IAS 32 & IFRS 9 Financial Instruments

Transcription

1 Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, Moldova IAS 32 & IFRS 9 Financial Instruments

2 Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, Moldova IAS 32 Financial Instruments: Presentation

3 Objective IAS 32 establishes principles for presenting financial instruments. It applies to classification of financial assets, financial liabilities and equity instruments from the issuer's perspective; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and liabilities can be offset; 3

4 Key concepts Financial instrument: A contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial asset: Any asset that is: cash (i.e. cash, bank deposits); A contractual right to receive cash or a financial asset from another entity (i.e. trade receivables, loan receivables); A contractual right to exchange financial instruments with another entity under potentially favourable terms (i.e. derivative asset); A contract that will or may be settled in an entity s own equity instruments (i.e. convertible corporate bonds); An equity instrument of another entity (i.e. investment in shares). 4

5 Key concepts Financial liability: is a contractual obligation to: Deliver cash or another financial asset to another entity (i.e. Bank overdraft, trade payables, loans payable, issued debt instruments (e.g. Bonds, loan notes), redeemable preference shares); Exchange financial instruments with another entity under potentially unfavourable terms i.e. Derivative liability); Be (or one that may be) settled in the entity's own equity instruments (i.e. Convertible corporate bonds). Equity instrument: is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (i.e. Ordinary shares irredeemable preference shares, share options / rights). 5

6 Compound Financial Instruments Compound instruments have both a liability and an equity component from the issuer's perspective. IAS 32 requires that the component parts, be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issue date and not revised for subsequent changes. For example, a convertible bond contains two components. One is a financial liability, which is the issuer's contractual obligation to pay cash, and the other is an equity instrument, which is the holder's option to convert into common shares. When the initial carrying amount of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. 6

7 Compound Financial Instruments Step 1: The fair value of the consideration in respect of the liability component is measured at the fair value of a similar liability that does not have any associated equity conversion option (can be done by discounting the future cash flows at the rate prevailing in the market for similar non-convertible obligations). This becomes the liability component's carrying amount at initial recognition. Step 2: The equity component (the equity conversion option) is the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. Equity component Total Present Value Present Value Of Financial = Proceeds - of Liability - of Interest Instrument 7

8 Classification of financial instruments The financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form. The entity must make the decision at the time of initial recognition. 8

9 Examples Financial Assets - cash and cash equivalents; - bank deposits; - Loans to customers; - accounts receivable; - notes receivable; - bonds purchased; - equity instruments of another entity; - derivatives. Financial Liabilities - accounts payable; - notes payable; - loans received; - bonds issued; - derivatives; - redeemable; preference shares. Equity Instruments - own ordinary shares; - Warrants issued; - share options issued; - share rights issued. 9

10 Interest, dividends, gains, and losses Interest, dividends, gains, and losses relating to a financial instrument classified as a liability should be reported in the income statement. Example: Dividend payments on redeemable preference shares (classified as liability) would thus be classified as interest expense in the same way that interest payments on a loan are classified as interest expense. On the other hand, interest, dividends, gains, and losses relating to equity instruments are recognised directly in equity. Example: Dividend payments on irredeemable preference shares, ordinary shares etc., are treated as a deduction from retained earnings in the Statement of Changes in Equity. 10

11 Offsetting Generally, it is inappropriate to net financial assets and financial liabilities and present only net amount in the Statement of Financial Position. IAS 32 requires a financial asset and a financial liability to be offset and the net amount reported when and only when, an entity: Has a legally unconditional enforceable right to set off the amounts A right to set-off ; and Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously Intention to settle net or simultaneously. When both conditions are met, net presentation reflects more appropriately the entity's expected future cash flows from settling the asset and the liability. 11

12 Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, Moldova IFRS 9 Financial Instruments

13 Current development On 24 July 2014, the International Accounting Standards Board (IASB) issued the final version of IFRS 9, bringing together all three phases of the financial instruments project: Phase 1: Classification and measurement of financial assets and financial liabilities (completed 11/09 & 10/10) Phase 2: Impairment methodology (completed 07/14) Phase 3: Hedge accounting (completed 11/13) IFRS 9 will eventually replace IAS 39 in its entirety and is effective for annual periods beginning on or after 1 January 2018, with early application permitted. 13

14 Content IFRS 9 contains requirements for financial assets and liabilities: Initial recognition Classification Initial & subsequent measurement Recognition of gain or loss Derecognition Impairment of a financial asset Accounting rules for hedging 14

15 What changes under IFRS 9 IFRS 9 main changes compared to IAS 39 include: Initial recognition; Classification Initial & subsequent measurement Recognition of gain or loss Derecognition Impairment of a financial asset Accounting rules for hedging 15

16 Financial Assets 16

17 Initial Measurement An entity shall recognise a Financial Asset at fair value of consideration given plus, in the case of a financial asset not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition of the financial asset. FVTPL = Fair Value FVOCI and Amortised Cost = Fair Value + transaction costs 17

18 Fair Value Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (IFRS 13). The quoted price at the year end date where an active market exists (Level 1 disclosure). The price, adjusted if necessary, from the most recent transaction if a quoted price is not available (Level 2 disclosure). Price arrived at using discounted cash flow analysis or option pricing models, if an active market is not available (Level 3 disclosure). 18

19 Amortised cost Amortised cost is the cost of an asset or liability adjusted to achieve a constant effective interest rate over the life of the asset or liability. The effective interest rate is the discount rate that will give a present value of future cash flows that equals the purchase price. The effective interest rate method determines how much interest income or expense will be reported in the income statement in each period. 19

