New standard calls on accountants to review financial instruments

The phrase ‘financial instruments’ seems to make all but the most dedicated of technical accountants’ hearts sink, writes Debbie Paterson. Related issues seem to sink to the bottom of any ‘to do’ list but, this year, it must be tackled again.

The reporting standard IFRS 9 Financial instruments is applicable to accounting periods starting on or after 1 January 2018. For NHS bodies, this means it is applicable in 2018/19. But, as expected, the standard is not applied in full, it is applied in accordance with the interpretations and adaptions set out in the Treasury’s Financial reporting manual (FReM) and the Department of Health and Social Care’s Group accounting manual (GAM).

The standard replaces IAS 39 and there are two key changes to be aware of.

First, the classification of financial assets has changed.  There are now only three classifications available:

• Amortised cost
• Fair value through other comprehensive income (OCI)
• Fair value through profit and loss.

To determine the appropriate classification, each financial asset must be reviewed to determine its contractual cash flow characteristics. Those arrangements with cash flows that are solely payments of principal and interest (the SPPI test) are either classified as amortised cost or fair value through OCI. This test is applied on an instrument-by-instrument basis.

Failing the SPPI test means the assets are classified as fair value through profit and loss – changes in value affect the bottom line. Examples include equity instruments; any instrument involving a derivative; and any instrument where the interest rate is linked to another characteristic such as EBITDA or income.

Provisions in contracts that could change the timing or amount of the contractual cash flows might result in the SPPI test being failed.

Most common financial assets in the NHS – trade receivables, straightforward loans (even interest-free ones) – will pass the SPPI test.

For those financial instruments that pass the SPPI test, a business model test is then applied to determine which classification each group of financial instruments falls into. The test is applied to groups of financial instruments because, while an organisation might only apply one business model, it could be that both models are in operation for different groups of asset. 

Assets held simply to collect the interest and the principal are classified as amortised cost financial assets. This will include trade receivables and loans held to collect the interest.

Assets being held to collect and sell are classified as fair value through OCI. This would include loan books that are held to collect interest but that will also be sold on in the right circumstances.

As most NHS bodies classify their financial assets as amortised cost under IAS 39, it is unlikely that the classification will change. But any complicated arrangements will need to be reviewed under the new standard particularly as any new standard attracts auditor and regulator interest.

The second key change to accounting for financial instruments relates to impairment of debt instruments classified as amortised cost or fair value through OCI.  Essentially, this is a move back towards the old ‘bad debt provision’.  The Treasury has mandated that a simplified approach is used in the public sector for trade receivables, contract assets and lease receivables – with an allowance recognised equal to the lifetime expected loss.  Under IFRS 9, this allowance is recognised against all financial assets, including those that are not yet overdue. The GAM sets out an example calculation of expected credit losses for one year – the same calculation is used for a lifetime calculation, but the probabilities used are over the whole term of the financial asset.

For all other financial assets, a three-stage approach is applied. This means that the credit risk needs to be assessed at each reporting date to see if it has changed significantly since initial recognition. The stage applied will depend on the credit risk and instruments can move up and down the stages as the credit risk changes.

NHS bodies are not allowed to recognise any impairments against intra-DHSC balances as it is expected that they will be recoverable.  Where there is objective evidence of impairment, NHS bodies are expected to consult with their regulatory body before writing off the debt or establishing an impairment allowance.