Contents. Financial instruments the complete standard. Fundamental changes call for careful planning. 1. Overview Complete IFRS 9

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1 Financial instruments the complete standard Contents Fundamental changes call for careful planning 1. Overview Complete IFRS 9 2. Classification and measurement Facts 3. Classification and measurement Impacts 4. Impairment Facts 5. Impairment Impacts 6. Next steps

2 Overview IFRS 9 Financial Instruments The complete standard In summary Bottom line The IASB has now issued the completed version of IFRS 9 Financial Instruments ( IFRS 9 or the standard ), which substantially brings to a close the challenging project launched in 2008 to replace IAS 39 Financial Instruments: Recognition and Measurement. IAS 39 has been revised in stages as follows. Version What s included? Retained from IAS 39 IFRS 9 (2009) IFRS 9 (2010) IFRS 9 (2013) New requirements for the classification and measurement of financial assets and financial liabilities. New requirements for general hedge accounting. 1 Requirements for recognition and derecognition of financial instruments with only minor amendments. The standard could have a major impact across an organisation particularly for financial institutions. Larger and more volatile bad debt provisions are likely. Companies need to start planning for transition, to understand the time, resources and changes to systems and processes needed. No convergence with US GAAP The FASB had launched a similar project to revise accounting for financial instruments but decided to continue in a different direction to the IASB. As a result, companies applying both US GAAP and IFRS in their financial reporting will be required to implement different guidance which could pose a significant operational challenge. IFRS 9 (Complete standard) Amendments to classification and measurement requirements for financial assets published in IFRS 9 (2009) and IFRS 9 (2010). New impairment model based on expected credit losses. Effective date and transition The standard will be effective for annual periods beginning on or after 1 January 2018, and will be applied retrospectively with some exemptions. Early adoption is permitted. The completed standard also amends IFRS 7 Financial Instruments: Disclosures to introduce new or amended disclosures. Restating comparatives is not required, and permitted only if information is available without use of hindsight. Although the complete standard has been issued, this talkbook deals only with certain aspects i.e. the full classification and measurement requirements and the new expected credit loss model for calculating impairment. 1 The new requirements for general hedge accounting were discussed in our Insider notes: IFRS 9 (2013) Hedge accounting and transition, issued in November

3 Fact sheet Classification and measurement Overview Financial asset classification based on: contractual cash flow characteristics; and objective of business model in which assets are managed. IAS 39 principles for financial liabilities retained subject to new own credit presentation for liabilities designated at fair value through profit or loss. Key sectors impacted The new standard may have a significant impact on the classification and measurement of: - financial assets held by banks e.g. those held to meet various liquidity needs; and - financial assets held by insurance companies to fund their insurance liabilities or to match the duration of their longer-term insurance liabilities. The impact on corporates will often be limited, although investment portfolios will be affected. Financial asset classification IFRS 9 has three primary measurement categories for financial assets. Amortised cost Assets that meet the following criteria: - contractual terms give rise, on specified dates, to cash flows that are solely payments of principal and interest (the SPPI criterion ); and - held in a business model whose objective is to hold them in order to collect contractual cash flows. Fair value through other comprehensive income (FVOCI) Assets that meet the SPPI criterion and are held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. Non-trading equity instruments for which fair value changes are irrevocably elected to be presented in OCI. Fair value through profit or loss (FVTPL) Assets irrevocably designated as at FVTPL to reduce accounting mismatches. All other financial assets. Reclassification between categories is only permitted if the business model objective has changed. SPPI assessment The assessment is linked to the concept of a basic lending arrangement. Principal is the fair value of the financial asset at initial recognition. Interest consists of consideration for the time value of money, credit risk, other basic lending risks (e.g. liquidity risk) and costs (e.g. administrative costs) as well as a profit margin. The standard has specific guidance on: - regulated interest rates; - modified time value of money; - de minimis or non-genuine contractual cash flow characteristics; and - other contractual provisions that change the timing or amount of contractual cash flows. There is no separation of embedded derivatives from financial asset hosts. Business model assessment Determined based on how groups of financial assets are managed together to achieve a particular business objective i.e. not at the individual instrument level. Business model is a matter of fact that can be assessed by considering all relevant evidence available including sales activity, business performance evaluation, risk management and how business managers are compensated. Financial liability measurement Financial liabilities are measured at amortised cost, with some exceptions that include liabilities held for trading or designated at FVTPL. Reclassifications between categories are not permitted. In general, for liabilities designated as at FVTPL: - a change in fair value that is attributable to changes in credit risk is presented in OCI; and - any other change in fair value is presented in profit or loss. 2

