Saturday, July 30, 2022

IFRS 9: Accounting mismatch and own credit risk

 


Welcome to IFRS is easy's flash term for the week

Accounting mismatch and own credit risk

In accounting, we are always conscious of what goes into the profit or loss section of our financial statements. This is also crucial when we talk about the golden principle of debit and credit. We expect that when we debit our asset with a particular amount, we should credit the liability with that same amount.

The above understanding is important because the same principle applies to our financial assets and financial liabilities. When you have both a financial asset and a financial liability in your books that arise as a result of each other, you expect that for simplicity, the way you measure the financial asset should be the same way you will measure the financial liability, but this may not necessarily be the case.

If you want to learn more about what financial assets and financial liabilities are, click here "Understanding financial instruments" and to learn about how to "Classify and measure financial instruments". Those two learnings are crucial to understanding accounting mismatch and own credit risk.

Accounting mismatch

So what is an accounting mismatch?

An accounting mismatch is a situation when measurement or recognition inconsistency would arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases.

Now don't get it twisted!

We will use an example to explain the above definition.

Company A issues loans that are measured at amortized cost (a financial liability) and uses the funds received from the loan issued to invest in financial assets that are held for the purpose of making short-term gains (by frequently buying and selling them). Cash flows from these investments are used to pay back the loans issued. The Company has assessed the financial assets as held for trading and as such measures them at fair value through profit or loss. 

The above implies that the financial liability is measured at amortised cost while the financial asset is measured at fair value through profit or loss. This means that the fair value changes on the investments (financial assets) will not agree with the profit or loss impact of the loans (financial liabilities) - this is simply what an accounting mismatch is all about.

Now, because there is an economic relationship between the financial liabilities (loan issued) and the financial assets (investments) recognized by Company A, and because both financial instruments are measured at different measurement bases (leading to an accounting mismatch) IFRS 9 permits that the financial instrument measured at amortised cost can rather be measured at fair value through profit or loss so that the fair value changes in the one measured at fair value through profit or loss can tie with the other financial instrument as well.

The above implies that the financial liability will be measured at fair value through profit or loss instead of at amortised cost.

Own credit risk

So what is an own credit risk?

Own credit risk arises when fair value option through profit or loss has been taken for a financial liability but some of the fair value changes relate to the issuer’s own credit risk.

What the above means is that where a financial liability e.g loan, is measured at fair value through profit or loss and the fair value changes account for the fact that the issuer (the borrower) will be unable to pay back the liability. This could be due to the borrower's credit rating decline or business losses.

IFRS 9 requires that the changes that relate to the issuer's credit risk (own credit risk) should not be taken to profit or loss, but rather to other comprehensive income.

To learn more about accounting mismatch and own credit risk with various practical examples, see the short YouTube video below for a series that gives a detailed explanation of this aspect of IFRS 9 Financial Instruments.



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I will be happy to receive any questions you may have that are not addressed in the article/video.

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Written by:
Adedamola Otun
For: IFRS IS EASY