20 Financial Assets - Classification and measurement model under IAS 39 Financial Assets Fair value through profit or loss (FVTPL) Loans and receivables Held to maturity (HTM) Available for sale (AFS) Fair value Amortised cost Amortised cost Fair value Fair value gains and losses are taken to income statement Take amortisation charges and impairment losses to income statement Take amortisation charges and impairment losses to income statement Fair value gains and losses are taken to equity Note: - Investments in unquoted equity instruments whose fair value cannot be reliably measured shall be measured at cost - The measurement of an asset/ liability may be adjusted because of a designated hedging relationship. 20

21 Financial Assets Classification under IAS 39 Fair value through profit or loss (FVTPL) Loans and receivables Assets that are held for trading and derivatives (except for a derivative that is a designated hedging instrument). Assets are held for trading if there is frequent buying or selling or if they were acquired for the purpose of reselling in the near future. This category includes any assets designated upon initial recognition at fair value through profit or loss (the fair value option ) Assets with fixed or determinable payments that are not quoted in an active market, including: Loans receivable Trade receivables Investments in unquoted debt instruments Deposits held with banks 21

22 Financial Assets Classification under IAS 39 Held to Maturity (HTM) Available for sale (AFS) Assets with fixed or determinable payments and fixed maturity, that are quoted in an active market and the entity has the intention and ability to hold to maturity. e.g. Investment in quoted debt instruments such as government bonds If the entity sells or reclassifies any HTM investments prior to maturity, the entity is not allowed to use the HTM classification during the following 2 year period except when the sale or reclassification: is due to an isolated event beyond the entity s control occurred less than 3 months before maturity Investments in debt and equity securities that do not fall into any other category e.g. An investment in shares that has a quoted price, and that is not heldfor-trading An investment in an equity instrument that is not quoted, and for which there is no intention to sell The entity has the option to classify certain other assets into this category. 22

23 Financial Assets - Classification and measurement model under IFRS 9 The following diagram summarises the overall structure of the classification and measurement model in IFRS 9. Under IFRS 9, there are 3 measurement categories: Amortised cost FVOCI (with recycling / without recycling), and FVTPL FVTPL catches all the instruments which are not measured in one of the other categories. As opposed to IAS 39, where AFS is the distinct residual category. In order for a financial asset to qualify for one of the other two measurement categories, it has to pass both, the contractual cash flow characteristics test and the business model test. 23

24 Financial Assets - Classification and measurement model under IFRS 9 Debt (including hybrid contracts) Derivatives Equity No Pass Business model test (at an aggregate level) Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Amortised cost No BM with objective that results in collecting contractual cash flows and selling financial assets FVOCI (with recycling) Contractual cash flow characteristics test (at instrument level) Yes Neither (1) nor (2) Fail FVTPL Fail Fail Held for trading? Yes No No FVOCI option elected? Yes FVOCI (no recycling) 24

25 Financial Assets - Classification and measurement model under IFRS 9 Debt (including hybrid contracts) Derivatives Equity No Pass Business model test (at an aggregate level) Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Amortised cost No BM with objective that results in collecting contractual cash flows and selling financial assets FVOCI (with recycling) Contractual cash flow characteristics test (at instrument level) Yes Neither (1) nor (2) Fail FVTPL Fail Fail Held for trading? Yes No No FVOCI option elected? Yes FVOCI (no recycling) 25

26 Contractual cash flow test The entity has to assess, whether the cash flows resulting from the financial asset are solely payments for principal and interest (SPPI) on specified dates. That test has to be performed on an instrument-by-instrument basis. Interest is consideration for the time value of money and the credit risk associated with the principal amount outstanding during a particular period of time. Note that derivatives and Equity instruments fail that test as the cash flows from those instruments are not SPPI. 26

27 SPPI Test Example 1 Scenario: Instrument A is a full recourse loan given to a customer. The loan facility is secured by a collateral. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 27

28 SPPI Test Example 1 Solution: YES The fact that a full recourse loan is collateralised does not in itself affect the analysis of whether the contractual cash flows are solely payments of principal and interest on the principal amount outstanding. 28

29 SPPI Test Example 2 Scenario: Instrument B is a bond with a stated maturity date. Payments of principal and interest on the principal amount outstanding are linked to an inflation index of the currency in which the instrument is issued. The inflation link is not leveraged and the principal is protected. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 29

30 SPPI Test Example 2 Solution: YES Linking payments of principal and interest on the principal amount outstanding to an unleveraged inflation index resets the time value of money to a current level. In other words, the interest rate on the instrument reflects real interest. Thus, the interest amounts are consideration for the time value of money on the principal amount outstanding. If however, the interest payments were indexed to another variable such as the debtor s performance (e.g. the debtor s net income) or an equity index, the test would fail the SPPI test (unless the indexing to the debtor s performance results in an adjustment that only compensates the holder for changes in the credit risk of the instrument). 30

31 SPPI Test Example 3 Scenario: Instrument C is issued by a regulated bank and has a stated maturity date. The instrument pays a fixed interest rate and all contractual cash flows are non-discretionary. However, the issuer is subject to legislation that permits a national resolving authority to impose losses on holders of Instrument C in particular circumstances. For example, it has the power to write down the par amount of Instrument C or to convert it into a fixed number of the issuer s ordinary shares if it determines that the issuer is having severe financial difficulties, needs additional regulatory capital or is failing. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 31

32 SPPI Test Example 3 Solution: YES The holder would analyse the contractual terms of the financial instrument to determine whether the SPPI test is met. The analysis would not consider the payments that arise as a result of the national resolving authority s power to impose losses on the holders of Instrument C. That is because that power, and the resulting payments, are not contractual terms of the financial instrument. In contrast, SPPI test would not be met if the contractual terms of the financial instrument permit or require the issuer or another entity to impose losses on the holder even if the probability is remote that such a loss will be imposed. 32

