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

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

2 Agenda Classification of financial assets Subsequent measurement of financial assets Financial assets measured at amortised cost Amortised cost and effective interest method Financial assets measured at fair value Impairment requirements Impairment of financial assets at amortised cost Impairment of Avalaible for sale (ASF) equity securities Subsequent measurement of financial liabilities Pagina 2

3 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. 3

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

4 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)

Subsequent measurement of financial assets Instrument Measurement Value changes Financial assets at fair value through profit or loss Held to maturity investments Loans and receivables Available for

5 Subsequent measurement of financial assets Instrument Measurement Value changes Financial assets at fair value through profit or loss Held to maturity investments Loans and receivables Available for sale Fair value Amortised cost (effective interest rate) Amortised cost (effective interest rate) Fair value P&L OCI (unless impaired) 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).

6 Which statements are correct? Equity securities held may be measured at amortised cost Fair value changes of derivatives are recognised in profit or loss Fair value changes of AFS financial assets are recognised in OCI Debt securities held may be measured at amortised cost

7 Subsequent measurement of financial assets There are 2 measurement criteria: 1) amortised cost 2) fair value

Financial assets measured at amortised cost The amortised cost is the amount at which they are measured at initial recognition (fair value), plus or minus cumulative amortisation using the effective

8 Financial assets measured at amortised cost The amortised cost is the amount at which they are measured at initial recognition (fair value), plus or minus cumulative amortisation using the effective interest method to calculate any difference between that initial amount and the maturity amount. Effective interest rate is the rate that exactly discounts the stream of principal and interest cash flows (estimated future cash flows), over the expected life of the financial instrument, to the initial net carrying amount. Effective interest rate corresponds to Internal Rate of Return. When applying the effective interest method, an entity generally amortises any fees, points paid or received, transaction costs and other premiums or discounts included in the calculation of the effective interest rate over the expected life of the instrument

9 Amortised cost and effective interest method Effective interest method calculates amortised cost and allocates interest income or expenses (as well as transaction costs and other initial differences) over relevant period Effective interest rate is calculated on initial recognition. It is not modified subsequently Effective interest rate exactly discounts estimated future cash flows, without taking account of future credit losses, to the net carrying amount Interest is recognised on an effective yield basis, which means that the coupon is adjusted for any fees, transactions costs, premiums, discounts and any steps in interest rate, where appropriate

10 Which statements are correct? Applying the amortised cost, the transaction costs and other initial differences are allocated over the life of the financial instruments? Applying the amortised cost, the transaction costs and other initial differences are recognised in profit and loss immediately? Interest effective rate corresponds to internal rate of return? Interest effective rate is calculated only for initial recognition?

11 Amortised cost: example 1 this example is focused on a case of a financial liability Nominal amount: (capital borrowed) euro Maturity: 5 years Transaction costs: euro Coupons: 6% (postponed) Initial value (amount received) = = euro Effective Interest Rate = IRR =? (solve the equation) The capital is paid only at maturity The effective interest rate (at initial recognition) is estimated as the rate that discounts exactly estimated future cash payments, over the expected life of the financial instrument, to the net carrying amount of the financial instrument on initial recognition. IV= CF (1+i) t IV= Initial Value (net present value) CF = Cash Flow (the stream of principal and interest cash flows) t = number of time periods 11

12 Amortised cost: example 1 Initial value: Time periods Future Cash flows Discounting factor Discounted cash flows (1,07) (1,07) (1,07) (1,07) (1,07)

Amortised cost: example 2 This example is applicable to financial assets/liabilities nominal amount: 1.

