We wrote about International Financial Reporting Standard 9 Financial Instruments in late 2017
. The standard has been applicable for one year, and readers of the first financial statements fully prepared to IFRS 9 will see its impact in spring 2019. This article explores key insights gained by non-financial entities implementing IFRS 9 over the year.
Dispelling the myth that “IFRS 9 doesn’t apply to me, as I have no financial instruments”
IFRS 9 applies to all entities that are covered by IFRS requirements and hold financial instruments. Financial instruments are not only financial derivatives and loans but also, for example, trade debtors, trade creditors, cash at bank, loans to related parties and borrowings.
Non-recourse factoring of trade receivables significantly affects classification of receivables
IFRS 9 has changed the classification of financial assets, emphasising the need to measure not only expected cash flows from a financial instrument but also the business model associated with holding it. Many entities in Latvia regularly put their trade receivables up for non-recourse factoring, and selling such receivables involves no deterioration of their solvency. For such trade receivables the business model is in fact “holding to collect cash flows and sell.” So, if the year-end balance sheet carries a trade receivable not yet sold, this should be measured at fair value, recognising the remeasurement in other income (equity reserve).
Features of measuring equity instruments
IFRS 9 has expanded the range of requirements for measuring equity instruments (e.g. shares or investment fund certificates that do not grant control, joint control or significant influence). Earlier it was permitted in certain cases to measure such instruments at cost, but today equity instruments are measured only at fair value, recognising the remeasurement result in either profit and loss, or other income. Cost can be used only if it is close to fair value. So entities should determine the fair value of their equity instruments and recognise it in financial statements accordingly.
Impairment calculation does not apply to trade receivables alone
Historically entities were used to recognising losses only after a loss event occurred. But the new model of IFRS 9 involves recognising an expected credit loss (ECL), i.e. estimating the probability of suffering a loss on default and the amount of loss, recognising an impairment accordingly. Entities should recognise an impairment at the initial recognition of an asset and accelerate provisioning for it. This calculation applies to each and every financial asset not carried at fair value with remeasurement to profit and loss. What this means in practice is that entities should estimate ECL on their loans to subsidiaries and other related parties, and on their bank account balances and similar financial assets. Expressed as a formula, ECL is a loss on default multiplied by probability of loss.
Impairment calculation for financial assets with no experience of credit loss
Big issues arise when it comes to estimating the probability and amount of loss on default for any assets with very limited or no experience of credit loss. For those assets, entities can use such external sources as Moody’s who regularly update and publish matrices with historical credit loss indicators by industry. Such external data can facilitate management estimates and provide a reasonable basis for them.
A provision matrix can be used for trade receivables
When it comes to calculating a provision for impaired trade receivables, entities can still use a provision matrix based on the age structure of receivables. The matrix should be improved to allow for potential losses on debtors with no overdue payments or short delays and to reflect economic growth forecasts. Improvement can be based on data from the past few (usually three to five) years about the ratio of bad debts and sales made on debt terms adjusted for future factors such as overall economic growth, GDP growth, or any other factor crucial to the entity.
The complete adoption of IFRS 9 requires an entity to make significant assumptions and carefully evaluate the IFRS 9 requirements. In 2018, entities have done plenty of work in implementing those requirements, yet in the future they will need to adjust and improve many of their calculations and renew their initial assumptions to reflect changes to their business activity and future forecasts.