Background
On 30 May 2024, the IASB issued ‘Amendments to the Classification and Measurement of Financial Instruments (“Amendment”) which amended IFRS 9 Financial Instruments and IFRS 7 Financial Instruments: Disclosures. The amendment is an outcome of IASB’s postimplementation review of the classification and measurement requirement phases of IFRS 9, which was concluded in 2022.
Key Highlights of amendments to IFRS 9 and IFRS 7:
a. Recognition and derecognition of financial assets and financial liabilities:
The amendment provides clarification on the date of recognition and derecognition of financial assets and financial liabilities. As per the clarification:
• A financial asset is derecognized on the date the contractual rights to the cash flows expire or the asset is transferred.
• A financial liability is derecognized on the ‘settlement date.’ For financial liability settled through electronic transfer, the amendment provides an accounting policy choice to derecognize financial liabilities before the settlement date subject to fulfillment of certain conditions
b. Classification of financial assets:
The amendment provides clarification related to the assessment of SPPI criteria for, arrangements wherein cash flows are linked to contingent events, the treatment of non-recourse assets, and contractually linked instruments (CLI).
c. Additional disclosure requirements for Investments in equity instruments designated at Fair Value Through Other Comprehensive Income (FVTOCI).
d. Additional disclosure requirements for financial assets and liabilities with contractual terms that reference a contingent event (including those that are ESG-linked).
Amendment to IFRS 9
01. Recognition and derecognition of financial assets and financial liabilities
IASB’s amendment to application guidance on recognition and derecognition principles of financial assets and financial liabilities includes clarification on the date of recognition and derecognition of a financial asset or financial liability as summarized below:
Financial assets
Date of recognition- The Entity shall recognize the financial asset on the date on which it becomes a party to the contractual provisions of the instrument.
Date of derecognition- The Entity shall derecognize the financial asset on the date the contractual rights to the cash flows expire or the asset is transferred.
Financial liabilities
Date of recognition- The Entity shall recognize the financial liabilities on the date on which it becomes a party to the contractual provisions of the instrument.
Date of derecognition- Entity shall derecognize the financial liability on the settlement date, which is the date of extinguishment of liability because the obligation specified in the contract is discharged or canceled or expires or the liability otherwise qualifies for derecognition.
The amendments also provide an optional exception relating to the derecognition of a financial liability settled through electronic transfer.
Derecognition of a financial liability settled through electronic transfer – Optional exception
As per the clarification issued by the amendment, the financial liability shall be derecognized on the settlement date. However, for a financial liability settled, in full or in part, in cash using an electronic payment system, the amendment allows the entity to make an accounting policy election to derecognize the liability before the settlement date, if the entity has initiated a payment instruction that resulted in:
- the entity having no practical ability to withdraw, stop, or cancel the payment instruction: If an entity has the ability to withdraw, stop, or cancel a payment instruction, the entity could not be considered to have discharged the liability as required by IFRS 9.
- the entity having no practical ability to access the cash to be used for settlement as a result of the payment instruction: If an entity has the practical ability to access the cash for a purpose other than settling the financial liability, it cannot be considered that the entity has delivered the cash or that the entity has discharged the liability by paying with cash as required by IFRS 9.
- the settlement risk associated with the electronic payment system is insignificant: ‘settlement risk’ generally refers to the risk that a transaction will not be settled (or completed) and that a debtor will not deliver cash to a creditor on the settlement date. For the purposes of the requirements in IFRS 9, the creditor is no longer exposed to any settlement risk associated with the transaction when a financial liability has been discharged by paying cash to a creditor.
As per the amendment, for the derecognition of financial liability settled through electronic transfer before the settlement date, the settlement risk should be insignificant. Settlement risk can be considered as insignificant provided the electronic payment system has the following characteristics:
- Completion of the instruction follows a standard administrative process; and
- There is only a short time between the entity i) ceasing to have the practical ability to withdraw, stop, or cancel the instruction and to access the cash and ii) when the cash is delivered to the counterparty.
Consistency in accounting policy election:
Entities making accounting policy election must apply it to all settlements made through the same electronic payment system. This accounting policy selection applies only to electronic payment systems and does not apply to other payment systems, such as cheques.
02. Classification of financial assets
IASB’s amendment on the classification of financial assets relates to the following three areas, having an impact on Solely Payments of Principal and Interest (SPPI) assessment of financial assets.
A. Contractual terms that can change the timing and amount of cash flows based on contingent events
With an intent to incentivize customers to meet the specified ESG objectives, there has been an increase in arrangements of financial assets with ESG-linked features, wherein the lending arrangements are subject to interest rate adjustments which are linked to the achievement of ESG targets.
IFRS 9 does not provide clear guidance on whether the contractual cash flows of financial assets with ESG-linked features represented SPPI, which is the primary condition for measurement at amortized cost. To address this matter, the IASB has amended IFRS 9, which is now applicable to all financial assets with contingent features, and not just to financial assets with ESG-linked features.
