9 Example: Financial liability at amortised cost
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Question
Finance cost 2
On 1 January 20X1, an entity issued a debt instrument with a coupon rate of 3.5% at a par value of
$6,000,000. The directly attributable costs of issue were $120,000. The debt instrument is repayable on
31 December 20X7 at a premium of $1,100,000.
What is the total amount of the finance cost associated with the debt instrument?
A
B
C
D
$1,470,000
$1,590,000
$2,570,000
$2,690,000
Answer
D
Issue costs
Interest $6,000,000 3.5% 7
Premium on redemption
Total finance cost
Question
$
120,000
1,470,000
1,100,000
2,690,000
Classification
During the financial year ended 28 February 20X5, MN issued the two financial instruments described
below. For each of the instruments, identify whether it should be classified as debt or equity, explaining in
not more than 40 words each the reason for your choice. In each case you should refer to the relevant
International Financial Reporting Standard.
(i)
Redeemable preference shares with a coupon rate 8%. The shares are redeemable on 28 February
20X9 at premium of 10%.
(ii)
A grant of share options to senior executives. The options may be exercised from 28 February
20X8.
Answer
(i)
Debt. The preference shares require regular distributions to the holders but more importantly have
the debt characteristic of being redeemable. Therefore, according to IAS 32 Financial instruments:
Presentation they must be classified as debt.
(ii)
Equity. According to IFRS 2 Share based payment the grant of share options must be recorded as
equity in the statement of financial position. It is an alternative method of payment to cash for the
provision of the services of the directors.
Question
Hybrid financial instrument
On 1 January 20X1, EFG issued 10,000 5% convertible bonds at their par value of $50 each. The bonds
will be redeemed on 1 January 20X6. Each bond is convertible at the option of the holder at any time
during the five-year period. Interest on the bond will be paid annually in arrears.
The prevailing market interest rate for similar debt without conversion options at the date of issue was
6%.
At what value should the equity element of the hybrid financial instrument be recognised in the financial
statements of EFG at the date of issue?
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Answer
Top tip. The method to use here is to find the present value of the principal value of the bond, $500,000
(10,000 $50) and the interest payments of $25,000 annually (5% $500,000) at the market rate for
non-convertible bonds of 6%, using the discount factor tables. The difference between this total and the
principal amount of $500,000 is the equity element.
$
373,500
105,300
478,800
500,000
21,200
Present value of principal $500,000 0.747
Present value of interest $25,000 4.212
Liability value
Principal amount
Equity element
Question
Subsequent measurement
After initial recognition, all financial liabilities should be measured at amortised cost.
True
False
Answer
False. Some may be measured at fair value through profit or loss.
4.10 Financial liabilities at fair value through profit or loss
Financial liabilities which are held for trading are re-measured to fair value each year in accordance with
IFRS 13 Fair value measurement (see Section 4.6) with any gain or loss recognised in profit or loss.
4.10.1 Exceptions
The exceptions to the above treatment of financial liabilities are:
(a)
It is part of a hedging arrangement (see Section 6)
(b)
It is a financial liability designated as at fair value through profit or loss and the entity is required to
present the effects of changes in the liability’s credit risk in other comprehensive income
(see 4.10. 2 below).
4.10.2 Credit risk
IFRS 9 requires that financial liabilities which are designated as measured at fair value through profit or
loss are treated differently. In this case the gain or loss in a period must be classified into:
Gain or loss resulting from credit risk, and
Other gain or loss.
This provision of IFRS 9 was in response to an anomaly regarding changes in the credit risk of a financial
liability.
Changes in a financial liability's credit risk affect the fair value of that financial liability. This means
that when an entity's creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice
versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be
recognised in profit or loss for the year. For example:
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STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)
PROFIT OR LOSS FOR THE YEAR
Liabilities at fair value (except derivatives and liabilities held for trading)
Change in fair value
Profit (loss) for the year
$'000
100
100
Many users of financial statements found this result to be counter-intuitive and confusing. Accordingly,
IFRS 9 requires the gain or loss as a result of credit risk to be recognised in other comprehensive income,
unless it creates or enlarges an accounting mismatch (see 4.10.4), in which case it is recognised in profit
or loss. The other gain or loss (not the result of credit risk) is recognised in profit or loss.
