How credit unions can implement IFRS 9, Financial Instruments
IFRS 9, Financial Instruments, brings significant changes to accounting standards for financial assets, effective for years starting on or after 1 January 2018. These changes will have an impact on the financial statements of credit unions and other lending organizations.
This article provides an overview of the measurement and classification of a credit union’s financial assets under IFRS 9 and also discusses impairment loss provisions.
Under IFRS 9, there is just one way to classify and measure financial assets. Under the previous method, a credit union classified its financial assets through either (a) their amortized cost, (b) fair value through other comprehensive income (FVTOCI) or (c) fair value through profit or loss (FVTPL). This was based on two factors:
- Which model the entity uses for managing its financial assets, and
- The financial asset’s contractual cash flow characteristics.
To see whether they can continue using their current method to account for their financial assets (e.g., recording member loans at amortized cost), credit unions will need to carry out an analysis using both of those tests. Generally, credit unions’ lending practices must pass the contractual cash flows test, which considers whether there will be dates on which there will be cash flows that are solely payments of principal or interest (SPPI) under the contractual terms of the financial asset.
The purpose of the business model test is to determine whether the purpose is to hold just to collect contractual cash flow, or if it is to collect and sell. If the intent is just to collect, the credit union should use amortized cost to classify member loans and other investments. However, FVTOCI should be used for classification if the purpose is to collect and sell. IFRS 9 also allows classification as FVTPL.
All derivatives must be classified as FVTPL because equity instruments and derivatives such as options and futures will never pass the SPPI test. However, a credit union must also consider the business model that is used for managing the equities. If they are held for trading, just as they are under IAS 39, equity instruments must be considered to be FVTPL. The credit union can opt for its choice of FVTPL or FVTOCI if the equities are not held for trading – but note that this choice is irrevocable.
Using FVTOCI to account for instruments is different from accounting for available sale investments using IAS 39. FVTOCI classification. The recycling into P&L of any realized or unrealized gains or losses is not allowed under FVTOCI classification. IFRS 9 has also taken away the exemption that has allowed equity instruments that do not have a quoted market price to be recognized at cost.
Accordingly, credit unions currently carrying equity investments at cost must consider how to value and classify these securities.
Impairment rules change
Another change involves impairment. Under the incurred-loss model of IAS 39, it might be that a credit union is looking at the probability that a counterparty has defaulted. However, under the forward-looking expected credit loss impairment model used by IFRS 9, in a similar situation the credit union would be looking at the probability that the counterparty will default in the future.
The three stages that must be considered, excluding originated or purchased credit impairment instruments, are:
- Stage 1: If there is a low credit risk associated with a financial asset at the reporting date, expected losses of 12 months must be recognized.
- Stage 2: If the credit risk increases significantly from initial recognition, there must be recognition of credit losses equal to the lifetime expected credit losses. Interest revenue would be calculated on the gross basis.
- Stage 3: If the credit impaired definition applies to the asset, an amount equal to lifetime expected credit losses would be recognized and interest revenue would be on the net basis, rather than on the gross amount.
Some of the challenges credit unions will face in implementing this new impairment model are:
- How to measure expected credit losses – either with best available information, whether historical or forecasts, or with probability-weighted cash flow estimates based on a range of possible outcomes
- How to define a “significant increase in credit risk” – most likely by applying a default definition consistent with internal credit risk management practices
- The impact of credit enhancements – such as CMHC insurance on credit risk
- Are systems set up to track changes in credit risk?
Given the changes that IFRS 9 will have on credit union operations, for smooth implementation it is important to consult with a financial advisor who has experience in this field.