13 Amortised cost: example 2 This example is applicable to financial assets/liabilities nominal amount: amount paid/received: maturity: 5 years coupons: 6% No transaction cost IRR evaluation:? (solving the equation) 13

14 Amortised cost: example 3 This example is applicable to financial assets/liabilities nominal amount: amount paid/received : maturity: 5 years coupons: 6%, 8%, 10%, 12%, 16,3% IRR evaluation: 10% (solving the equation) IRR 100 (1 IRR) (1 IRR) (1 IRR) 4 ( ) 5 (1 IRR) 14

15 Amortised cost: example 4 (financial liability) Loan amount (received): Maturity: 5 years Nominal interest rate: 5% Other initial difference (up front fee paid): 3% Effective interest rate: 5,71% (calculated) CF's IRR 5,71% Opening balance Effective interests Cash flows Amortised cost (end of year) Year 1 970,0 55,3 50,0 975,3 Year 2 975,3 55,7 50,0 981,0 Year 3 981,0 56,0 50,0 987,0 Year 4 987,0 56,3 50,0 993,3 Year 5 993,3 56, ,0 0 TOTAL 280, ,00

16 Definition of fair value: first elements the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Comments: It specifies that the entity is selling the asset. It refers to the transfer of a liability It is not a forced or distressed sale It is clear it is market based It states explicitly when the sale or transfer takes place

Financial assets measured at fair value Financial assets at fair value through profit or loss Fair value changes are recognised in profit and loss Dr Financial asset 20 Cr Profit and loss 20.

17 Financial assets measured at fair value Financial assets at fair value through profit or loss Fair value changes are recognised in profit and loss Dr Financial asset 20 Cr Profit and loss 20. Assume that the carrying amount of the financial asset is 100 (purchased during the year) the fair value at the end of the year is 120 In the financial statement the company records a profit of 20. In other situations the company could record a loss.

18 Financial assets measured at fair value Financial assets at available for sale. Fair value changes are recognised in OCI (see IAS 1). Subsequently the amount recognised is reclassified in an equity reserve, known as AFS reserve. This reserve can be either positive or negative. Assume that the carrying amount of the financial asset is 100 (purchased during the year) the fair value at the end of the year is 80 Dr Other comprehensive income 20 Cr Financial asset 20 Dr AFS reserve 20 Cr Other comprehensive income 20

19 Impairment requirements A financial asset or a group of financial assets is impaired if, and only if, 1. there is objective evidence of impairment as a result of one or more events that occurred after initial recognition; and 2. the loss event has an impact on estimated future cash flows. An impairment loss is measured as the difference between: the asset s carrying amount and the present value of estimated future cash flows for loans and receivables or held to maturity investments; and the acquisition cost (less any impairment losses previously recognised) and current fair value for available for sale financial assets.

Financial assets at amortised cost: objective evidence of impairment At each balance sheet date, the entity should assess whether there is objective evidence of impairment for an asset or group of

20 Financial assets at amortised cost: objective evidence of impairment At each balance sheet date, the entity should assess whether there is objective evidence of impairment for an asset or group of financial assets Significant financial difficulty of the issuer/obligor Default or breach of contract Granting of a concession that the creditor would not otherwise consider Bankruptcy or financial reorganisation of the borrower Disappearance of an active market for the assets concerned Measurable decrease in the estimated future cash flows

(including those individually assessed) with

21 Financial assets at amortised cost: impairment assessment Objective evidence of impairment of individually significant assets? Yes Measure impairment N o Evidence of impairment for group of financial assets (including those individually assessed) with similar credit risk (i.e. collective assessment ) N o Yes Measure impairment collectively No impairment

22 Financial assets at amortised cost: impairment on a portfolio basis Future cash flows Estimated cash flows Historic loss experience Changes in related observable data Discount rate Original effective interest rate Losses incurred but not reported At each year end, if there is an objective evidence of impairment, the present value of the estimated cash flows is re calculated and impairment loss recognised for the difference between this amount and the carrying value of the portfolio. The estimated cash flows take into account incurred losses, not expected future losses

23 Financial assets at amortised cost Amortised cost: example 5 23 Loan amount provided nominal amount: maturity: 5 years coupons: 10% Other initial difference: up front 5% IRR evaluation? % 11,37% cash flow present value Year Year Year Year Year Effective interest rate (IRR) is the rate that exactly discounts estimated future cash flows to the net carrying amount (net carrying amount is: = 950). IRR is 11.37%