On derecognition any gains or losses recognised in other comprehensive income are not transferred to
profit or loss, although the cumulative gain or loss may be transferred within equity.
4.10.3 Example of IFRS 9 presentation
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)
PROFIT OR LOSS FOR THE YEAR
Liabilities at fair value (except derivatives and liabilities held for trading)
Change in fair value not attributable to credit risk
Profit (loss) for the year
$'000
90
90
OTHER COMPREHENSIVE INCOME (NOT RECLASSIFIED TO PROFIT OR LOSS)
Fair value loss on financial liability attributable to change in credit risk
Total comprehensive income
10
100
4.10.4 Accounting mismatch
The new guidance allows the recognition of the full amount of change in the fair value in the profit or loss
only if the recognition of changes in the liability's credit risk in other comprehensive income would create
or enlarge an accounting mismatch in profit or loss. That determination is made at initial recognition and
is not reassessed.
An accounting mismatch is a measurement or recognition inconsistency arising from measuring assets or
liabilities or recognising the gains or losses on them on different bases.
4.11 Impairment of financial assets
FAST FORWARD
Key term
The impairment model in IFRS 9 is based on the premise of providing for expected losses.
Credit-impaired financial asset. A financial asset is credit impaired when one or more events have
occurred that have a detrimental impact on the estimated future cash flows of that financial asset.
(IFRS 9)
IFRS 9 lists the following indications that a financial asset or group of assets may be impaired:
208
(a)
Significant financial difficulty of the issuer
(b)
A breach of contract, such as a default in interest or principal payments
(c)
The lender granting a concession to the borrower that the lender would not otherwise consider, for
reasons relating to the borrower's financial difficulty
(d)
It becomes probable that the borrower will enter bankruptcy
(e)
The disappearance of an active market for that financial asset because of financial difficulties
(f)
The purchase or origination of a financial asset at a deep discount that reflects the incurred credit
losses
7: Financial instruments Part B Accounting standards
It is not always possible to single out one particular event; rather, several events may combine to cause an
asset to become credit-impaired.
4.12 Expected credit loss model
The impairment model in IFRS 9 is based on the premise of providing for expected losses. The financial
statements should reflect the general pattern of deterioration or improvement in the credit quality of
financial instruments within the scope of IFRS 9. This is a forward-looking impairment model.
4.12.1 Background
IAS 39, the forerunner of IFRS 9, used an 'incurred loss' model for the impairment of financial assets.
This model assumed that all loans would be repaid there was until evidence to the contrary, that is until
the occurrence of an event that triggers an impairment indicator. Only at this point was the impaired loan
written down to a lower value. The global financial crisis led to criticism of this approach for many
reasons, including that it leads to an overstatement of interest revenue in the periods prior to the
occurrence of a loss event, and produces deficient information.
In a 2009 ED Amortised cost and impairment, the IASB proposed to remedy this by measuring expected
credit losses through adjusting the effective interest rate of a financial instrument. The IASB issued an
Exposure Draft Supplement with revised proposals in January 2011, both based on recognition of
'expected' rather than 'incurred' credit losses. Feedback on both Exposure Drafts was that the proposed
methodologies would be difficult to apply in practice.
In March 2013 the IASB issued a third set of proposals for impairment of financial assets following
feedback on the earlier Exposure Draft and Exposure Draft Supplement. The proposals in this Exposure
Draft formed the basis of the IFRS 9 impairment model.
4.12.2 Objective of the IFRS 9 impairment model
The objective of the IFRS 9 impairment model is to recognise expected credit losses for all financial
instruments within the scope of the requirements. Expected credit losses are defined as the expected
shortfall in contractual cash flows. An entity should estimate expected credit losses considering past
events, current conditions and reasonable and supportable forecasts.