IASB’s amendment to application guidance on contractual cash flows that are solely payments of principal and interest provides guidance on:
(i) How an entity assesses whether contractual cash flows of a financial asset are consistent with a basic lending arrangement
As per the amendment, in assessing whether the contractual cash flows of a financial asset are consistent with a basic lending arrangement, an entity may have to consider the different elements of interest separately. Rather than focusing on how much compensation an entity receives, it should focus on what an entity is being compensated for since there may be a possibility that the entity is being compensated for something other than basic lending risks and costs.
The amendment clarifies that contractual cash flows are inconsistent with a basic lending arrangement if they are indexed to a variable factor that is not a basic lending risk or cost (for example, the value of equity instruments or the price of a commodity) or if they represent a share of the debtor’s revenue or profit, even if such contractual terms are common in the market in which the entity operates.
(ii) Assessing contractual cash flow characteristics of financial assets with features linked to environmental, social, and governance (ESG) concerns
In some cases, a contingent feature gives rise to contractual cash flows consistent with a basic lending arrangement both before and after the change in contractual cash flows, but the nature of the contingent event itself does not relate directly to changes in basic lending risks or costs. For example, the terms of a loan may specify that the interest rate is adjusted by a specified amount if the debtor achieves a contractually specified reduction in carbon emissions.
In such a case, the financial asset has contractual cash flows that are solely payments of principal and interest on the principal amount outstanding if, and only if, in all contractually possible scenarios, the contractual cash flows would not be significantly different from the contractual cash flows on a financial instrument with identical contractual terms, but without such a contingent feature.
The amendment explains that SPPI requirements may still be met even when the nature of the contingent event does not relate directly to changes in basic lending risks and costs, provided that their cash flows are not significantly different from an identical financial asset without such a feature.
B. Non-recourse feature in financial assets
SPPI testing of a financial asset requires consideration of various contract features, including non-recourse features. The amendment enhances the description of the term non-recourse by clarifying that a financial asset can be considered to have non-recourse features if the entity’s (creditor’s) contractual right to receive cash flows is limited to the cash flows generated by specified assets.
In other words, the entity is primarily exposed to the specified assets’ performance risk rather than the debtor’s credit risk. For example, a creditor’s ultimate right to receive cash flows may be contractually limited to the cash flows generated by specified assets of a structured entity.
The existence of a non-recourse feature does not necessarily preclude the financial asset from meeting the SPPI testing criteria, the existence of a nonrecourse feature requires an entity to look through the link between the particular underlying assets or cash flows and the contractual cash flows of the financial asset being classified to assess whether the contractual cash flows of the financial asset are payments of principal and interest on the principal amount outstanding. As per the amendment, an entity shall also consider how this link is affected by other contractual arrangements, such as subordinated debt or equity instruments issued by the debtor which are expected to absorb any shortfalls in cash flows generated by the underlying assets.
For e.g. XYZ Inc. sets up a Newco to receive a concession from the local government for the construction and operation of a water purification plant. Newco will be financed in the following manner:
- 95% provided by senior loans from Bank, which:
- will be repaid over 20 years after construction ends – i.e. the period during which Newco will receive cash flows from its customers for the services it will provide; • bear fixed interest
- 5% provided by the XYZ Inc. in the form of equity and subordinated loans which are expected to absorb any shortfalls in cash flows generated by the project.
C. Contractually linked instruments
The amendment relates to transactions with non-recourse features, wherein an issuer may prioritize payments to the holders of financial assets using multiple contractually linked instruments, concentrating credit risk through tranches of debt. It clarifies the characteristics of contractually linked instruments (CLI), distinguishing them from other transactions. As per the amendment:
- CLIs must feature a waterfall payment structure, resulting in the concentration of credit risk by allocating losses disproportionately between different tranches.
- CLIs are not created where multiple debt instruments of differing seniority are issued to facilitate lending to a single creditor holding the junior tranche since these are structured to provide enhanced credit protection to a creditor (or group of creditor).
For example, a structured entity may be set up to hold the underlying assets to generate cash flows to repay the creditor. The structured entity issues senior and junior debt instruments. The creditor holds the senior debt instrument, and the entity sponsoring the structured entity that holds the junior debt instrument has no practical ability to sell the junior instrument without the senior debt instrument becoming payable. - The CLI requirements in IFRS 9 apply only if the underlying pool includes one or more instruments with contractual cash flows that are solely payments of principal and interest.
The amendments clarify the underlying pool can include financial instruments not in the scope of IFRS 9 classification and measurement (e.g., lease receivables) but must have cash flows that are equivalent to SPPI, which would not be the case for lease receivables that are subject to residual value risk, or that comprise variable lease payments that are indexed to a variable factor that is not a basic lending risk or cost (for example, a market rental rate).
