FRTAP Poland Financial Reporting Technical Assistance Program

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Michael Wells 15-16 February 2016, Warsaw

financed by a grant from Switzerland through

1 Michael Wells February 2016, Warsaw Introduction and update: more complex issues under IFRS FRTAP Poland Financial Reporting Technical Assistance Program FRTAP Poland is financed by a grant from Switzerland through the Swiss Contribution to the enlarged European Union.

2 »What is a financial instrument?» liability and equity»scope and IAS 39 categories (sub-classifications)»recognition and measurement» amortised cost» fair value (including own credit risk)»disclosures»regulatory books 2

3 »Understand what a financial instrument is»understand the scope of IAS 39»Understand how to recognise financial instruments in accordance with IAS 39»Understand how to measuring financial instruments in accordance with IAS 39 3

4 IAS 1 IAS 32 IAS 39 IFRS 7 IFRS 9 Disclosure of critical judgement Disclosure of major sources of uncertainty Presentation of financial instruments Liability v/s equity Measurement Valuations Impairment Financial assets and liabilities Disclosure of risks in financial statements in 2018 replaces IAS

6 » A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity of another entity paragraph 11 of IAS 32 Financial Instruments: Presentation.» Financial assets are:» cash» a contractual right to receive cash or another financial asset» a contractual right to exchange financial assets or liabilities with another entity on potentially favourable terms» an equity instrument (for example, plain vanilla ordinary shares of another entity). 6

7 » Financial liabilities are:» a contractual obligation to deliver cash or another financial asset» a contractual right to exchange financial assets or liabilities with another entity on potentially unfavourable terms» A rule: a financial asset or a financial liability also arises where a contract may be settled in the entity s own equity instruments, for which the entity will receive or deliver either a variable number of its own.» An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. 7

8 »A derivative is a type of financial instrument that has specific characteristics (paragraph 9 of IAS 39)» its value changes in response to the change in a specified interest rate, commodity price, foreign exchange rate» it requires no initial net investment» it is settled at a future date.» examples include: financial options, forward contracts and interest rate swaps 8

9 » Is each item below a financial instrument? Choose one of: 1) Yes; 2) No; or 3) it depends. A. $1 million cash B. 1 million cash C. A loan from a bank D. A loan to an employee E. Trade receivable F. Trade payable G. Obligation to pay $1 million income tax H. 1 million ounces of gold I. A fixed price contract to buy 1 million ounces of gold 9

10 IAS 32 Establishes principles for presenting financial instruments as liabilities or equity. Applies to all entities and to all types of financial instruments. When an entity issues a financial instrument, it should classify it according to the substance of the contract under which it has been issued. Classification will be as a financial asset, a financial liability or an equity instrument. 10

11 »What do you think: (1) liability; (2) equity; or (3) a part of each?»on 1 January 2015, three companies (A, B and C) each raise $100 million cash in exchange for the following: Company A on 31/12 each year for 10 years whatever dividend is declared, if any on 01/01/2025 After 01/01/2025 whatever dividend is declared, if any whatever dividends are declared, if any, and on liquidation a proportionate share of A s net assets (i.e. a residual interest) B $10 million $100 million Not applicable (claim extinguished) C $8 million $100 million or 1 million ordinary shares If on 01/01/2025 holders chose: - cash then same as B above. - shares then same as A above. 11

13 »The scope of IAS 39 is specified in paragraphs 2 to 7 of that standard» financial instruments not within the scope of other standards» contracts to buy or sell a non-financial item that can be settled net in cash but own use exception»before IAS 39 many financial instruments were off-balance sheet.»ias 39 was amended during the recent banking crisis. 13

14 IAS 39 classifications Fair Value through profit or loss (eg derivatives) Available for sale Loans and receivables Held to maturity 14

15 1 Decision is also based on management intentions, ie whether for trading activities or to hold on to maturity. 2 Can be complex 3 Held to maturity restricted use because of tainting rules 15

16 »Measured at fair value» gains and losses presented in profit or loss.»no impairment testing as carried at fair value.»includes:» financial instruments held for trading» derivatives» instruments to which the entity has applied the entity fair value option (FVO).»Some banks disclose the FVO under the designated at fair value. 16

17 »Measured at fair value» gains and losses presented in other comprehensive income (OCI).»When position is closed, gains and losses are reclassified in profit or loss (sometimes called recycling ).»If assets are impaired (significant or prolonged decline): losses are presented in profit or loss.» sometimes difficult to determine whether loss is an impairment as defined (can be subjective). 17

18 »AFS equity is impaired if:» objective evidence of impairment (for example, financial difficulty, bankruptcy, etc; or there are significant changes in legal, economic, technological changes)»afs debt instrument is impaired only if above applies and» if losses are significant and prolonged» significant and prolonged are not defined 18