33 SPPI Test Example 4 Scenario: Instrument D is a variable interest rate instrument with a stated maturity date that permits the borrower to choose the market interest rate on an ongoing basis. For example, at each interest rate reset date, the borrower can choose to pay three-month LIBOR for a three-month term or one-month LIBOR for a one-month term. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 33

34 SPPI Test Example 4 Solution: YES The contractual cash flows are solely payments of principal and interest on the principal amount outstanding as long as the interest paid over the life of the instrument reflects consideration for the time value of money, for the credit risk associated with the instrument and for other basic lending risks and costs, as well as a profit margin. The fact that the LIBOR interest rate is reset during the life of the instrument does not in itself disqualify the instrument. 34

35 SPPI Test Example 5 Scenario: Instrument E is a bond that is convertible into a fixed number of equity instruments of the issuer. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 35

36 SPPI Test Example 5 Solution: NO The holder would analyse the convertible bond in its entirety. The contractual cash flows are not payments of principal and interest on the principal amount outstanding because they reflect a return that is inconsistent with a basic lending arrangement (i.e. the return is linked to the value of the equity instrument of the issuer). 36

37 SPPI Test Example 6 Scenario: Instrument F is a loan that pays an inverse floating interest rate (i.e. the interest rate has an inverse relationship to market interest rates). Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 37

38 SPPI Test Example 6 Solution: NO The contractual cash flows are not solely payments of principal and interest on the principal amount outstanding. The interest amounts are not consideration for the time value of money on the principal amount outstanding. 38

39 SPPI Test Example 7 Scenario: Instrument G is a perpetual instrument but the issuer may call the instrument at any point and pay the holder the par amount plus accrued interest due. It pays a market interest rate but payment of interest cannot be made unless the issuer is able to remain solvent immediately afterwards. Deferred interest does not accrue additional interest. Question: Are the contractual cash flows Solely Payments of Principal and Interest (SPPI)? 39

40 SPPI Test Example 7 Solution: NO The contractual cash flows are not payments of principal and interest on the principal amount outstanding. That is because the issuer may be required to defer interest payments and additional interest does not accrue on those deferred interest amounts. As a result, interest amounts are not consideration for the time value of money on the principal amount outstanding. If interest accrued on the deferred amounts, the contractual cash flows could be payments of principal and interest on the principal amount outstanding. 40

41 Financial Assets - Classification and measurement model under IFRS 9 Debt (including hybrid contracts) Derivatives Equity No Pass Business model test (at an aggregate level) Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Amortised cost No BM with objective that results in collecting contractual cash flows and selling financial assets FVOCI (with recycling) Contractual cash flow characteristics test (at instrument level) Yes Neither (1) nor (2) Fail FVTPL Fail Fail Held for trading? Yes No No FVOCI option elected? Yes FVOCI (no recycling) 41

42 Business model test Each portfolio has to undergo the business model test. The business model under which the portfolio is managed results in the classification of all the financial assets in that portfolio. The three possible outcomes of this test, with the corresponding classification, are: Hold-to collect contractual cash flows (CCF) Amortised cost Hold-to collect CCF and sell FVOCI (with recycling) Neither of the above two FVTPL 42

43 Business model test Amortised cost: The business model leading to amortised cost is relatively simple. If the objective of the business model is to hold the financial assets to collect contractual cash flows, then the financial assets are held at amortise cost. This is similar to the HTM category under IAS 39, but does not preclude infrequent or insignificant sales, and there is not tainting effect on the remainder of the AMC portfolio if some assets are sold. Deciding on business model test is a matter of facts, that is how an entity actually manages its financial assets, rather than management s intent. 43

44 Business model test Example 1 Scenario: An entity holds investments to collect their contractual cash flows. The funding needs of the entity are predictable and the maturity of its financial assets is matched to the entity s estimated funding needs. The entity performs credit risk management activities with the objective of minimising credit losses. In the past, sales have typically occurred when the financial assets credit risk has increased such that the assets no longer meet the credit criteria specified in the entity s documented investment policy. In addition, infrequent sales have occurred as a result of unanticipated funding needs. Reports to key management personnel focus on the credit quality of the financial assets and the contractual return. The entity also monitors fair values of the financial assets, among other information. Question: How shall the above portfolio be classified? 44

45 Business model test Example 1 Solution: Amortised Cost Although the entity considers, among other information, the financial assets fair values from a liquidity perspective (i.e. the cash amount that would be realised if the entity needs to sell assets), the entity s objective is to hold the financial assets in order to collect the contractual cash flows. Sales would not contradict that objective if they were in response to an increase in the assets credit risk, for example if the assets no longer meet the credit criteria specified in the entity s documented investment policy. Infrequent sales resulting from unanticipated funding needs (e.g. in a stress case scenario) also would not contradict that objective, even if such sales are significant in value. 45

46 Business model test Example 2 Scenario: An entity s business model is to purchase portfolios of financial assets, such as loans. Those portfolios may or may not include financial assets that are credit impaired. If payment on the loans is not made on a timely basis, the entity attempts to realise the contractual cash flows through various means - for example, by contacting the debtor by mail, telephone or other methods. The entity s objective is to collect the contractual cash flows and the entity does not manage any of the loans in this portfolio with an objective of realising cash flows by selling them. In some cases, the entity enters into interest rate swaps to change the interest rate on particular financial assets in a portfolio from a floating interest rate to a fixed interest rate. Question: How shall the above portfolio be classified? 46

