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9 Example: Financial liability at amortised cost

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?



206



7: Financial instruments  Part B Accounting standards



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:



Part B Accounting standards  7: Financial instruments



207



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)



Part B Accounting standards  7: Financial instruments



209



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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7: Financial instruments  Part B Accounting standards



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.



Part B Accounting standards  7: Financial instruments



211



(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.



212



7: Financial instruments  Part B Accounting standards



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.



Part B Accounting standards  7: Financial instruments



213



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%



214



7: Financial instruments  Part B Accounting standards



$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.



Part B Accounting standards  7: Financial instruments



215



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



7: Financial instruments  Part B Accounting standards



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