International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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requirements of IAS 39. [IFRS 9.5.2.3, 5.3.2, 5.7.3, 7.2.21].
Also, derivatives and non-derivative debt financial instruments may be designated as
hedging instruments which can affect whether fair value or foreign exchange gains and
losses are recognised in profit or loss or in other comprehensive income. [IFRS 9.B5.7.2].
Hedge accounting is covered in Chapter 49.
2.9.2
Regular way transactions
Except for its rules on transfers of assets, IFRS 9 requires an entity to recognise a
financial asset in its statement of financial position when, and only when, the entity
becomes party to the contractual provisions of the instrument and to derecognise a
financial asset when, and only when, the contractual rights to the cash flows from the
financial asset expire (see Chapter 45 at 2.1). [IFRS 9.3.1.1, 3.2.3]. In other words, IFRS 9
requires a financial asset to be recognised or derecognised on a trade date basis, i.e. the
date that an entity commits itself to purchase or sell an asset. [IFRS 9.B3.1.5]. However, the
standard permits financial assets subject to so called ‘regular way transactions’ to be
recognised, or derecognised, either as at the trade date or as at the settlement date
(see Chapter 45 at 2.2). [IFRS 9.3.1.2, B3.1.3, B3.1.5, B3.1.6]. Whichever method is used, it is
applied consistently and symmetrically (i.e. to acquisitions and disposals) to each of the
main categories of financial asset identified by IFRS 9, i.e. mandatorily measured at
amortised cost, at fair value through other comprehensive income or at fair value
through profit or loss or designated as measured at fair value through profit or loss or at
fair value through other comprehensive income (equity investments only) (see
Chapter 45 at 2.2). [IFRS 9.B3.1.3].
Where settlement date accounting is used for regular way transactions, any change in
the fair value of the asset to be received arising between trade date and settlement date
is not recognised for those assets that will be measured at amortised cost. For assets that
will be recorded at fair value, such changes in value are recognised: [IFRS 9.5.7.4, B3.1.6]
• in profit or loss for assets classified as measured at fair value through profit or loss; and
• in other comprehensive income for debt instruments classified, and equity instruments
designated, as measured at fair value through other comprehensive income.
For financial assets measured at amortised cost or at fair value through other
comprehensive income, IFRS 9 requires entities to use the trade date as the date of
initial recognition for the purposes of applying the impairment requirements.
[IFRS 9.5.7.4]. This means that entities that use settlement date accounting may have to
recognise a loss allowance for financial assets which they have purchased but not yet
recognised and, correspondingly, no loss allowance for assets that they have sold but
not yet derecognised (see Chapter 47 at 7.3.2).
Financial instruments: Subsequent measurement 3697
On disposal, changes in value of such assets between trade date and settlement date are
not recognised because the right to changes in fair value ceases on the trade date.
[IFRS 9.D.2.2]. This is illustrated in Chapter 45 at 2.2.3.
2.9.3
Liabilities arising from failed derecognition transactions
There are special requirements for financial liabilities (including financial guarantee
contracts) that arise when transfers of financial assets do not qualify for derecognition,
or are accounted for using the continuing involvement approach. [IFRS 9.4.2.1(b)]. These
are dealt with in Chapter 48 at 5.3.
3
AMORTISED COST AND THE EFFECTIVE INTEREST
METHOD
The amortised cost measurement requirements, including the calculation of effective
interest rates under IFRS 9, are the same as under IAS 39, although the terminology has
changed. IFRS 9 contains four key definitions relating to this method of accounting,
which are set out below: [IFRS 9 Appendix A]
• The amortised cost is the amount at which the financial asset or financial liability
is measured at initial recognition minus any principal repayments, plus or minus
the cumulative amortisation using the effective interest method of any difference
between that initial amount and the maturity amount and, for financial assets,
adjusted for any loss allowance.
• The gross carrying amount is the amortised cost of a financial asset before adjusting
for any loss allowance.
• The effective interest method is the method that is used in the calculation of the
amortised cost of a financial asset or a financial liability and in the allocation and
recognition of the interest revenue or interest expense in profit or loss over the
relevant period.
• The effective interest rate (EIR) is the rate that exactly discounts estimated future
cash payments or receipts through the expected life of the financial asset or
financial liability to the gross carrying amount of a financial asset or to the
amortised cost of a financial liability. [IFRS 9.5.4.1, IFRS 9 Appendix A].
