Under IAS 39, it can be quite challenging at times to compare the accounting treatment for the same type of financial instruments as it can be classified in various ways. It is not surprising to find more than 20 options or combinations for classifying or measuring financial assets. A debt instrument can be classified as one category for a corporate such as held to maturity; however, a bank can have two or three categories for the same type of instrument. Under IFRS 9, IASB has taken a more simplified approach by reducing the classification to two categories: amortized cost or fair value. The approach appears simpler, but it does present some new challenges, particularly for those organizations with large and/or complex portfolios.
Fundamentally, the classification of financial assets under IFRS 9 depends on two criteria: the contractual cash flow of the instrument and the entity’s business model for managing its financial instruments. An entity can classify an instrument at amortized cost if contractual cash flows are solely payments of principal and interest and if the business model is to hold instruments to collect contractual cash flows (‘business model test’). If an instrument fails to meet both criteria, then the financial asset should be measured at fair value.
Business model test is a new accounting concept and is a shift from previous accounting principles on how financial instruments are classified. The assessment of a business model is based on how key personnel actually manage the business, rather than management’s intent for specific financial assets. It implies a more rigorous test and may potentially require entities to provide additional evidence or accumulate more historical analysis.
IFRS 9 seems to have taken a more strategic or broader approach as the business model test requires companies to assess the nature of their business and how it allocates its financial assets and not just by simply establishing the nature and risk of the asset itself. It will have a far-reaching impact on an entity’s business – its strategy and policies. For example, banks may need to revisit their ALM policies/strategies and consider impact to IFRS 9.
There are certain flexibilities allowed under the new standard. For instance, an entity can define more than one business model however, the challenge would be defining the various business models that would be consistent with the company’s strategy and risk appetite. For banks and other companies with significant financial assets, this would be a major exercise and it would require a robust system of monitoring these assets going forward.
Once again, the principle implied in the accounting standard will require some further interpretation. It would seem that the question would not be if the asset is risky or not, but rather, if the business strategy behind an entity’s portfolio of assets is considered risky as defined under IFRS 9.