47 Business model test Example 2 Solution: Amortised Cost The objective of the entity s business model is to hold the financial assets in order to collect the contractual cash flows. The same analysis would apply even if the entity does not expect to receive all of the contractual cash flows (e.g. some of the financial assets are credit impaired at initial recognition). Moreover, the fact that the entity enters into derivatives to modify the cash flows of the portfolio does not in itself change the entity s business model. 47

48 Business model test Example 3 Scenario: An entity has a business model with the objective of originating loans to customers and subsequently selling those loans to a securitisation vehicle. The securitisation vehicle issues instruments to investors. The originating entity controls the securitisation vehicle and thus consolidates it. The securitisation vehicle collects the contractual cash flows from the loans and passes them on to its investors. It is assumed for the purposes of this example that the loans continue to be recognised in the consolidated statement of financial position because they are not derecognised by the securitisation vehicle. Question: How shall the above portfolio be classified on a group level? 48

49 Business model test Example 3 Solution: Amortised Cost The consolidated group originated the loans with the objective of holding them to collect the contractual cash flows. However, the originating entity has an objective of realising cash flows on the loan portfolio by selling the loans to the securitisation vehicle, so for the purposes of its separate financial statements it would not be considered to be managing this portfolio in order to collect the contractual cash flows. 49

50 Business model test Example 4 Scenario: A financial institution holds financial assets to meet liquidity needs in a stress case scenario (e.g., a run on the bank s deposits). The entity does not anticipate selling these assets except in such scenarios. The entity monitors the credit quality of the financial assets and its objective in managing the financial assets is to collect the contractual cash flows. The entity evaluates the performance of the assets on the basis of interest revenue earned and credit losses realised. However, the entity also monitors the fair value of the financial assets from a liquidity perspective to ensure that the cash amount that would be realised if the entity needed to sell the assets in a stress case scenario would be sufficient to meet the entity s liquidity needs. Periodically, the entity makes sales that are insignificant in value to demonstrate liquidity. Question: How shall the above portfolio be classified? 50

51 Business model test Example 4 Solution: Amortised Cost (The objective of the entity s business model is to hold the financial assets to collect contractual cash flows). The analysis would not change even if during a previous stress case scenario the entity had sales that were significant in value in order to meet its liquidity needs. Similarly, recurring sales activity that is insignificant in value is not inconsistent with holding financial assets to collect contractual cash flows. In contrast, if an entity holds financial assets to meet its everyday liquidity needs and meeting that objective involves frequent sales that are significant in value, the objective of the entity s business model is not to hold the financial assets to collect contractual cash flows. Similarly, if the entity is required by its regulator to routinely sell financial assets to demonstrate that the assets are liquid, and the value of the assets sold is significant, the entity s business model is not solely to hold financial assets to collect contractual cash flows. Whether a third party imposes the requirement to sell, or that activity is at the entity s discretion, is not relevant to the analysis. 51

52 Business model test FVOCI: The IASB introduced FVOCI as a measurement category in order to overcome cases where the business model objective is achieved by both collecting contractual cash flows and selling financial assets. For example, a bank holds a portfolio as a liquidity buffer as required by the regulator (i.e. Central Bank). That portfolio consists of plain-vanilla bonds which are intended to be held until maturity. However, the regulator also requires the bank to churn that portfolio on an annual basis to demonstrate that the assets are in fact liquid. Such a portfolio could not qualify for AMC (see example 4). 52

53 Business model test FVOCI: In this category, fair value changes are recognised in OCI while interest income and possible impairment are recognised through P&L as if the asset were recorded at AMC. This means that on initial recognition, a 12-month expected loss will need to be recorded in profit or loss with an offsetting credit to OCI. Changes in fair value for reasons other than credit (e.g. a liquidity discount) will not be recorded in profit or loss until derecognition. The amounts accumulated in OCI are recycled to P&L on sale. The assessment of the business model is performed on a portfolio level. 53

54 Business model test Example 5 Scenario: An entity anticipates capital expenditure in a few years. The entity invests its excess cash in short and long-term financial assets so that it can fund the expenditure when the need arises. Many of the financial assets have contractual lives that exceed the entity s anticipated investment period. The entity will hold financial assets to collect the contractual cash flows and, when an opportunity arises, it will sell financial assets to re-invest the cash in financial assets with a higher return. The managers responsible for the portfolio are remunerated based on the overall return generated by the portfolio. Question: How shall the above portfolio be classified? 54

55 Business model test Example 5 Solution: Fair Value through Other Comprehensive Income (FVOCI). The objective of the business model is achieved by both collecting contractual cash flows and selling financial assets. 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. In contrast, consider an entity that anticipates a cash outflow in five years to fund capital expenditure and invests excess cash in short-term financial assets. When the investments mature, the entity reinvests the cash in new short-term financial assets. The entity maintains this strategy until the funds are needed, at which time the entity uses the proceeds from the maturing financial assets to fund the capital expenditure. Only sales that are insignificant in value occur before maturity (unless there is an increase in credit risk). The objective of this contrasting business model is to hold financial assets to collect contractual cash flows. 55

56 Business model test Example 6 Scenario: A financial institution holds financial assets to meet its everyday liquidity needs. The entity seeks to minimise the costs of managing those liquidity needs and therefore actively manages the return on the portfolio. That return consists of collecting contractual payments as well as gains and losses from the sale of financial assets. As a result, the entity holds financial assets to collect contractual cash flows and sells financial assets to reinvest in higher yielding financial assets or to better match the duration of its liabilities. In the past, this strategy has resulted in frequent sales activity and such sales have been significant in value. This activity is expected to continue in the future. Question: How shall the above portfolio be classified? 56