The IASB believes that this will provide users of financial statements with more useful and timely
information.
4.12.3 Key definitions
The following definitions are important in understanding this section, and you should refer back to them
when studying this material.
Key terms
Credit loss. The expected shortfall in contractual cash flows. (IFRS 9)
Expected credit losses. The weighted average of credit losses with the respective risks of a default
occurring as the weights. (IFRS 9)
Lifetime expected credit losses. The expected credit losses that result from all possible default events
over the expected life of a financial instrument. (IFRS 9)
Past due. A financial asset is past due when a counterparty has failed to make a payment when that
payment was contractually due. (IFRS 9)
Purchased or originated credit-impaired financial asset. Purchased or originated financial asset(s) that
are credit impaired on initial recognition. (IFRS 9)
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4.12.4 Scope
IAS 39 was criticised for treating the impairment of different items in different ways. Under IFRS 9, the
same impairment model applies to the following.
(a)
Financial assets measured at amortised cost
(b)
Financial assets mandatorily measured at fair value through other comprehensive income
(c)
Loan commitments when there is a present obligation to extend credit (except where these are
measured at fair value through profit or loss)
(d)
Financial guarantee contracts to which IFRS 9 is applied (except those measured at fair value
through profit or loss)
(e)
Lease receivables within the scope of IAS 17 Leases; and
(f)
Contract assets within the scope of IFRS 15 Revenue from contracts with customers (ie rights to
consideration following transfer of goods or services)
4.12.5 Basic principle behind the model
The financial statements should reflect the general pattern of deterioration or improvement in the
credit quality of financial instruments within the scope of the model.
IFRS 9 requires entities to base their measurement of expected credit losses on reasonable and
supportable information that is available without undue cost or effort. This will include historical,
current and forecast information.
Expected credit losses are updated at each reporting date for new information and changes in
expectations, even if there has not been a significant increase in credit risk.
4.12.6 On initial recognition
The entity must create a credit loss allowance/provision equal to twelve months' expected credit
losses. This is calculated by multiplying the probability of a default occurring in the next twelve months
by the total lifetime expected credit losses that would result from that default. (This is not the same as
the expected cash shortfalls over the next twelve months.)
The intention is that the amount recognised on initial recognition acts as a proxy for the initial expectation
of credit losses that are factored into the pricing of the instrument, which do not represent an economic
loss to an entity because they are expected when pricing the instrument.
4.12.7 Subsequent years
If the credit risk increases significantly since initial recognition this amount will be replaced by lifetime
expected credit losses. If the credit quality subsequently improves and the lifetime expected credit losses
criterion is no longer met, the twelve-month expected credit loss basis is reinstated.
4.12.8 Rebuttable presumption: provide if 30 days past due
There is a rebuttable presumption that lifetime expected losses should be provided for if contractual cash
flows are 30 days past due (overdue).
4.12.9 Financial instruments with low credit risk
Certain financial instruments have a low credit risk and would not, therefore, meet the lifetime expected
credit losses criterion. Entities do not recognise lifetime expected credit losses for financial instruments
that are equivalent to 'investment grade', which means that the asset has a low risk of default.
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4.12.10 Amount of impairment
The amount of the impairment to be recognised on these financial instruments depends on whether or not
they have significantly deteriorated since their initial recognition.
Stage 1
Financial instruments whose credit quality has not significantly deteriorated since their
initial recognition
Stage 2
Financial instruments whose credit quality has significantly deteriorated since their initial
recognition
Stage 3
Financial instruments for which there is objective evidence of an impairment as at the
reporting date
For stage 1 financial instruments, the impairment represents the present value of expected credit losses
that will result if a default occurs in the 12 months after the reporting date (12 months expected credit
losses).