19 »Reversal of impairment is allowed if fair value improves but» AFS debt: past impairment should be reversed through profit or loss» AFS equity: past impairment should be reversed through equity 19

20 »Regulatory approach»prudential filter» Prudential filter is applied to unrealised gains/losses on AFS debt.» No prudential filter on AFS equity in some countries. 20

21 »Measured at amortised costs»used when difficult to obtain the price»impairment test applies»allowed to use FVO but designation must be at inception only» if FVO is used, the instrument, for example, a loan is measured at fair value»loans and receivables mainly used for retail banks loan portfolios 21

22 »Measured at amortised cost»impairment test applies»non-derivative instruments»intends to and is able to hold to maturity»allowed to use FVO but designation must be at inception only» if FVO is used, the instrument, for example, a loan is measured at fair value 22

23 »HTM is subject to tainting rules:» If a bank sells part of a HTM portfolio, all the bank s HTM instruments should be transferred to available for sale for a period of two years» The bank is prohibited from classifying any investments as HTM for the next two years»tainting rules applied at group level. Why do we have tainting rules? 23

24 »Once a financial asset has been classified into a particular category on initial recognition, IAS 39 restricts the circumstances in which it is permissible or necessary to transfer that asset into another category.»these rules were eased in 2008.»It is now possible to reclassify certain financial assets from a category requiring fair value into another category at amortised costs under limited circumstances. 24

25 »Derivatives and financial assets designated as at fair value through profit or loss are not eligible for reclassification.»irrevocable designation at inception prevents cherry picking.»but a non-derivative financial asset can be reclassified out of held for trading into another category if:» (1) Financial assets meet the definition of loans and receivables and entity has the intent and ability to hold it for the foreseeable future or to maturity. 25

26 » (2) For other financial assets only in rare circumstances provided that these financial assets are no longer held for the purpose of selling or repurchasing in the near term.» rare circumstances: from a single event that is unusual and highly unlikely to recur in the near-term. 26

27 FROM CATEGORY TO Held for trading Designated at fair value Loans and receivables Held to maturity Available for sale Held for trading N Y Y Y Designated at fair value N N N N N Loans and receivables N N N Y Held to maturity N N N Y Available for sale N N Y Y 27

29 »Recognise when first becomes a party to the contractual provisions of the instrument (paragraph 14 of IAS 39) 29

30 »At initial recognition measure a financial asset or a financial liability at its fair value» plus (minus) transactions costs if asset (liability) is subsequently measured at amortised cost (paragraph 43 of IAS 39)»When equity shares are issued, the transaction costs should be deducted from equity, net of any related income tax benefits. The transaction costs to be deducted are only the incremental costs directly attributable to the transaction that would have been otherwise avoided. (paragraph 25 of IAS 32) 30

31 »Yesterday a separate session was held on measuring fair value 31

33 »Effective Interest Method How to value at amortised cost? Effective interest method At initial recognition: fair value plus (or, if liability, minus) transaction costs Minus principal repayments Accrue interest using the effective interest method (amortisation) at the internal rate of return implicit in the instrument Minus any reduction for impairment or uncollectibility 33

34 » Effective Interest Method (EIM)» The EIM is a method of calculating the amortised cost of a financial asset or a financial liability and of allocating the interest income or interest expense over the relevant period.» The method is as follows:» The effective interest rate (EIR) is the rate that exactly discounts estimated future cash payments or receipts through the asset s expected life.» The EIR is sometimes termed the level yield to maturity or to the next repricing date and is the internal rate of return of the asset or liability for that period. 34

35 »To calculate the EIR, an entity should estimate cash flows considering all the financial instrument s contractual terms (for example, pre-payment, call and similar options but should not consider future credit losses.»in some rare cases, it might not be possible to reliably estimate the cash flows of a financial instrument. In those rare cases, the entity should use the contractual cash flows. 35

36 »The calculation of the EIR also includes the transaction costs and fees. This means that they are amortised through profit or loss over the instrument s life. 36

37 37»After initial recognition the historical cost of a liability may be adjusted for:» finance costs: the accrual of interest and the accretion of a discount or premium» the fulfilment or settlement of the liability» (for financial liabilities) changes in estimates of future cash flows but not reflecting subsequent changes in prices caused by other factors. 37

38 38»On 1 January 2014 borrowed $1,000,000 from the bank» receive $1,000,000 on 01/01/2014» promise to pay $1,210,000 on 01/01/2016» in other words, effective interest rate (IRR) = 10% Michael JC Wells 38

