IFRS 9 The final standard

Transcription

1 EUROMONEY CREDIT RESEARCH POLL: Please participate. Click on to take part in the online survey. IFRS 9 The final standard In July 2014, the International Accounting Standards Board (IASB) published the final version of IFRS 9 Financial Instruments. The new standard will replace IAS 39. The IASB has been working on the project to replace IAS 39 since November The project was separated into three phases: classification and measurement of financial assets and financial liabilities, impairment and hedge accounting. All three projects have resulted in a more or less comprehensive change of the existing standards. The IAS 39 categorization of financial instruments into one of four measurement categories has been completely overhauled. IFRS 9 now contains three principal classification categories for the measurement of financial assets: amortized cost, fair value through other comprehensive income (FVOCI) and fair value through profit and loss (FVTPL). The new standard will replace the incurred-loss model of IAS 39 with an expected credit-loss model. That means not only credit losses that have already occurred but also losses that are expected in the future have to be recognized. The hedge accounting requirements will be based more on principles and will align hedge accounting more closely with risk management. The effectiveness requirements will particularly become less complex and must not be applied retrospectively anymore. Contents Summary 2 Classification and measurement 3 Financial assets 3 Financial liabilities 7 Equity instruments 7 Embedded derivatives 8 Impairment 9 The new model 11 Measurement of expected credit losses 14 Hedge Accounting 17 Hedging instruments 17 Hedged items 19 Hedge effectiveness 21 Presentation 23 Rebalancing and discontinuation 24 Effective date and transition 25 Effective date 25 Transition 25 Related research Sector Flash ESMA on EECD enforcement decisions on IFRS application 25 November 2014 Sector Flash Insurance Europe on the impact of IFRS in the EU 20 November 2014 Sector Flash IFRS-F on the impact of IFRS in the EU 4 November 2014 Sector Flash FEE on the impact of IFRS in the EU 15 October 2014 Sector Flash IASB annual improvements to IFRS cycle 2 October 2014 Sector Flash IMF on supervisory roles in IFRS loan loss provisioning 24 September 2014 Sector Flash IFRS 9 impact on banks expected loan losses 18 September 2014 Sector Flash Impact of IFRS in the EU 7 August 2014 Sector Flash IFRS 9 finalized 24 July 2014 IFRS 9 will have a large impact on how banks are required to account for credit losses on their loan portfolios due to a change to an expected credit-loss model. Loan loss provisions will increase. Profits will be reduced, particularly in the first year of the implementation of IFRS 9. Combined with tougher regulatory capital requirements, this accounting change may force banks to hold more capital for the same risks. The mandatory effective date of the new standard is 1 January 2018; however, an earlier adoption is possible. Author Natalie Tehrani Monfared Senior Credit Analyst (UniCredit Bank) natalie.tehrani@unicredit.de Bloomberg UCCR Internet UniCredit Research page 1 See last pages for disclaimer.

2 Summary Classification and measurement The IAS 39 categorization of financial instruments into one of four measurement categories has been completely overhauled. Under IFRS 9, categorization is based on the contractual cash flow characteristics of the instruments and the business model within which they are held. A new measurement category of fair value through other comprehensive income (FVOCI), will apply to instruments held within a business model in order to collect contractual cash flows and held for sale. Equity instruments have to be classified at fair value through profit and loss unless an entity makes an irrevocable decision to classify the instrument as FVOCI. Moreover, the requirements for the treatment of hybrid instruments (embedded derivatives) have changed. However, apart from the own-credit risk requirements, classification and measurement of financial liabilities is unchanged. Impairment The current IAS 39 incurred-loss model will be replaced by an impairment model that is based on expected credit losses. Besides lease receivables, contract assets, loan commitments and financial guarantee contracts, financial instruments measured at amortized cost and at fair value through other comprehensive income fall within the scope of the new standard. Moreover, new requirements have been added for purchased or originated credit-impaired financial assets. IFRS 9 implements the following requirements regarding a loss allowance: Provided no significant increase in credit risk is present, the loss allowance corresponds to the present value of the 12-month expected credit loss and interest revenues are calculated on the gross carrying amount of the asset. If the credit risk of a financial instrument has increased significantly, the loss allowance is calculated as the present value of the lifetime expected credit loss. However, the term significantly increase in credit risk is not defined in IFRS 9. The determination of interest revenues is still based on the gross carrying amount. If the credit risk of a financial instrument has increased significantly and objective evidence of impairment exists, the loss allowance is calculated as the present value of the lifetime expected credit loss and the determination of interest revenues is based on the net carrying amount. The new requirements have to be applied retrospectively. That is, the effects of the adaption of the new standard have to be recognized in equity from the day of first application. Thus, the previous year s data does not have to be amended. Hedge Accounting IFRS 9 implements a more principle-based standard that aligns hedge accounting more closely with risk management. The three types of hedge accounting remain: cash flow hedge accounting, fair value hedge accounting and hedge of a net investment in a foreign operation. However, there are significant changes regarding the eligible transactions for hedge accounting. The way that forward contracts and options are accounted for has been amended to reduce volatility in profit and loss. The requirements to achieve, continue and discontinue a hedge accounting relationship are amended. Moreover, the effectiveness test has been replaced by a principle of an economic relationship; a retrospective assessment of hedge effectiveness is no longer required. When an entity first applies IFRS 9, it can decide to continue to apply the hedge accounting requirements of IAS 39 until the IASB s macro hedge accounting project is finalized. Effective date and transition IFRS 9 is applied for annual periods beginning on or after 1 January Earlier application is permitted. The general IFRS 9 principle is a retrospective application of the standard; however, there are certain exceptions from this principle. UniCredit Research page 2 See last pages for disclaimer.