For financial instruments classified as stage 2 or 3, an impairment is recognised at the present value of
expected credit shortfalls over their remaining life (lifetime expected credit loss). Entities are required to
reduce the gross carrying amount of a financial asset in the period in which they no longer have a
reasonable expectation of recovery.
4.12.11 Interest
For stage 1 and 2 instruments interest revenue would be calculated on their gross carrying amounts.
Interest revenue for stage 3 financial instruments would be recognised on a net basis (ie after deducting
expected credit losses from their carrying amount).
4.12.12 Summary
The following table gives a useful summary of the process.
Stage 1
Stage 2
Stage 3
When?
Initial recognition
(and subsequently if
no significant
deterioration in
credit risk)
Credit risk increases
significantly
(rebuttable
presumption if > 30
days past due)
Objective evidence
of impairment exists
at the reporting date
Credit losses
recognised
12-month expected
credit losses
Lifetime expected
credit losses
Lifetime expected
credit losses
Calculation of
effective
interest
On gross carrying
amount
On gross carrying
amount
On carrying amount
net of allowance for
credit losses after
date evidence exists
4.12.13 Measuring expected credit losses
Credit losses are the present value of all cash shortfalls. Expected credit losses are an estimate of credit
losses over the life of the financial instrument. An entity should consider the following when measuring
expected credit losses.
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(a)
The probability –weighted outcome. Expected credit losses should not be a best or worst-case
scenario, but should reflect the possibility that a credit loss will occur, and the possibility that it will
not.
(b)
The time value of money: they should be discounted at the reporting date.
(c)
Reasonable and supportable information that is available without undue cost or effort, including
information about past events, current conditions and forecasts of future conditions. A ‘crystal ball’
is not required.
4.12.14 Example: portfolio of mortgages and personal loans
Credito Bank operates in South Zone, a region in which clothing manufacture is a significant industry. The
bank provides personal loans and mortgages in the region. The average loan to value ratio for all its
mortgage loans is 75%.
All loan applicants are required to provide information regarding the industry in which they are employed.
If the application is for a mortgage, the customer must provide the postcode of the property which is to
serve as collateral for the mortgage loan.
Credito Bank applies the expected credit loss impairment model in IFRS 9 Financial instruments. The bank
tracks the probability of customer default by reference to overdue status records. In addition, it is required
to consider forward-looking information as far as that information is available.
Credito Bank has become aware that a number of clothing manufacturers are losing revenue and profits as
a result of competition from abroad, and that several are expected to close.
Required
How should Credito Bank apply IFRS 9 to its portfolio of mortgages in the light of the changing situation in
the clothing industry?
Solution
Credito Bank should segment the mortgage portfolio to identify borrowers who are employed by suppliers
and service providers to the clothing manufacturers. This segment of the portfolio may be regarded as
being ‘in Stage 2’, that is having a significant increase in credit risk. Lifetime credit losses must be
recognised.
In estimating lifetime credit losses for the mortgage loans portfolio, Credito Bank will take into account
amounts that will be recovered from the sale of the property used as collateral. This may mean that the
lifetime credit losses on the mortgages are very small even though the loans are in Stage 2.
Question
Particular defaults identified
Later in the year, more information emerged, and Credito Bank was able to identify the particular loans
that defaulted or were about to default.
Required
How should Credito Bank treat these loans?
Answer
The loans are now in Stage 3. Lifetime credit losses should continue to be recognised, and interest
revenue should switch to a net interest basis, that is on the carrying amount net of allowance for credit
losses.
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4.12.15 Undrawn facilities
Under IFRS 9, the ‘three stage’ expected credit loss model also applies to the undrawn portions of
overdraft, credit card and other approved but undrawn facilities.
Stage
Apply to
Recognise
Stage 1 – No significant
increase in credit risk
Expected portion to be drawn down within the
next 12 months
12 months expected
credit losses
Stage 2 – Significant increase in Expected portion to be drawn down over the
credit risk
remaining life of the facility
Question
Lifetime credit losses
Undrawn overdraft facilities
Debita Bank applies the expected credit loss impairment model of IFRS 9. At 30 September 20X4, the bank
approved a total of $10 million overdraft facilities which have not yet been drawn.
