IFRS 9: Financial Instruments#

Classification and measurement#

A financial asset is classified using two tests:

Business model: how the firm manages the asset. It may hold it to collect the contractual cash flows, hold it to collect cash flows and also sell it, or hold it for trading and other purposes.
Contractual cash flows: whether the cash flows are solely payments of principal and interest (SPPI) on the principal outstanding.

Classification of financial assets#
Category	When it applies	Where changes in value go
Amortised cost	Held to collect cash flows, and the cash flows pass the SPPI test.	Not remeasured to fair value. Interest income is recognised in profit or loss, and impairment is applied.
Fair value through other comprehensive income (FVOCI)	Held to collect cash flows and to sell, and the cash flows pass the SPPI test.	Fair value changes go to OCI and are recycled to profit or loss on sale. Interest and impairment go to profit or loss.
Fair value through profit or loss (FVTPL)	Everything else, including trading positions, derivatives, and assets that fail the SPPI test.	All fair value changes go to profit or loss.

Derivatives are always at FVTPL unless they are in a designated hedge accounting relationship. This is why the valuation of derivatives, including the XVA adjustments in the XVA series, flows directly into reported profit or loss.

Equity instruments are at FVTPL, with an irrevocable election to take fair value changes to OCI for those not held for trading. Amounts taken to OCI under that election are never recycled.

Financial liabilities are generally at amortised cost, except for those held for trading, derivatives, and those designated at fair value through profit or loss under the fair value option.

Own credit#

For a liability designated at fair value, IFRS 9 requires the part of the change in fair value that is due to the firm’s own credit risk to be shown in OCI, and the rest in profit or loss. This removes the counterintuitive gain that a firm used to book when its own credit worsened. It does not apply to derivatives or to trading liabilities, where the DVA adjustment still goes to profit or loss. See CVA: Credit Valuation Adjustment.

Day-one profit or loss#

When the price paid at inception differs from the model value, the difference can only be recognised in profit or loss immediately if the fair value is evidenced by a Level 1 price or by a valuation technique that uses only observable market data. Otherwise it is deferred and recognised over the life of the instrument. The levels are described in Fair-value hierarchy: Levels 1, 2 and 3.

Impairment: expected credit losses#

IFRS 9 replaced the incurred loss model with an expected credit loss (ECL) model. It applies to assets at amortised cost and FVOCI, and to loan commitments and financial guarantees. Assets at FVTPL are not impaired, as their fair value already reflects credit risk.

The loss allowance depends on the stage of the asset:

The three stages of impairment#
Stage	Credit quality	Allowance
1	Performing, with no significant increase in credit risk since initial recognition.	12-month expected credit losses.
2	A significant increase in credit risk since initial recognition, but not yet credit impaired.	Lifetime expected credit losses.
3	Credit impaired, that is, in default or with objective evidence of loss.	Lifetime expected credit losses, with interest income on the net carrying amount.

The expected loss is the probability of default multiplied by the loss given default and the exposure at default, discounted, and it must be unbiased and probability weighted. It uses forward-looking information, including several macroeconomic scenarios. The same ingredients drive CVA, but the purposes differ: ECL is a provision against the loss on a loan, while CVA is the market price of counterparty risk on a derivative.

Hedge accounting#

Hedge accounting is optional. It lets the firm match the P&L from a hedging instrument, usually a derivative, with the P&L from the item it hedges, which would otherwise be recognised at different times. IFRS 9 ties the rules more closely to risk management than IAS 39 did, and replaced the 80 to 125% effectiveness test with a principles-based assessment. There are three types:

Fair value hedge: hedges the exposure to changes in the fair value of an asset or liability. Both the hedge and the hedged item go through profit or loss.
Cash flow hedge: hedges the variability of future cash flows. The effective part of the hedge goes to a cash flow hedge reserve in OCI and is recycled when the hedged cash flow affects profit or loss.
Net investment hedge: hedges the foreign currency exposure of a foreign operation.

Firms may choose to continue to apply the IAS 39 hedge accounting rules for macro hedging of interest rate risk on portfolios, and many banks do.

A valuation control view#

IFRS 9 shapes the work of valuation control in these places:

Scope of fair value: the classification decides which positions are carried at fair value, and so which are in scope of independent price verification (IPV). FVTPL and FVOCI positions are, and amortised cost positions are not.
Level 3 and day-one P&L: the deferral rules need a clear, evidenced view on whether a valuation uses only observable inputs.
Inputs shared with ECL: probabilities of default and loss given default feed both ECL and credit adjustments such as CVA, so the data, the proxy mappings and the scenarios should be consistent.
Hedge accounting: the valuation of the hedging instrument must be accurate and independent, as it drives the hedge reserve and any ineffectiveness.
Own credit: the split between the own credit component and the rest of the fair value change must be calculated and controlled.

How fair value itself is measured is set by IFRS 13: Fair Value Measurement.