Amendments to IFRS 7
01. Investments in equity instruments designated at fair value through other comprehensive income (FVTOCI) (amendments to Paragraph 11A and Paragraph 11B of IFRS 7)
IASB’s amendment to IFRS 7 relates to disclosure requirements for the change in fair value during the period with respect to Investments in equity instruments designated at FVTOCI. As per the amendment entity shall be required to make the following additional disclosures in respect of equity investment designated at FVTOCI:
Fair value gain or loss presented in other comprehensive income during the period, disclosing separately for each class of investment:
• fair value gain or loss related to investments derecognized during the reporting period; and
• fair value gain or loss related to investments held at the end of the reporting period.
Any transfers of the cumulative gain or loss within equity during the reporting period in respect to the investments derecognized during that period.
The aggregate fair value for each investment class as at the end of the reporting period, instead of disclosing the fair value of each equity investment, as required earlier.
Implementation Guidance for amendment
Paragraphs IG11A and IG11B provide guidance on implementing some of the disclosure requirements in paragraphs 11A and 11B of IFRS 7 Financial Instruments: Disclosures are added to Guidance on implementing IFRS 7.
The following guidance as added by amendment provides Illustrative example of manner of disclosure requirements for IASBs amendments to IFRS 7 related to equity instruments designated at FVTOCI:
IG11A. The guidance in this paragraph and paragraph IG11B illustrates one possible way in which an entity could provide some of the disclosures required by paragraphs 11A and 11B of IFRS 7. The guidance does not purport to illustrate all possible ways of applying those disclosure requirements.
Having met the requirements in paragraph 5.7.5 of IFRS 9 Financial Instruments, Entity A has elected to present subsequent changes in the fair value of its investments in equity instruments in other comprehensive income. In accordance with its accounting policies, Entity A transfers accumulated gains or losses from other comprehensive income to retained earnings only when an investment is derecognized. Entity A has a reporting year end of 31 December.
As at 1 January 20X1 Entity A’s equity investments had an aggregate carrying amount of CU800,000, and the cumulative changes in fair value of these investments recognised in accumulated other comprehensive income as at that date were CU200,000. There were no disposals from this portfolio before 1 January 20X1. On 31 July 20X1 Entity A acquired a non-controlling interest in Entity Y, a non-listed entity, for CU155,000.
On 30 June 20X1 Entity A received CU1,000 of dividend income from Entity X. On 30 September 20X1 Entity A disposed of its investment in Entity X for CU200,000, resulting in a cumulative gain of CU50,000. Entity A’s remaining investments had an aggregate fair value of CU820,000, as at 31 December 20X1.
Entity A received total dividend income of CU5,000 from these remaining investments in 20X1.
The total change in fair value of Entity A’s equity investments during the period was CU65,000, including CU20,000 relating to its investment in Entity X.
The following table shows the Company’s equity investments in non-listed entities in Europe, the Middle East and Africa (EMEA). The Company holds these investments for strategic purposes on a medium- to long-term basis; the Company typically holds less than 5% interest in each entity and does not have a controlling interest in these entities. The investments are not held for trading. The Company has elected to present subsequent changes in the fair value of these investments in other comprehensive income. Accumulated gains or losses are transferred to retained earnings only when an investment is disposed.
02. Contractual terms that could change the timing or amount of contractual cash flows
In order to enable the users of financial statements to better understand the effects of contingent events that do not relate directly to changes in basic lending risks and costs (such as the time value of money or credit risk), which could change the timing or amount of contractual cash flows, the amendments have added the following new disclosure requirements:
- A qualitative description of the nature of the contingent event;
- Quantitative information about the possible changes to contractual cash flows that could result from those contractual terms (for example, the range of possible changes); and
- The gross carrying amount of financial assets and the amortized cost of financial liabilities subject to the contingent features.
Applicability:
These disclosure requirements apply to financial instruments with ESG-linked features and to all other financial assets at amortised cost, or FVTOCI and financial liabilities at amortised cost. These disclosures are not required for financial instruments measured at FVTPL because the changes in the fair value of such instruments recognized in profit or loss provide sufficient information for users of financial statements. For Example, XYZ Inc. shall be required to make these additional disclosures for a class of financial liabilities measured at amortized cost whose contractual cash flows change if XYZ Inc. achieves a reduction in its carbon emissions.
Effective date and transition
Effective date
The amendment is effective for annual reporting periods beginning on or after 1 January 2026. Earlier application is permitted. If an entity chooses to apply these amendments for an earlier period, it is required to either apply:
• All the amendments at the same time and disclose that fact; or
• Only the amendments related to the classification of financial assets for that earlier period and disclose that fact.
Transition
For transition requirements, an entity shall apply the amendments retrospectively in accordance with IAS 8. Key considerations of transition provisions are below mentioned:
a. Date of transition- The date of initial application is the beginning of the annual reporting period in which the entity first applies the amendments.
b. Restatement of the prior period- The transition provisions do not require a restatement of prior periods; however, entities are permitted to restate prior periods if it is possible to do so without the use of hindsight.
c. Recognition of the impact of transition- Entities not restating prior periods are required to recognize the effect of applying the amendments as an adjustment to the opening balance of financial assets and financial liabilities and the cumulative effect, if any, as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate) at the date of initial application.