Debita Bank considers that $8 million is in Stage 1 (ie, no significant increase in credit risk). Of that $8
million in Stage 1, $4 million is expected to be drawn down within the next 12 months, with a 3%
probability of default over the next 12 months.
Debita Bank considers that $2 million is in Stage 2 and $2 million is expected be drawn down over the
remaining life of the facilities, with a probability of default of 10%.
Required
Calculate the additional allowance required in respect of the undrawn overdraft facilities, taking account of
the above information.
Answer
Stage
Stage 1
Stage 2
$4 million × 3%
$2 million × 10%
Expected credit loss
$
120,000
200,000
320,000
Under the IFRS 9 model, Debita bank would recognise an additional allowance of $320,000 for the
undrawn portion of its overdraft facilities.
4.12.16 Recognition of impairment
In all three cases credit losses would be recognised in profit or loss and held in a separate allowance
account (although this would not be required to be shown separately on the face of the statement of
financial position). Where the expected credit losses relate to a loan commitment or financial guarantee
contract a provision rather than allowance would be made.
4.12.17 Adjustment of loss allowance
Entities must recognise in profit or loss, as an impairment gain or loss, the amount of expected credit
losses (or reversal) that is required to adjust the loss allowance at the reporting date to the amount that is
required to be recognised in accordance with IFRS 9.
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4.12.18 Presentation
(a)
With the exception of investments in debt measured at fair value through OCI, for all three stages,
credit losses are recognised in profit or loss and held in a separate allowance account which is
offset against the carrying amount of the asset.
(b)
For investments in debt measured at fair value through OCI, the portion in the fall in fair value
relating to credit losses should be recognised in profit or loss with the remainder being
recognised in other comprehensive income. No allowance account is needed because the
financial asset is already carried at fair value (automatically reduced for any fall in value including
credit losses).
4.12.19 Simplified approach for trade and lease receivables
For trade receivables that do not have an IFRS 15 financing element, the loss allowance is measured at
the lifetime expected credit losses, from initial recognition.
For other trade receivables and for lease receivables, the entity can choose (as a separate accounting
policy for trade receivables and for lease receivables) to apply the 3 Stage approach or to recognise an
allowance for lifetime expected credit losses from initial recognition.
4.12.20 Example: trade receivable provision matrix
On 1 June 20X4, Kredco sold goods on credit to Detco for $200,000. Detco has a credit limit with Kredco
of 60 days. Kredco applies IFRS 9, and uses a pre-determined matrix for the calculation of allowances for
receivables as follows.
Expected loss
Days overdue
provision
Nil
1%
5%
311 to 1 to 30
31 to 60
15%
61 to 90
20%
90 +
25%
Detco had not paid by 31 July 20X4, and so failed to comply with its credit term, and Kredco learned that
Detco was having serious cash flow difficulties due to a loss of a key customer. The finance controller of
Detco has informed Kredco that they will receive payment.
Ignore sales tax.
Required
Show the accounting entries on 1 June 20X4 and 31 July 20X4 to record the above, in accordance with
the expected credit loss model in IFRS 9.
Solution
On 1 June 20X4
The entries in the books of Kredco will be:
DEBIT Trade receivables
CREDIT
Revenue
$200,000
$200,000
Being initial recognition of sales
An expected credit loss allowance, based on the matrix above, would be calculated as follows:
DEBIT
CREDIT
Expected credit losses
Allowance for receivables
Being expected credit loss: $200,000 × 1%
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$2,000
$2,000
On 31 July 20X4
Applying Kredco’s matrix, Detco has moved into the 5% bracket, because it has exhausted its 60-day
credit limit. (Note that this does not equate to being 60 days overdue!) Despite assurances that Kredco will
receive payment, the company should still increase its credit loss allowance to reflect the increased credit
risk. Kredco will therefore record the following entries on 31 July 20X4
DEBIT
CREDIT
Expected credit losses
Allowance for receivables
$8,000
$8,000
Being expected credit loss: $200,000 × 5% – $2,000
Question
Trade receivables provision matrix
Redblack Co has a customer base consisting of a large number of small clients. At 30 June 20X4, it has a
portfolio of trade receivables of $60 million. Redblack applies IFRS 9, using a provision matrix to
determine the expected credit losses for the portfolio. The provision matrix is based on its historical
observed default rates, adjusted for forward looking estimates. The historical observed default rates are
updated at every reporting date.
