Accounting for Financial Instruments under IFRS 9

IFRS 9, Financial Instruments, is IFRS’s primary accounting standard addressing the recognition, measurement, and reporting of financial assets and liabilities. Two other IFRS standards support IFRS 9 and cover the presentation of financial instruments as debt or shareholders’ equity (IAS 32) and disclosure requirements for financial instruments (IFRS 7). All other financial instrument-related accounting issues are covered by IFRS 9, including core concepts such as:

• Classification and measurement of financial assets and liabilities, including derivative financial instruments
• Impairment of financial assets
• Hedge accounting

GAAP Dynamics offers a comprehensive learning collection IFRS 9: Financial Instruments providing an in-depth look at the standard through 5 separate eLearning courses that earn you 7 CPE credits. In this blog, we will take a quick look at each of these core areas of IFRS 9, providing you with a primer of key principles and considerations for accounting and reporting for financial instruments under IFRS. Alternatively, earn 1-hour of CPE and gain more insight on the overall standard by taking our eLearning, Financial Instruments: Overview of IFRS 9, which also provides a summary of the entire standard in one hour!

IFRS 9: Classification and Measurement of Financial Assets

Classification and measurement of financial assets is part of IFRS 9 impact almost all entities, as it affects trade receivables, debt and equity investments, loans, among other financial assets. Under IFRS 9, financial assets are classified into one of three categories:

1. Amortized cost
2. Fair value through OCI (FVOCI)
3. Fair value through P&L (FVPL)

These categories are presented in this order as the guidance is formulated such that entities must “earn” the right to classify their “debt” financial assets at amortized cost. If not “earned”, then FVOCI may be possible if the entity’s business model suggests this is appropriate, or, if neither of these classification qualifies, FVPL is, by default, is applied.

Note that equity and derivative financial assets are going to be limited in how they are classified, with classification as FVPL in almost all instances. This is due to the nature of these financial assets and the fact that they do not meet the cash flow characteristics requirements (discussed below) because they lack contractual rights to both principal and interest payments. As a result, FVTPL is generally the classification result. I say “generally”, because there is a classification alternative for certain equity financial assets that are NOT held for trading purposes and for which the reporting entity has elected the equity financial asset to be classified as FVOCI. However, for these instruments, there is “no recycling” of unrealized or realized gains or losses through P&L (i.e., realized gains/losses remain in shareholders’ equity/OCI forever, even after sale of the instrument) and the election for this treatment is irrevocable. As a result, this classification alternative is not commonly applied!

Classification of Debt Financial Assets

Let’s take a closer look at the classification of debt securities as this tends to be the most critical area when it comes to classification and measurement under IFRS 9. In order for a financial asset with the characteristics of debt to be classified as either amortized cost or FVOCI, two assessments must be made. One of these assessments, the “contractual cash flow characteristics” test is quite objective and rules-based, while the other assessment, the “business model” assessment is very subjective and principals-based. As consideration of the objective test on cash flow characteristics often will result in a definitive classification, we recommend you consider this first, even though within IFRS 9 it is addressed second.

This chart from one of our IFRS 9 courses lays out the process for analysis, highlighting the considerations for financial assets with debt characteristics.

Contractual Cash Flow Characteristics (a.k.a. SPPI) Test

In order for a financial asset to be classified as either amortized cost or FVOCI, the asset must have contractual cash flows that represent “solely payments of principal and interest” (SPPI) on the principal amount outstanding. In other words, a financial asset must have a principal amount, and payments earned over the life of the instrument for interest that are contractual.

As noted earlier, for this reason, equity and derivative instruments are clearly eliminated from amortized cost or FVOCI classification. However, debt securities may qualify. IFRS 9 specifically defines what it means by SPPI and therefore, this assessment is generally an objective one that requires an understanding of the specific terms of the financial instrument’s contractual terms.

Principal should be quite straightforward and represents the fair value of the financial asset at initial recognition. But it may change over the life of the asset, such as the case when principal payments are repaid over the life of the instrument (e.g. an amortizing loan).

Interest, on the other hand, is more interesting. As defined by IFRS 9, interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time, and for the basic lending risks and costs, as well as a profit margin. This means that compensation for anything other than these factors that are generally consistent with a “plain vanilla” lending arrangement would likely cause the instrument to fail the SPPI test.

