IFRS Conversion Considerations: Financial Instruments

Organizations considering a conversion to the International Financial Reporting Standards (IFRS) from U.S. Generally Accepted Accounting Policies (U.S. GAAP) should note that there are significant differences surrounding financial instruments. Financial instruments encompass a number of balance sheet items, including trade receivables and payables, notes receivable and payable (issued debt), investments in debt and equity securities, loan receivables and payables, derivative assets and liabilities, and ordinary equity shares and preferred shares. The concept of financial instruments is covered under board concepts in the IFRS guidance through International Accounting Standard 32, Financial Instruments: Presentation; IFRS 9, Financial Instruments; IFRS 7 Financial Instruments: Disclosures; and Fair Value Measurement, while U.S. GAAP includes guidance for financial instruments in numerous areas within the Codification. This article is the part of a series covering considerations for organizations contemplating a conversion from U.S. GAAP to IFRS.

The basic principles of the two accounting standards are similar. Both require financial instruments to be classified into specific categories for measurement of the instruments, provide guidance on when to recognize and derecognize instruments, require derivative instruments to be recognized on the balance sheet, require detailed disclosures for these financial instruments, and permit hedge accounting. Financial instruments are permitted to be measured at amortized cost, fair value or both for bifurcated combined instruments depending on their nature. Both require subsequent measurement of the valuation and a regular determination if the financial instruments become impaired. While there are a number of differences between the two standards, some of the most common areas are discussed below.

Collectability of Financial Instruments:

Under IFRS 9, instruments such as trade and other receivables, contract assets, loans receivable and lease receivables should be considered for collectability, and appropriate reserves should be established to determine their proper valuation. The U.S. GAAP impairment model (before the adoption of the Current Expected Credit Loss (CECL) model under Accounting Standard Codification Section 326) is an incurred loss model, while the IFRS 9 model is an expected loss model. Under an expected loss model, an entity is required to assess whether there has been a significant deterioration in credit quality since initial recognition. The differences between the models could cause significant variances in the impairment losses recognized and the timing of their recognition.

IFRS requires that forward-looking information be considered when assessing the need to record a potential credit loss. If the risk of an expected credit loss has significantly increased, management should consider the need for additional reserves based on the facts and circumstances that exist at that measurement date. In instances where collection on these financial instruments is delayed, a credit loss should also be recorded if the entity is not able to recover compensation for the lost time value of money.

Given the complexities of determining an expected credit loss, IFRS 9 provides a simplified approach that may be elected for trade receivables. Under this election, a provisions matrix can be established based on historic collection using a probability-weighted outcome of their aging categories. The consideration should also incorporate forward-looking macro-economic indicators. The simplified approach allows entities to recognize lifetime expected losses on all trade receivables without the need to identify significant increases in specific credit risk.

U.S. GAAP guidance has worked towards convergence with some of the forward-looking principles under the CECL model. Large SEC filers adopted this model in 2020; however, subsequent reporting relief has been provided for other reporting entities, pushing CECL implementation back for years beginning after 12/15/2022 for smaller reporting company SEC filers, private businesses, and nonprofits.

Measurement of Debt Securities, Loans and Receivables:

Under U.S. GAAP, the classification is largely dependent on the instrument’s legal structure and management’s intent. At acquisition, debt instruments are classified as one of three categories: held-to-maturity (amortized cost), trading (fair value recorded through income), or available-for-sale (fair value recorded through other comprehensive income (OCI)). Loans and receivables are classified as either held-for-investment (amortized cost) or held-for-sale (lower of cost of fair value). The fair value option is also an available election under all circumstances.

Under IFRS, the classification and measurement are based on the instrument’s contractual cash flow (CCF) and the business model under which it is managed. The assessment of the CCF determines whether the contractual terms of the financial asset solely provide cash flow interest and principal payments on specified dates. Instruments with these terms are then subsequently measured based on the managing business model. If the instrument is being managed with the objective of holding to collect future cash flows, then the debt instrument may be recorded at amortized cost. An instrument with specified future cash flows being managed with the objective of both collecting the cash flows and selling the asset should be measured at fair value, recorded through OCI. If OCI is elected, gains and losses are realized into profit or loss at the derecognition date.  The fair value option measured through profit or loss should be utilized for all other instruments. This method may also be elected in place of amortized cost or utilizing OCI for any instrument. Transitioning from U.S. GAAP to IFRS could result in some instruments being previously classified as held-to-maturity or available-for-sale now being recorded through the fair value option against profit or loss.

