PwC alternatives alert, February 23, 2010

Significant changes to the classification and measurement of financial assets: IFRS 9 financial instruments

A transition to International Financial Reporting Standards (IFRS) from US generally accepted accounting principles (US GAAP) appears inevitable for US public companies and, ultimately, investment companies. Although the time frame for the transition is still uncertain, it is important for practitioners in the asset management industry to stay abreast of recent developments, especially in the area of reporting investments or "financial instruments." Significant changes to the current accounting rules are underway, and more are scheduled in the very near future.

IAS 39, Financial Instruments: Recognition and Measurement (IAS 39) established principles for recognizing and measuring financial assets, financial liabilities, and some contracts to buy or sell non-financial items. The IASB has divided its project to replace IAS 39 into three main phases and expects to complete all phases and replace IAS 39 in its entirety by the end of 2010. For Phase 1, the IASB issued IFRS 9 Financial Instruments (IFRS 9) in November 2009. IFRS 9 addresses the classification and measurement of financial assets. As the IASB completes the remaining two phases, it will delete the relevant sections in IAS 39, and new chapters in IFRS 9 will replace the associated requirements of IAS 39.

Main changes in classification and measurement of financial assets

The first phase of IFRS 9 addressed the classification and measurement of financial assets. The principles provided the foundation for any standard governing the reporting of financial instruments; indeed, much of the discussion during the financial crisis focused on the classification and measurement of financial assets under the current standard.

Under IAS 39, financial assets were classified into four categories: (i) Financial assets at fair value through profit and loss, (ii) Held-to-maturity investments, (iii) Loans and receivables, and (iv) Available-for-sale financial assets. IFRS 9 replaces the multiple classification and measurement models with a single model that has only two classification categories: amortized cost and fair value. Similar to IAS 39, IFRS 9 requires financial assets to be measured initially at fair value (i.e., the transaction price or the fair value of the consideration given); however, IFRS 9 requires all financial assets to be measured subsequently at either amortized cost or fair value after considering (a) the business model of the entity for managing the financial asset and (b) the contractual cash flow characteristics of the financial asset.

Investments in debt instruments

To determine the classification and measurement of investments in debt instruments under IFRS 9, the analysis should start with the business model element. If the business model of the entity is aimed at managing the debt instruments in order to maximize fair value gains through trading, the debt instruments are to be measured at fair value with gains and losses recognized in the income statement; an analysis of the contractual cash flow characteristics of the financial assets is unnecessary. On the other hand, if the objective of the business model is to hold the debt instruments in order to collect the contractual cash flows, then the cash flow characteristics of the instrument need to be analyzed in order to determine whether the criteria are met for subsequent measurement at amortized cost. Gains and losses from investments in debt instruments measured at amortized cost, unless part of a hedging relationship, are only recognized in the income statement when the asset is derecognized, reclassified to be measured at fair value, or impaired. If the criteria for amortized cost are not met, then the investments in debt instruments will default to being measured subsequently at fair value, with changes recognized in profit or loss.

The evaluation of an entity's business model is not dependent on management's intentions for individual instruments, and such determination should not be made using an instrument-by-instrument approach; rather, it is determined on a higher level of asset aggregation (e.g., portfolio of investments).

IAS 39 permitted an entity to designate a financial asset on initial recognition to be measured at fair value (the "fair value option"), with changes in fair value recognized in the income statement. This fair value option becomes obsolete under IFRS 9, as the standard now requires fair value accounting under the business model considerations for investments in debt instruments that are managed and evaluated on a fair value basis.

The IFRS 9 classification principles also indicate that all derivative instruments should be carried at fair value.

Investments in equity instruments

The IFRS 9 classification principles indicate that all investments in equity instruments should be measured at fair value. However, management has an option to present unrealized and realized fair value gains and losses on investments in equity instruments that are not held for trading (e.g., shares held by private equity funds in portfolio companies) in "other comprehensive income" (as opposed to being presented as a component of "net income"). Such designation is available on initial recognition on an instrument-by-instrument basis and is irrevocable. There is no subsequent recycling of fair value gains and losses to profit or loss; however, dividends from such investments representing return on investments will continue to be recognized in profit or loss.

Investment company considerations

The objective of an investment company is to manage its portfolio to realize fair value gains rather than to collect the contractual cash flows. Financial assets which are held for trading are not considered to be held for collecting contractual cash flows. Investment companies generally follow a fair value driven business model, in which the entire portfolio is managed on a fair value basis with the objective of realizing cash flows through the sale of financial assets.

Investment companies applying IFRS 9, therefore, will apply the fair value model to all financial assets when the assets are held for trading, and to other portfolios that are managed and evaluated on a fair value basis, and will recognize gains and losses in profit or loss. Consequently, the criteria for measuring financial assets at amortized cost are less relevant for investment companies. However, as stated previously, investment companies may elect to recognize fair value gains and losses from investments in equity instruments not held for trading in other comprehensive income.

Key transition aspects

The effective date of IFRS adoption is the first annual period beginning on or after January 1, 2013, with early application permitted. IFRS 9 is to be applied retrospectively, in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, with certain exceptions. If an entity adopts IFRS 9 before January 1, 2012, it does not need to restate prior periods. Differences arising from the adoption of IFRS 9 between the carrying amounts and fair value of financial assets are to be recognized in the opening retained earnings of the reporting period that includes the date of initial application.

When an entity adopts the standard, it is required to assess whether it meets the condition described above regarding the business model of managing its financial assets on the basis of the facts and circumstances that exist at the initial application date. The classification of financial assets should be applied retrospectively, regardless of the business model in prior reporting periods. Even if the purpose and business objective change for certain financial assets, the entity's current business model for managing these financial assets will determine the classification of these financial assets for all prior periods presented.

Future phases in the replacement of IAS 39

IFRS 9 represents the first milestone in the IASB's planned replacement of IAS 39. The next steps involve reconsideration and re-exposure of the classification and measurement requirements for financial liabilities, in addition to the remaining two phases of the project.

Phase 2 of the replacement project focuses on impairment methodology. The related exposure draft, Financial Instruments: Amortized cost and Impairment, was issued by the IASB in November 2009, with a comment deadline of June 30, 2010.

Phase 3 will seek to simplify and improve hedge accounting. An exposure draft is expected to be published in the first half of 2010. In addition, the IASB is working on a derecognition project scheduled for completion in the second half of 2010.

For additional information, please contact your PwC engagement team or any of the partners in our practice.