By Gatuyu t.j

January 2018, a new accounting standard will come in force, and significantly affect the treatment of financial instruments both in corporate transactions and for tax.

Introduction

Various villains have been cited as the triggers of the financial crisis of 208/09 which resulted to economic recession. These include subprime mortgages, collateralize debt obligations, housing bubble, derivatives instruments, hubris of “too big to fail” institutions, among others.

However, financial instruments, and their accounting practice, have been apportioned a bigger share of the blame. This is due to the nature of financial instruments, which are defined as contracts that give rise to a financial asset of one entity and a financial liability of another entity, for having volatile prices as compared to immovable assets.

Financial instruments are blamed for triggering financial crisis due to their accounting treatment. They are recognized in financial statement through their fair value according to the intention of the company. These intentions may be either holding them to maturity, for sale, recognizing them at fair value through profit and loss or having them as loans and receivables.

In addition, where the instruments are held for sale, they are carried by a company at market value. However, where a firm intends to hold the instrument to maturity, they carry them at cost while adjusting for impairment.

This is a messy practice. It results into an entity having different values for one instrument. Firms keep on marking the instruments to markets, sometimes on wishful valuations.  In event of a crisis, firms dispose the assets in fire-sale prices, which may result to collapse of markets.

The coming of IFRS 9

It is these shortcomings that triggered the International Accounting Standards Board (IASB) to in July 2014 issue a new International Financial Reporting Standard 9 to guide accounting for financial instruments. The standard will be effective as from January 2018 and discontinues the existing standard, IAS 39.

IFRS 9 radically changes modalities of accounting for financial instruments and enhances disclosures in financial markets. It comes at a time Nairobi Securities Exchange (NSE) is gearing to operationalize the Futures Exchange for trading in derivative instruments which are volatile financial instruments.

IFRS 9 introduces three key issues. These are on classification and measurement of financial instruments, impairment, and hedge accounting.

On classification and measurement, the standard retains the current practice of categorising financial liabilities either at “fair value” or at “amortized cost”, the latter being where amortisation loss is factored in to the value of the instrument.

However, the difference is where a financial instrument is categorised at amortized cost; the business model of an entity must be to hold that instrument until its maturity for the purpose of collecting contractual cash flows. These cash flows must meet the “SPPI criterion,” which is for “solely payment of principal and interest.”

Instruments, such as exchange traded derivatives, which may not meet “SPPI criterion” for they generate trading profit, are classified at fair value, with their gains and losses recognised as comprehensive incomes.

The second aspect is on treatment of impairment.  Currently, firms account for loss on financial liabilities credit exposures, only when such loss has been incurred. The practice will be replaced by the expected loss model, where a firm must approximate the expected credit loss for the whole life of the exposure of the instrument.

Approximating “expected loss” on credit exposures more so by banks is a hard pill especially in view of changing economic dimensions.  It will force banks to increase their loan-loss provisions in line with credit losses they anticipate and limit intermediation to risky borrowers.

The third introduction is on hedge accounting, which is geared towards reducing volatility created marking-to-market of derivative instruments, resulting to price fluctuations. It aims at aligning entities’ hedging practice with their risk management activities and improves hedge effectiveness due to enhanced disclosures.

Review of strategies

Many listed companies will take interest of this, in view that most recently Kenya airways suffered wrath of hedging instruments, when it entered into oil forward contracts that caused the airline huge losses, after fall in value of oil prices, which was the underlying asset.

Additionally, IFRS 9 will contribute in combating international tax avoidance. By introducing a universal way of classifying financial instruments will reduce hybrid mismatches, where a company classifies an instrument as a debt in one jurisdiction and as equity in another. In view that debt instruments are tax efficient as interest deductibility is allowable, firms classify same instrument differently in various countries, contributing to profit base erosion in a country where it’s classified as debt.

IFRS 9 may also have its flipside. The high disclosures requirements and constant reviews especially on volatile instruments may cause panic in the markets and trigger a crisis.

Banks and firms in the capital markets will be the most affected and will need to review and rethink their strategies to be in line with the standard.