IFRS 9: Insights into the Critical Aspects of the New Accounting Standard - Part I

IFRS 9 will be enforced starting the 1st of January 2018.

Born in the banking sector, this accounting standard will also be adopted by insurance companies that prepare their financial statements using the international accounting standards. These changes have a big impact on insurance companies for a few reasons: the complexity related to the prescriptive content of the new accounting standard and the coming of IFRS 4. Insurance companies are waiting for the new accounting standard (IFRS 4) to come into effect. Expected in 2021, this will change the recognition of liabilities (namely, the insurance provisions. The result will be a difference between the balance sheet asset valuation based on the new IFRS 9 and the valuation of liabilities that will replicate (through the new IFRS 4) the basic principles of IFRS 9 (fair value rules) starting in 2021.

Indeed, today two different transitional ways to apply the new IFRS 9 (named deferral and overlay) are allowed.

The new international accounting standard IFRS 9 replaces the current IAS 39 in the valuation of the financial instruments held by a financial institution (bank or insurance).

The new standard leverages the financial instruments in an innovative way and it will change the way the CFOs work. Indeed it combines “administrative” competence with “planning/forecast” capabilities, completely changing the current accounting procedures.   

Let’s see why:
First of all it is important to remember that the new accounting standard is based on 3 pillars (in this blog we will analyse the first pillar; the other two will be discussed in the next blog)

  • 1. Classification and valuation of financial instruments
  • 2. Impairment model
  • 3. Hedge Accounting

IFRS9: insights into the critical aspects of the new accounting standard

Classification and valuation of the financial instruments

The classification of the financial instruments upon initial recognition determines their valuation for the purposes of the Financial Statement. The classification “supports” the entire system of valuation of the financial instruments. The financial activities (including those containing embedded derivatives) can be classified in three different categories:

  • a. Amortized Costs (AC)
  • b. Fair value with classification of the changes in equity (FVTOCI – Fair Value Through Other Comprehensive Income); fair value changes that are the counterpart of an equity reserve
  • c. Fair value with  classification of the  changes in the income statement (FVTPL - Fair Value Through Profit & Loss)

The classification is based on two factors:

  • i. the business model (BM) used by the company (bank and/or insurance) to manage the financial activities included in the classification where the BM is that of the single portfolio (or of homogeneous portfolios) in which the securities are inserted and not the BM of the overall company, namely the purposes for which a title is held in a given portfolio (or in homogenous portfolios)
  • ii. the types of cash flows generated by the securities identified by the related specific contractual characteristics

A security can be held to:

  • I. collect the cash flows until maturity (Hold To Collect),
  • II. collect the cash flows until subsequent disposal (Hold To Collect and Sell) or to
  • III. optimize the cash flows by detecting all the changes in fair value through their dealing (Other Business Model).

Once the purposes for which a security is held have been defined, it is necessary to analyse the characteristics of the cash flows that distinguish the security.

The simplest ones are the expression of the payment of capital and interests. They represent the creditworthiness of the debtor and the interests represent only the time value of money (e.g.: debt instruments) and they don’t remunerate further risk components or contractual and/or financial options (cash flows are Solely Payments of Principal and Interests - SPPI)

In order to verify the type of cash flows, it is necessary to apply the SPPI test that verifies how much the cash flows of the instrument to be classified move away from the basic model mentioned above. The wider the gap, the more the security will be intended to be classified in a category in which the change of fair value of the activities will be recorded in the income statement. 

By combining point (i) and (ii) we will have the following possible classifications for certain financial activities

the business model (BM) used by the company (bank and/or insurance) to manage the financial activities

The orange one probably represents the classification that can be most widely used by the insurance companies. 

This first pillar shows an important characteristic of the new standard related to the fact that the application of a BM depends on the professional judgement of who registers the security into the company’s accounting systems as well as on the availability of lots of information on which to rely, such as

  • Historical analysis of the methods adopted by the company to reach its goals;
  • Business plans
  • Importance (amount) and frequency of the sales activities of the financial instruments in each portfolio (or homogenous categories of portfolios)

It is important to remember that the change of BM is rare and it is allowed only if important changes in the company’s internal or external context occur. Moreover it must be declared by the Board of Directors and available to third parties. 

This assessment “structure”, which is necessary for the application of an accounting standard, highlights the need for an advanced information system able to make information and data available to the CFO in order to strengthen his/her classification choices (consider all forms of reconciliation between accounting impacts and business models). Such impacts on systems, processes and company procedures are even more evident in the second pillar of the accounting standard.

Read the next blog post


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