3 Classification and measurement Background Classification determines how financial assets and liabilities 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 accounting for financial instruments. IAS 39 contains many different classification categories, is rule-based and very complex to apply. Based on feedback received, the IASB replaced the classification and measurement categories and decided to implement a principle-based approach with classification based on the business model and the nature of cash flows. Financial assets Financial assets can be classified under the following three measurement categories: Classification of financial assets Amortised cost Fair value through other comprehensive income (FVOCI) Fair value through profit and loss (FVTPL) Source: UniCredit Research, IFRS 9 Contractual cash flows and business model Categorization is based on the contractual cash flow characteristics of the instruments and the business model within which they are held. IFRS 9 removes the existing categories held-to-maturity, loans and receivables and available-for-sale. Under IFRS 9, assets can be classified at amortized cost, at FVTPL and at FVOCI. The chart below provides an overview of the classification of financial assets (including derivatives): Financial assets Equity instrument? yes Derivatives? no Contractual cash flows are only principal and interests? yes Business model's objective is to hold assets to collect contractual cash flows? Held for trading? no OCI option elected? yes no yes no yes no no Business model's objective is to hold assets to collect contractual cash flows and sell financial assets? yes yes FVOCI (equity instruments) FVTPL FVOCI (debt instruments) Amortised cost Initial recognition at fair value plus transaction cost Changes in fair value are recognized in OCI Dividends are recognized in profit and loss Initial recognition at fair value Changes in fair value are recognized in profit and loss Initial recognition at fair value plus transaction cost Interests, credit losses and exchange gains or losses are recognized in profit and loss Other gains and losses are recognized in OCI Initial recognition at fair value plus transaction cost (= book value at initial recognition) Interests, credit losses and exchange gains or losses are recognized in profit and loss Source: UniCredit Research, IFRS 9 UniCredit Research page 3 See last pages for disclaimer.

