The classification and measurement of financial instruments under IFRS 9 is challenging for auditors, tax consultants, and heads of accounting. The standard requires a differentiated consideration of business models and cash flow characteristics to ensure appropriate classification and subsequent measurement. This article highlights the essential aspects of IFRS 9 and demonstrates how to successfully implement the requirements in practice. It considers both the classification requirements and the special features of impairment and hedge accounting.
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With the introduction of IFRS 9, the International Accounting Standards Board (IASB) has created a new approach for the classification and measurement of financial instruments, replacing the complex regulations of IAS 39.
The aim of the new regulation was to make the accounting for financial instruments more transparent and comprehensible while better reflecting the economic substance of business transactions.
At its core, classification under IFRS 9 is based on a principle-oriented approach with two key criteria: the entity's business model for managing its financial assets and the contractual cash flows of the financial instrument.
These two factors significantly determine which measurement category a financial instrument should be classified into and which subsequent measurement should be applied. For those preparing financial statements, this means a fundamental reorientation of their valuation logic and processes.
Unlike the predecessor standard IAS 39 with its numerous categories and exceptions, classification under IFRS 9 follows a clear, logical decision tree with objective criteria.
Business Model Approach for Classifying Financial Instruments
An entity's business model forms the first pillar of classification under IFRS 9. This analyzes the objective with which financial assets are held. The standard essentially distinguishes three types of business models:
What's crucial: The assessment of the business model is not made at the individual instrument level, but at the portfolio level. And it must reflect actual management practice. The classification must not be based on hypothetical scenarios but must be verifiable through corporate management and internal reporting.
Cash Flow Characteristics as the Second Criterion
As the second classification criterion, IFRS 9 examines the characteristics of the contractual cash flows. The focus here is on the "SPPI test" (Solely Payments of Principal and Interest). A financial instrument only meets this criterion if the contractual cash flows represent exclusively repayments and interest payments on the outstanding nominal amount.
The concept of interest includes:
Complex structures such as leverage effects, inverse interest structures, or linkages to equity indices typically result in failing the SPPI test. Special attention is also required for contractual clauses such as early repayment options or term extensions, which require separate analysis.
Impact on Subsequent Measurement
The combination of business model and cash flow characteristics directly determines the applicable measurement category and thus the subsequent measurement:
For equity instruments not held for trading purposes, there is also an irrevocable option for FVOCI measurement, whereby here - unlike with debt instruments - there is no recycling possibility upon disposal.
This clear system leads to more consistent accounting that better reflects the actual business model and economic substance of financial instruments than the previous regulations.
The measurement categories under IFRS 9 form the foundation for the subsequent measurement of financial instruments and have far-reaching effects on the balance sheet and statement of comprehensive income. The following examines the two most important categories in more detail.
Amortized Cost
Measurement at amortized cost represents the central category for many companies. This is particularly true for banks and financial service providers with extensive loan portfolios.
Requirements for classification:
For a financial instrument to be measured at amortized cost, two cumulative conditions must be met:
When assessing the business model, it should be noted that occasional sales do not necessarily call the classification into question. IFRS 9 recognizes that sales due to credit deterioration, to manage concentration risks, or shortly before maturity can be compatible with the "Hold to Collect" model.
Critical for this assessment are the frequency, volume, and reasons for the sales (such as the mentioned examples of credit deterioration, concentration risks, or sales shortly before maturity) in relation to the overall portfolio, as well as their compatibility with the documented business model.
Effective Interest Method in Practice:
The subsequent measurement at amortized cost is carried out using the effective interest method. This distributes acquisition costs, premiums, discounts, and fees over the term of the instrument.
The effective interest rate is determined at initial recognition and corresponds to the interest rate that exactly discounts the expected future payments to the gross carrying amount of the financial asset.
In practice, special challenges arise with instruments with variable interest rates or early repayment options:
For variable interest instruments, the effective interest rate must be periodically adjusted to interest rate changes. For instruments with repayment options, the expected cash flows must be estimated taking these options into account, which may require complex valuation models.