Below are some examples of typical securities and whether or not they pass the SPPI test:

Typical instruments that pass the SPPI test:

• Fixed rate trade receivables, debt securities and loans
• Variable rate instruments that are tied to a typical interest rate benchmark (e.g. LIBOR, US Treasury, etc.) where the rate is in line with the term of the instrument until the next interest reset date

Typical instruments that will require close assessment and may fail the SPPI test:

• Bonds that pay interest based on the change in price of a stock or stock index
• Loans whose interest is variable and based on revenues for a given period
• Convertible bonds
• Other “hybrid instrument” financial assets with embedded derivative that are not clearly and closely related to its host (Note that this was a consideration for financial assets under IAS 39, however, is now addressed through the SPPI consideration, meaning that hybrid financial assets no longer require analysis for embedded derivatives)

In order to make this assessment, each financial asset debt contract must be reviewed and its contractual terms must be analyzed to determine whether or not the SPPI test has been met. Although this assessment is more objective in nature, special consideration may need to be given to features such as prepayments, extensions, credit protective measures, and others that may or may not impact the assessment.

If it is determined that the contractual cash flows from the financial asset represent payments solely related to principal and interest, then the second assessment must be performed.

Business Model Assessment

Unlike the SPPI test, the business model assessment requires more judgment and is based on how an entity “manages” its financial assets to general cash flows. The business model may be identified as:

• “to hold and collect contractual cash flows” – in which case amortized cost classification is appropriate
• “to hold and collect contractual cash flows AND to sell financial assets” – in which case FVOCI is appropriate
• Neither of the above – in which case FVPL classification is appropriate

This business model assessment is determined by “key management personnel”, which should be a higher level of aggregation representing the level at which the assets are managed to achieve a particular business objective.

The fact that this assessment be performed at a higher level means that not every asset in the portfolio need meet the business model itself, but rather the portfolio as a whole. Therefore, some sales prior to a financial asset’s maturity may not tarnish the portfolio’s business model “to hold and collect contractual cash flows”. However, the more sales that occur within the portfolio, the more difficult it is to assert the overall business objective is “to hold and collect contractual cash flows” or maybe even “to hold and collect contractual cash flows AND to sell financial assets”.

As you can see, judgment will need to be applied, as there are no definitive rules to assist with the business model assessment. However, IFRS 9 does state that the business model is a “matter of fact” and not merely an assertion. In other words, an entity’s actions should be observed that support the business model and its objectives for the financial assets!

These concepts and many others, including the classification of financial liabilities, are comprehensively covered in our 1.5 hour eLearning course, Financial Instruments: Classification and Measurement under IFRS 9.

IFRS 9: Impairment of financial assets

The impairment model under IFRS 9 is referred to as the expected credit loss model, or ECL. It moves away from the previous “incurred loss” model, which only recognized losses after they occurred, instead introducing this forward-looking “expected” credit loss model, aiming for more timely and proactive recognition of potential financial distress and offering a much clearer picture of an entity’s financial health at the reporting date.

At its core, IFRS 9’s ECL model operates on a three-stage approach for financial assets, reflecting varying degrees of credit risk:

• Stage 1: 12-Month ECL – This stage is used when a financial instrument is initially recognized or existing financial assets whose credit risk has not significantly increased. Companies recognize credit losses expected to occur within the next 12 months. Interest revenue is calculated on the gross carrying amount of the asset, meaning the full principal amount.
• Stage 2: Lifetime ECL (Non-Credit-Impaired) – If there’s a significant increase in credit risk (SICR) since initial recognition, but the asset isn’t yet credit-impaired, the ECL shifts to a “lifetime” basis. This means estimating losses over the entire expected life of the instrument, not just the next 12 months. Even though the risk has increased, the asset isn’t considered “impaired” yet, so it continues to generate interest on its full gross carrying amount. This stage is crucial for capturing assets that are showing early warning signs, enabling management to take preventative measures before a full impairment occurs.
• Stage 3: Lifetime ECL (Credit-Impaired) – When a financial asset becomes credit-impaired, which is essentially equivalent to an “incurred loss” under older models and guidance, lifetime ECLs are still recognized. This means a full assessment of losses over the asset’s remaining life. However, a key change is that interest revenue is now calculated on the amortized cost (gross carrying amount less the loss allowance), reflecting the impaired nature of the asset. This reduction in recognized interest income further highlights the asset’s troubled status. Examples include assets where significant payment defaults have occurred, or there’s strong evidence of a borrower’s financial difficulty, indicating that recovery of the full amount is unlikely.