4 Introduction Business model assessment The business model assessment determines whether financial assets must be measured at amortized cost, at FVOCI or at FVTPL. The first two categories only apply to assets that also meet the contractual cash flow criterion. Thus, financial assets that do not meet the contractual cash flow criterion are classified as FVTPL, irrespective of the business model in which they are held. The term business model refers to the way an entity manages its financial assets in order to generate cash flows. IFRS 9 provides detailed guidance on how to assess the business model and differentiates between three models, each of which results in a particular measurement category: Held-to-collect model: The objective of this model is to hold assets to collect contractual cash flows over the life of the instrument. The sale of financial assets is rare and incidental and takes place only when there is an increase in the asset s credit risk. The measurement category is amortized cost. Held-to-collect and for-sale model: The objective of this model is to hold assets to collect contractual cash flows and to sell the assets. Compared to the held-to-collect model, this model typically involves greater frequency and value of sales. The measurement category is FVOCI (subject to meeting the contractual cash flow criterion). Other models: These models can, for example, aim to trade, manage assets on a fair value basis or maximize cash flows via sale. The measurement category is FVTPL and the contractual cash flow criterion is irrelevant. However, an entity s business model does not depend on the management s intentions for an individual instrument, i.e. it is not an instrument-by-instrument approach. Moreover, a single entity may have more than one business model for managing its financial instruments. Consequently, classification need not be determined at the reporting entity level. Side note IFRS 9 states that, if more than an infrequent number of sales are made out of a portfolio, and those sales are significant in value, then an entity needs to assess whether such sales are consistent with the objective of collecting contractual cash flows (and recognition at amortized cost). Moreover, IFRS 9 states that whether such sales are required exogenously is irrelevant. This contradicts the fact that banks are regularly required (at least once a year) to monetize a part of their liquid assets that count against the liquidity coverage ratio (LCR). However, such liquid assets could be measured at FVOCI without causing volatility in profit and loss (rather in equity). Amortized cost category Financial assets are measured at amortized cost if they are held within a business model in which assets are managed in order to collect contractual cash flows and if they meet the contractual cash flow requirement. The latter requires the contractual cash flows of the instrument to be solely payments of principal and interest. Recognition and measurement The initial recognition of financial assets in this category is at fair value plus eligible transaction costs. The amortized costs are calculated as the initially recognized fair value amount minus principal repayments, plus or minus (if required) cumulative amortization of any difference between the initial and the maturity amount, minus (if required) loss allowance. Interest revenues, expected credit losses and reversals as well as foreign exchange gains and losses are recognized in profit and loss. Interest revenue is calculated using the effective interest method. UniCredit Research page 4 See last pages for disclaimer.

5 Contractual cash flow criterion Financial assets are only eligible to be recognized at amortized cost if they fulfill the contractual cash flow criterion, i.e. cash flows are solely payments of principal and interest. Contractual cash flows that are solely payments of principal and interest are consistent with a basic lending arrangement. In a basic lending arrangement, consideration for the time value of money and credit risk are typically the most significant elements of interests. Principal is defined as the fair value of the financial asset at recognition and not the amount that is due under the contractual terms. Interests are the consideration for the time value of money and credit risk. However, interest can also include a profit margin or a consideration for other lending risks and costs, e.g. liquidity risk or administrative costs. Time value of money is the element of interest that provides consideration only for the passage of time and not for other risks and costs associated with the holding of financial assets. IFRS 9 provides some guidance on specific contractual features and types of instruments: Many financial assets have features that are not in line with the contractual cash flow criterion. Such features can be disregarded if they are non-genuine (i.e. extremely rare, highly abnormal and very unlikely) or de minimis (i.e. the magnitude of their impact is too trivial or minor to merit consideration). Financial assets containing contractual features that introduce exposure to risk or volatility unrelated to a basic lending arrangement do not meet the contractual cash flow criterion, e.g. financial assets with exposures to changes in equity or commodity prices. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest, e.g. stand-alone options and swap contracts. Financial assets containing such features do not meet the contractual cash flow criterion. In extreme economic circumstances, interest can be negative, e.g. if the holder of an asset pays for the deposit of its money for a particular period of time. Nevertheless, such financial assets may meet the contractual cash flow criterion. Financial assets that do not meet the contractual cash flow criterion are always measured at FVTPL. The only exceptions are equity instruments for which an entity applies the OCI option. FVOCI category Financial assets are classified as subsequently measured at fair value through other comprehensive income if they are held within a business model in which financial assets are managed in order to collect contractual cash flows and held for sale. Moreover, they must meet the contractual cash flow criterion (see above). Recognition and measurement The initial recognition of financial assets in this category is at fair value plus eligible transaction costs. Gains and losses that result from fair value changes of the instruments are recognized in OCI. The cumulative gain or loss recognized in OCI will be reclassified from equity to profit or loss when the asset is derecognized. Interest revenues, expected credit losses and reversals as well as foreign exchange gains and losses are recognized in profit and loss. UniCredit Research page 5 See last pages for disclaimer.

