IFRS 9 Financial Instruments (AASB 9) was issued to replace IAS 39 (AASB 139) Discuss critically the shortcomings and

criticisms of IAS 39 (AASB 139) which have given rise to IFRS 9 (AASB 9). How will the application of IFRS 9 (AASB 9) impact on the accounting for financial instruments in financial reports? Your discussion should be illustrated and informed by reference to two listed companies (ASX or other sources for the most recent years), that are either using IAS 39 (AASB 139) or that have decided to early adopt IFRS 9 (AASB 9).

Introduction

The IASB currently is revising its accounting requirements for financial instruments. The objectives of the project include improving the decision-usefulness of financial statements for users by simplifying the classification and measurement requirements for financial instruments (NF6).

With the

awareness of the shortcomings and criticisms of IAS 39 (AASB 139), IASB has issued a new financial instruments standard referred to as IFRS 9 Financial Instruments. This paper will, with scholarly
thorough research, discuss about the matter of the IFRS 9 application and its impact on the accounting for financial instruments in financial reports. Two chosen companies will be exemplified to portrait a better picture regarding the impact of the replacement.

IAS 39 (AASB 139)

AASB 139 requires: financial assets and liabilities to be recognised in the balance sheet; financial assets to be classified into one of four categories; financial Assets at Fair Value through Profit and Loss; held-to-Maturity Investments; loans and Receivables; and
available-for-Sale Financial Assets.

financial liabilities to be classified into one of two categories; financial Liabilities at Fair Value through Profit and Loss; and Other Financial Liabilities. Initial measurement of financial assets and liabilities at fair value;

 Financial assets and liabilities to be measured, subsequent to initial measurement, at either fair value or amortised cost depending on which class they are recognised in; Increases or decreases in the value of financial assets and liabilities to be taken to the profit and loss or to equity depending on which class they are recognised in; and Financial assets to undergo impairment testing where there is objective evidence that the asset is impaired. (NF 2)

IFRS 9 (AASB 9)
IFRS 9 was first published in November 2009 in reaction to the financial crisis, but addressed only the classification and measurement of financial assets. The latest changes are in line with the IASB's phased approach to the completion of IFRS 9, under which chapters will be added to the existing Standard as and when other phases of the overall project are completed (work is currently being undertaken on impairment methodology and hedge accounting). When complete, IFRS 9 will replace IAS 39 Financial Instruments: Recognition and Measurement in its entirety. (5) Executive summary (6, first impression)

Shortcomings and criticisms of AASB 139

Complicated to comply
The introduction of AASB 139 Financial Instruments: Recognition and Measurement (AASB 139) provides audit committees with an ideal opportunity to add transparency and integrity to the area of accounting for derivatives. However, failure to get this complicated area right will mean further risk in financial reporting. Experience in the US has found that four years after FAS 133, a similar standard to AASB 139, was introduced in the US, that companies are still suffering retrospective restatements of their numbers due to non-compliant hedge documentation. This can be both embarrassing and career limiting. The CFO and CEO of Fannie Mae (of the largest mortgage serving companies in the US) currently face legal prosecution over incorrect hedge documentation. (1) If ASIC follows the US lead it will inevitably inspect companies compliance with AASB 139. This may lead to newspaper headlines or worst, prosecution. (1) AASB 139 creates potentially onerous requirements in the area of hedging because for the first time there are specific rules as to when you can achieve hedge accounting. Failure to understand and comply with the rules may have disastrous outcomes. The rules require: (1) that all derivatives be recorded on the balance sheet at fair value. This in itself can be a difficult exercise as few accountants are trained in fair valuing derivatives, in addition the fair valuation of illiquid derivatives in Australia can be problematic. (1) formal documentation must be prepared to qualify for hedge accounting; failure to comply with all aspects of the formal documentation results in speculative accounting treatment for the derivative instrument; i.e. gains and losses will simply

go straight to the profit and loss. Perseverance Gold has already announced that it wrote off $30 million of unrealised gains and losses on its gold hedges as it had not correctly completed all of the formal hedge documentation.(1) Australia has some of the most complex hedging issues around the world due to the commodity based nature of the Australian economy and as a result, Australia is interpreting the standard in a number of areas where there has been no precedent. (1)

The requirements to formally document and fair value all derivatives can add transparency and integrity to accounting records. Transparency will occur as all hedge relationships must be clearly articulated and supported by quantitative support and, the integrity of accounting records should improve as AASB 139 requires accountants to understand and manage the derivative numbers from inception of the hedge. Accordingly the questions posed seek to determine whether the opportunity has been obtained, or has the real risk of noncompliance with AASB 139 been added to the company. (1)