Calculating ECLs involves a probability-weighted estimate of credit losses. This isn’t just a simple percentage, but instead requires consideration of a range of possible outcomes and their associated probabilities. Entities must leverage a robust blend of data, e.g., historical data (what happened in the past), current conditions (what’s happening now), and reasonable and supportable forward-looking information. This last point is vital, as it necessitates incorporating macroeconomic factors like GDP growth, unemployment rates, interest rate changes, and commodity prices into the loss calculations. This forward-looking element is what fundamentally differentiates IFRS 9 from previous guidance, pushing entities to be more predictive rather than reactive.

Simplifications for applying the ECL model

To ease the burden of applying the ECL model, IFRS 9 includes specific simplifications and practical expedients (some which are mandatory and some that are elective). For example, entities are required to apply a simplified approach for trade receivables and contract assets that do not contain a significant financing component (typically short-term receivables). Under this simplified approach, entities always measure the loss allowance at an amount equal to lifetime ECLs, effectively bypassing the three-stage model and the need to track SICR.

Another simplification involves financial instruments with low credit risk at the reporting date. For these instruments, entities have the option not to assess whether there has been a SICR since initial recognition, and instead assume measurement in Stage 1 is appropriate. This “low credit risk exemption” is often applied to instruments considered “investment grade” or similar, recognizing that their inherent risk profile makes detailed monitoring less critical.

These expedients aim to provide practical relief while maintaining the integrity of the forward-looking impairment model.

Impairment is a critical and often challenging aspect of IFRS 9 to apply. We take learners through these key principles and related challenges in our 1.5 hour eLearning, Financial Instruments: Impairment under IFRS 9.

IFRS 9: Derivatives and embedded derivatives

Derivatives are a type of financial instrument defined within IFRS 9. While we typically associate derivatives with swaps, forwards/ futures, and options, these instruments are “defined” within the standard based on the instruments characteristics and whether it is included or excluded from the scope of IFRS 9. Derivatives are those financial instruments that meet each of the following characteristics:

• Value changes in response to an underlying: Its value fluctuates based on changes in some type of “variable” (e.g., specified interest rate, financial instrument price, commodity price, foreign exchange rate, index, among others!).
• Requires little or no initial net investment: Compared to other financial instruments that require a substantial upfront payment (like buying a bond or equity share), derivatives are often entered into with minimal or no initial investment.
• Settled at a future date: The contract will be settled at some point in the future, either through physical delivery of the underlying or, more commonly, through a net cash settlement.

While each of these characteristics must be present, what often complicates identification of derivatives is the scope exceptions within IFRS 9. There are many! If an instrument qualifies for the scope exception, other accounting (including “off-balance sheet” accounting) should be determined. Scope exceptions include:

• “Regular-way” security trades
• Contracts to buy/sell non-financial items, if:
  • Cannot be settled net in cash or another financial instrument; or
  • Entered into and continued to be held in accordance with the entity’s expected purchase, sale or usage requirements
• Certain
  • Insurance contracts
  • Financial guarantees
  • Loan commitments
• Derivatives that serve as impediments to derecognition/sales accounting
• Other IFRS 9 scope exceptions:
  • Derivatives on own shares classified within shareholders’ equity under IAS 32
  • Contracts issued by the entity in connection with stock-based compensation arrangements under IFRS 2
  • Contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date
  • Lease rights and obligations under IFRS 16

Once we identify our in-scope derivatives, the accounting and measurement is a bit more straightforward (but not necessarily easy!). Derivatives are recognized on the balance sheet as a financial asset or liability. They are initially and subsequently measured at fair value, with changes in fair value typically recognized through the income statement (i.e., FVTPL). The only exception for this relates to derivatives used in certain qualifying hedge accounting arrangements (discussed below). Of course, fair value can be a challenge, particularly for some of the more interesting and exotic derivative contracts (but that’s a topic for another blog!).