6 FVTPL category All financial assets that are neither categorized as amortized cost nor as FVOCI are measured at fair value through profit or loss. However, an entity has the option (known as fair value option), at initial recognition, to irrevocably designate a financial asset as measured at FVTPL, if doing so eliminates or significantly reduces an accounting mismatch (i.e. a measurement or recognition inconsistency) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses in different ways. However, derivatives must be measured at FVTPL. Recognition and measurement The initial recognition of financial assets in this category is at fair value. Any change in the fair value is recognized in profit or loss. Reclassification The reclassification of financial assets is required if the business model for managing the instruments has changed. Such changes are expected to be very rare and must be significant to the entity s operations and demonstrable to external parties. A change in the business model will occur only when an entity either begins or ceases to perform an activity that is significant to its operations, e.g. the entity has acquired, disposed of or terminated a business line. However, such a change must be effected before the reclassification date. Measurement Reclassification is applied prospectively from the reclassification date. Both the amortized cost and the FVOCI category require that the effective interest rate be determined at initial recognition. Both of those categories also require that the impairment requirements be applied in the same way. The chart below illustrates the measurement on reclassification of assets: Reclassification into FVTPL FVOCI Amortized cost Reclassification out of Amortized cost FVOCI FVTPL Financial asset continues to be measured at fair value Cumulated OCI gain or loss is reclassified from equity to profit or loss The fair value on the reclassification date is the new book value Any difference between the previous amortized cost and the fair value is recognized in profit and loss Financial asset continues to be measured at fair value Subsequent changes in fair value are recognized in OCI Measurement of the fair value at the reclassification date Any difference between the previous amortized cost and the fair value is recognized in OCI The fair value on the reclassification date is the new gross book value The effective interest rate is calculated based on the new gross book value Reclassification at fair value at the reclassification date Cumulated OCI gain or loss is removed from equity and adjusted against the fair value (new amortised cost) Source: UniCredit Research, IFRS 9 UniCredit Research page 6 See last pages for disclaimer.

7 Classification Financial liabilities IFRS 9 retains almost all IAS 39 requirements on the classification of financial liabilities. Hence, under the new standard financial liabilities are measured at amortized cost except for the following: Financial liabilities that are held for trading; measured at FVTPL. Financial liabilities that are designated at FVTPL on initial recognition. Contingent consideration recognized by an acquirer in a business combination; such liabilities are measured at FVTPL. Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies; for these liabilities IFRS 9 provides specific guidance for the measurement. Financial guarantee contracts. Commitments to provide a loan at a below-market interest rate. Recognition and measurement The initial recognition of a financial liability measured at amortized cost is at fair value plus eligible transaction costs. However, if an entity irrevocably designates a liability at FVTPL upon initial recognition, fair value changes of this liability are recognized as follows: The amount of changes in the fair value attributable to changes in the credit risk of the liability is presented in OCI and will never be reclassified to profit or loss. The remaining amount of changes in the fair value is recognized in profit or loss. Side note FVTPL category FVOCI category Side note The fair value option for financial liabilities was introduced by IAS 39. Many market participants have expressed concerns about entities that apply this option and recognize gains in profit or loss when the credit rating deteriorates (and vice versa). IFRS 9 addresses this issue by requiring those changes to be recognized in OCI. Equity instruments Equity instruments have to be classified at FVTPL unless an entity decides to classify the instrument in the FVOCI category (see below). In the FVTPL category, gains and losses due to fair value changes as well as dividends are recognized in profit and loss. An entity can make an irrevocable decision to classify an equity instrument that is not held for trading in the FVOCI category. If an equity instrument is classified in this category, the fair value changes (gains and losses) are recognized in OCI. Dividends are recognized in profit and loss unless they represent a repayment of part of the cost of the investment. The cumulative gain or loss recognized in OCI will never be reclassified. Accounting under the equity fair value option is different from accounting under the debt fair value option because the impairment requirements of IFRS 9 are not applied to equity instruments, all foreign exchange differences are recognized in OCI and the amounts once recognized in OCI are never reclassified to profit or loss. Only dividends are recognized in profit and loss. UniCredit Research page 7 See last pages for disclaimer.

8 New requirements for hybrid contracts Embedded derivatives IFRS 9 retains the IAS 39 definition of an embedded derivative. However, if a hybrid contract contains a host contract that is an asset within the scope of IFRS 9, the embedded derivative is not separated. Instead, the whole hybrid instrument is classified according to the requirements for the classification and measurement of financial assets and liabilities (see above). The chart below illustrates the accounting of embedded derivatives under IFRS 9: Host contract is an asset within the scope of IFRS 9 yes no Application of IFRS 9 to the entire hybrid contract (financial asset or liability) No separation of the derivative Must the derivative be separated from the host contract? yes Derivative Host contract no Apply IFRS 9, i.e. classification and measurement at FVTPL Apply IFRS 9 or another IFRS standard Source: UniCredit Research, IFRS 9 Separation required If a hybrid instrument contains a host contract that is not an asset within the scope of IFRS 9, it must be assessed whether the embedded derivative has to be separated from the host contract and be accounted for as a derivative under IFRS 9. Examples are: Financial assets that do not fall within the scope of IFRS 9, e.g. insurance contracts and lease receivables Financial liabilities, e.g. loans Non-financial items, e.g. forward purchase contracts of goods If an embedded derivative is separated, the host contract has to be accounted for in accordance with the appropriate IFRS standards. However, a separation is only required if all of the following conditions are fulfilled: The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. The hybrid contract is not measured at fair value with changes in fair value recognized in profit or loss. UniCredit Research page 8 See last pages for disclaimer.