39 39 Date Account (element: classification) Debit Credit 01/01/2014 Asset: cash 1,000,000 Liability: loan 1,000,000 31/12/2014 Expense: finance cost 100,000 10% x $1,000,000 Liability: loan 100,000 31/12/2015 Expense: finance cost 110,000 10% x $1,100,000 Liability: loan 110,000 01/01/2016 Liability: loan 1,210,000 $1,000,000 + $100,000 + $110,000 Asset: cash 1,210,000 39

40 40»On 1 January 2014» purchase goods for $1,210,000 on 2-year interest-free credit» cash sale price = $1,000,000» effective interest rate (IRR) = 10% Michael JC Wells 40

41 41 Date Account (element: classification) Debit Credit 01/01/2014 Asset: inventory 1,000,000 Liability: trade creditor 1,000,000 31/12/2014 Expense: finance cost 100,000 10% x $1,000,000 Liability: trade creditor 100,000 31/12/2015 Expense: finance cost 110,000 10% x $1,100,000 Liability: trade creditor 110,000 01/01/2016 Liability: trade creditor 1,210,000 $1,000,000 + $100,000 + $110,000 Asset: cash 1,210,000 41

42 42» On 1 January 2014 you issue promise to pay $1,000,000 on 31 December 2023 (in 10 years)» receive $613,913 on 01/01/2014» in other words, effective interest rate (IRR) = 5%» On 2 January 2014 your credit rating is downgraded» your borrowing rate increases to 10%» the fair value of the traded bonds falls to $385,543» Note: even though the fair value of the liability changed on 2 January 2014 (and the liability could then be settled at $385,543 by buying the debt in the market) its amortised cost does not reflect the change in its fair value because the amount and timing of the cash outflow ($1,000,000) remains unchanged. Michael JC Wells 42

43 Date Account (element: classification) Debit 01/01/2014 Asset: cash 613,913 Credit Liability: traded bond 613,913 31/12/2014 Expense: finance cost 30,696 5% x $613,913 Liability: traded bond 30,696 31/12/2015 etc Expense: finance cost interest accreted at 5% Liability: traded bond interest accreted at 5% 31/12/2023 Liability: traded bond 1,000, $613,913 + $30,696 + Asset: cash 1,000,000 43

What are the key disclosures re. impairment in financial statements?

44 When is impairment required? What is impairment in accounting standards? What are the key inputs to calculate accounting impairment? What are the key disclosures re. impairment in financial statements? Is impairment and accurate calculation? Or is judgement involved? Who should calculate impairment? 44 44

45 »IAS 39 requires all financial assets with the exception of those measured at fair value through profit or loss to be reviewed for impairment.»a financial asset is impaired when its carrying value exceeds the present value of the future cash flows discounted at the financial asset s original effective interest rate.» what does this measurement mean? 45

46 »Impairment issues are only relevant to financial assets that are carried as amortised cost»a presentation issue is also relevant to available for sale financial assets whose fair value changes are usually recognised in other comprehensive income. 46

47 »IAS 39 deals with impairment of financial assets through a 2- step process:» First an entity must carry out an impairment review of its financial assets at each balance sheet date. The aim of this review is to determine whether there is objective evidence of impairment for these assets. (see paragraph 58 of IAS 39)» Secondly, if there is objective evidence of impairment, the entity should measure and record the impairment loss in the reporting period. (see paragraph 58 of IAS 39) 47

48 »Incurred versus expected losses» Under IAS 39, a financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the asset s initial recognition. This is known as loss event. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. 48

49 »Incurred versus expected losses» In addition the loss event must have a reliably measurable effect on the present value of estimated future cash flows and be supported by current observable data. (see paragraph 59 of IAS 39).»Losses expected as a result of future events, no matter how likely are not recognised.» for example, an expectation that a recession will occur or unemployment will rise are not taken into account. 49

50 »Incurred versus expected losses» A bank lends $1,000 to a group of customers. Based on historical experience, Entity A expects that 1% of the principal amount of loans given to the customers will not be collected.» Can the bank reduce the carrying amount of the loan asset by $10 on initial recognition through the recognition of an immediate impairment loss? Please discuss. 50

51 »IAS 39 provides examples of factors that may individually or taken together provide sufficient objective evidence that an impairment loss has been incurred in a financial asset or group of financial assets IAS 39 paragraph 59: Disappearance of an active market. Significant financial difficulty of issuer or obligor. Probable that borrower will enter bankruptcy. A breach of contract such as default in interest or principal payments. 51

52 »A downgrade of an entity s credit rating is not, of itself, evidence of impairment.»other objective evidence of impairment:» debtors liquidity.» fair value of collateral.» solvency, business and financial risk exposures. (paragraph 60 of IAS 39)»A decline in fair value of a financial asset below its cost or amortised cost in not necessarily evidence of impairment. 52