57 Business model test Example 6 Solution: Fair Value through Other Comprehensive Income (FVOCI). The objective of the business model is to maximise the return on the portfolio to meet everyday liquidity needs and the entity achieves that objective by both collecting contractual cash flows and selling financial assets. In other words, both collecting contractual cash flows and selling financial assets are integral to achieving the business model s objective. 57

58 Business model test Example 7 Scenario: An insurer holds financial assets in order to fund insurance contract liabilities. The insurer uses the proceeds from the contractual cash flows on the financial assets to settle insurance contract liabilities as they come due. To ensure that the contractual cash flows from the financial assets are sufficient to settle those liabilities, the insurer undertakes significant buying and selling activity on a regular basis to rebalance its portfolio of assets and to meet cash flow needs as they arise. Question: How shall the above portfolio be classified? 58

59 Business model test Example 7 Solution: Fair Value through Other Comprehensive Income (FVOCI). The objective of the business model is to fund the insurance contract liabilities. To achieve this objective, the entity collects contractual cash flows as they come due and sells financial assets to maintain the desired profile of the asset portfolio. Thus both collecting contractual cash flows and selling financial assets are integral to achieving the business model s objective. 59

60 Business model test FVTPL: The rest of the financial assets go into the FVTPL category. Also, derivatives and instruments held for trading are mandatorily in this category. 60

61 Business model test FVTPL: One business model that results in measurement at fair value through profit or loss is one in which an entity manages the financial assets with the objective of realising cash flows through the sale of the assets. The entity makes decisions based on the assets fair values and manages the assets to realise those fair values. In this case, the entity s objective will typically result in active buying and selling. Even though the entity will collect contractual cash flows while it holds the financial assets, the objective of such a business model is not achieved by both collecting contractual cash flows and selling financial assets. This is because the collection of contractual cash flows is not integral to achieving the business model s objective; instead, it is incidental to it. 61

62 Financial Assets - Classification and measurement model under IFRS 9 Debt (including hybrid contracts) Derivatives Equity No Pass Business model test (at an aggregate level) Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Amortised cost No BM with objective that results in collecting contractual cash flows and selling financial assets FVOCI (with recycling) Contractual cash flow characteristics test (at instrument level) Yes Neither (1) nor (2) Fail FVTPL Fail Fail Held for trading? Yes No No FVOCI option elected? Yes FVOCI (no recycling) 62

63 Conditional fair value option Conditional fair value option means that an asset which would otherwise be measured at Amortised Cost or FVOCI can be designated, at initial recognition only, to be measured at FVTPL if this eliminates or significantly reduces a measurement or recognition inconsistency ( accounting mismatch ) that would otherwise arise from measuring any assets or liabilities and recognising any gains or losses on them on different bases. For example, an entity holds a fixed-rate loan receivable that it hedges with an interest rate swap. Measuring the loan asset at amortised cost and the interest rate swap at FVTPL, creates a measurement mismatch. In this case, the loan receivable could be designated at FVTPL under the Fair Value Option. 63

64 Financial Assets - Classification and measurement model under IFRS 9 Debt (including hybrid contracts) Derivatives Equity No Pass Business model test (at an aggregate level) Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Amortised cost No BM with objective that results in collecting contractual cash flows and selling financial assets FVOCI (with recycling) Contractual cash flow characteristics test (at instrument level) Yes Neither (1) nor (2) Fail FVTPL Fail Fail Held for trading? Yes No No FVOCI option elected? Yes FVOCI (no recycling) 64

65 Equity investments Equity investments (i.e. investments in shares) can only be measured at Fair Value since contractual cash flow on specified dates is not a characteristic of equity instruments. Thus FVTPL classification is used. If however, an equity investment is not held for trading, the entity has the irrevocable option, at initial recognition only, to classify it at FVOCI, with only dividend income recognised in I/S. Such designation is done on an instrument-by-instrument basis. This sounds similar to the AFS category for equity instruments under IAS 39 but with the differences that the amounts in OCI never get recycled to P&L (on disposal it is reclassified in equity (R/E)). Consequently, no impairment testing is required. 65

66 Reclassification of Financial Assets between AMC & FVTPL Reclassification is required when, and only when, an entity changes its business model for managing them. Any reclassification is to be accounted for prospectively from the Reclassification date: Which is the first day of the first reporting period following the change in business model that results in an entity reclassifying financial assets Reclassification from amortised cost to fair value measure instrument at fair value on that date; recognise difference between carrying amount and fair value in a separate line in profit or loss Reclassification from fair value to amortised cost fair value of the instrument on the date of reclassification becomes its new carrying amount Detailed disclosures will be required in interim reports and annual financial statements Reclassification not allowed where: The FVOCI option has been exercised, or The Fair Value option has been exercised. 66

67 Financial Liabilities 67

68 Initial Measurement An entity shall recognise a Financial Liability at fair value of consideration received minus, in the case of a financial liability at amortised cost, transaction costs that are directly attributable to the issue of the financial liability. FVTPL = Fair Value Amortised Cost = Fair Value - transaction costs 68

69 Financial Liabilities - Classification and measurement model under IAS 39 Financial Liabilities All other liabilities Fair Value through profit or loss (FVTPL) Amortised cost Fair value Take amortisation charges and impairment losses to the income statement Fair value gains and losses are taken to the income statement Note: - The measurement of an asset/ liability may be adjusted because of a designated hedging relationship. 69

70 Financial Liabilities - Classification under IAS 39 Fair value through profit or loss (FVTPL) Other liabilities - Amortised cost Liabilities that are held for trading and derivatives (except for a derivative that is a designated hedging instrument). e.g. an issued debt instrument that the entity intends to repurchase soon to make a gain from short-term movement in interest rates. This category includes any liabilities designated upon initial recognition at fair value through profit or loss (the fair value option ) This is the default category for financial liabilities that do not meet the definition of financial liabilities at fair value through profit or loss. For many companies, most financial liabilities will fall into this category. e.g. accounts payable, loan payable, issued debt instruments (e.g. redeemable preference shares), deposits from customers 70

