Financial Instruments IND AS 109

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1 Financial Instruments IND AS 109 Study Group Meeting of CTC 13 June 2017

2 Agenda Introduction Classification and measurement Expected credit losses (ECL) Page 1 14 June 2017 IFRS 9 Financial Instruments

3 Introduction IASB issues IFRS 9 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 Classification and measurement Impairment (expected credit losses) Hedge accounting IFRS 9 is effective for annual periods beginning on or after 1 January 2018, with early application permitted In India Ind AS 109 has been introduced and have become effective for the companies to whom Ind AS is applicable. Page 2 14 June 2017 IFRS 9 Financial Instruments

4 Key terms Financial Instrument: A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial Asset: Any asset that is: Cash Equity instrument of another entity Contractual right to receive cash/ another financial asset or exchange financial assets /liabilities under conditions that are favorable to the entity A contract that will or may be settled in the entity s own equity instruments Financial Liability: Any liability that is: A contractual obligation to deliver cash or another financial asset or exchange financial assets /liabilities under conditions that are unfavorable to the entity A contract that will or may be settled in the entity s equity instruments 3

5 Key terms (contd.) Equity Instrument: Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities 4

6 What has changed? IFRS 9 Measurement and recognition Impairment Impact on classifications Hybrids Nonquoted securities Reclassifications Three measurement and income recognition categories: Amortized cost Fair value through profit and loss (FVTPL) Fair value through other comprehensive income (FVTOCI) NEW Impairment only for amortized cost assets No available for sale or held to maturity categories No embedded derivatives in financial assets Full contract to be treated as FVTPL No cost exemption for unquoted equities Limited reclassifications

7 IASB s classification and measurement Overview Objective of entity s business model is to hold financial asset in order to collect contractual cash flows Contractual terms give rise solely to principal and interest on principal Amortized cost (one impairment method) Fair value option (FVO) for accounting mismatch All other instruments: Equities Derivatives Some hybrid contracts 6 Fair value through profit and loss (No impairment) Equities: Fair value through OCI presentation available (No impairment)

8 IASB s classification and measurement Business model Objective of entity s business model is to hold to collect contractual cash flows Top-down approach by business unit Not an instrument by instrument approach to classification Not based on management s intent No requirement to hold to maturity No tainting rules for assets at amortized cost Reclassifications Changes in the business model would require reclassification Top-down approach Can have multiple business models within legal 7 entity

9 IASB s classification and measurement Contractual terms Contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on principal Leverage is not ok Certain prepayment options are ok Certain extension options are ok Non-genuine cash flow characteristics are ignored Non-genuine: affects contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur 8

10 IASB s classification and measurement Other comprehensive income alternative Option only for investments in equity instruments not held for trading Instrument by instrument Changes in fair value recognized through OCI except dividend income No recycling Foreign exchange Dividends Recognized as income per IAS 18 Not recognized if dividend represents return of capital 9 Foreign Exchange OCI equities are not monetary items per IAS 21 Foreign exchange element is recognized in OCI permanently like other fair value change

11 IASB s classification and measurement Hybrid contracts Hybrid contracts Financial asset host Non-financial host or financial liability host No separation part of classification Existing separation guidance retained 10

12 Classification and measurement Operational issues Broad implementation that involves multiple stakeholders Some operational simplifications include: Reduction in and clearer rationale for classification and measurement categories Elimination of bifurcation requirements for financial instruments (still retained for financial liabilities under IFRS) Elimination of the tainting rules related to sale of held-tomaturity securities 11

13 Classification and measurement Operational issues (cont.) Several other implementation undertakings including: Accounting policies, operating processes and systems changes to identify contractual terms which give rise to solely principal and interest cash flows Impacts on economic hedging of risks associated with previously bifurcated embedded derivatives and application of valuation techniques to hybrid financial instruments in their entirety Valuation processes and controls for valuations of unquoted equities Implications of new classification and measurement on capital requirements 12

14 IFRS 9 classification and measurement model main changes from IAS 39 Financial instruments in the scope of IFRS 9 Financial assets Financial liabilities New classification criteria New categories that use OCI Page June 2017 IFRS 9 Financial Instruments

15 The new classification and measurement model for financial assets 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) Page June 2017 IFRS 9 Financial Instruments

16 How to assess the business model Change in circumstances Relevant information Performance evaluation & reporting Risks & risk management Remuneration Residual category versus positive definition Unit of account Items managed together Portfolio segmentation Business model assessment Type of objective Collection of cash flows Relevance of sales Page June 2017 IFRS 9 Financial Instruments

17 Type of interest rate Regulated All types Contractual cash flow characteristics test solely principal and interest, unless: Type of deviation from pure principal and interest cash flows All types Only time value of money Not genuine De minimis Not significantly different cash flows compared to pure principal and interest Broadly consistent with time value of money + Exception for some prepayment options that are deeply out of the money Page June 2017 IFRS 9 Financial Instruments: final and complete standard

18 FVOCI measurement category Examples of business models likely to result in OCI Liquidity buffers subject to significant churning Liquidity buffers for everyday liquidity needs Assets to fund insurance liabilities FVOCI mechanics Fair value gains and losses of the asset are recorded in OCI Cumulative gains and losses recycled to P&L upon derecognition ECLs are derived using the same model as amortised cost instruments and are recorded in P&L with offseting entry in OCI Interest income is calculated using effective interest method and recorded in P&L Page June 2017 IFRS 9 Financial Instruments

19 Measurement: Calculation of amortized cost of financial asset Amortized cost is calculated using the effective interest method. The effective interest rate inherent in a financial instrument is the rate that exactly discounts the cash flows associated with the financial instrument through maturity to the net carrying amount at initial recognition. The computation includes all fees and points paid or received. 18