53 »The standard provide additional guidance about impairment indicators that are specific to investments in equity instruments: Significant adverse changes in technological, market or legal environment. Structural changes in the industry or number of competitors. Significant or prolonged decline in fair value of an investment in an equity instrument below its cost. Changes in level of demand for goods or services, changes in consumer tastes 53

54 Impairment of assets at costs The amount of the loss should be measured as the difference between the asset s carrying amount and the present value of estimated future cash flows. The future cash flows should be discounted at the financial asset s original effective interest rate. IAS 39 para 63. The amount of the loss should be recognised in profit or loss. IAS 39 para 63. The asset s carrying amount in the entity s balance sheet is stated net of any related allowance. IAS 39 para AG 84 54

55 » Where an impaired financial asset is secured by collateral, the calculation of the present value of the estimated future cash flows of the collateralised financial asset should reflect the cash flows that may result from foreclosure less costs for obtaining and selling the collateral, whether or not foreclosure is probable. IAS 39 para AG84.» As the measurement of the impaired financial asset reflects the collateral asset s fair value, the collateral is not recognised as an asset separately from the impaired financial asset, unless it meets the recognition criteria for an asset in another standard. IAS 39 IG para E4.8 55

56 »General provisions for bad and doubtful debt:» In some previous GAAPs, matrix or formula are used that specifies fixed provision rates for the number of days a loan or debt is overdue.» Such a method of provisioning is not acceptable under IAS 39 unless it produces a result that is sufficiently close to the one obtained by following a discounted cash flow methodology. IAS 39 para IG E4.5 General provision based on prudence are not allowed under IAS

57 »Available for sale» When a decline in the fair value of an AFS asset has been recognised directly in OCI and there is objective evidence that the asset is impaired, the cumulative loss that had been recognised directly in OCI should be reclassified from equity and recognised in profit or loss even though the asset has not been derecognised. IAS 39 para

58 »Reversal of impairment losses» If after an impairment loss has been recognised for an AFS financial asset the fair value of the AFS instrument increases, the treatment required by the standard for reversals of impairment losses on AFS debt instruments differs from those on AFS equity instruments: AFS debt instrument AFS debt instruments: past impairment losses should be reversed through the P&L when fair value increases and the increase can be objectively related to an event occurring after the impairment loss was recognised in P&L. 58

59 »Reversal of impairment losses» For AFS equity instruments, past impairment losses recognised in P&L should not be reversed through P&L when fair value increases. IAS 39 para 69. AFS equity instrument This means that subsequent increases in fair value including those that have the effect of reversing earlier impairment losses are all recognised in equity. 59

61 »Yesterday a separate session was held on measuring fair value 61

62 »Changes in own credit risk of an entity could result in a gain or a loss.» Gains and losses due to changes in own credit risk on financial liabilities at fair value are presented in profit or loss» a recent amendment allows an entity to presenting such gains and losses in OCI (an entity adopting this aspect of IFRS 9 need not apply early other aspects of IFRS 9).»Some apply a prudential filter. 62

63 »In some jurisdictions, banks are required to disclose the amount in prudential regulatory returns.»also a disclosure requirement in IFRS 7. 63

65 » Trading book» Banking book» Still used by some practitioners and regulators although IAS 39 classifications are used in the financial statements» Some investment banks do not have a banking book; only a trading book» Some text also refers to banking and trading book (for example, interest rate risk in the banking book)» So can be a source of confusion 65

66 Trading Book Banking Book Trading (Fair value through P&L) Loans and receivables (amortised cost) Also includes some AFS instruments (fair value through reserves) Held to maturity (amortised cost) Its not always a perfect match between accounting and regulatory definitions Some AFS instruments and Fair Value Option 66

68 » Disclosures related to IAS 39 are prescribed in IFRS 7.» Disclosures about risks in financial instruments: Market risk, credit risk and liquidity risk.» Qualitative and quantitative disclosures.» One of the key criteria for IFRS 7 disclosures is: seen through the eyes of management but it makes financial statements less comparable.» IFRS 7 was amended during the crisis.» There are also some disclosure requirements related to financial instruments in IAS 1, e.g. assumptions made re. valuations. 68

69 »Disclosures are required for the following instruments measured at fair value» Level 1: Quoted market price.» Level 2: valuation techniques are used; using observable inputs.» Level 3: Valuation techniques are used; with significant unobservable inputs.»the disclosure requirements are in IFRS 7 and IFRS

HKAS 32, HKAS 39 and HKFRS 7

Assets & Liabilities (HKAS 39) 24 April 2008 Nelson Lam 林智遠 MBA MSc BBA ACA ACS CFA CPA(Aust) CPA(US) FCCA FCPA(Practising) MSCA 2005-08 Nelson 1 HKAS 32, HKAS 39 and HKFRS 7 Anyone who says they understand