71 Financial Liabilities - Classification and measurement model under IFRS 9 Financial liabilities are measured at amortised cost, unless they are required or elected (fair value option) to be measured at FVTPL. Required Financial liabilities held for trading Derivatives Elected ( Fair Value Option ) This designation can only be made upon initial recognition and is irrevocable. Criteria for exercising the fair value option include: the liability is managed on a fair value basis electing fair value will eliminate or reduce an accounting mismatch or the instrument is a hybrid that would require separation of an embedded derivative. 71

72 Financial Liabilities - Classification and measurement model under IFRS 9 Where an entity opts the fair value option, any change in fair value of the liability must be separated into two elements as follows: Changes in fair value due to own credit risk, which are taken to other comprehensive income (not recycled). Other changes in fair value, which are taken to profit or loss. One possible approach is to separate the interest rate charged on the financial liability into a benchmark rate (e.g. such as LIBOR) and an instrument-specific rate. Any change in fair value which is not wholly due to the change in LIBOR is a change in own credit risk. 72

73 Financial Liabilities - Classification and measurement model under IFRS 9 Financial Liabilities Note: Reclassification is not allowed!!! Amortised cost Financial Liabilities not held for trading FVTPL Derivatives Liabilities held for trading Fair value option Changes in fair value due to own credit risk FVOCI (No recycling) 73

74 Own credit risk - Example On 1 January 20X8 ABC issues a 7 year bond at par value of $300,000 and annual fixed coupon rate of 9%, which is also the market rate, when LIBOR is 6%. Therefore the instrument-specific element of IRR = (9% - 6%) is 3%. At 31 December 20X8, LIBOR has moved to 5.5%, thus making the benchmark interest rate (5.5% + 3%) 8.5% (i.e. LIBOR plus the instrument-specific element of IRR). If the fair value of the liability is consistent with a market interest rate of, say, 8.3%, then any change in the fair value of the liability from the benchmark rate to fair value must be due to something other than the change in the benchmark rate i.e. it must be due to the change in the liability s credit risk. Required: Calculate the amounts to be included within the financial statements for the year ended 31 December 20X8. 74

75 Own credit risk - Solution PV at benchmark rate 8.5% Cash flow Factor PV Year $ $ , , , , ,809 PV at market rate 8.3% Cash flow Factor PV Year $ $ , , , , ,594 75

76 Own credit risk - Solution Therefore, the change in the fair value of the liability which is not due to the change in the benchmark rate must be due to the change in the liability s credit risk. PV of liability at market rate of 8.3% (on SOFP at reporting date) 309,594 PV of liability at benchmark rate of 8.5% 306,809 Other comprehensive income 2,785 $ 76

77 Impairment of financial instruments 77

78 Impairment of financial instruments under IAS39 All financial assets, except for those measured at FVTPL, are subject to an impairment review. IAS 39 requires that an assessment should be made, at each reporting date, as to whether there is any objective evidence that a financial asset is impaired, (i.e. whether a loss event has occurred that has had a negative impact on the expected future cash flows of the asset). The loss event causing the negative impact must have already happened. An event expected to cause impairment in the future should not be anticipated (incurred loss model). The treatment of any impairment loss differs according to the type of financial asset. 78

79 Financial assets carried at amortised cost Impairment loss = Carrying Value PV of the estimated future cash flows of the asset, discounted at the original effective interest rate (not the current market interest rate). Any impairment loss is recognised as an expense in profit or loss. Interest on impaired assets is accrued at the original effective interest rate. 79

80 Financial assets carried at cost Unquoted equity investments that cannot be reliably measured at fair value are included in the statement of financial position at cost. Impairment loss = Carrying Value - PV of estimated future cash flows of the asset, discounted at the current market rate of return for a similar financial asset. Any impairment loss is recognised as an expense in profit or loss. 80

81 Financial assets carried at FVOCI If the fair value of a financial asset has been recognised in other comprehensive income (FVOCI) and there is evidence that the asset is impaired, the cumulative loss that had been recognised as other comprehensive income must be removed from equity and recognised as an expense in profit or loss, even though the asset has not been derecognised. 81

82 Objective of IFRS 9 impairment model The objective of the impairment requirements is that at each reporting date, an entity shall measure and recognise the loss allowance at an amount equal to the lifetime expected credit losses of all financial instruments for which there have been significant increases in credit risk since initial recognition. An entity shall recognise in profit or loss, as an impairment gain or loss, the amount of expected credit losses (or reversal). 82

83 Variation of the expected credit loss model Scope of ECL requirements IFRS 9 Financial Instruments Trade receivables that do not contain a significant financing component Trade receivables that contain a significant financing component Other debt financial assets measured at AMC or at FVOCI Loan commitments and financial guarantee contracts not accounted for at FVTPL IFRS 15 Revenue from Contracts with Customers Contract assets that do not contain a significant financing component Contract assets that contain a significant financing component General approach Simplified approach Policy election at entity level Policy election at entity level IAS 17 Leases Lease receivables Policy election at entity level 83

