IFRS 9 Financial Instruments

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2 IFRS 9 Financial Instruments Session 705 Wednesday June 10, 2015

3 IFRS 9 Financial Instruments Presented by: Betsy G. Rose Assistant Vice President - Product Management State Street Global Exchange Maria Bifulco Vice President Investment Reporting Prudential

4 IFRS 9 Financial Instruments Agenda A brief history of IFRS 9 SEC current thoughts on implementing IFRS in the US IFRS 9 Classification and Measurement IFRS 9 Impairments IFRS 9 Hedging How an insurance company needs to prepare for the changes or implementation of IFRS practical view

5 IFRS 9 Financial Instruments A Brief History Q IFRS 9 issued as a complete standard Q IFRS 9 issued covering Hedging Q IASB issues ED for limited amendments to Classification and Measurement Q Change mandatory effective date from to Q IASB issues ED on Classification and Measurement Q IASB issues IFRS 9 covering Classification and Measurement Q IASB issues ED on Fair Value Options for Financial Liabilities Q IASB reissues IFRS 9 Q Proposal to change effective date of IFRS 9

6 IFRS 9 Financial Instruments IFRS in the U.S. a Brief History Mid 2000 s - SEC determined to switch to IFRS and abandon U.S. GAAP 2007 SEC allowed foreign companies to report under IFRS SEC published a proposed roadmap for the use of financial statements prepared in accordance with IFRS by U.S. issuers and set an effective date 2012 SEC published a final report with no recommendation to accept or reject IFRS

7 IFRS 9 Financial Instruments SEC Current Thoughts on Implementing IFRS in the US SEC Chair Mary Jo White called a resumption of the work on IFRS a high priority James Schnurr states it might be possible for companies to voluntarily provide IFRS information Seven months into Schnurr s tenure it is not clear when an IFRS rule will come to pass SEC Commissioner Kara Stein said she doubted the need for IFRS in the U.S. Members of Congress have challenged SEC plans to revive the rulemaking

8 IFRS 9 Financial Instruments Timeline IFRS 9 Status - Final Effective 1/1/2018 (early adoption permitted)

9 IFRS 9 Financial Instruments At a Glance Classification and Measurement Single classification and measurement approach for financial assets Based on business model in which they are managed as well as cash flow characteristics Impairments Single model applicable to all financial instruments Forward looking expected credit loss model More timely recognition of losses Hedging Improved hedge accounting model that links risk with accounting

10 IFRS 9 Classification and Measurement What is it? Classification determines how financial assets are accounted for in financial statements and in particular, how they are measured on an ongoing basis Requirements for classification and measurement are the foundation of the accounting for financial instruments The requirements for impairment and hedge accounting are based on that classification

11 IFRS 9 Classification and Measurement 1 st Criteria - Business Model How an entity manages its financial assets in order to generate cash flows Determined not by individual instrument but by portfolio of investments: can split into sub-portfolios

12 IFRS 9 Classification and Measurement Types of Business Models Amortized Cost Hold in order to collect contractual cash flow FVOCI Hold to collect contractual cash flows and selling financial assets Other If business model is not one of the two previous models, financial assets are measured at fair value through profit and loss

13 IFRS 9 Classification and Measurement 2 nd Criteria - Cash Flow Characteristics Solely Payments of Principal and Interest (SPPI) IFRS 9 provides more extensive guidance on assessment of SPPI Interest is comprised of a return for the time value of money and credit risk Interest can also include return for liquidity risk For contractual cash flows to be SPPI, they must include return consistent with a basic lending arrangement

14 IFRS 9 Classification and Measurement Business Model and Cash Flow Combined Classification as SPPI Depends on your business model Amortized cost Fair value through other comprehensive income (FVOCI) Classification as non SPPI Fair value through profit and loss - FVTPL (residual category)

15 IFRS 9 Classification and Measurement General Classifications Simple Debt Equities Liabilities Amortized Cost Fair Value through Profit and Loss * Amortized Cost ** Fair Value through Other Comprehensive Income * Irrevocable election to classify as FVOCI ** Option to measure at fair value through profit and loss if particular criteria are met