4 Impact sheet Classification and measurement Significant judgements to be made The business model approach will require judgement to ensure that financial assets are classified in the right category. Judgement may be required in determining whether the SPPI criterion is met. If the time value of money is modified for example where the interest rate resets every month to a oneyear rate then determining whether the SPPI criterion is met may require a quantitative assessment. This will require an entity to: identify the characteristics of a benchmark instrument in which the time value of money is not modified; identify reasonably possible scenarios; and determine whether there could be a significant difference between: the undiscounted contractual cash flows of the financial asset being assessed; and the undiscounted cash flows of the benchmark instrument. Possible changes in volatility in profit or loss and equity The standard may have a significant impact on the way financial assets are classified and measured, resulting in changes in the volatility in profit or loss and equity. The type and degree of change will depend on the nature of an entity s financial instruments and how they are managed. Early application of the own credit requirements for financial liabilities would help to reduce volatility in profit or loss sooner than the effective date of the standard. To understand the potential implications for volatility in profit or loss and equity, entities will need to : assess the business models of existing financial assets as part of the transition effort; and plan to assess the classification of new transactions under IFRS 9. Banks and other financial institutions may need to enhance systems and processes to separately analyse credit risk of financial liabilities designated as at FVTPL. Regulatory capital requirements may be impacted For banks and other financial institutions that have to comply with the Basel capital requirements or other national capital adequacy requirements, many asset measures used to calculate regulatory capital resources and requirements are based on the entity s financial statements. The way in which an entity classifies financial assets could therefore affect the way its capital resources and requirements are calculated. Extra resources may be needed for transition Entities that have already applied, or are planning to early apply, IFRS 9 (2009) and/or IFRS 9 (2010) may have to re-engineer the conversion process to take into account the requirements of the final standard. THE BOTTOM LINE The standard could have a major impact across an organisation particularly for financial institutions. Different drivers of volatility in profit or loss and equity could impact your future results. Begin your business model and solely P&I assessments and plan to assess both existing contracts and those you expect to enter into before

5 Fact Sheet Impairment Overview Expected credit loss model to replace IAS 39 s incurred loss model. Applies to: debt assets (including both loans and securities, and lease and trade receivables) measured at amortised cost or FVOCI; contract assets; certain financial guarantees; and loan commitments. Not applicable to equity investments. Dual measurement approach: 12-month expected credit losses or lifetime expected credit losses. Simplified approach for certain trade and lease receivables and contract assets. Interest income recognised using effective interest rate. Special rules for assets that are credit-impaired on initial recognition. Key sectors impacted Banks are likely to see a significant impact far-reaching implications are expected for credit systems and processes. Insurance companies should expect a substantial impact there is no simplification for debt instruments measured at FVOCI. For leasing companies, the extent of the impact will depend on the type of leases and the impairment approach elected. Corporates will see a limited impact for trade receivables. All sectors will be affected by extensive new disclosure requirements. Dual measurement approach 12-month expected credit losses Defined as the portion of lifetime expected credit losses that represent the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date. Recognised for all instruments unless criterion for lifetime expected credit losses is met. Impairment trigger no longer required before impairment allowance is recognised. Lifetime expected credit losses Defined as expected credit losses that result from all possible default events over life of financial instrument. Recognised if credit risk on instrument has increased significantly since initial recognition. Conditions for recognising lifetime expected credit losses may be assumed not to be met if credit risk is low e.g. for investment-grade assets. Special rules for certain assets Trade and lease receivables and contract assets Trade receivables or contract assets that do not contain a significant financing component will always carry a loss allowance equal to lifetime expected credit losses. For trade receivables or contract assets that contain a significant financing component and lease receivables, an entity can elect either to: apply the general approach; or recognise lifetime expected credit losses at all times. Assets that are credit-impaired on initial recognition The effective interest rate is calculated at initial recognition using estimated future cash flows net of lifetime expected credit losses. Subsequent changes in lifetime expected credit losses are recognised in profit or loss, and as a corresponding allowance balance. Disclosures Disclosures Extensive qualitative and quantitative disclosures, generally by class of financial instruments, including: description of credit risk management practices including how an entity determined whether credit risk has increased significantly; explanation of inputs, assumptions and techniques used when applying the impairment requirements; reconciliation of loss allowance and explanation of significant changes in the gross carrying amount; and information on modified assets and on collateral. 4

