The global credit crunch/financial crises that began in 2008 and the recession that followed were largely blamed on the complex financial assets and liabilities introduced to the markets whose credit risks were not effectively captured by the financial reporting framework for financial instrument at the time (International Accounting Standard 39). The process to change this standard began immediately in 2009, with further amendments in 2010 and 2013. The new standard, International Financial Reporting Standards (IFRS) 9, was finally issued on July 1, 2014. The effective date for the new standard was then set at January 1, 2018 to give enough room for companies and businesses to study and assess the potential impact of the new standard on their statement of financial position (SOFP).
IFRS 9 is a response to criticisms that IAS 39 is too complex, inconsistent with the way entities manage their businesses risks and defers the recognition of credit losses on loans and receivables until too late in the credit cycle. The new standard brought major changes in the areas of classification and measurement of financial assets and liabilities, impairment of financial assets, hedging transactions and disclosure requirements.
This article explores some of the changes introduced by the new standard in accounting for financial assets and possible tax implications.
IAS 39 vs IFRS 9: What has changed?
Classification and Measurement
Financial assets includes cash, investment in equity and contractual right to receive cash or another financial asset from another entity. Some examples of financial assets include trade receivables, loan receivables, equity investment, bond investments, fixed deposits, investments in treasury bills and commercial papers among others.
IAS 39 classified financial assets into four categories. These are Fair Value Through Profit Or Loss (FVTPL), Loan Receivable (LR), Held To Maturity (HTM) Assets and Available For Sales (AFS) Assets. FVTPL financial assets were assets held for trading on short-term basis or have been designated as such by management. All types of derivative investments were also classified as FVTPL. LR relates to financial assets brought about through the provision of money goods or services. Such assets must have fixed or determinable payment patterns, not traded in an active market and are usually fixed at maturity. HTM financial assets are similar to LR except that the holder intends to hold the investment to maturity and they may be traded in active market. AFS financial assets are those that could not be classified into the other three categories.
IAS 39 further provided that FVTPL and AFS financial assets should always be measured at fair value, while LR and HTM financial assets were to be measured at amortized costs using the effective interest method. The effective interest method uses the effective interest rate to allocate the amortized cost of the financial asset and allocate the interest income over the tenor of the asset. The effective interest rate is the rate that exactly discounts estimated future cash receipts through the expected life of the financial instrument to the net carrying amount of the financial asset.
IFRS 9, on the other hand, streamlined the classification and measurement of financial assets into three. The first classification relates to those assets carried at amortized costs (AC). Financial assets categorized as AC are required to meet the business model and contractual cash flow tests. The business model test presupposes that the objective of holding such financial assets is to collect the contractual cash flows promised by such investment. The contractual cash flow test requires such promised cash flow to be in the form of principal and interest payment only. Thus, investment in debt instruments and trade receivables, where the objective is to collect the principal amount outstanding and any interest accrued on the principal, are examples of financial assets categorized as AC. This is similar to the LR and HTM financial assets under IAS 39.
The second category relates to financial assets measured at fair value through the profit or loss (FVTPL), while the last classification relates to financial assets carried at fair value through other comprehensive income (FVOCI). FVTPL category relates to assets that do not meet the AC criteria, as well as financial assets designated as such at initial recognition. FVOCI includes equity investments held on a long term basis and debt instruments that meet both contractual cash flow and short term trading objectives of the investor. FVTPL or FVOCI are always carried at fair value.
IAS 39 provided that financial assets measured at amortized costs be subjected to annual impairment review with the aim of ascertaining if any impairment loss has occurred in the period. It requires impairment loss to be recognized where a loss event, that affects the recoverability of estimated future cash flow from a financial asset, has occurred. The loss event gives objective evidence that the cash flow relating to a financial asset may not be fully recovered.
The process requires an entity to assess, at the end of each reporting period, whether there is any objective evidence that any of its financial asset or group of financial assets measured at amortized cost is impaired. If any such evidence exists, the entity must recognize an impairment loss in profit or loss immediately. The amount of the loss is measured as the difference between the asset's carrying amount (i.e. the amount reported in the SOFP) and the present value of estimated future cash flows discounted at the financial asset's original effective interest rate (i.e. the effective interest rate computed at initial recognition). The carrying amount of the asset is thereafter reduced by the amount of impairment loss.
Impairment assessment were required to be evaluated on individual and collective basis. The individual assessment applies to financial assets that are significant in value while collective assessment applies to assets that suffers no impairment on individual basis or those assets that cannot be assessed on individual basis.
IFRS 9 introduced a completely new basis for assessing impairment of financial assets carried at AC. This basis, called the Expected Loss Model (ELM), requires entities to recognize impairment loss from the first day of entering into such contract and need not wait for the occurrence of a loss event before carrying out an impairment assessment. The new standard establishes a three-stage approach for impairment of financial assets, based on whether there has been a significant deterioration in the credit risk (probability of not being able to recover the cash flow from a financial asset) of a financial asset. These three stages then determine the amount of impairment to be recognized.