16 IFRS 9 Classification and Measurement Comparisons Topic Current GAAP Proposed GAAP IFRS 9 Categories Trading (FVTNI) Available for Sale (AFS) Held to Maturity (Amortized Cost) No changes Fair Value through Profit and Loss (FVTPL) Fair Value through Other Comprehensive Income (FVOCI) Classification Based on business model No changes Business model/intent Cash Flow Characteristics Debt All three categories are allowed No changes All three categories allowed Equity FVTNI AFS Fair Value OCI Option: Equities FVTNI AFS amounts in accumulated OCI are recycled to net income at sale Reclassifications Permitted in certain circumstances Only FVTNI AFS eliminated FVTPL Not allowed Allowed if elected at purchase Irrevocable Cannot recycle OCI amounts to profit or loss at sale No changes Required if the business model changes Record on the first day of the period of the change

17 IFRS 9 - Impairments Why did the IASB address impairments? The delayed recognition of credit losses did not occur until there was evidence of a trigger. This was designed to limit an entity s ability to create hidden reserves that can be used to flatten earnings. As the financial crisis unfolded it was clear that the incurred loss model allowed companies to postpone losses. The complexity of IAS 39, which used multiple impairments model was also a concern

18 IFRS 9 - Impairments Overview A forward looking impairment model Recognize expected credit losses at all times Update the amount of expected credit losses at each reporting date The model is forward looking No longer necessary to have a trigger event Same impairment model for all financial instruments Improved disclosures

19 IFRS 9 - Impairments Scope The new Current Expected Credit Loss Model (CECL) should be applied to: Investments in debt instruments at amortized cost Investments in debt instruments measured at fair value through other comprehensive income (FVOCI) All Loan commitments not measured a fair value through profit and loss Scope Exception: CECL model does not apply to purchased credit impaired assets

20 IFRS 9 Impairments Stages Stage 1 Stage 2 Stage 3 12 month expected credit losses are recognized in P/L Loss allowance established Interest revenue calculated on the gross carrying amount Credit risk increases significantly from when the instrument is purchased Calculate lifetime expected credit losses Calculation of interest revenue the same as Stage 1 Financial assets are assessed individually Financial asset is credit impaired Lifetime expected credit losses are still recognized Interest revenue calculated on gross carrying amount minus allowance

21 IFRS 9 - Impairments 12 Month Expected Credit Losses What it is It is the effect of the entire credit loss on an asset weighted by the probability that this loss will occur in the next twelve months What it is not Expected cash shortfall over the next twelve months Credit losses on assets forecasted to default in the next twelve months

22 IFRS 9 - Impairments Illustration of 12 Month Expected Credit Losses Alternative Alternative 1 2 Probability of Alternative Occurring Forecasted Cash Flows.5% 99.5% 750,000 (25% loss) 1,000, month expected credit loss =.005 *.25 * 1,000,000 = 1,250

23 IFRS 9 - Impairments Lifetime Expected Credit Losses What it is The expected present value of losses that arise if a borrower defaults on their obligation through the life of the financial instrument The weighted average credit losses with the probability of default as the weight Because expected credit losses consider the amount and timing of payments, a credit loss (i.e. cash shortfall) arises even if the entity expects to be paid in full but later than when contractually due

24 IFRS 9 Impairments Stages Stage 1 Stage 2 Stage 3 12 month expected credit losses are recognized in P/L Loss allowance established Interest revenue calculated on the gross carrying amount Credit risk increases significantly from when the instrument is purchased Calculate lifetime expected credit losses Calculation of interest revenue the same as Stage 1 Financial assets are assessed individually Financial asset is credit impaired Lifetime expected credit losses are still recognized Interest revenue calculated on gross carrying amount minus allowance

25 IFRS 9 - Impairments Assessing Significant Increases in Credit Risk May be done on a collective basis (like geographic region, industry, credit rating) or individual basis. Ensures that lifetime expected credit losses are recognized even if evidence is not yet available on an individual level Generally expected to be recognized before a financial instrument becomes past due or is re-structured Rebuttable presumption that the credit risk has increased significantly when contractual payments are more than 30 days past due. The rebuttable presumption is not an absolute rather the latest point

