ROB TULLY & IAN CHARLES DISCUSS VOLATILITY IN THE P&L UNDER IFRS 9, AND THE "OVERLAY" EXEMPTION UNDER IFRS 4.

I posed the following question in the blog written a couple of weeks ago “Other than by the exercise of different designation choices under IFRS 9 compared to IAS 39, in what circumstance would IFRS 9 trigger increased volatility in the P&L”?  Here is the answer.

Under IAS 39, a hybrid financial asset containing a host contract and an embedded derivative would typically (subject to meeting the appropriate criteria) have the embedded derivative separated from the host contract. The IAS 39 classification and measurement requirements would then apply to each of the bifurcated underlying items.  For example, an investment in a convertible bond will have the bond element separated from the conversion feature, and the appropriate accounting will be applied to the two elements.  For the bond element, this could well be amortised cost (AC), and for the conversion feature (effectively a call option on shares), this would mean fair value through P&L (FVtPL).

The accounting treatment under the rules in IFRS 9 would be different. IFRS 9 states that where there is an embedded derivative with a financial asset host the whole instrument is classified and measured in accordance with the requirements of IFRS 9 (IFRS 9 para 4.3.2).  This means that this same convertible bond holding would no longer be bifurcated but instead the classification and measurement of the entire instrument would depend on the result of the business model test, and the contractual nature of cash flows test. 

The contractual cash flows of a financial asset containing an embedded derivative would not be “solely payments of principal and interest on principal” (SPPI). Therefore, the instrument, whether it passes a business model test or not, would be accounted for at FVtPL. This means that any change in fair value arising from changes in market interest rates that affect the bond element, will now be reflected in profit or loss whereas under IAS 39, such fair value changes would not have been reflected in profit or loss but merely disclosed (IFRS 7 para 25).

Consider an example:  An entity applies IAS 39.  It has purchased a convertible bond for CU10m, and has separated the bond into the bond element CU9.4m, and the derivative element CU0.6m.  The bond is classified as “loan and receivable” so AC is applied over the life of the bond to accrete interest through to the redemption amount.  The derivative element is FVtPL. 

Suppose that the fair value of the derivative element at the end of year 1 is CU0.8m (probably computed using an option pricing model).  The statement of profit or loss will therefore record a fair value gain of CU0.2m.  Suppose also that the market interest rate for similar “plain vanilla” bonds has fallen, and the fair value has risen by, say, CU0.3m.  This FV gain would not be recorded in the statement of comprehensive income, but would be apparent (given sufficient granularity of FV disclosure under IFRS 7) in the fair value disclosures.

Now consider that same convertible bond held by an entity applying IFRS 9. The convertible bond would be recorded at FVtPL in its entirety, meaning that there will be fair value gains recorded in profit or loss of CU0.5m.

As an interesting aside, the insurance industry is bracing itself for the release of the new insurance contracts standard IFRS 17. Early adoption of IFRS 9 coupled with the adoption of the new insurance standard might lead to levels of unacceptable volatility in financial statements of insurance entities.

To deal with this the IASB introduced an amendment to IFRS 4 Insurance Contracts at the end of last year to allow insurers who early adopt IFRS 9 (yes, there may be one or two) to protect their P&L from this volatility.

I will not go into the whys and wherefores of the so called “overlay” amendment to IFRS 4, but I am interested in the implication that there could be different fair value P&L volatilities when IFRS 9 is applied as opposed to IAS 39.  Although the circumstance of a bifurcated instrument under IAS 39 compared to an entire instrument under IFRS 9 (as illustrated above) is not presented as a worked example in the 2016 amendment to IFRS 4, it is mentioned as an example of when there may be greater P&L volatility under IFRS 9 than under IAS 39, within the Basis for Conclusions to the amendment (IFRS 4 amendment BC240 b) i)). 

I have been asked whether the same “overlay” exemption can be applied when there is an issued liability at FVtPL where the effect of credit risk on fair value changes is separated under IFRS 9 and recorded in OCI.  For example, if market interest rates fall in the same period that the credit risk premium increases the separated fair value elements would move in opposite directions, causing the profit or loss to record a larger fair value gain.  Simple answer – no.  The amendment allowing the “overlay” approach under IFRS 4 applies to designated financial assets only. 

But my interest in writing this item was not the overlay approach, but whether or not there could be increased volatility under the application of IFRS 9 when compared to IAS 39, other than for reasons of designation choice.  The answer is clearly “yes” – for the circumstances of the embedded derivative with a financial asset host, and the separation of the credit risk element in a financial liability at fair value through profit or loss.