IFRS 9 Classification and Measurement

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1 IFRS 9 Classification and Measurement January

2 Contents Overview of IFRS 9 What s new? Main changes from IAS 39 Classification of financial assets Measurement of financial assets Reclassifications Effective date and transition requirements Key points to remember 1

3 Overview of IFRS 9 What s New? Impact Topic IFRS 9 Financial sector Other corporates Recognition and derecognition Classification and measurement Expected credit losses (Impairment) Hedge accounting IAS 39 model New model New model Amended model Legend: Low impact Medium impact High impact 2

4 Main changes from IAS 39

5 Financial Asset Main changes from IAS 39 Measurement categories Similar categories: IFRS 9 IAS 39 FVTPL FVTPL Amortised cost Loans and receivables/htm* FVOCI AFS* *Significant changes in criteria for classifying assets. 4

6 Main Changes From Current IAS 39 Guidance Financial liability measurement categories IFRS 9 retains almost all of the existing requirements from IAS 39. Change: gain or loss on a financial liability designated at FVTPL attributable to changes in own credit risk generally presented in OCI with remaining change in fair value presented in profit or loss. 5

7 Classification of financial assets

8 Classification of Financial Asset: Debt Instruments Debt instrument Are the asset s contractual cash flows solely payments of principal and interest (SPPI)? Yes Is the business model s objective to hold to collect contractual cash flows? Yes No No No Is the business model s objective both to collect contractual cash flows and to sell? Yes FVTPL FVOCI * Amortized cost * * Subject to FVTPL designation option - if it reduces accounting mismatch 7

9 The Solely P&I (SPPI) Criterion Do the cash flows consist of only principal and interest? That is consistent with a basic lending arrangement. Definition Principal Fair value of asset on initial recognition. Interest Consideration for time value of money, credit risk, other basic lending risks (such as liquidity risk); other associated costs (such as administrative costs); and a profit margin. 8

10 SPPI: Contractual Terms that Change Timing/Amount of Cash Flows What does it mean? The contract may define circumstances where the cash flows will/may change. Examples: Floating interest rate Prepayment feature Term extension feature Assessment of SPPI criterion takes into account cash flows that could arise before and after the change in cash flows nature of any contingent event that would change the timing or amount of cash flows 9

11 Variable interest rates Will meet SPPI criterion if: Variable interest rate consists of consideration for the time value of money and credit risk associated with outstanding principal Example: Interest rate is reset every 3 months based on a 3-month LIBOR rate 10

12 Term extension feature Will meet SPPI criterion if: Terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest during the extension period Example: Interest rate is reset every 3 months based on a 3-month LIBOR rate 11

13 SPPI: Prepayment Features A contractual term that permits or requires prepayment at an amount substantially representing unpaid principal and interest meets the SPPI criterion. Amount can include reasonable compensation for early termination but generally prepayments at other amounts would fail SPPI. Exception for financial assets that don t meet SPPI criterion because of prepayment feature: can still measure financial assets at amortised cost or FVOCI if criteria met. Exception aimed in particular at acquired credit-impaired assets or assets originated at below market rates. 12

14 Exception for Amortised Cost/FVOCI Certain Prepayment Features Exception applies if all these conditions are met: 1 Asset is originated or acquired at a discount or premium to contractual par amount. Discount or premium 2 Prepayment amount = contractual par + accrued interest, which may include reasonable compensation for early termination. Prepayment at par + interest 3 When the financial asset is originally recognised, fair value of prepayment feature is insignificant. FV prepayment feature insignificant 13

15 SPPI example (1) - Prepayment Feature Bank buys a debt instrument for its fair value of CU40. The debt is prepayable by the issuer at par of CU100 at anytime. The issuer is in severe financial difficulties and the debt instrument is considered to be credit-impaired. Other than the prepayment option, the terms of the debt instrument meet the SPPI criterion. 14

16 SPPI example (2) Company C holds a US$ denominated bond with a stated maturity by issuer E. The payments of principal and interest are linked to an unleveraged inflation index of the United States. The functional currency of issuer E is the US$. Does the bond meet the SPPI criterion? 15

17 SPPI example (3) A Government of Jamaica variable rate bond maturing in It pays a fixed interest at 12% for 6 months, then interest will be paid at a variable rate of 1.5% points above the weighted average yield rate applicable to the GOJ 6- month Treasury Bill rate. Does the bond meet the SPPI criterion? 16

18 SPPI example (4) Instrument B is a bond that is convertible into a fixed number of equity instruments of the issuer. Does the bond meet the SPPI criterion? 17

