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1.4.1 Financial Liability Categories

A financial liability is any liability that is a contractual obligation to deliver cash or some other financial asset to another entity or to exchange financial instruments with another entity under conditions that are potentially unfavourable.

Under IFRS 9 there are only two categories of financial liabilities (see Figure 1.5): at amortised cost and at FVTPL. The following table summarises the accounting treatment of each category of financial liabilities:

Figure 1.5 IFRS 9 financial liabilities classification categories.

The category of financial liabilities at FVTPL has two sub-categories: liabilities held for trading and those designated to this category at their inception using the FVO. Financial liabilities classified as held for trading include:

• financial liabilities acquired or incurred principally for the purpose of generating a short-term profit (i.e., held for trading);

• a derivative not designated in a cash flow or net investment hedging relationship, or the ineffective part if designated;

• obligations to deliver securities or other financial assets borrowed by a short seller;

• financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking.

The following instruments are measured under specific guidance in IFRS 9:

• financial guarantee contracts; and

• commitments to provide a loan at a below market interest rate.

1.4.2 Partial Repurchases of Financial Liabilities

When an entity repurchases own financial liabilities, the repurchased part is derecognised. According to IFRS 9, “if an entity repurchases a part of a financial liability, the entity shall allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised based on the relative fair values of those parts on the date of the repurchase. The difference between (a) the carrying amount allocated to the part derecognised and (b) the consideration paid, including any non-cash assets transferred or liabilities assumed, for the part derecognised shall be recognised in profit or loss.”

1.4.3 Changes in Credit Risk in Financial Liabilities at FVTPL

The amount of change in the fair value of a liability designated at FVTPL under the FVO that is attributable to changes in credit risk must be presented in other comprehensive income (OCI), unless:

• Presentation of the fair value change in respect of the liability's credit risk in OCI would create or enlarge an accounting mismatch in profit or loss. In this case, the fair value change attributable to changes in credit risk must be recognised in profit or loss. This determination is made at initial recognition of the individual liability and will not be reassessed.

The remainder of the change in fair value is presented in profit or loss.

To determine whether the treatment would create or enlarge an accounting mismatch, the entity must assess whether it expects the effect of the change in the liability's credit risk to be offset in profit or loss by a change in fair value of another financial instrument. In reality, such instances are expected to be rare, unless an entity, for example, holds an asset whose fair value is linked to the fair value of the liability.

The changes in credit risk recognised in OCI are not recycled to profit or loss on settlement of the liability.

The following instruments, when recognised at FVTPL, are not required to isolate the change in fair value attributable to credit risk (i.e., all gains and losses are presented in profit or loss):

• financial guarantee contracts; and

• loan commitments.

Measurement of a Liability's Credit Risk

IFRS 9 largely carries forward guidance from IFRS 7 on how to determine the effect of changes in credit risk. An entity determines the amount of the fair value change that is attributable to changes in its credit risk either:

• as the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk (e.g., a benchmark interest rate, the price of another entity's financial instrument, a commodity price, a foreign exchange rate or an index of prices or rates); or

• using an alternative method, if it provides a more faithful representation of the changes in the fair value of the liability attributable to the changes in its credit risk.

IFRS 9 clarifies that this would include any liquidity premium associated with the liability.

If the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, under IFRS 9 the amount of fair value changes that is attributable to changes in credit risk may be estimated using the so-called default method as follows:

1. The entity first calculates the liability's internal rate of return at the start of the period using the liability's fair value and contractual cash flows at that date. It then deducts from this internal rate of return the observed (benchmark) interest rate at the start of the period so as to arrive at an “instrument-specific component” of the internal rate of return.

2. Next, the entity computes a present value of the cash flows of the liability at the end of the period using the liability's contractual cash flows at that date and a discount rate equal to the sum of (i) the observed (benchmark) interest rate at that date and (ii) the instrument-specific component of the internal rate of return determined in 1).

3. The entity then deducts the present value calculated in 2) from the fair value of the liability at the end of the period. The resulting difference is the change in fair value that is not attributable to changes in the observed (benchmark) interest rate and which is assumed to be attributable to changes in credit risk.

This default method is appropriate only if the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate and that, when other factors are significant, an alternative measure that more faithfully measures the effects of changes in the liability's credit risk should be used. For example, if the liability contains an embedded derivative, the change in fair value of the derivative would be excluded in calculating the fair value change amount attributable to changes in credit risk.