3.1
Effective interest rate (EIR)
When calculating the EIR, an entity should estimate the expected cash flows by
considering all the contractual terms of the financial instrument (e.g. prepayment,
extension, call and similar options). The calculation includes all fees and points paid or
received between parties to the contract that are an integral part of the EIR, transaction
costs, and all other premiums or discounts. [IFRS 9 Appendix A]. Except for purchased or
originated financial assets that are credit-impaired on initial recognition, ECLs are not
considered in the calculation of the EIR. This is because the recognition of ECLs is
decoupled from the recognition of interest revenue (see
Chapter
47 at
3.1).
[IFRS 9 Appendix A, BCZ5.67].
Guidance related to what fees should and should not be considered integral is also
included in IFRS 9. Fees that are an integral part of the EIR of a financial instrument are
3698 Chapter 46
treated as an adjustment to the EIR, unless the financial instrument is measured at fair
value, with the change in fair value being recognised in profit or loss. In those cases, the
fees are recognised as revenue or expense when the instrument is initially recognised.
[IFRS 9.B5.4.1]. However, the recognition of day 1 profits for the difference between the
transaction price and the initial fair value on initial recognition is restricted to situations
where the fair value is based on a quoted price in an active market for an identical asset
or liability (i.e. a Level 1 input) or based on a valuation technique that uses only data
from observable markets. (See Chapter 45 at 3.3).
Fees that are an integral part of the EIR of a financial instrument include:
• origination fees received on the creation or acquisition of a financial asset. Such
fees may include compensation for activities such as evaluating the borrower’s
financial condition, evaluating and recording guarantees, collateral and other
security arrangements, negotiating the terms of the instrument, preparing and
processing documents and closing the transaction. Thes
e fees are an integral part
of generating an involvement with the resulting financial instrument;
• commitment fees received to originate a loan when the loan commitment is not
measured at fair value through profit or loss and it is probable that the entity will
enter into a specific lending arrangement. These fees are regarded as
compensation for an ongoing involvement with the acquisition of a financial
instrument. If the commitment expires without the entity making the loan, the fee
is recognised as revenue on expiry; and
• origination fees paid on issuing financial liabilities measured at amortised cost.
These fees are an integral part of generating an involvement with a financial
liability. An entity distinguishes fees and costs that are an integral part of the EIR
for the financial liability from origination fees and transaction costs relating to the
right to provide services, such as investment management services. [IFRS 9.B5.4.2].
Fees that are not an integral part of the EIR of a financial instrument and are accounted
for in accordance with IFRS 15 include:
• fees charged for servicing a loan;
• commitment fees to originate a loan when the loan commitment is not measured
at fair value through profit or loss and it is unlikely that a specific lending
arrangement will be entered into; and
• loan syndication fees received to arrange a loan and the entity does not retain part
of the loan package for itself (or retains a part at the same EIR for comparable risk
as other participants). [IFRS 9.B5.4.3].
For a purchased or originated credit-impaired financial asset (see Chapter 47 at 3.3), the
credit-adjusted effective interest rate is applied when calculating the interest revenue
and it is the rate that exactly discounts the estimated future cash payments or receipts
through the expected life of the financial asset to the amortised cost of a financial asset.
An entity is required to include the initial ECLs in the estimated cash flows when
calculating the credit-adjusted EIR for such assets. [IFRS 9.5.4.1, B5.4.7, Appendix A].
However, this does not mean that a credit-adjusted EIR should be applied solely
because the financial asset has high credit risk at initial recognition. The application
Financial instruments: Subsequent measurement 3699
guidance explains that a financial asset is only considered credit-impaired at initial
recognition when the credit risk is very high or, in the case of a purchase, it is acquired
at a deep discount. [IFRS 9.B5.4.7].
It is important to note that the EIR is normally based on estimated, not contractual, cash
flows and there is a presumption that the cash flows and the expected life of a group of
similar financial instruments can be estimated reliably. However, in those rare cases when
it is not possible to estimate reliably the cash flows or the expected life of a financial
instrument (or group of instruments), the contractual cash flows over the full contractual
term of the financial instrument (or group of instruments) should be used. [IFRS 9 Appendix A].
When applying the effective interest method, an entity generally amortises any fees,
points paid or received, transaction costs and other premiums or discounts that are
included in the calculation of the EIR over the expected life of the financial instrument.
However, there may be situations when discounts or premiums are amortised over a
shorter period (see 3.3 below).
For floating-rate financial assets and floating-rate financial liabilities, periodic re-
estimation of cash flows to reflect the movements in the market rates of interest alters
the EIR. If a floating rate financial asset or a floating rate financial liability is recognised
initially at an amount equal to the principal receivable or payable on maturity, re-
estimating the future interest payments normally has no significant effect on the
carrying amount of the asset or the liability. [IFRS 9.B5.4.5].
