Financial Instruments: Recognition and Classification

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1 Risk and Accounting Financial Instruments: Recognition and Classification Marco Venuti 2018

2 Agenda Recognition Transaction costs Classification Classification financial assets Fair value option Embedded derivatives Classification financial liabilities Presentation Disclosure Pagina 2

Recognition All financial assets and financial liabilities, including derivatives, should be recognised on the balance sheet when the entity becomes

consideration received Transaction costs are incremental cost that are directly attributable to the acquisition, issue or disposal of a financial asset

3 Recognition All financial assets and financial liabilities, including derivatives, should be recognised on the balance sheet when the entity becomes party to the contractual provisions of the instrument Financial assets Financial liabilities fair value of consideration given fair value of consideration received Transaction costs are incremental cost that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. Transaction costs included in initial measurement of financial instruments not classified as at Fair Value Through Profit and Loss (FVTPL).

4 A question for you Which of the financial instruments below should be recognised on the balance sheet of an entity? The commitment to purchase an interest rate swap The conclusion of a cross currency swap contract The receiving of a sum from the bank for the purchase of a foreign exchange currency forward Transaction price is normally the best evidence of fair value on initial recognition

5 Which statements are true? Unconditional receivables and payables are recognised as assets or liabilities when the entity enter into a contract Derivatives with a fair value of zero are not eligible for recognition when the entity becomes a party to its contractual provisions Derivatives with a fair value different from zero are not eligible for recognition when the entity becomes a party to its contractual provisions Planned future transactions are recognised as assets or liabilities

6 Transaction costs: Transaction costs are additional costs that are directly attributable to the transaction are carried out with third party (such as an agent, an adviser, the tax authority) include fees paid to agents, advisers, brokers and dealer, levies by regulatory agencies and security exchanges, and transfer taxes and duties. Transaction costs included in initial measurement of financial instruments not classified as at Fair Value Through Profit and Loss (FVTPL).

7 Which statements are true? Agency costs are included in transaction costs Directly attributable transaction costs are not included in initial measurement of debt securities not classified as FVTPL Directly attributable transaction costs are not included in initial measurement of financial instruments classified as FVTPL Internal administrative and holding costs are transaction costs

8 A question for you: Alfa invests in a zero coupon bond Zero coupon bond is a bond bought at a price lower than the nominal value which is repaid at maturity and which does not give rise to periodic interest payments Nominal amount of the bond L$ 200 Purchase price L$ 180 Directly attributable transaction costs L$ 4 Alfa does notclassify the bond as FVTPL At what amount should Alfa recognise the zero coupon bond?

9 Classification IAS 39 requires that financial assets are classified in 4 categories and financial liabilities in 2 categories. The classification of financial instruments dictates measurement bases to apply. Classification is decided at initial recognition. Upon initial recognition reclassification is allowed only for specific categories and in particular circumstances. 9

Classification of financial assets Category Financial assets at fair value through profit or loss (FVTPL) Loans and receivables (L&R) Held to maturity (HTM) Available for sale (AFS) Definition

10 Classification of financial assets Category Financial assets at fair value through profit or loss (FVTPL) Loans and receivables (L&R) Held to maturity (HTM) Available for sale (AFS) Definition Financial assets held for trading Derivatives, other than some hedging instruments Financial assets designated to this category at initial recognition (fair value option) Non-derivative financial assets with: fixed or determinable payments; and not quoted in an active market Non-derivative financial assets with: fixed or determinable payments fixed maturity; and intent and ability to hold to maturity Non-derivative financial assets that are not classified into another category (residual category)

11 Fair value option Designation of financial instruments as at fair value through profit or loss is permitted, when: The designation eliminates or significantly reduces accounting mismatches A group of financial assets and/or liabilities is managed on a fair value basis An embedded derivative that meets particular conditions Only available at initial recognition Designation is irrevocable

12 A question for you Which classifications are allowed for the following financial assets? Equity securities held Purchased receivables Loan originated by the entity Interest rate swaps (not used for hedge accounting) Trading bonds Debt securities held (exchange quoted)

13 Which statements are true? Bond held for trading are designated as FVTPL FV option is irrevocable and applies to financial instruments which are held for trading HTM can include debt instrument listed Loans and receivables (LR) include debt instrument listed Derivatives are designated as FVTPL LR are to be not held for trading and not quoted in an active market

the term of debt Transactions in third currency Index linked payments When to separate?