24 Financial assets at amortised cost Amortised cost: example 5 24 The company amortised, using the effective interest rate, the up front (cost transactions) over the expected life of the instrument. Applying the cost amortisation, the transaction costs and other initial differences are allocated gradually over the life of the instrument (using an accrual basis of accounting). Amortised cost means recording the asset so that at any time it is equal to the net present value of future estimated cash flows, discounted using the instrument s original effective interest rate Opening balance Effective interests Cash flows Year end Year Year Year Year Year

25 Impairment of financial instruments measured at amortised cost Example 5.1 Suppose that the company: The interest of the year 3 is not paid The Company expects to collect only the payment of the principal at the end of the year 5. Present Value Cash flow Year Year Year The company revises its estimates of receipts and thus it shall adjust the carryng amount of the financial asset. At the end of the year 3, the amortised cost of the receivable is 806 (present value of the expected cash flows using the IRR calculated on initial recognition). 806 is minus that 977 such that it is necessary ro recognise a loss

26 Impairment of financial instruments measured at amortised cost Example 5.1 Opening balance Effective interests Cash flows End year Impairment loss Year Year Year Year Year is the difference between: 1077 (original amortised cost) and 806 (adjusted amortised cost). 806 is the present value of the expected cash flows using the IRR calculated on initial recognition In the subsequent years the company shall used the original IRR applied to the adjusted amortised cost (see above example ).

27 A question for you Which elements are taken in consideration for impairment test? Existence of objective evidence of impairment Modified expected cash flows as a consequence of a or more evidences of impairment Current effective interest rate Original effective interest rate Incurred losses Expected losses

28 Reversal Debt instruments Impairment loss can be reversed through profit or loss if the increase can be objectively related to an event occurring after the loss was recognised. The company shall recognise the amount of the reversal in profit and loss immediately. 28

29 Impairment of available for sale equity securities Additional indicators of impairment for equity securities Adverse effects of changes in technological, market, economic or legal environment, in which the entity operates Significant or prolonged decline in the fair value of an investment in the equity instrument When a decline in the fair value on an AFS financial asset has been recognised in OCI and there is objective evidence that the asset is impaired, the cumulative loss that had been recognised in OCI shall be reclassified from equity (AFS reserve) to profit loss. The impairment loss is measured as the difference between the acquisition cost (less any impairment losses previously recognised) and current fair value for available for sale financial assets. Equity instruments Impairment loss cannot be reversed through profit or loss if subsequently there is a value increase objectively related to an event occurring after the loss was recognised

30 A question for you For financial assets classified in AFS, where is a gain or a loss from a disposal recognised? A. When a financial asset is derecognised as a result of a disposal, the cumulative gain or loss previously recognised in OCI shall be reclassified from AFS reserve to profit and loss B. When a financial asset is derecognised as a result of a disposal, the cumulative gain or loss previously recognised in OCI shall be reclassified from AFS reserve to another reserve (such as Retained earnings) C. When a financial asset is derecognised as a result of a disposal, nothing happens

31 Which statements are correct? The AFS reserve is reversed in profit and loss when there is an impairment or a disposal of the financial asset When there is not an objective evidence of impairment, a decline in the fair value on an AFS financial asset is recognised in OCI When there is not an objective evidence of impairment, a decline in the fair value on an AFS financial asset is recognised in profit and loss When there is an objective evidence of impairment, a decline in the fair value on an AFS financial asset is recognised in profit and loss Impairment loss of an equity instrument cannot be reversed through profit or loss

Derivatives, other than some hedging instruments Financial liabilities designated to this category

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

33 Subsequent measurement of financial instruments Instrument Measurement Value changes Financial liabilities at fair value through profit or loss or designated as such Other liabilities Fair value Amortised cost P&L

Financial Instruments: Recognition and Classification

Risk and Accounting Financial Instruments: Recognition and Classification Marco Venuti 2018 Agenda Recognition Transaction costs Classification Classification financial assets Fair value option Embedded