Risk and Accounting. IFRS 9 Financial Instruments. Marco Venuti 2018

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1 Risk and Accounting IFRS 9 Financial Instruments Marco Venuti 2018

2 Agenda Reasons for issuing IFRS 9 Classification approach by IFRS 9 Classification and Measurement of financial assets Contractual cash flow characteristics test (step 1) Business model test (step 2) Fair Value Through Other Comprehensive Income Fair Value Option IFRS 9 vs IAS 39: Impairment Expected loss model Pagina 2

3 Reasons for issuing IFRS 9 IAS 39 requirements were difficult to understand, apply and interpret. The IASB s objective in issuing IFRS 9 was to develop a new Standard for the financial reporting of financial instruments that is principlebased and less complex. IFRS 9 is IASB s response to the financial crisis and represents a fundamental reconsideration of the accounting for financial instruments. Main changes in comparison to IAS 39 Classification of financial assets Impairment of financial assets The deadline for IFRS 9 compliance and implementation is for periods commencing

4 Classification approach by IFRS 9 IFRS 9 replaces the rules based model in IAS 39 with an approach which bases classification and measurement on the business model of an entity, and on the cash flows associated with each financial asset. Two criteria for classification of Financial Assets Solely Payment of Principle and Interest (SPPI test) Principal: amount transferred by holder (fair value at initial recognition) Interest: consideration for time value of money and credit risk associated with the principal amount outstanding during a particular period of time. Business Model (BM) BM refers how an entity manages its financial assets in order to generate cash flows : Hold to collect (contractual cash flow) Hold to collect and sell Other Business Model 4

5 Classification and Measurement of financial assets Step 1 Step 2 Business model = hold to collect Business model = hold to collect and sell Other business models Cash flows are solely payments of principal and interest (SPPI) Amortised cost FVOCI FVTPL Other types of cash flows FVTPL FVTPL FVTPL 5

6 Contractual cash flow characteristics (step 1) The first condition for a financial asset to qualify for amortised cost classification is that the financial asset must meet the SPPI (solely payments of principal and interest) contractual cash flow characteristics test. Contractual cash flows are considered to meet SPPI if the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding on specified dates i.e. the contractual cash flows are consistent with a basic lending arrangement. Remarks: If the contractual cash flows are linked to features such as changes in equity or commodity prices, they would not pass the SPPI test because they introduce exposure to risks or volatility that are unrelated to a basic lending arrangement Contractual cash flow characteristic that introduces leverage do not have the characteristics of interest e.g. option, forward and swap contracts 6

7 Example : contractual cash flow characteristics Instrument A 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 analysis The contractual cash flows meet SPPI test? Yes. The interest rate on the instrument reflects real interest as the interest amounts are consideration for the time value of money on the principal amount outstanding. It does not reflect other factors. For example, if the interest payments were indexed to another variable such as the debtor s performance (eg the debtor s net income) or an equity index, the contractual cash flows are not payments of principal and interest on the principal amount outstanding. 7

8 Characteristics of the financial asset test Examples Instruments that will qualify A bond with a stated maturity date. Principal and interest are linked to an inflation index that is not leveraged. A variable interest rate loan with a stated maturity date that permits the borrower to change the period of the market interest rate at each interest reset date on an ongoing basis. A bond with a stated maturity date and pays a variable market interest. A full recourse loan secured by collateral. Instruments that will NOT qualify A convertible bond that is convertible into equity instruments of the issuer. A loan that pays an inverse floating rate, i.e. the interest rate has an inverse relationship to the market interest rates. A constant maturity bond with an interest payments indexed to an equity instrument Page 8

9 Questions for you Which kinds of investment meet the SPPI contractual cash flows characteristic test? a bond repayable in five year with a fixed interest rate a loan repayable on demand with a fixed interest rate a perpetual bond (which provide the holder with the contractual right to receive payments on account of interest at fixed dates extending into the indefinite future) a bond with repayable at maturity date and with interest linked to an inflation index that is not leveraged a bond with contractual interest payments linked to a share price (e.g. the price of FCA, GM etc.) a convertible note that converts into equity instruments a derivative

10 Business model test The second condition for the qualification of a financial asset is the business model. An entity's business model refers to how an entity manages its financial assets in order to generate cash flows. The objective of the entity s business model is to hold instruments to collect contractual cash flows rather than to sell instruments prior to contractual maturity to realise fair value changes: Not an instrument by instrument approach Classification to be determined at the portfolio level It is a matter of fact and not management intent an entity s business model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. Page 10

11 Kinds of business model (step 2) Holding assets in order to collect contractual cash flows Both collecting contractual cash flows and selling financial assets Other business models Realise cash flows by collecting contractual payments over the life of the instrument Typically involve lower frequency and value of sales Both collecting contractual cash flows and selling sale integral to achieving the objective of the business model Typically involve greater frequency and value of sales Neither held to collect nor held to collect and for sale Collection of contractual cash flows is incidental to the objective of the model Measurement: amortised cost Measurement: FVOCI 11 Measurement: FVTPL

12 Business model test hold to collect Example A financial institution holds financial assets to meet liquidity needs in a stress case scenario. Credit quality of the financial assets is monitored Objective in managing the financial assets: collect the contractual cash flows. Financial assets are monitored on the basis of their fair value from a liquidity perspective Objective: cash amount that would be realised 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. 12