9 Impairment Introduction The new IFRS 9 impairment model is based on expected credit losses and replaces the IAS 39 incurred-loss model. A reason for this significant change is the fact that during the financial crisis the delayed recognition of credit losses (i.e. when the loss had already been incurred) was identified as a main weakness of IAS 39. The amendment of the impairment model is one of the most important changes from IAS 39 to IFRS 9 and the new requirements have to be applied retrospectively. At the date of the first application of IFRS 9 (at the latest 1 January 2018) a loss allowance for expected credit losses on any financial asset measured at amortized cost or at FVOCI has to be recognized. At each reporting date, entities must determine whether the credit risk of the financial instrument has increased significantly since initial recognition. The chart below illustrates the concept of the new impairment model: Asset is credit-impaired at initial recognition? no yes Recognition of changes in lifetime credit losses Asset is a trade receivable or a contract asset that contains a significant financing component or a lease receivable for which the lifetime expected credit loss measurement has been elected? yes no Asset is a trade receivable or a contract asset without a significant financing component? no yes Recognition of lifetime expected credit losses Significant increase in credit risk since initial recognition? yes no Recognition of 12-month expected credit losses Source: UniCredit Research, IFRS 9 Three-stage model The IFRS 9 impairment model can be described as a three-stage model: Stage 1: Any purchased asset is first classified as being in stage 1 (besides purchased or originated credit-impaired assets). Assets with no significant increase in credit risk since initial recognition or with a low credit risk at the reporting date (see page 12) remain in stage 1. For these assets, the loss allowance recognized corresponds to the 12-month expected credit loss. Interest revenues are calculated on the gross carrying amount of the asset, i.e. without deduction for credit allowance. UniCredit Research page 9 See last pages for disclaimer.

10 Stage 2: Assets with a significant increase in credit risk since initial recognition are reclassified from stage 1 to stage 2 unless they still have a low credit risk at the reporting date (see page 12). For these assets, the loss allowance recognized corresponds to the lifetime expected credit loss. However, interest revenues are still calculated on the gross carrying amount of the asset, i.e. without deduction for credit allowance. Stage 3: Assets with a significant increase in credit risk since initial recognition and an objective evidence of impairment are reclassified from stage 2 to stage 3. For these assets, the loss allowance recognized corresponds to the lifetime expected credit loss. Interest revenues are calculated on the net carrying amount of the asset, i.e. net of credit allowance. The following chart illustrates the interaction between expected credit losses and the guidance on the recognition: Initial recognition Significant increase in credit risk Asset becomes credit-impaired Loss allowance Interest revenue 12-month expected credit loss Lifetime expected credit loss Assets not credit-impaired at initial recognition Effective interest rate applied to gross carrying amount Effective interest rate applied to net carrying amount Assets credit-impaired at initial recognition Credit-adjusted effective interest rate applies to amortized cost Source: UniCredit Research, IFRS 9 Side note The initial application of the IFRS 9 impairment model may have a negative impact on equity because equity will no longer only reflect incurred credit losses but will also include expected credit losses. The impact on banks and insurance companies is expected to be particularly large. However, a bank s regulatory capital may also be affected via the reduction of common equity Tier-1 capital. Moreover, the new model may cause volatility in equity and profit and loss because external information used as inputs may be volatile (e.g. ratings, credit spreads) and any move from a 12-month to a lifetime-expected credit-loss measurement can result in large changes in the corresponding loss allowance. UniCredit Research page 10 See last pages for disclaimer.