Fair Value through Other Comprehensive Income (FVOCI)
The FVOCI category represents a middle ground. Here, value changes are recorded in other comprehensive income without affecting profit or loss, while the income statement continues to reflect the effects of measurement at amortized cost.
Scope of application for debt instruments:
Debt instruments are assigned to the FVOCI category when they are held within a business model whose objective is achieved both by collecting contractual cash flows and by selling ("Hold to Collect and Sell"), and when they simultaneously pass the SPPI test.
Typical examples are liquidity reserves or investment portfolios where regular reallocations are made to optimize returns or to adjust to duration requirements.
The accounting is at fair value in the balance sheet, while interest income, currency translation differences, and impairments are recognized in the income statement as if measured at amortized cost.
The difference between these income statement effects and the total change in value is reported in other comprehensive income (OCI). Upon derecognition, the amounts accumulated in OCI are reclassified to the income statement (recycling).
Special features for equity instruments:
For equity instruments not held for trading purposes, there is an irrevocable option to measure at fair value with recognition of value changes in other comprehensive income. This option must be exercised at initial recognition and can be chosen separately for each instrument.
Unlike debt instruments, no recycling takes place for equity instruments in the FVOCI category. This means: Realized gains or losses are not reclassified to the income statement upon disposal, but transferred directly to retained earnings.
Impairments are also not recognized in the income statement. Only dividends are reported as income in the income statement, provided they do not represent a return of capital.
This special feature means that for equity instruments in the FVOCI category, the income statement only reflects dividend income, while all value changes - even when realized - never affect the income statement. This can make comparability with instruments accounted for using other methods more difficult and should be considered when choosing this option.
In addition to classification and measurement, IFRS 9 has also fundamentally reformed the regulations on impairment and hedge accounting.
These two areas were particularly criticized under the predecessor standard IAS 39 - the impairment provisions due to their backward-looking nature ("too little, too late") and hedge accounting due to its rigid, rule-based requirements.
With the new "Expected Credit Loss model," IFRS 9 represents a paradigm shift from a past-oriented to a forward-looking approach to risk provisioning.
At the same time, the hedge accounting regulations have been made more flexible to better align accounting representation with companies' actual risk management.
Both innovations mean considerable implementation effort for those preparing financial statements, but simultaneously open up opportunities for a more economically meaningful presentation.
The Expected Credit Loss model represents one of the most significant paradigm shifts of IFRS 9: Instead of waiting for loss events that have already occurred as under IAS 39, IFRS 9 requires forward-looking recognition of expected credit losses.
This future-oriented approach aims to avoid the "too late" formation of impairments criticized during the 2008 financial crisis.
Three-stage Model for Risk Provisioning
IFRS 9 introduces a three-stage model where the amount of risk provisioning depends on the development of credit risk since initial recognition. The intensity of impairment increases from stage to stage:
Stage 1 (Performing) includes financial instruments without a significant increase in credit risk since initial recognition. Here, expected credit losses are only considered for the next 12 months. This impairment reflects the probability of default within the next 12 months, multiplied by the expected loss in case of default. Practically all financial instruments are initially assigned to this stage upon acquisition.
In Stage 2 (Underperforming), a significant increase in credit risk has occurred since initial recognition, without objective evidence of impairment already existing. Here, risk provisions must be formed based on expected credit losses over the entire remaining term (Lifetime ECL). This typically leads to a significant increase in impairment.
In Stage 3 (Non-Performing), there is objective evidence of impairment that has already occurred. Lifetime ECLs must also be recognized here, but interest income is now calculated based on the net carrying amount (after deduction of impairment), while in Stages 1 and 2, the gross carrying amount is decisive.
The assessment of whether a significant increase in credit risk exists requires a comparison of the current risk with the risk at initial recognition. IFRS 9 allows various indicators such as rating changes, changes in probability of default, payment delays of more than 30 days, or watchlist entries. For instruments with low credit risk (Investment Grade), a simplified regulation applies, according to which these can generally remain in Stage 1.