Fair value accounting

In short, economic valuation is not an objective of accounting. We conclude that by requiring fair value accounting for financial instruments and derivatives IAS39 seriously undermines accountability for financial capital by undermining the comparability and objectivity of financial statements, and that its rules for hedge accounting introduce spurious income and equity volatility that obscures underlying performance and financial position. We argue that, because of the paradoxes that arise in attempting to reform IAS39 by moving to comprehensive fair value accounting, it will remain a highly controversial, and may possibly be a make or break issue for the IASB. In short, as the most advanced expression of its asset-liability conceptual framework, it is possible that the problems IAS39 creates, will, by revealing its incorrigible ambiguity of the framework, be the Achilles heel of the IASB - or at least of its current, notoriously combative chairman, Sir David Tweedie.2 A review of the conceptual framework is on the IASBs mist do list (IASB Update, March, 2004). (NF 9) One comparability problem arises because IAS39 allows management the option of separating the interest element and the spot price of a forward contract (IASB, 2003, para.74 (a)).15 IAS39 (2000) gave the following example from its Implementation Guidance that deals comprehensively with the very common hedging of foreign currency risk associated with a future sale using a forward currency contract. It shows how such a hedge is initially a cash flow hedge of the future sale and then becomes a fair value hedge of the receivable, the subject of the second comparability problem (NF 9)

Impairment model

The rise of AASB 9 to replace AASB 139

Classifying and measuring financial liabilities

Most of the requirements in IAS 39 for the classification and measurement of financial liabilities have been carried forward unchanged to IFRS 9. Changes have however been made to address issues related to own credit risk where an entity takes the option to measure financial liabilities at fair value. (5)
Majority of requirements retained

Under IAS 39 most liabilities are measured at amortised cost or bifurcated into a host instrument measured at amortised cost, and an embedded derivative, measured at fair value. Liabilities that are held for trading (including all derivative liabilities) are measured at fair value. These requirements have been retained. (5)
Own credit risk

The requirements related to the fair value option for financial liabilities have however been changed to address own credit risk. Where an entity chooses to measure its own debt at fair value, IFRS 9 now requires the amount of the change in fair value due to changes in the entity's own credit risk to be presented in other comprehensive income. This change addresses the counter-intuitive way in which a company in financial trouble was previously able to recognise a gain based on its theoretical ability to buy back its own debt at a reduced cost. (5) The only exception to the new requirement is where the effects of changes in the liabilitys credit risk would create or enlarge an accounting mismatch in profit or loss, in which case all gains or losses on that liability are to be presented in profit or loss. (5)
Elimination of the exception from fair value measurement for certain derivative liabilities

The new version of IFRS 9 also eliminates the exception from fair value measurement for derivative liabilities that are linked to and must be settled by delivery of an unquoted equity instrument. Under IAS 39, if those derivatives were not reliably measurable, they were required to be measured at cost. IFRS 9 requires them to be measured at fair value. (5)
Derecognising financial assets and financial liabilities.

The requirements in IAS 39 related to the derecognition of financial assets and financial liabilities have been incorporated unchanged into the new version of IFRS 9. (5) The IASB had originally envisaged making changes to the derecognition requirements of IAS 39. In the summer of 2010, however, the IASB revised its strategy and decided to retain the existing requirements in IAS 39 for the derecognition of financial assets and financial liabilities but to finalise improved disclosure requirements. Accordingly new disclosure requirements were issued in October 2010 as an amendment to IFRS 7 Financial Instruments: Disclosures (see TA Alert 2010-48), while IAS 39's derecognition requirements have been incorporated into IFRS 9 unchanged.(5)

Differences between this Standard and AASB 139

The main changes from AASB 139 are described below. Complexity (a) Financial assets are classified based on (a) the objective of the entitys business model for managing the financial assets; and (b) the characteristics of the contractual cash flows. This replaces the numerous categories of financial assets in AASB 139, each of which had its own classification criteria. Application guidance has been included in AASB 9 on how to apply the conditions necessary for amortised cost measurement. Impairment model (b) AASB 9 allows an irrevocable election on initial recognition to present gains and losses on investments in equity instruments that are not held for trading in other comprehensive income. Dividends in respect of these investments that are a return on investment can be recognised in profit or loss and there is no impairment or recycling on disposal of the instrument. Fair value (c) Financial assets can be designated and measured at fair value through profit or loss at initial recognition if doing so eliminates or significantly reduces a measurement or recognition inconsistency that would arise from measuring assets or liabilities, or recognising the gains and losses on them, on different bases.

(d) Hybrid contracts with financial asset hosts are classified and measured in their entirety in accordance with the classification criteria. Embedded derivative assets that are separated from financial liability or nonfinancial hosts in accordance with AASB 139 are to be accounted for in accordance with AASB 9. (e) Investments in unquoted equity instruments (and contracts on those investments that must be settled by delivery of the unquoted equity instrument) must be measured at fair value. However, in limited circumstances, cost may be an appropriate estimate of fair value. (f) Investments in contractually linked instruments that create concentrations of credit risk (tranches) are classified and measured using a look through approach. Such an approach looks to the underlying assets generating cash flows and assesses the cash flows against the classification criteria (discussed in (a) above) to determine whether the investment is measured at fair value or amortised cost. (g) Financial assets are reclassified when there is a relevant change in the entitys business model changes.

Conclusion