Derivatives and Hedge Accounting:

Derivatives should be accounted for at fair value under both standards, with changes recorded through profit and loss and outline certain contractual characteristics that must be present to be accounted for as a derivative. Embedded derivatives are required to be bifurcated if there are differing economic characteristics and risks than the associated host contract under both standards. While U.S. GAAP requires an underlying notional value to qualify as a derivative instrument, IFRS does not maintain a requirement that a notional amount be indicated. Contracts without a defined notional value, such as requirement contracts that do not specify a certain number of units, but rather refer to the number of units required to satisfy a party’s actual utilization or consumption needs, may not meet the definition of a derivative under U.S. GAAP, but would qualify under IFRS. Both standards also provide exceptions for when a derivative may qualify for hedge accounting.

IFRS considers cash flow hedges to be effective if the following criteria are met, in accordance with IFRS 9 6.4.1:

1. The hedging relationship consists only of eligible hedging instruments and eligible hedged items.
2. At the inception of the hedging relationship, there is a formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.
3. In addition, the hedging effectiveness requires that an economic relationship exist between the hedged item and the hedging instrument, the effect of credit risk does not dominate the value changes that result from that economic relationship, and the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.

IFRS outlines three types of permissible hedging relationships: fair value hedge (a hedge against exposure against fair value fluctuations in assets and liabilities), cash flow hedge (a hedge against variability in cash flows attributable to particular assets and liabilities), and hedge of a net investment in a foreign operation. Generally, the U.S. GAAP threshold is a higher standard for instruments to qualify for hedge accounting.

First-time adopters of IFRS are required to account for derivatives at their opening IFRS balance as assets or liabilities measured at fair value. Both standards require entities to document and continuously assess hedge effectiveness. Generally, hedges that are determined to be highly effective under U.S. GAAP would expect to meet the IFRS requirement of having an economic relationship. IFRS also provides additional hedging opportunities for entities within a consolidated group to hedge on behalf of a subsidiary with foreign currency exposure. A parent organization is permitted to bypass an intermediate subsidiary and directly hedge against currency risk at a lower-level subsidiary.

Alternative Investments:

U.S. GAAP provides a practical expedient to determine the estimated fair value of certain alternative investments based on the net asset value (NAV). Under IFRS, there is no practical expedient for measurement under NAV. Instead, IFRS requires alternative investments to be measured at their fair value on the recognition date and at fair value for subsequent measurement.

Derecognition of Financial Instruments:

When assessing the derecognition of financial instruments, U.S. GAAP focuses on legal isolation and control, while the IFRS model is based on the principles of a risk-and-rewards model and then a control model. Under U.S. GAAP, derecognition of financial assets occurs following legal transfer of the asset. The asset must be legally isolated from the transferor, effective control is provided to the acquirer, and the asset can be pledged or exchanged by the acquirer. Derecognition may be applied to a portion of the asset if it meets the participating interest requirement. Under the participating interest requirement a share must: (1) have proportionate ownership rights with equal priority to other holders, (2) have no recourse to, or subordination by, any other participating interest holder, and (3) not entitle any participating interest holder to receive cash before any other participating interest holder.

IFRS considers a mixed model incorporating both transfers of control and risk and rewards from ownership. Control is surrendered when the transferee can sell the transferred asset without any restrictions. IFRS does not incorporate a legal isolation test. Derecognition can be applied to a portion of the financial assets only if the cash flows are specifically identified, represent a pro-rata share or the asset, or a pro-rata share of specifically identified cash flows.

Once the transfer of financial instruments meets the conditions for derecognition, both U.S. GAAP and IFRS provide similar guidance for determining the gain or loss incurred as well as the carrying amounts of any assets obtained and liabilities assumed. However, as the standards have different definitions of the unit of account for derecognition and different definitions of a newly created asset, the measurement of the gain or loss may differ between the two standards.

First-Time IFRS Adopters

In connection with IFRS 1, First-Time Adoption of International Financial Reporting Standards, a first-time adopter must recognize all financial assets and liabilities at their opening valuations according to the provisions outlined in IFRS 9. In addition, IFRS entities must apply the IFRS 9 derecognition criteria prospectively following adoption. There is no requirement for retrospective application of transactions that have already been derecognized before the adoption date.

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