84 General Approach Change in credit risk since initial recognition Improvement Deterioration Start here Loss allowance updated at each reporting date Lifetime expected credit losses criterion When and how Stage 1 Stage 2 Stage 3 12-month expected credit losses As soon as a financial asset is originated or purchased, 12-month expected credit losses are recognised in profit or loss and a loss allowance is established. Lifetime expected credit losses 30 DPD 90 DPD If the credit risk has increased significantly since initial recognition, full lifetime expected credit losses are recognised. The resulting credit quality is not considered to be low credit risk. Lifetime expected credit losses If the credit risk of a financial asset increases to the point that it is considered credit-impaired. Interest revenue Interest revenue is calculated using the effective interest rate on the gross carrying amount (without adjustment for expected credit losses). Interest revenue is calculated using the effective interest rate on amortised cost (gross carrying amount adjusted for the loss allowance)

85 General Approach As a general approach, expected credit losses are required to be measured through a loss allowance at an amount equal to: the 12-month expected credit losses (expected credit losses that result from default events on financial instrument that are possible within 12 months after the reporting date); or Full lifetime expected credit losses (expected credit losses that result from all possible default events over the expected life of the financial instrument). A loss allowance for full lifetime expected credit losses is required for a financial instrument if the credit risk of that financial instrument has increased significantly since initial recognition. Definition of default is not defined by the standard and there is a 90 days past due rebuttable presumption. 85

86 Lifetime and 12-month Expected Credit Losses ECL are expected shortfalls in the contractual cash flows. Lifetime ECL reflect the expected shortfalls over the entire life of a financial instrument i.e. in assessing credit risk, the entity considers the likelihood of not collecting some or all of the contractual cash flows over the remaining maturity of the financial instrument (i.e. the probability of a default occurring over the remaining life). 12 month ECL are the lifetime losses that would arise on an asset weighted by the probability of a default occurring in the next 12 months. It isn t just expected cash shortfalls in the next 12 months or the losses on those assets that are expected to default in the next 12 months. 86

87 Assessing significant increases in credit risk An entity, at each reporting date, should compare: The risk of a default occurring as at the reporting date, with The risk of a default occurring as at the date of initial recognition. Generally a financial instrument would have a significant increase in credit risk before there is objective evidence of impairment and before default occurs. There is a rebuttable presumption that: The credit risk on a financial asset has increased significantly since initial recognition when contractual payments are 30 dpd or more. Default does not occur later than when a financial asset is 90 dpd. If reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information. 87

88 Operational simplifications in assessing significant increases in credit risk Low credit risk For financial instruments that are equivalent to investment grade quality, an entity would continue to recognise 12-month ECL An entity can assume that a financial instrument has not significantly increased in credit risk if it has low credit risk at the reporting date The low credit risk notion is not a bright-line trigger and that financial instruments are not required to be externally rated More than 30 days past due (DPD) Rebuttable presumption that there is a significant increase in credit risk when contractual payments are more than 30 DPD The more than 30 DPD rebuttable presumption is intended to serve as a backstop and should identify significant increases in credit risk before default or objective evidence of impairment. 88

89 Low vs high credit risk financial instruments: how would the model work? Threshold Investment grade Non-investment grade S&P AA+ A BBB+ BBB- BB B+ B B- CCC/C D 12-mth PD* 0% 0.08% 0.15% 0.37% 0.76% 2.50% 5.46% 8.64% 26.82% 100% Allowance 12-month 12-month or lifetime Implementation challenges Tracking credit risk measures from origination Developing practical absolute credit risk thresholds Mapping internal grading to external rating and/or probabilities of default (PD) Using delinquency-based approaches and the more than 30 DPD rebuttable presumption Segmenting the portfolios by shared risk characteristics Probabilities of default (PD) are based on S&P Global Corporate Average Cumulative Default Rates By Rating Modifier ( ) 89

90 Measuring expected credit losses An entity shall measure expected credit losses of a financial instrument in a way that reflects: An unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes (calculation incorporates Probabilities of Default PDs); The time value of money (present value of all cash shortfalls). A cash shortfall is the difference between the contractual cash flows that are due to an entity and the cash flows that the entity expects to receive. Note that a credit loss arises even if the entity expects to be paid in full but at a later stage than when contractually due.; Reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. 90

91 Measuring expected credit losses: Implementation Challenges Defining default Determining 12-month and lifetime ECL Unbiased and probability-weighted estimate No prescribed approaches Not best estimate Best available information + + Past Current Future Area of judgement Availability of data Reliability of forecasts The time value of money Choice of discount rate 91

92 Illustrative example: PD approach 12-month ECL allowance Challenges PD x LGD x EAD 0.15% x 25% x $1 m = $375 Loan originated at $1 million, i.e., exposure at default (EAD) 25% gross carrying amount irrecoverable if loan defaults, i.e., loss given default (LGD) 0.15% probability of a default (PD) in next 12 months Correlating PD and LGD Relying on rating agencies data Individual vs collective assessment 92

93 Illustrative example: Provision Matrix Trade receivables from the large number of small customers amount to $30 million divided into groups with common risk characteristics. Probability of Default Current 1-30 days past due days past due days past due > 90 days past due 0.3% 1.6% 3.6% 6.6% 10.6% Gross carrying amount Lifetime expected credit loss allowance (gross carrying amount x lifetime expected credit loss rate) Current 0,3% = 45, days past due 1,6% = 120, days past due 3,6% = 144, days past due 6,6% = 165,000 >90 days past due 10,6% = 106,000 30,000, ,000 93

94 Simplified approach and purchased or originated credit-impaired assets Simplified approach Scope: trade receivables, contract assets under IFRS 15 and lease receivables under IAS 17 Loss allowance based on lifetime ECL (Stage 1 is omitted) No tracking of changes in credit risk Purchased or originated creditimpaired assets Scope: financial assets that are credit-impaired on purchase or origination ECL on initial recognition reflected in credit-adjusted EIR (no day one 12-month ECL) Loss allowance based on subsequent changes in lifetime ECL 94