19 SPPI assessment - process and challenges Below is an illustration of the key steps that financial institutions typically take to perform the SPPI assessment and the challenges they face in the process Initial impact assessment Design Testing and documentation Identify likely SPPI fail features and features where more extensive review is required List of likely problem products or portfolios based on known features Deep dive analysis of contractual terms Design the sampling methodology and SPPI questionnaire Split of standardised vs. nonstandardised products based on nature of contractual terms and conditions Sample sizes based on risk of products failing SPPI Attribute vs. statistical sampling Coordination with internal audit Perform and complete SPPI testing to determine classification of assets Resource plan to run testing alongside business as usual processes Assessment of the availability of documentation Review and challenge at appropriate level! Coverage/completeness of products and portfolios reconciliation to BM assessment population Appropriate level of segmentation sufficiently homogenous portfolios Questionnaire detail user friendly vs. coverage of IFRS 9 requirements and specific product features Treatment of failed portfolios carve out fail population and re-cluster and retest the remaining population 18

20 Business Model Assessment Business model refers to how an entity manages its financial assets in order to generate cash flows. Business model is a matter of fact typically observable through the activities undertaken. Does not depend on management s intention for an individual instrument. However, judgment is often needed. 19

21 Types of Business Models Held-to-collect contractual cash flows Financial assets held to collect contractual cash flows over the life of the instrument. Need not hold all instruments until maturity. Selling assets is incidental to business model objective. Held both to collect contractual cash flows and to sell Both collecting contractual cash flows and selling financial assets are integral to achieving objective of business model. Typically involves greater frequency and value of sales compared to held to collect model. Other business models Models that do not meet the above criteria. 20

22 Examples of Business Models Liquidity portfolio to meet funding needs in stress conditions Fund assets managed on a fair value basis Liquidity portfolio to meet everyday funding needs Retails loans held for securitisation Trading instruments Financial assets to fund insurance liabilities 21

23 Business model assessment - Assessment Considerations How are risks managed? How is performance evaluated? Actual and expected levels of sales? How are managers compensated? Any other factors? Assessed at a level at which groups of assets are managed, e.g. a portfolio. 22

24 Business Model Example 1 Corporate Company T holds investments to collect their contractual cash flows. The maturities of the investments are matched to T s estimated, and generally predictable, funding needs. In the past, sales of investments have typically occurred when the investments credit risk has increased such that it no longer meets T s investment policy. Infrequent sales have occurred as a result of unanticipated funding needs. Management also considers the investments fair value from a liquidity perspective. 23

25 Business Model Example 2- Bank Bank B holds financial assets to meet liquidity needs in a stress case scenario (e.g. run on bank s deposits). B monitors credit quality of the assets and its objective is to collect the contractual cash flows. B evaluates performance of assets on basis of interest earned and credit losses incurred. B also monitors fair value of financial assets from liquidity perspective to ensure cash realized in sale in stress case scenario will be sufficient to meet the liquidity needs. Periodically B makes sales insignificant in value to demonstrate liquidity. 24

26 Business Model Example 3 - Insurer H, an insurance company, holds financial assets to fund its insurance contract liabilities. H uses proceeds from contractual cash flows on financial assets to settle insurance contract liabilities as they come due. H undertakes significant buying and selling activity on regular basis to rebalance portfolio of assets and to meet cash flow needs as they arise. 25

27 Applying Business Model Criterion to Funds Many funds manage their portfolios on a fair value basis. Performance is evaluated with reference to fair value. Managers are compensated based on the fair value of the assets managed. Such portfolios must be measured at FVTPL. However, some funds may have different business objectives. 26

28 Classification of Trade Receivables Classification criteria Likely to meet? SPPI Held-to-collect business model Trade receivables are likely to meet both criteria: Cash flows are generally fixed. Generally held to collect cash flows. Watch out for the impact of securitisation and other transactions, including factoring, and for more complex contractual terms. 27

29 Trade Receivables Entity P, a manufacturing company, has a business model that involves selling trade receivables it originates to a securitisation vehicle S. S issues notes to investors secured on the receivables purchased from P. S collects the contractual cash flows from the loans and passes them on to investors in the notes. P consolidates S and the trade receivables continue to be recognised in the consolidated financial statements of P. Q: Are the trade receivables held in a held-to-collect business model? 28

30 Trade Receivables Solution In consolidated financial statements of P The consolidated group originated the receivables with the objective of holding them to collect the contractual cash flows. In separate financial statements of P P s objective as a standalone entity is to realise cash flows on the receivables portfolio by selling the receivables to S. It is not managing the portfolio to collect the contractual cash flows. 29

31 Investments Entity C anticipates capital expenditure in a few years. C invests its excess cash in short- and long-term investments so that it can fund the expenditure when the need arises. Many of the investments have contractual maturities that exceed C s anticipated investment period. Investments are held to collect the contractual cash flows but, when an opportunity arises, investments are sold to re-invest the cash in investments with a higher return. The managers responsible for the portfolio are remunerated based on the overall return generated by the portfolio. Q: In what business model are the investments held? A. Held-to-collect. B. Both held-to-collect and for sale. C. Other. 30