Practical Implementation of Impairment Regulations
The implementation of the ECL model presents companies with significant methodological and data-related challenges. Three key parameters must be determined for calculating expected credit losses:
The Probability of Default (PD) must be estimated for both the 12-month period and the entire remaining term. Forward-looking information such as economic forecasts must be taken into account.
The Loss Given Default (LGD) indicates what proportion of the receivable is likely not to be recovered in case of default. Collateral, its value development, and liquidation costs play a decisive role here.
The Exposure at Default (EAD) forecasts the amount of the outstanding receivable at the time of default, taking into account expected repayments and possible utilization of credit lines.
In practice, various implementation approaches have been established:
Banks and large financial service providers often use complex statistical models based on their internal risk management systems and regulatory models. However, these need to be adapted to IFRS 9 requirements, as regulatory models often make conservative assumptions and do not have the same future orientation.
For industrial companies and smaller financial institutions, IFRS 9 offers simplifications such as the Simplified Approach for trade receivables, contract assets, and lease receivables. Here, Lifetime ECLs are recorded directly without stage allocation. This is often done based on impairment matrices that differentiate historical default rates by past-due bands and adjust them for forward-looking factors.
A particular complexity lies in the integration of macroeconomic forecasts. IFRS 9 requires consideration of various future scenarios, which in practice is often implemented by modeling base, positive, and negative scenarios with appropriate weighting.
The introduction of the ECL model has led to a significant increase in impairments for many companies, as risk provisions must now be formed even for supposedly "good" loans (Stage 1), and higher amounts must be recognized early when credit risk deteriorates (Stage 2). This has led to noticeable equity effects, particularly for banks, and increased the volatility of risk provisions.
Hedge Accounting under IFRS 9 represents a significant advancement compared to the regulations of IAS 39, which were often criticized as too rigid. The new standard aims to better align the accounting representation of hedging relationships with companies' actual risk management while simultaneously lowering application hurdles.
New Regulations and Their Effects
IFRS 9 significantly expands the scope of hedge accounting. While under IAS 39 many economically sensible hedging strategies did not qualify for hedge accounting, now considerably more risk positions can be designated as hedged items. For example, components of non-financial items (such as the commodity price component of a procurement contract) are permissible as hedged items, provided they are separately identifiable and reliably measurable.
IFRS 9 also offers more flexibility regarding hedging instruments. Certain written options can now be designated as part of a hedging strategy. Particularly relevant for practice: Non-derivative financial instruments measured at fair value through profit or loss can be used as hedging instruments for all risks - not just for currency risks as under IAS 39.
Another significant innovation concerns the treatment of the time value of options and the forward element of forward transactions: These components can now be recorded separately in other comprehensive income as "costs of hedging," which reduces unwanted earnings volatility and increases the attractiveness of these instruments for hedging purposes.
The "intrinsic value" of the option, however, continues to be recognized in the income statement. This differentiated treatment enables a more precise representation of the economic functioning of hedging relationships.
Simplified Documentation Requirements
While IFRS 9 maintains the basic principle that hedging relationships must be formally designated and documented, it makes the requirements more practical. The documentation must still include the identification of the hedged item and the hedging instrument, the nature of the hedged risk, and the method for assessing effectiveness.
New is the concept of "risk management strategy" as an overarching framework within which individual "risk management objectives" are defined for specific hedging relationships. This two-tier structure makes it possible to document general aspects of the hedging strategy once and only record the specific aspects for each individual hedging relationship separately.
Particularly helpful for practice: The documentation no longer needs to be available at the exact time of designation but can be completed within a reasonable period. This reduces operational pressure, especially for hedging transactions concluded at short notice.
Effectiveness Measurement and Verification Requirements
The most significant simplification concerns effectiveness measurement. The retrospective effectiveness test required under IAS 39 with the rigid 80-125% range has been eliminated. Instead, the assessment of effectiveness is now exclusively forward-looking and principle-based.
A hedging relationship meets the effectiveness requirements if:
The methods for measuring effectiveness are not prescribed and can include qualitative or quantitative analyses. For simple hedging relationships, such as hedging foreign currency loans with currency swaps, a qualitative analysis of the critical conditions (currency, term, nominal) is often sufficient.