At initial recognition of a financial asset, an entity recognizes a loss allowance based on the amount of cash flow estimated to be lost to default events that are likely to occur within the next 12 months from the company's reporting date. This is technically called the 12-month expected credit losses. This means that the actual loss does not need to take place within the 12 month period.
"A significant tax implication is the deductibility of impairment loss under the incurred loss model of IFRS 9. This is because the provision of the Companies Income Tax Act (CITA) follows closely the objective evidence approach as provided in section 24(f) of CITA."
An entity thereafter is also required to carry out a three-stage assessment of impairment. The first stage applies where the credit risk associated with the financial asset has not increased significantly since initial recognition. Here, the entity only recognizes the 12-month expected credit losses. The second stage occurs where the credit risk of the financial asset has increased significantly since initial recognition of the asset, the entity is required to recognize a lifetime expected losses. The lifetime expected losses is the amount of cash flow estimated to be lost to default events that are likely to occur over the life of the asset. The last stage applies where an objective evidence of impairment exist as at the reporting date. Where this is the case, the entity is required to recognize the lifetime expected losses based on the loss event that has occurred. This stage is similar to the incurred loss model under IAS 39.
For assets carried at fair value, impairment loss adjustment is carried out automatically as movement in fair values of the assets ensures that any impairment loss that has occurred on the financial statement is captured in the statement of profit or loss and other comprehensive income.
Tax implication of IFRS 9 and the Implication to the financial industry
One major area of impact of IFRS 9 is the large increase in loan loss/impairment loss provisioning booked by companies (especially Banks, insurance and other financial services companies) compared to the requirements of IAS 39. The huge provisioning/expense dived deeply into the net income of companies, especially Deposit Money Banks (DMBs).
Deductibility of Impairment Loss
A significant tax implication is the deductibility of impairment loss under the incurred loss model of IFRS 9. This is because the provision of the Companies Income Tax Act (CITA) follows closely the objective evidence approach as provided in section 24(f) of CITA. This section details the circumstances under which bad and doubtful debts (impairment loss) are allowed as deductible expense when determining the income tax liability of a business entity. The section presupposes that the debt must have become bad as a matter of fact and incurred in connection with or in the course of the trade or business of the entity. Such debt must relate to income/receipts already included in determining the Income tax of the entity or advances made in the ordinary course of business of the entity. In practice, the Federal Inland Revenue Service (FIRS) demands objective evidence to prove that the debts are doubtful or have become bad. The evidence required by the FIRS usually include an age analysis of the debt, efforts made by the taxpayer to recover the money as well as objective evidence that the taxpayer's customer(s) would not be able to pay the money. Only when these conditions are met will the FIRS allow bad and doubtful debts as deductible expenses in Income tax computations. It is as a result of this that FIRS allows specific impairment loss charged to Income statement while the collective impairment loss is disallowed.
IFRS 9, on the other hand, introduces a three-stage impairment loss provisioning with only stage three being similar to IAS 39 framework. It is therefore most likely that the FIRS may not allow the stage-one and state-two impairment losses as deductible.
Deferred Tax Implication
A related but indirect impact of the above is the increase in the deferred tax asset that would be carried in the books of the company as a result of increased non-deductible impairment loss. This creates a deductible temporary difference leading to increased deferred tax asset in the SOFP of the company.
Taxability of Fair Value Gain/Loss on FVTPL Assets
Another major area of tax impact is in the recognition of fair value gain or loss for tax purposes. The FIRS Circular on the tax Implications of IFRS Adoption states that the FIRS would consider gains from FVTPL assets as taxable income except where specifically exempted. The Companies Income Tax (Exemption of Bonds and Short Term Government Securities) Order, 2011 exempts income/gain/profit and interest from short-term government securities and all types of Bonds (federal/ state/local government, private or supra national). This exemption expires in 2022. Hence, significant tax impact may be deferred till the expiration of the Order.
There is no doubt that IFRS 9 will have a significant tax impact on the financial position of companies. This is especially so in relation to the new methodology for impairment of financial assets and the resulting current and deferred tax implications. Consequently, IFRS 9 may lead to increased cash outflow and additional deferred tax assets.
As new changes are introduced by accounting standards, it is imperative that the Nigerian tax laws are updated to close the gap between accounting and tax basis for transaction recognition as seen in other parts of the world. In the UK for example, the tax regulations require all transitional adjustments arising from the adoption of IFRS 9 in respect of credit losses to be spread over a 10 year period, regardless of when the debt falls due. Similarly in South Africa, the regulators have issued amendments to the tax laws to cater for the impact of IFRS 9 adoption. The Nigerian tax administrators should also follow suite and issue a circular to address the myriad issues relating the new standard.
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