26 IFRS 9 - Impairments Assessing Significant Increase in Credit Risk (cont.) Instruments with low credit risk do not have to calculate lifetime expected credit losses. An example is an instrument that has an investment grade rating although this is not a prerequisite for being considered low risk The CECL model relies on a relative assessment of credit risk. This means that a loan with the same characteristics could be included in Stage 1 for one entity and in Stage 2 for another, depending on the credit risk at initial recognition of the loan for each entity

27 IFRS 9 - Impairments Recap Considerations Information used Lifetime Losses Probability weighted outcome Reasonable and supportable information Recognized when there are significant increase in credit risk Time value of money Past events, current events and forecasts Generally occurs before the asset becomes credit impaired or a default occurs

28 IFRS 9 - Impairments Disclosures How are losses determined Basis for calculation How are losses measured How are changes in credit risk assessed Reconciliations Opening to closing balance for 12 month loss Opening to closing balance for lifetime losses Reconcile both carry amounts and allowances Other Credit risk of financial assets by rating grade Financial asset on which contract cash flows have been modified

29 IFRS 9 - Impairments Comparisons Topic Current GAAP Proposed GAAP IFRS 9 Scope of CECL Model Debt securities Most debt instruments (other than FVTNI) AFS debt securities are excluded. Recognition Threshold Measurement Probable or Other-Than- Temporary Varies depending on the nature of the financial asset No Threshold. Impairment is based on expected credit losses Single measurement approach: all contractual cash flows that the entity does not expect to collect. Amortized Cost Fair Value through OCI No Threshold. Impairment is based on expected credit losses Dual measurement approach: 12-month expected credit losses and lifetime expected credit losses Recognition Adjust Cost Basis Record an Allowance Record an Allowance Write-offs Write off in the period the asset is deemed uncollectible Same as current GAAP Write off if there is no reasonable expectation of future recovery

30 IFRS 9 - Hedging Overview The new guidance relaxes the current requirement for the hedging relationship to be highly effective in order to qualify for hedge accounting The 80% to 125% bright line test eliminated and replaced with the principle of an economic relationship Retrospective assessment of hedge effectiveness is no longer required Significant changes to the types of transactions eligible for hedge accounting (hedging of non-financial items)

31 IFRS 9 - Hedging Overview (cont.) Flexibility of new accounting requirements is counterbalanced by enhanced disclosure requirements Entities will have an accounting policy choice as to whether to apply the hedge accounting model in IAS 39 or IFRS 9. This choice will be revisited when the IASB finalizes its work on the macro hedging project

32 IFRS 9 What Can an Insurance Company Do? Practical Experience Determine what foreign subsidiaries will adopt IFRS 9. i.e. Korea and Taiwan are currently using IFRS, but interpretations are different. Japan has not adopted IFRS yet. Prepare a preliminary assessment or diagnostic analysis of GAAP and IFRS differences or IFRS 39 and IFRS 9 differences. What are the possible high level implications to accounting policies, processes, and systems? Ask your external auditors for guidance and tools. Assess infrastructure systems and reporting. Can you handle multiple bases of accounting? Can you handle multiple bases of impairment analysis?

33 IFRS 9 What Can an Insurance Company Do? Practical Experience (cont.) Create a high level timeline working back from first date of reporting (2018). Remember you need two year comparatives. Pick a Financial Statement to begin modifying for GAAP and IFRS differences or IFRS 39 to IFRS 9 difference (For example, December 31, 2014). System Business Analysts interpret the accounting policy documents and create system specifications and infrastructure changes. Try to ensure Corporate (US) and Subsidiaries (Korea, Taiwan, etc.) are consistent with interpretation of IFRS, where possible. If not, can you handle more than one IFRS interpretation.

34 IFRS 9 What Can an Insurance Company Do? Practical Experience (cont.) IFRS implementation does not just impact the financial department include systems, tax, corporate, operations, reporting, asset managers etc. Communication is key Timeframe to implement generally takes longer than companies expect Implementation project could reveal areas of incorrect application of US GAAP

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GAAP & IFRS Updates: What you need to know

GAAP & IFRS Updates: What you need to know Claire Gemmell Account Manager Rhead Hatch Product Owner Learning Objectives Identify differences in the classification and measurement of financial instruments