IFRS 9 also introduces the concept of "rebalancing": If a hedging relationship continues to meet the effectiveness requirements but shows ineffectiveness, the hedge ratio can be adjusted without having to terminate and redesignate the hedging relationship. This reduces administrative effort and avoids unwanted accounting effects.
Ineffectiveness must still be calculated and recognized in profit or loss. Quantitative methods are usually required for this, with the dollar offset method or regression analyses frequently being used.
Despite the simplifications, hedge accounting remains complex and requires careful implementation. However, the new regulations offer the opportunity to align hedge accounting more closely with actual risk management activities and thereby improve the transparency of financial reporting.
The implementation of IFRS 9 proved to be a comprehensive major project for many companies, extending far beyond pure accounting. Since the mandatory first-time application on January 1, 2018, preparers of financial statements have gathered extensive experience; nevertheless, open questions and room for interpretation remain, requiring continuous adjustments.
The practical implementation of the standard demands not only profound changes in accounting systems but also close integration with risk management, the treasury department, and IT.
The implementation of the Expected Credit Loss model, in particular, has proven to be data-intensive and methodologically challenging. At the same time, the more flexible hedge accounting regulations open up new possibilities for a more economically meaningful representation of hedging relationships.
In the following, we highlight the essential aspects of practical implementation as well as current developments and challenges that are of particular relevance to users.
The transition to IFRS 9 represented a profound change for many companies, going far beyond a mere change in accounting rules. Although the initial transition phase has now been completed, the implemented systems and processes remain relevant and are subject to continuous improvements.
System Requirements and Process Adjustments
The implementation of IFRS 9 has led to significant adjustments to the IT landscape in many companies. In particular, the Expected Credit Loss model requires the integration of risk data that was previously often only available in risk management, but not in financial accounting. The challenge was to break down data silos and create a consistent data basis for accounting and risk management.
For the classification of financial instruments, processes had to be established that enable a systematic assessment of the business model and cash flow characteristics. This often includes:
The implementation of the ECL model proved particularly challenging. Here, not only new calculation models had to be developed, but also processes for the regular updating of macroeconomic scenarios and the monitoring of significant risk increases. The stage transfers between the three stages of the impairment model must be transparently documented and mapped in the system.
In the area of hedge accounting, the more flexible regulations allow for new hedging strategies but also require adjusted processes for the designation, effectiveness measurement, and rebalancing of hedging relationships. Many companies have implemented or expanded specialized treasury management systems to meet these requirements.
A particular challenge is the integration of these various systems into the closing process. The processing of large amounts of data, complex calculations, and the need to model different scenarios have led to longer closing times in many cases. Companies are continuously working to optimize and automate these processes.
Impact on Key Figures and Reporting
The introduction of IFRS 9 has had significant effects on key financial indicators and external reporting. These effects are particularly evident in the following areas:
The equity ratio was negatively impacted at many financial institutions due to higher impairments under the ECL model. In particular, the transition effect upon first-time application led to a one-time reduction in equity, which had regulatory implications and was cushioned by supervisory authorities through transitional arrangements.
Earnings volatility has increased due to various aspects of IFRS 9. The ECL model responds more sensitively to changing economic conditions, which became particularly evident during crisis periods such as the COVID-19 pandemic. At the same time, the more frequent application of fair value measurement leads to stronger market value effects on earnings.
The notes disclosures have expanded considerably. IFRS 7, in conjunction with IFRS 9, requires extensive qualitative and quantitative information on classification, the impairment model, and hedge accounting. In particular, the disclosure requirements for expected credit losses, including sensitivity analyses and the explanation of model assumptions, have significantly increased the scope of reporting.
For internal management, many companies had to adapt their key performance indicator systems. The new measurement categories and the ECL model require a more differentiated view of earnings components. In particular, the distinction between "real" credit losses and model-related value adjustments is relevant for business management.
Communication with investors and analysts has become more complex. Companies had to explain how the new regulations affect their specific situation and what assumptions underlie the impairment models. Many institutions now publish additional indicators to ensure comparability over time.
