’s IFRS 9 for Corporates).

A provision matrix is an effective way of measuring ECL consistently from period to period. It may prove especially appropriate for corporates with a high volume of sales and cash collections from trade receivables. However, corporates should use appropriate groupings of trade receivables based on credit risk characteristics (e.g. geography or debtor credit rating), and determine loss rates by group of similar risk characteristics.

Corporates with highly seasonal revenue patterns, however, may turn to other methods. This is because cash collections from trade receivables either may not follow a linear pattern or may peak dramatically at certain points during the fiscal year. Using a provision matrix approach in such cases could result in loss rates that are not suitable for ECL measurement.

Arguably the most challenging aspect of applying IFRS 9 ECL to trade receivables is the concept of reasonable and supportable forecasts and how to integrate this into the ECL calculation. This forward-looking estimate should take into account changes in macro-economic conditions that impact the ability of debtors to continue to pay.

Other financial assets

Other financial assets measured at amortized cost such as lending instruments, debt securities (e.g. corporate bonds, national bonds) or issued financial guarantee contracts require impairment recognition under the ECL model. For those, the simplified approach is not available. This brings extra complexity to the modeling because of the need to manage asset migrations between the 12 month and lifetime ECL measurement buckets in the general approach.

Assets in the scope of the ECL model that had a zero credit loss provision under IAS 39 (because they were not ‘impaired’) may have to have some allowance under IFRS 9. This is an important change because the lack of a credit loss experience in a company’s history cannot be used as the sole basis to conclude that the expected credit loss for a financial asset measured at amortized cost is zero.

Considerations for dual reporters (IFRS vs. US GAAP)⁶

US GAAP has also changed in the past few years with respect to classification and measurement, as well as the forthcoming changes to measurement of credit losses.

Key classification and measurement differences between IFRS 9 and US GAAP

Key differences between IFRS 9 ECL and US GAAP CECL⁸

Effective dates

One of the key challenges for dual reporters will be managing the different US GAAP and IFRS 9 effective dates. While IFRS 9 is already effective, CECL is not until 2020 at the earliest, and even later for many companies. This means that IFRS 9 will be in use while legacy US GAAP continues to be used until CECL comes into effect.

Contributing authors

Reza Van Roosmalen, John Lyons, Mahesh Narayanasami, Valerie Boissou, Patricia Alonso de la Fuente

¹ IFRS 9, Financial Instruments, is effective for annual periods beginning on or after January 1, 2018. However, companies can elect to defer applying the new hedge accounting guidance until the IASB’s macro hedging project is complete. Insurers can elect to defer adopting IFRS 9 in its entirety until IFRS 17, Insurance Contracts, becomes effective.

 ² IAS 37, Provisions, Contingent Liabilities and Contingent Assets

³ IFRS 13, Fair Value Measurement

⁴ IFRS 7, Financial Instruments: Disclosures

⁵ The provision matrix approach must follow the principles described in IFRS 9 paragraph 5.5.17.

⁶ Read more in our publication: IFRS compared to US GAAP.

⁷ ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, became effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods therein.

⁸ ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), is effective for public business entities that are SEC filers for fiscal periods beginning after December 15, 2019; one-year deferral for public entities that are non-SEC filers and two-year deferral for all other entities. The ASU contains a new credit loss model that replaces the existing incurred loss models for financial assets measured at amortized cost being the current expected credit loss model (CECL).