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- March 2010
- ED 189 Financial Instruments: Amortised Cost and Impairment
ED 189 Financial Instruments: Amortised Cost and Impairment
- By Rob Mackay
- Published 31/03/2010
- March 2010
- Unrated
ED 189 Financial Instruments: Amortised Cost and Impairment is the second phase of the IASB’s project to revise and replace IAS 39 Financial Instruments: Recognition and Measurement.
The first phase of the project resulted in the December 2009 release of AASB 9 Financial Instruments which addresses the recognition and measurement of financial assets. The IASB anticipates that a standard on the second phase will be released in the latter half of 2010 and would be available for early adoption.
ED 189 is intended to clarify the amortised cost model and to improve the approach to measuring and reporting impairment losses associated with financial assets.
The proposals include a single method of impairment testing, rather than the multiple methods currently included in AASB 139. The proposals will also impact the recognition and disclosure of impairment losses, the calculation of amortised cost and the application of the effective interest method. The changes are likely to affect all entities reporting under Australia Accounting Standards.
Amortised cost
Whilst the concept of amortised cost is not new, AASB 139 neither specifies the objective of an amortised cost measurement, nor does it clearly identify the measurement principles involved. The proposals in the ED address amortised cost in a more comprehensive manner.
The objective of amortised cost measurement is that it should ‘provide information about the effective return on a financial asset or financial liability by allocating interest revenue or interest expense over the expected life of the financial instrument’.
In determining the effective return, the amortised cost method essentially requires the valuation of current cash flow information at each measurement date which reflects conditions on initial recognition.
Measurement principles
The measurement proposals will apply to all financial assets and liabilities carried at amortised cost.
The key terms are:
Amortised cost: a cost-based measurement of a financial instrument that uses amortisation to allocate interest revenue or interest expense. Effective interest method: a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) that uses the effective interest rate.
Effective Interest Rate: The rate that (or spread that, in combination with the interest rate components that are reset in accordance with the contracts) exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset
or financial liability.
The expected cash flow estimates used to calculate amortised cost at each measurement date reflect the information on hand at that date. Such information includes:
A probability weighted estimation of possible cash flow outcomes is used in determining expected cash flows.
The proposals in the ED also clarify that estimates of expected cash flows in relation to financial liabilities should not consider the entities own non-performance risk.
When calculating amortised cost, the ED proposes to allow expected cash flows to be estimated at a group or portfolio level or at an individual financial instrument level. For example, financial assets may be grouped based on credit risk after giving due consideration to the asset type, the payment status and other relevant factors. The basis applied should provide the best estimate of expected cash flows and the entity should ensure that credit losses are not double counted.
The effective interest rate
The effective interest rate is used to determine amortised cost and the allocation of interest revenue or expense over the life of the financial asset or liability.
For fixed rate instruments, the effective interest rate is determined on initial recognition of the financial instrument and will remain unchanged throughout its life. As estimates of expected cash flows (including expected future credit losses) will impact the effective interest rate, the accuracy of the estimates is critical.
The ED proposes to allow the use of practical expedients in calculating amortised cost if the overall effect of using these expedients is not materially different to using the effective interest rate method. The practical expedients are designed to facilitate a cost effective method of determining amortised cost for less complex financial instruments.
A practical expedient may apply where the discounting of trade receivables is immaterial and the entity would not need to determine an effective interest rate or recognise any interest over the life of the asset. Instead the entity would measure the trade receivables and revenue on initial recognition at the invoice amount less the initial estimate of undiscounted expected future credit losses.
The first phase of the project resulted in the December 2009 release of AASB 9 Financial Instruments which addresses the recognition and measurement of financial assets. The IASB anticipates that a standard on the second phase will be released in the latter half of 2010 and would be available for early adoption.
ED 189 is intended to clarify the amortised cost model and to improve the approach to measuring and reporting impairment losses associated with financial assets.
The proposals include a single method of impairment testing, rather than the multiple methods currently included in AASB 139. The proposals will also impact the recognition and disclosure of impairment losses, the calculation of amortised cost and the application of the effective interest method. The changes are likely to affect all entities reporting under Australia Accounting Standards.
Amortised cost
Whilst the concept of amortised cost is not new, AASB 139 neither specifies the objective of an amortised cost measurement, nor does it clearly identify the measurement principles involved. The proposals in the ED address amortised cost in a more comprehensive manner.
The objective of amortised cost measurement is that it should ‘provide information about the effective return on a financial asset or financial liability by allocating interest revenue or interest expense over the expected life of the financial instrument’.
In determining the effective return, the amortised cost method essentially requires the valuation of current cash flow information at each measurement date which reflects conditions on initial recognition.
Measurement principles
The measurement proposals will apply to all financial assets and liabilities carried at amortised cost.
The key terms are:
Amortised cost: a cost-based measurement of a financial instrument that uses amortisation to allocate interest revenue or interest expense. Effective interest method: a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) that uses the effective interest rate.
Effective Interest Rate: The rate that (or spread that, in combination with the interest rate components that are reset in accordance with the contracts) exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset
or financial liability.
The expected cash flow estimates used to calculate amortised cost at each measurement date reflect the information on hand at that date. Such information includes:
- The contractual terms including principle and interest repayments, prepayment options, call options etc;
- Fees and points paid or received between the transacting parties; and
- For a financial asset, expected credit losses over the life of the asset.
A probability weighted estimation of possible cash flow outcomes is used in determining expected cash flows.
The proposals in the ED also clarify that estimates of expected cash flows in relation to financial liabilities should not consider the entities own non-performance risk.
When calculating amortised cost, the ED proposes to allow expected cash flows to be estimated at a group or portfolio level or at an individual financial instrument level. For example, financial assets may be grouped based on credit risk after giving due consideration to the asset type, the payment status and other relevant factors. The basis applied should provide the best estimate of expected cash flows and the entity should ensure that credit losses are not double counted.
The effective interest rate
The effective interest rate is used to determine amortised cost and the allocation of interest revenue or expense over the life of the financial asset or liability.
For fixed rate instruments, the effective interest rate is determined on initial recognition of the financial instrument and will remain unchanged throughout its life. As estimates of expected cash flows (including expected future credit losses) will impact the effective interest rate, the accuracy of the estimates is critical.
The ED proposes to allow the use of practical expedients in calculating amortised cost if the overall effect of using these expedients is not materially different to using the effective interest rate method. The practical expedients are designed to facilitate a cost effective method of determining amortised cost for less complex financial instruments.
A practical expedient may apply where the discounting of trade receivables is immaterial and the entity would not need to determine an effective interest rate or recognise any interest over the life of the asset. Instead the entity would measure the trade receivables and revenue on initial recognition at the invoice amount less the initial estimate of undiscounted expected future credit losses.
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