95 Measuring expected credit losses Expected credit losses Present value of all cash shortfalls over the remaining life, discounted at the original EIR Numerator: Cash shortfalls The period over which to estimate ECL: maximum contractual period (for revolving credit facilities, this extends beyond contractual period) Probability-weighted outcomes: possibility that a credit loss occurs, no matter how low that possibility is Reasonable and supportable information: reasonably available information about the past, current and future forecasts Denominator: Discount rate Discounting period: from cash flows date to reporting date Assets: EIR or approximate (if credit-impaired on initial recognition, then use credit-adjusted EIR) Commitments and guarantees: EIR of resulting asset (if not determinable, then use current rate representing risk of the cash flows) 95

96 Deterioration in credit quality (stage 2) Initially an asset is assessed for impairment based on 12-month expected credit losses. If there is a deterioration in credit quality from initial recognition, then it is assessed for impairment on lifetime expected credit losses. \ Interest income is calculated on the gross carrying amount (the amount before deducting the allowance balance) until there is a significant deterioration in credit risk, when it is calculated on the net carrying amount. 96

97 Deterioration in credit quality (stage 3) If the asset deteriorates to the point that it is essentially non-performing (i.e. there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset), interest is calculated by applying the effective interest rate to the carrying amount net of the allowance balance to better reflect the yield on the asset. The point where this occurs is when an incurred loss would arise under IAS 39 (i.e. when there is objective evidence of impairment) using that concept in IAS

98 Impairment Indicators Indicators that credit risk has increased significantly may include: Significant adverse changes in the expected performance and behaviour of the borrower; An actual or expected internal credit rating downgrade for the borrower; Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower s ability to meet its debt obligations, such as an actual or expected increase in interest rates or in unemployment rates; An actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased balance sheet leverage, etc; Significant increases in credit risk on other financial instruments of the same borrower; An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower s ability to meet its debt obligations; Significant changes, such as reductions in financial support from a parent entity or other affiliate. 98

99 Uncollectability (write-off) An entity would write off a financial asset, or part of a financial asset, in the period in which the entity has no reasonable expectation of recovery of the financial asset (or part of the financial asset) The gross carrying amount of a financial asset would be reduced as a result of the write-off A write-off constitutes a derecognition event 99

100 Reversal of impairment losses If an entity has measured the loss allowance for a financial instrument at an amount equal to lifetime expected credit losses in the previous reporting period, but determines at the current reporting date that condition about significant increase of credit risk since initial recognition is no longer met, the entity shall measure the loss allowance at an amount equal to 12- month expected credit losses at the current reporting date. Any impairment loss reversal is recognised in the Profit or Loss. 100

101 Transition and effective date IFRS 9 is effective for annual periods beginning on or after 1 January 2018, with early application permitted Retrospective application with transition reliefs permitted Initial credit risk Approximated based on reasonable and supportable information available without undue cost or effort May apply low credit risk or more than 30 days past due If undeterminable, recognise lifetime expected credit losses Comparatives Restatement of prior periods not required (permitted to do so unless this requires the use of hindsight) Cumulative impairment loss allowance is recognised in the opening retained earnings The same transition reliefs apply for first-time adopters 101

102 How will IFRS 9 impact entities? Greater judgement and diversity of application Estimating ECL Assessing when lifetime ECL are required Likely to result in earlier recognition of credit losses May increase the credit loss allowance depending on: Duration and quality of financial instruments Application of the current IAS 39 model Potential volatility due to change in estimates Cliff effect when financial instruments move between 12- month ECL and lifetime ECL and vice versa Modification of current credit risk management and financial reporting systems 102

103 Contact us: Marios E. Maltezos Senior Manager Technical Advisory Services Baker Tilly in South East Europe Tel , Fax This presentation has been prepared for general guidance on matters of interest only, and does not constitute professional advice. Do not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. Τo the extent permitted by law, Baker Tilly Klitou and Partners Ltd (Baker Tilly in Cyprus), its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of anyone acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it Baker Tilly in Cyprus. All rights reserved. Baker Tilly in Cyprus is an independent member of Baker Tilly International. Baker Tilly International Limited is an English company. Baker Tilly International provides no professional services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. Baker Tilly in Cyprus is not Baker Tilly International s agent and does not have the authority to bind Baker Tilly International or act on Baker Tilly International s behalf. None of Baker Tilly International, Baker Tilly in Cyprus, nor any of the other member firms of Baker Tilly International has any liability for each other s acts or omissions. The name Baker Tilly and its associated logo is used under licence from Baker Tilly International Limited.

104 Our Experts CVs Marios E. Maltezos FCCA, ACIB Experience Competencies Senior Manager, Technical Advisory Services Baker Tilly in South East Europe Extensive experience in IFRSs IFRS implementation practitioner 14-year experience in IFRS training and seminars Relevant project experience (12 years) Implementation of IFRSs in Financial sector Evaluation of provisioning methodology and implementation of IAS39 and IFRS9 requirements to Banks In-house and open public IFRS training in Europe and Middle East Marios has a long experience in the Banking and Professional services sectors. He specialises in providing high quality IFRS advisory services and training to both large and medium sized clients of Baker Tilly in South East Europe. He is a Senior Manager heading the Technical Advisory Services of the firm and his clients are engaged in a range of sectors including manufacturing, trading, professional services and financial services. Prior to joining Baker Tilly in SEE, Marios worked for 20 years in a leading financial institution in Cyprus, serving the organisation from the positions of Group Senior Accountant and Group Senior Internal Auditor. He is also a lecturer for various ACCA examinations. Marios has delivered repeatedly IFRS courses and seminars to more than fifteen different countries in Europe and Middle East during the past 14 years.