At 30 June 20X4, Redblack estimates the following provision matrix.
Expected default
rate
Current
1 to 30 days overdue
31 to 60 days overdue
61 to 90 days overdue
More than 90 days overdue
0.3%
1.6%
3.6%
6.6%
10.6%
Gross carrying
amount
$’000
30,000
15,000
8,000
5,000
2,000
60,000
Credit loss allowance
Default rate × gross carrying amount
$’000
90
240
288
330
212
1,160
At 30 June 20X5, Redblack has a portfolio of trade receivables of $68 million. The company revises its
forward looking estimates and the general economic conditions are deemed to be less favourable than
previously thought. The partially competed provision matrix is as follows.
Expected default rate
Current
1 to 30 days overdue
31 to 60 days overdue
61 to 90 days overdue
More than 90 days overdue
0.5%
1.8%
3.8%
7%
11%
Gross carrying amount
$’000
32,000
16,000
10,000
7,000
3,000
68,000
Required
Complete the provision matrix for Redblack at 30 June 20X5 and show the journal entries to record the
credit loss allowance.
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Answer
Expected default
rate
Current
1 to 30 days overdue
31 to 60 days overdue
61 to 90 days overdue
More than 90 days overdue
0.5%
1.8%
3.8%
7%
11%
Gross carrying
amount
$’000
32,000
16,000
10,000
7,000
3,000
68,000
Credit loss allowance
Default rate × gross carrying amount
$’000
160
288
380
490
330
1,648
The credit loss allowance has increased by $488,000 to $1,648,000 as at 30 June 20X5. The journal entry
at 30 June 20X5 would be:
DEBIT
CREDIT
Expected credit losses
Allowance for receivables
$488,000
$488,000
Being expected credit loss
4.12.21 Purchased or originated credit-impaired financial assets
IFRS 9 requires that purchased or originated credit-impaired financial assets are treated differently
because the asset is credit-impaired at initial recognition. For these assets, an entity must recognise
changes in lifetime expected losses since initial recognition as a loss allowance with any changes
recognised in profit or loss. Under the requirements, any favourable changes for such assets are an
impairment gain even if the resulting expected cash flows of a financial asset exceed the estimated cash
flows on initial recognition.
4.12.22 Disclosures
IFRS 9 requires extensive disclosures with emphasis on information that identifies and explains the
amounts in the financial statements that arise from expected losses and the effect of deterioration and
improvement in the credit risk of financial instruments.
The disclosures must be provided either in the financial statements or by way of a cross reference to other
statements, such as a risk report, available to users at the same time as the financial statements.
Disclosures include a reconciliation, a description of inputs and assumptions used to measure expected
credit losses, and information about the effects of the deterioration and improvement in the credit risk of
financial instruments.
4.12.23 Possible effects
Possible effects of the new model include the following.
216
(a)
It is likely that this model will result in earlier recognition of credit losses than under the current
incurred loss model because it requires the recognition not only of credit losses that have already
occurred, but also losses that are expected in the future. However, in the case of shorter term and
higher-quality financial instruments the effects may not be significant.
(b)
The new model will require significantly more judgment when considering information related to
the past, present and future. It relies on more forward-looking information, which means that any
losses would be accounted for earlier than happens under the current rules.
(c)
Costs of implementing the new model are likely to be material.
(d)
There are differences between the IASB and the FASB approach which may lead to significant
differences in the figures reported
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