6 Impact Sheet Impairment Significant increase in the number and complexity of judgements Judgement is required to assess future credit losses for all exposures. The model relies on robust estimates of: expected credit losses; and the point at which there is a significant increase in credit risk since initial recognition of an asset. For making those estimates, companies will need to decide how key terms such as significant increase and default will be defined in the context of their instruments. The measurement of expected losses should reflect: reasonable and supportable information that is available without undue cost or effort about past events, and current conditions; and reasonable and supportable forecasts of future economic conditions. The standard: does not prescribe a method to calculate expected credit losses; and acknowledges that methods used may vary based on facts and circumstances. THE BOTTOM LINE Credit risk is at the heart of a bank s business, so the standard is likely to have a significant impact on banks and similar institutions. Operationalising the new requirements may be challenging Expanded data/calculation requirements may include: estimates of 12-month expected credit losses; estimates of lifetime expected credit losses; and data to show whether significant increase in credit risk has occurred or reversed. Equity, covenants and regulatory capital may be affected Initial application may result in a large negative impact on equity for banks and, potentially, insurers and other financial services companies. The regulatory capital of banks may also be impacted. This is because equity will reflect not only incurred credit losses but also expected credit losses. The impact on an entity will be substantially influenced by: the size and nature of its financial instrument holdings and their classification; the judgements that it has made in applying the IAS 39 requirements; and the judgements that it makes under the new model. Larger and more volatile bad debt provisions are likely. Banks with less sophisticated credit systems may have difficulty implementing the new requirements They may currently lack the data or systems to perform the expected credit loss calculations. They may have little previous internal expertise in developing expected loss models. KPIs will be affected for banks and similar entities Credit risk is at the heart of a bank s business, so transition to the expected loss model is likely to have a significant impact on key performance indicators. The standard is likely to introduce new volatility in financial statements because: credit losses will be recognised for all financial assets in the scope of the model rather than only for those assets for which losses have been incurred; external data used as inputs may be volatile e.g. ratings, credit spreads and predictions about future conditions; and any move from a 12-month expected credit loss measurement to a lifetime expected credit loss measurement may result in a big change in the corresponding allowance. Disclosure requirements are extensive Sourcing the additional information required could be a complex and time-consuming process that will have an impact on resources and systems. Implementation could be challenging, with far-reaching implications for banks credit systems and processes, including interaction with the regulatory requirements. 5

Next steps IFRS 9 Financial Instruments The complete standard You will need to consider the impact on your business from an accounting, tax and regulatory perspective, as well as the impact on your

Accounting, tax and reporting Systems and processes Perform a comprehensive review of all financial assets, to ensure that they are appropriately classified and measured.

7 Next steps IFRS 9 Financial Instruments The complete standard You will need to consider the impact on your business from an accounting, tax and regulatory perspective, as well as the impact on your systems and processes, business and people. Here are some of the impacts that we envisage. Accounting, tax and reporting Systems and processes Perform a comprehensive review of all financial assets, to ensure that they are appropriately classified and measured. Decide how the expected credit loss model will be applied to different financial assets, and how key terms such as significant increase and default will be defined in the context of the financial assets held. Develop appropriate impairment methodologies and controls to ensure that judgement is exercised properly and consistently and is supported by appropriate evidence. Put in place processes to collect additional data required. Perform a test run on the calculations that will be needed. Assess the impact on regulatory capital and tax requirements. Update accounting policy manuals. Identify additional disclosure requirements. Business Upgrade accounting systems to ensure that they can capture fair value, amortised cost and any other information needed for classification and measurement. Decide which systems and processes need to be changed to collect new data and perform new calculations. Consider whether any data or calculations used for regulatory purposes e.g. Basel I may be used, and what adjustments are necessary. Evaluate the changes needed to key internal controls over financial and regulatory reporting. Perform a dry run of data collection processes, to help ensure the integrity of source data. Develop a transition plan for parallel runs, including reconciliations. Establish contingencies for data collection needs. People and change Assess the risks affecting business models and how their performance is evaluated. Evaluate the impact of accounting change on management compensation metrics, and performance targets and measures. Perform a comprehensive review of contractual terms. Assess the impact on KPIs and internal management reporting. Factor new expected credit loss requirements into stress testing. Assess the impact of accounting change on general business issues e.g. contractual terms, risk management practices etc. Budget for necessary changes to people, processes and systems. Develop communication plans to minimise surprises for stakeholders. Set up a project team with representatives from credit, accounting, tax, regulatory and IT teams, and with an appropriate governance structure. Develop and execute training plans for employees across functions and locations. Ensure that the project provides realistic timescales and accountabilities. Assess how changes to processes may impact the way in which work is performed, including how teams are structured. Identify whether there is a need for additional staff with appropriate expertise, or a need to engage external help. Revise performance evaluation targets and measures, and communicate them to affected personnel. Embed knowledge build a dry run into the adoption plan to test staff understanding. 6

First Impressions: IFRS 9 Financial Instruments

IFRS First Impressions: IFRS 9 Financial Instruments September 2014 kpmg.com/ifrs Contents Fundamental changes call for careful planning 2 Setting the standard 3 1 Key facts 4 2 How this could impact you