In most cases, a floating rate will be specified as a benchmark rate, such as LIBOR, plus
(or for a very highly rated borrower, less) a fixed credit spread. Hence it might be more
accurate to say that the rate has a floating component and a fixed component. But it is also
possible for the credit spread to be periodically reset to a market rate. Neither ‘floating-
rate’ nor ‘market rates of interest’ are defined in the standard. However, the IFRIC noted
in its January 2016 agenda decision on separation of an embedded floor from a floating
rate host contract that the term ‘market rate of interest is linked to the concept of fair
value as defined in IFRS 13 and is described in paragraph of AG64 of IAS 39 as the rate of
interest for a similar instrument (similar as to currency, term, type of interest rate and
other factors) with a similar credit rating’ (or the equivalent in paragraph B5.1.1 of IFRS 9).
This implies that the market rate of interest may include the credit spread appropriate for
the transaction and not just the benchmark component of the rate. [IFRS 9.B5.1.1].
The application of the effective interest method to floating-rate instruments and
inflation-linked debt is considered in more detail at 3.3 and 3.6 below.
As set out in Chapter 43 at 6, an issued compound financial instrument such as a
convertible bond is accounted for as a financial liability component and an equity
component. In accounting for the financial liability at amortised cost, the expected cash
flows should be those of the liability component only and the estimate should not take
account of the bond being converted.
3.2
Fixed interest rate instruments
The effective interest method is most easily applied to instruments that have fixed
payments and a fixed term. The following examples, adapted from the Implementation
Guidance to the standard, illustrate this. [IFRS 9.IG.B.26, IG.B.27].
3700 Chapter 46
Example 46.4: Effective interest method –
amortisation of premium or discount on acquisition
At the start of 2019, a company purchases a debt instrument with five years remaining to maturity for
its fair value of US$1,000 (including transaction costs). The instrument has a principal amount of
US$1,250 and carries fixed interest of 4.7% payable annually (US$1,250 × 4.7% = US$59 per year).
In order to allocate interest receipts and the initial discount over the term of the instrument at a constant
rate on the carrying amount, it can be shown that interest needs to be accrued at the rate of 10%
annually. In each period, the amortised cost at the beginning of the period is multiplied by the EIR of
10% and added to the gross carrying amount. Any cash payments in the period are deducted from the
resulting balance.
The table below provides information about the gross carrying amount, interest income, and cash flows of
the debt instrument in each reporting period.2 [IFRS 9.IG.B.26].
(a)
(b = a × 10%)
(c)
(d = a + b – c)
Gross carrying
Gross carrying
amount at the start
amount at the end
of the year
Interest income
Cash flows
of the year
Year (US$)
(US$)
(US$)
(US$)<
br />
2019 1,000
100
59
1,041
2020 1,041
104
59
1,086
2021 1,086
109
59
1,136
2022 1,136
113
59
1,190
2023
1,190
119
1,250 + 59
–
Example 46.5: Effective interest method – stepped interest rates
On 1 January 2019, Company A acquires a debt instrument for its fair value of £1,250 (including
transaction costs). The principal amount is £1,250 which is repayable on 31 December 2023. The rate of
interest is specified in the debt agreement as a percentage of the principal amount as follows: 6% in 2019
(£75), 8% in 2020 (£100), 10% in 2021 (£125), 12% in 2022 (£150) and 16.4% in 2023 (£205). It can be
shown that the interest rate that exactly discounts the stream of future cash payments to maturity is 10%.
In each period, the amortised cost at the beginning of the period is multiplied by the EIR of 10% and
added to the gross carrying amount. Any cash payments in the period are deducted from the resulting
balance. Accordingly, the gross carrying amount, interest income and cash flows of the debt instrument
in each period are as follows:
(a)
(b = a × 10%)
(c)
(d = a + b – c)
Gross carrying
Gross carrying
amount at the start
amount at the end
of the year
Interest income
Cash flows
of the year
Year (£)
(£)
(£)
(£)
2019 1,250
125
75
1,300
2020 1,300
130
100
1,330
2021 1,330
133
125
1,338
2022 1,338
134
150
1,322
2023
1,322
133
1,250 + 205
–
It can be seen that, although the instrument is issued for £1,250 and has a maturity amount of £1,250, its gross
carrying amount does not equal £1,250 at each reporting date. [IFRS 9.IG.B.27].