13 Business model test: hold to collect and sell Example Entity A holds investments to collect their contractual cash flows. Entity A performs credit risk management activities to minimise credit losses. In the past, sales have typically occurred when the financial assets credit risk has increased, ie credit criteria specified in the entity s documented investment policy no longer met. 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. Entity A also monitors fair values of the financial assets, among other information. * 13

14 Questions for you Which elements are compliant with a hold to collect business model? Purchased loans hold to collect their contractual cash flow Infrequent sales of purchased loans Frequent sales of purchased loans Which elements are compliant with a hold to collect and sales business model? Purchased bonds hold to collect their contractual cash flow Sale bonds in the case that the contractual interest is below market interest (past frequent sales) Trading activity

15 CHARACTERISTICS OF THE INSTRUMENT SPPI No SPPI Classification and Measurement of financial assets hold to collect Amortised cost FVTPL BUSINESS MODEL hold to collect and sell FVTOCI FVTPL all the other FVTPL FVTPL 15

16 Fair Value Through Other Comprehensive Income (FVOCI) Investments in debt instruments Equity investments Meet SPPI FVPL FVOCI Option (Irrevocable election) Hold to collect and Sell FVOCI Variazioni di FV a OCI Recycling al momento della derecognition FV changes are recognised in OCI No recycling Election Irrevocable election at initial recognition. Election on an instrument by instrument basis 16

17 Fair Value Option (FVO) for financial assets* Fair value option available, if Accounting mismatch Managed on fair value basis Embedded derivative(s) Not managed to collect contractual cash flows FV Hybrid contracts with financial host classified in entirety * FVO unchanged for financial liabilities Page 17

18 Which statements are correct? Financial assets that meet both hold to collect test and SPPI test are measured at amortised cost All equity investments to be measured at fair value For equity investments that are not held for trading, entities can make an irrevocable election at initial recognition to classify the instruments as at FVOCI When an equity instrument measured at is derecognised as a result of a disposal, the cumulative change in fair value is required to remain in OCI IFRS 9 required that the derivative embedded within a hybrid contract is to be bifurcated from the host contract and accounted for separately

19 IFRS 9 vs IAS 39: Impairment IFRS 9 represents a step change when compared to IAS 39 (the incurred loss model). IAS 39 uses an incurred loss approach for financial assets, where loss is only recognised when a trigger event occurs. This results in too little, too late recognition of loan losses. IFRS uses an expected loss approach in a way to recognise timely credit losses

20 IFRS 9 vs IAS 39: Impairment Modello IAS 39 VERSUS Modello IFRS 9 Incurred loss model Expected loss model Performing loans NO impairment loss Non performing loans Lifetime impairment loss Performing loans Expected loss prossimi 12 mesi UnderPerforming loans Lifetime expected loss Non performing loans Lifetime impairment loss

21 IFRS 9 Expected Credit Loss Model Recognition credit expected losses (loss allowance) At the reporting date, credit risk of the portfolio has increased significantly since initial recognition? 12 month expected credit losses (ECL) Lifetime expected credit losses (ECL)

22 Example 1: assessing significant increases in credit risk since initial recognition Significant increase in credit risk Bank X provides a loan to Company Y. At the time of origination of the loan: It was expected that Company Y would be able to meet the covenants for the life of the instrument. Generation of revenue and cash flow was expected to be stable in Company Y s industry over the term of the loan. At initial recognition, Bank X considers that the loan is not an originated credit impaired loan. Subsequent to initial recognition: Company Y has underperformed on its business plan for revenue generation and net cash flow generation due to macroeconomic changes. Company Y has increased its leverage ratio Company Y is now close to breaching its covenants Trading prices for Company Y s bonds have decreased, market spreads have increased, not explained by changes in the market environment Bank X expects a further deterioration in the macroeconomic environment 22

23 Example 2: assessing significant increases in credit risk since initial recognition No significant increase in credit risk Bank X provides a loan to Company Y. At the time of origination of the loan: It was expected that Company Y would be able to meet the covenants for the life of the instrument. Generation of revenue and cash flow was expected to be stable in Company Y s industry over the term of the loan. At initial recognition, Bank X considers that the loan is not an originated credit impaired loan. Subsequent to initial recognition Sales of Company are stable There are not macroeconomic changes. Company Y has increased its leverage ratio in non meaningful way Company Y is not close to breaching its covenants 23 IFRS Foundation

24 Example 3: Provision matrix A provision matrix is used to determine the expected credit losses for the portfolio, based on its historical observed default rates over the expected life of the trade receivables and is adjusted for forward looking estimates Current 1 30 days past due days past due days past due Default rate 0.3% 1.6% 3.6% 6.6% 10.6% More than 90 days past due Gross carrying amount Default rate Lifetime ECL allowance CU CU A B AxB Current ,3% days past due ,6% days past due ,6% days past due ,6% More than 90 days past due ,6% * 24

25 A question for you Which elements are taken in consideration for impairment test? Past events Current conditions Future economic conditions (forward looking information) Determining whether there is a significant increase in credit risk since initial recognition Not reasonable and supportable information

IAS 32 & IFRS 9 Financial Instruments

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