14 Embedded derivatives How to identify? An implicit or explicit term in a contract that makes it behave like a derivative (*) Instruments with conversion features Instruments with option to extend the term of debt Transactions in third currency Index linked payments When to separate? The embedded derivative is not closely related to economic characteristics and risks of the host contract (e.g. leverage, optionality feature) Embedded derivative would be derivative if it was freestanding The host contract is not carried at fair value through profit or loss (*) Embedded derivitives modify significantly cash flow of host instrument

15 Examples A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument; Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract by which the amount of interest or principal is indexed to the value of equity instruments are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar

16 Embedded derivatives(continued) Accounting following separation: Apply rules of IAS 32/39 (or other applicable IAS if host is not a financial instrument) to the host contract Measure the separated derivative at fair value through profit or loss Accounting when separation is difficult: If it is difficult to separate the embedded derivative, may choose to fair value through profit or loss for the entire combined contract Accounting when impossible to separate: If the embedded derivative cannot be reliably identified and measured, the entire combined contract is accounted for as a financial instrument at fair value

17 A question for you Which of the embedded derivatives reported is not closely related to economic characteristics and risks of the host contract? The embedded derivatives is an inflation-related index (provided that the contract is not leveraged and the index related to inflation does not regard other economic environments); Equity-indexed interest payments embedded in a host debt Commodity-indexed interest payments embedded in a host debt An equity conversion feature in a convertible debt instrument

18 Classification of financial liabilities Category Definition Financial liabilities at fair value through profit or loss (FVTPL) Financial liabilities held for trading Derivatives, other than some hedging instruments Financial liabilities designated to this category at initial recognition (fair value option) Other financial liabilities (OFL) All financial liabilities that are not classified as FVTPL

19 A question for you Which classifications are allowed for the following financial liabilities? Loan from associate Bond issued Interest rate swaps (not used for hedge accounting) A compound instrument issued Liabilities whose cash flow are contrattuallybased on the performance of assets otherwise measured at fair value Customer deposits Trade payables Borrowings

20 Presentation IAS/IFRS provide only a minimum of items to present in the formats of the financial statements. As a minimum the balance sheet shall include the following financial items: - Cash and cash equivalents - Trade and other receivables - Other financial assets - Trade and other payables - Other financial liabilities IFRS 7 requires that the categories provided by IAS 39 (4 categories for financial assets and 2 for financial labialities) are dosclosed either in the balance sheet or in the notes. Presentation of the items depends also on the approach followed (current/non current or liquidity distinction). Formats provided by Bank of Italy and Ivass are more analytical. For example, banks present 16 items: 9 for financial assets and 7 for financial libilities.

21 Banca Intesa 2016

22 Disclosure (IFRS 7) Provide disclosures to enable users to evaluate significance of financial instruments for entity's overall financial position and performance Disclosures to enable users to evaluate nature and extent of risks arising from financial instruments to which entity is exposed and how the entity manages those risks Description of financial risk management Objectives Policies Details of hedging policies for each type of hedging relationship

23 Kinds of risk Credit risk: risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation Liquidity risk: risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities that are settled by delivering cash or another financial asset Other kinds of risk: Operating risk Event risk Contagion risk Legal risk Etc. Market risk: risk that fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (includes currency, interest rate and other price risk) currency risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates.

24 Qualitative disclosures An entity discloses for each type of risk Exposure to the risk and how it arises Entity s objectives, policies and processes for managing the risk Methods used to measure the risk The reason for any changes in the above are disclosed

25 Quantitative disclosures An entity discloses for each type of risk Summary quantitative data based on information internally provided to entity s key management personnel Detailed disclosures in IFRS 7 paras Concentrations of risk If quantitative data at end of reporting period are unrepresentative of entity s exposure to risk during the period, further representative information is disclosed

26 Specific quantitative disclosures Credit risk disclosure includes: Information about credit quality of assets neither past due nor impaired Analysis of assets that are past due or impaired Information about collateral A particular attention to: Maximum exposure to credit risk (excluding collateral) at the balance sheet date Significant concentrations of credit risk Liquidity risk: Maturity analysis for financial liabilities based on remaining contractual maturities Market risk Sensitivity analysis showing how profit or loss and equity would have been affected by changes in the relevant risk variable. Regarding Interest rate risk a particular attention : Contractual repricing or maturity dates (whichever is earlier) Effective interest rates

27 Terms, conditions and accounting policies When financial instrument creates exposure to any of the following risks Market risk currency risk FV interest rate risk price risk Credit risk Liquidity risk Cash flow interest rate risk Principal Maturity date the following warrant disclosure Early settlement options Conversion options and details Schedule of receipts and payments Rate of interest, dividends etc Collateral held or pledged Currency

Risk and Accounting. Financial Instruments: Classification and Measurement. Marco Venuti 2018

Risk and Accounting. Financial Instruments: Classification and Measurement. Marco Venuti 2018 Risk and Accounting Financial Instruments: Classification and Measurement Marco Venuti 2018 Agenda Classification of financial assets Subsequent measurement of financial assets Financial assets measured