IFRS 9 Financial Instruments

What it is

IFRS 9 Financial Instruments is the accounting standard that tells a firm how to classify, measure, impair and hedge its financial assets and liabilities. It replaced IAS 39 from 1 January 2018. In the EU it applies through the IAS Regulation to the consolidated accounts of listed groups, which covers most large banks and insurers.

The standard has three parts. Classification and measurement places each financial asset at amortised cost, fair value through other comprehensive income (FVOCI) or fair value through profit or loss (FVTPL). The choice depends on the business model and on the SPPI test of contractual cash flows. Impairment requires an expected credit loss (ECL) allowance from initial recognition, using three stages. Hedge accounting lets firms reflect their risk management in the accounts.

Why it matters

For a bank, IFRS 9 impairment is usually the largest judgement in the financial statements. Loss allowances move profit, capital and the room to pay dividends. Because ECL uses forward-looking economic scenarios, provisions rise as soon as the outlook worsens, before borrowers miss payments. Classification decides whether a change in value hits profit, equity or nothing until the asset is sold.

Worked example

Illustrative numbers. A bank lends EUR 1,000,000 for five years. At origination the borrower has a 12-month probability of default (PD) of 1 percent and the loss given default (LGD) is 40 percent. The Stage 1 allowance is 1,000,000 x 1% x 40% = EUR 4,000.

Two years later the borrower is downgraded. The lifetime PD over the remaining three years is now 12 percent, a significant increase in credit risk, so the loan moves to Stage 2. The allowance becomes 1,000,000 x 12% x 40% = EUR 48,000, ignoring discounting and repayments. The extra EUR 44,000 is charged to profit or loss. If the borrower later defaults, the loan moves to Stage 3 and interest income is calculated on the carrying amount net of the allowance.

Who uses it

• General Accountants and Group Reporting Accountants book allowances and prepare the IFRS 7 disclosures.
• Credit Risk Analysts and Credit Risk Model Developers build the PD, LGD and exposure models and the staging rules.
• External Audit (Financial Services) teams test models, management overlays and scenario weights.
• Accounting Advisory Associates advise on classification, the SPPI test and implementation.
• Regulatory Reporting Analysts map stages and allowances into FINREP and capital calculations.

Common confusions

• IFRS 9 ECL and regulatory expected loss are different numbers. IFRS 9 uses point-in-time, forward-looking estimates and lifetime losses for Stage 2. Capital models use a 12-month through-the-cycle PD and a downturn LGD.
• Stage 2 does not mean a loan is impaired. Only Stage 3 assets are credit-impaired.
• FVOCI works differently for debt and equity. Gains on debt instruments are recycled to profit on sale, while gains on equity instruments designated at FVOCI never are.
• Hedge accounting is optional. IFRS 9 also lets firms keep applying the IAS 39 hedge accounting rules, which many banks do for portfolio hedges of interest rate risk.