32 Investments Solution Business model: both held-to-collect and for sale The entity will make decisions on an ongoing basis about whether collecting contractual cash flows or selling financial assets will maximise the return on the portfolio until the need arises for the invested cash. 31

33 Business model assessment - process and challenges Below is an illustration of the key steps that financial institutions typically take to perform the business model ( BM ) assessment and the challenges they face in the process Segmentation Workshop discussion Documentation Segregate balance sheet items in scope by business and further by products/portfolios Examples of business segments: Retail Prime Mortgages Treasury Corporate Lending Credit Trading Discuss with business units to understand the business objectives for each product/portfolio type Workshops attended by relevant representatives from the Business, Operations, Credit, Finance, Risk as appropriate: - Understand the business activities - Understand business and portfolio strategy - Validate portfolio segmentation - Analyze factors relevant in the BM assessment Prepare BM documentation addressing each of the IFRS 9 requirements by business units Business overview and objectives Key consideration of relevant factors in the BM assessment (e.g., disposal activities, management compensation) Recommended business model Highlight any changes from IAS 39 classification! Coverage/completeness of products and portfolios Appropriate granularity for BMs finding the balance between having granular enough BMs vs. too many BMs making it impracticable to operationally handle 32

34 Financial Asset Classification: Equity Instruments Equity instrument Held for trading? Yes No No OCI option? Yes FVTPL FVOCI* * amounts recognized in OCI are not reclassified to profit or loss on derecognition and no impairment loss recognized in profit or loss. 33

35 Embedded Derivatives Is host contract a financial asset in the scope of IFRS 9? Yes No Do not separate Follow the requirements on separation, as in IAS 39 Consider impact on SPPI criterion 34 34

36 Embedded derivatives Company B has an investment in a convertible bond. The holder has the option to convert it into a fixed number of equity shares of the issuer. The convertible bond is analysed for classification in its entirety The conversion option results in a failure of the SPPI criterion. The bond is classified as at FVTPL in its entirety 35

37 Measurement of financial assets

38 Measurement of Financial Assets Measurement category Amortised cost All gains and losses - Debt investments at FVOCI Equity investments at FVOCI P&L OCI Presentation of gains/losses same as under IAS 39? Interest, impairment losses, foreign exchange gains and losses, gain or loss on disposal Dividends (unless clearly represents recovery of part of cost of investment) FVTPL All gains and losses - Other gains and losses Fair value gains and losses 37

39 Measurement of Financial Assets: Equity Investments Equity investments at FVOCI: On derecognition, amounts recognised in OCI are not reclassified to profit or loss (different to debt investments at FVOCI). No impairment loss recognised in profit or loss. No cost exemption for equity investments and derivatives linked to such investments. 38

40 Classification and measurement - considerations Key impacts Significant judgments to be made Possible changes in volatility in profit or loss and equity Regulatory capital requirements may be impacted Extra resources may be needed for transition Expected impact Reporting Business Systems / processes People and change Immediate next steps Bottom line Understand changes and develop implementation strategy Begin your business model assessment and plan to assess both your existing contracts and those you expect to enter into before 2018 Standard could have a major impact across an organization particularly for financial institutions Different drivers of volatility in profit or loss and equity could impact future results 39

41 Reclassifications

42 Reclassifications Financial assets Reclassification is required if the business model has changed. Expected to be very infrequent as changes must be significant to the entity s operations and demonstrable to external parties. Financial liabilities Reclassifications are not permitted. Reclassify Financial Assets Reclassify Financial Liabilities 41

43 Effective date and Transition requirements

44 Effective Date Issue date July 24, 2014 Effective date January 1, 2018 Annual report December 31, Mar June Sep Dec Early adoption permitted Interim reports 43

45 Transition for Classification and Measurement Retrospective application, with some exemptions Comparatives need not be restated (can be restated if possible without using hindsight) Limited reopening of the FV option 44

46 Retrospective application and comparative information Assets & liabilities already derecognised on initial application Not permitted to restate even if comparatives are restated voluntarily No cost exemption for equity investments and derivatives linked to such investments. Permitted but not required to restate prior periods Measurement Permitted but not required to restate prior periods Difference on initial application Recognised in opening retained earnings of accounting period of initial application Interim reporting Do not apply IFRS 9 to interim periods before date of initial application, if impracticable to do so 45

47 Key points to remember

48 Key Points to Remember! Criteria for classification significantly different to IAS 39 (judgment required). Evaluating contractual terms and determining business model likely to be a substantial project for most in financial sector. Impact on financial ratios, regulatory capital, new product approval process and business strategy. 47

49 Questions? 48

50 Thank you Disclaimer: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 49

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