Experience since first-time application shows that while IFRS 9 contributes to a more differentiated and economically meaningful representation of financial instruments, it has simultaneously increased the complexity of financial reporting.
Companies face the challenge of making this complexity understandable to external addressees while further developing their internal management systems accordingly.
Several years after the mandatory first-time application of IFRS 9, certain interpretations have become established, while new application questions and challenges have emerged. The dynamics of financial markets and special events such as the COVID-19 pandemic have put the practical application of the standard to the test.
Interpretations and Application Questions
The IFRS Interpretations Committee (IFRIC) has addressed various application questions since the introduction of IFRS 9 that had led to different interpretations in practice. Particularly relevant were clarifications on the classification of financial instruments with specific contractual clauses.
For example, the question was clarified whether loans with prepayment penalties can pass the SPPI test. The IFRIC determined that reasonable compensation for early termination of the contract is compatible with the SPPI criterion, even if the compensation represents compensation for lost interest.
The treatment of financial instruments with ESG components (Environmental, Social, Governance) has also gained importance. For loans with variable interest rates linked to the achievement of sustainability goals, the question arises whether this variability is compatible with the SPPI criterion. The prevailing interpretation suggests that moderate interest adjustments due to ESG factors do not violate the SPPI test, provided they have a relation to credit risk.
In the area of the impairment model, questions about considering forward-looking information and the definition of a "significant increase in credit risk" have proven particularly challenging. Various approaches have been established in practice, although comparability between companies remains limited.
Practical Experience Since Introduction
The experiences since the introduction of IFRS 9 show a differentiated picture. On one hand, the impairment model has proven more robust in times of crisis than the old incurred loss model of IAS 39. The early recognition of expected losses has contributed to more gradual formation of impairments.
On the other hand, the COVID-19 pandemic has revealed the limits of the model. The sudden deterioration of economic prospects led to significant stage transfers and a sharp increase in impairments, which intensified earnings volatility. Many institutions faced the challenge of distinguishing between temporary effects due to government support measures and long-term changes in creditworthiness.
In the area of classification, it has become apparent that the business model assessment is less flexible in practice than originally assumed. Once established business models can only be changed under strict conditions, which limits strategic flexibility. At the same time, many companies have used the opportunity to achieve an accounting representation that better corresponds to their economic management through targeted portfolio formation.
The more flexible hedge accounting regulations are increasingly being used to represent more complex hedging strategies. In particular, the possibility of designating risk components of non-financial items has led to a more economically meaningful presentation in raw material processing industries.
Implementation Challenges
Despite years of application experience, significant hurdles remain in implementing IFRS 9. Data quality remains a critical factor, especially for ECL calculation. Historical data on default probabilities and loss rates are often incomplete or not granular enough, which complicates modeling.
The integration of macroeconomic scenarios into impairment models confronts companies with methodological difficulties. The correlation between macroeconomic factors and credit risks is often complex and non-linear. In addition, the models must be regularly validated and adapted to changing economic conditions.
The governance requirements have proven more demanding than expected. The complexity of the models and the multitude of assumptions require robust control processes and clear assignment of responsibilities. In particular, the monitoring of model risks and the documentation of expert judgments require careful governance structures.
Resource intensity also remains a challenge. The ongoing development and maintenance of systems as well as the regular updating of models tie up significant human and financial resources. Many companies are therefore working on further automation and increasing the efficiency of their IFRS 9 processes.
A future-oriented task is the integration of sustainability aspects into IFRS 9 application. Consideration of climate risks in credit risk assessment and the valuation of financial instruments with sustainability components are gaining increasing importance and require new methodological approaches.
The practical experiences with IFRS 9 show: Despite its complexity, the standard contributes to a more economically meaningful representation of financial instruments. At the same time, implementation remains a continuous process that requires ongoing adjustments and improvements.
Companies that view IFRS 9 not just as a compliance exercise but as an opportunity to integrate accounting and risk management can benefit from improved control and transparency in the long term.
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