20 Amortised cost and effective interest method Amortised cost Initial Recognition Cumulative amortisation using effective interest method impairment /uncollectibility = /+ Principal Repayments Effective Interest Method - Method of calculating amortisation cost and of allocating interest Income / Expenses over the relevant period Effective Interest Rate Rate that exactly discounts estimated future cash payments and receipts through the expected life of the financial instrument At each reporting date apply the effective interest rate to carrying amount to determine interest income and interest expense 19

21 Calculating amortised cost - Example Treasury note with face value Rs. 100,000, 5 year maturity, 6% coupon rate Purchase price Rs. 95,900 Discount Rs. 4,100 IRR (i.e. effective rate) is 7% Note : Any expenditure incurred for raising finance can also be considered in the working of IRR. FD Dept. Cost? 20

22 Calculating amortised cost - Example Year BB Effective interes t Coupon Discount amortis ation EB a b=a*7% c=100000*6% d=b-c e=a+d 1 95,900 6,713 6, , ,613 6,763 6, , ,376 6,816 6, , ,192 6,873 6, , ,065 6,935 6, ,000 Total 34,100 30,000 4, Note : Over the period Rs get adjusted.

23 Measurement: Calculation of amortized cost of financial asset Amortized cost is calculated using the effective interest method. The effective interest rate inherent in a financial instrument is the rate that exactly discounts the cash flows associated with the financial instrument through maturity to the net carrying amount at initial recognition. The computation includes all fees and points paid or received. 22

24 Amortised cost and effective interest method Amortised cost Initial Recognition Cumulative amortisation using effective interest method impairment /uncollectibility = /+ Principal Repayments Effective Interest Method - Method of calculating amortisation cost and of allocating interest Income / Expenses over the relevant period Effective Interest Rate Rate that exactly discounts estimated future cash payments and receipts through the expected life of the financial instrument At each reporting date apply the effective interest rate to carrying amount to determine interest income and interest expense 23

25 Calculating amortised cost - Example Treasury note with face value Rs. 100,000, 5 year maturity, 6% coupon rate Purchase price Rs. 95,900 Discount Rs. 4,100 IRR (i.e. effective rate) is 7% Note : Any expenditure incurred for raising finance can also be considered in the working of IRR. FD Dept. Cost? 24

26 Calculating amortised cost - Example Year BB Effective interes t Coupon Discount amortis ation EB a b=a*7% c=100000*6% d=b-c e=a+d 1 95,900 6,713 6, , ,613 6,763 6, , ,376 6,816 6, , ,192 6,873 6, , ,065 6,935 6, ,000 Total 34,100 30,000 4, Note : Over the period Rs get adjusted.

27 Scope and variation of the expected credit loss model Scope of ECL requirements IFRS 9 Financial Instruments General approach Simplified approach Trade receivables that do not contain a significant financing component Trade receivables that contain a significant financing component Other debt financial assets measured at AC or at FVOCI Loan commitments and financial guarantee contracts not accounted for at FVPL 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 Policy election at entity level Policy election at entity level IAS 17 Leases Lease receivables Policy election at entity level Page June 2017 IFRS 9 Financial Instruments

28 Expected credit loss model general approach Loss allowance updated at each reporting date Lifetime ECL criterion Interest revenue recognised Stage 1 12-month ECL (credit losses that result from default events that are possible within the next 12-months) Effective Interest Rate (EIR) on gross carrying amount Stage 2 Stage 3 Lifetime ECL Credit risk has increased significantly since initial recognition (whether on an individual or collective basis) + Credit-impaired EIR on gross carrying amount EIR on amortised cost (gross carrying amount less loss allowance) Change in credit risk since initial recognition Improvement Deterioration Page June 2017 IFRS 9 Financial Instruments

29 General approach - simplifications and presumptions for assessing deterioration Low credit risk equivalent to investment grade 30 days past due backstop Assessing significant increases in credit risk Use change in 12-month risk as approximation for change in lifetime risk Assessment on a collective basis or at counterparty level Set transfer threshold by determining maximum initial credit risk Page June 2017 IFRS 9 Financial Instruments

30 General approach significant increase in credit risk at portfolio level Bottom-up approach Common borrower characteristics Regions LTV Scoring Region A 1 LTV<50% Forward-looking information House prices (e.g. falling house prices) Interest-rate (e.g. interest rate rise) Unemployment GDP Top-down approach No individual identification Marginal impact of macroeconomic changes? 2 Sub-portfolios Region B Region C Region D Region E 50%<LTV<80% 80%<LTV<100% 100%<LTV % of loans Page June 2017 IFRS 9 Financial Instruments

31 Simplified approach and purchased or originated credit-impaired assets Simplified approach Scope: contract assets, trade receivables and lease receivables Loss allowance based on lifetime ECL No tracking of changes in credit risk Purchased or originated credit-impaired assets Scope: financial assets that are credit-impaired on purchase or origination ECL on initial recognition reflected in creditadjusted EIR (no day one 12-month ECL) Loss allowance based on subsequent changes in lifetime ECL Page June 2017 IFRS 9 Financial Instruments

32 Measurement of 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) Page June 2017 IFRS 9 Financial Instruments

33 Thank you IFRS 9 Financial Instruments 13 June 2017

Financial Instruments

Financial Instruments A summary of IFRS 9 and its effects March 2017 IFRS 9 Financial Instruments Roadmap financial assets Debt (including hybrid contracts) Derivatives Equity (at instrument level) Pass