Embedded derivatives

Embedded derivatives add another layer of complexity to this topic. While IFRS 9 effectively eliminates the need to assess embedded derivatives that exist within hybrid instruments with FINANCIAL ASSET hosts (due to the SPPI assessment discussed above), assessment for separation of embedded derivatives from its host contracts is still required for hybrid instruments with NON-FINANCIAL ASSET hosts as well as all hybrid instruments (financial and non-financial) that are classified as liabilities.

The accounting for embedded derivatives depends on whether the embedded derivative is required to be separated from its host for measurement purposes. IFRS 9 generally requires an embedded derivative to be separated from its host contract and measured separately at FVTPL if all of the following conditions are met:

• Not closely related: The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract.
• Standalone derivative criteria met: A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative under IFRS 9 (including consideration of the scope exceptions!).
• Not FVTPL: The entire hybrid contract is not already measured at fair value through profit or loss. If the hybrid contract is already FVTPL, then separating the embedded derivative is unnecessary, as the entire contract’s value changes are already recognized in profit or loss.

If these conditions are met, the embedded derivative is bifurcated and subsequently measured at FVTPL, just like a freestanding derivative. The host contract is then accounted for based on its own classification (e.g., amortized cost for a debt instrument). If the conditions are not met, the hybrid instrument is treated as one combined instrument, following the accounting and measurement guidelines dictated by the host instrument.

As you can see, derivatives and embedded derivatives can get a bit tricky. We pride ourselves in trying to demystify these instruments and make them less intimidating. We do this in our 1.5 hour eLearning, Financial Instruments: Derivatives and Embedded Derivatives under IFRS 9.

IFRS 9: Hedge accounting

Operating a business frequently exposes an entity to various risks from market fluctuations, such as changes in interest rates, foreign exchange rates, or commodity prices. These risks can introduce significant volatility into it’s financial statements unless hedge accounting is applied. Hedge accounting under IFRS 9 is an optional accounting treatment designed to mitigate this volatility by aligning the timing of gain and loss recognition between a “hedged item” (the risk being managed) and a “hedging instrument” (typically a derivative used to offset that risk).

The core purpose of IFRS 9’s hedge accounting is to provide a more representative picture of an entity’s risk management activities in its financial statements. Without it, derivatives, which would otherwise be measured at FVTPL, would create immediate and potentially large swings in earnings that don’t reflect the underlying economic hedging strategy of the entity. Hedge accounting allows companies to defer or modify the recognition of these derivative gains or losses to match when the hedged risk impacts profit or loss. However, hedge accounting must be EARNED by an entity, by applying a qualifying hedging strategy meeting certain requirements.

IFRS 9 outlines three primary types of hedging relationships:

• Fair Value Hedge: This hedges the exposure to changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment, that could affect profit or loss.
• Cash Flow Hedge: This hedges the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability (like future interest payments on variable-rate debt) or a highly probable forecast transaction.
• Hedge of a Net Investment in a Foreign Operation: This hedges the foreign currency exposure of a net investment in a foreign operation, applying accounting similar to cash flow hedges.

To qualify for hedge accounting, the relationship must meet strict criteria, including formal documentation, an economic relationship between the hedged item and hedging instrument, and ensuring that credit risk does not dominate the value changes. IFRS 9 provides greater flexibility than previously under IFRS, by moving to a more principles-based approach to assessing hedge effectiveness, allowing for qualitative assessments when appropriate. This aims to better align accounting outcomes with actual risk management strategies.

Hedge accounting can be complicated, but we set our learners off on the right path to a fundamental understanding of these strategies and requirements in our 1.5 hour eLearning, Financial Instruments: Hedge Accounting Under IFRS 9.

Let us help you!

As you can see, there is a lot going on in the world of financial instruments. Despite the challenges and complexities surrounding financial instruments, breaking things down to its elements and focusing on the core principles and concepts of IFRS 9, with some application and illustrative examples, will go a long way to gaining confidence and a fundamental understanding of this topic area.  Let us help you get you there with our comprehensive learning path.

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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.