11 12-month versus lifetime The new model Expected credit losses IFRS 9 replaces the IAS 39 incurred-losses model with an expected-credit-losses model. Under the new model it is no longer necessary for a loss event to occur before an impairment loss is recognized. Impairments under IFRS 9 are measured as: either 12-month expected credit losses; or lifetime expected credit losses. 12-month expected credit losses are those that arise from possible default events within the 12 months following the reporting date. These are all cash shortfalls that would result if a default occurs in the 12 months following the reporting date. If the credit risk of an instrument has not increased significantly since initial recognition, an entity should measure the loss allowance at an amount equal to the 12-month expected credit losses. Lifetime expected credit losses are the expected credit losses that result from all possible default events over the expected life of a financial instrument. Significant increase in credit risk At each reporting date, entities must determine whether the credit risk of a financial instrument has increased significantly since initial recognition. In assessing whether this has happened, entities determine the change in the probability of default (PD) over the expected life rather than the change in the expected credit loss. Hence, changes in loss given default (LGD) are not considered in this assessment. Instead, the current risk of default at the reporting date is compared with the risk of default at initial recognition. However, significant increase in credit risk is not defined in IFRS 9. This is one of the most critical judgment areas of the new impairment model. Approaches for assessing changes in credit risk Entities may apply various approaches when assessing whether the credit risk increased significantly. This includes using different approaches for different financial instruments. An approach that does not include an explicit PD as an input (e.g. a credit loss rate approach) can be used provided that the entity is able to separate the changes in risk of a default from changes in other drivers of expected credit losses. However, any approach used should consider the following: The change in the risk of a default occurring since initial recognition The expected life of the financial instrument Reasonable and supportable information that is available without undue cost or effort that may affect credit risk Independent of the approach used the characteristics of the financial instrument and the default patterns in the past for comparable financial instruments have to be considered. The IFRS 9 application guidance contains a non-exhaustive list of information that may be relevant in assessing changes in credit risk. UniCredit Research page 11 See last pages for disclaimer.

12 Probability of default (PD) Because of the relationship between the expected life and the PD, the change in credit risk cannot be assessed simply by comparing the change in the absolute risk of a default occurring over time, because the PD usually decreases as time passes if the credit risk is unchanged and the financial instrument is closer to maturity. Thus, when using the PD, the probability of default over the remaining life of the instrument must be considered. For financial instruments for which default patterns are not concentrated at a specific point during the expected life, changes in the PD over the next 12 months may be a reasonable approximation of the changes in the lifetime PD. However, a 12-month PD is not appropriate in the following cases: For financial instruments with significant payment obligations only beyond the next 12 months When changes in macroeconomic or other credit-related factors occur that are not adequately reflected in the 12-month PD When changes in credit-related factors only have an impact on the credit risk of the financial instrument beyond 12 months Payments more than 30 days past due Regardless of the way in which an entity assesses significant increases in credit risk, there is a rebuttable presumption that the credit risk has increased significantly when contractual payments are more than 30 days past due. However, IFRS 9 clarifies that lifetime expected credit losses are generally expected to be recognized before an instrument becomes past due. Therefore, an entity can rebut the presumption if it has reasonable and supportable (more forward-looking) information that demonstrates that the credit risk has not increased significantly even though the contractual payments are more than 30 days past due. Instruments with low credit risk Investmentgrade rating As an exception from the general requirement, entities may assume that the credit risk has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date. This simplification can be applied on an instrumentby-instrument basis. The credit risk can be assumed to be low in the following cases: If the instrument has a low risk of default If the borrower has a strong capacity to meet its contractual cash flow obligations in the near term If adverse changes in economic and business conditions in the longer term may reduce the ability of the borrower to fulfil its contractual cash flow obligations The standard states that an external rating of investment grade (i.e. a rating of at least BBB-) is an example of an instrument that may be considered as having low credit risk. However, financial instruments are not required to have an external rating to be considered to have low credit risk. An entity can also use its internal credit risk ratings or other methodologies to assess whether or not an instrument has a low credit risk. In this case, the internal model must be consistent with a globally understood definition of low credit risk and consider the risks and the type of instruments that are being assessed. Side note An external rating is only a lagging indicator and does not reflect information and events that occurred after the latest update of the rating. Moreover, the definition of default used by the rating agency might be different from that used by the entity. Thus, an entity must consider whether there is evidence of an increase in credit risk for instruments with investment-grade ratings as well. UniCredit Research page 12 See last pages for disclaimer.

13 Modified or renegotiated contractual cash flows Modified financial assets If the contractual cash flows on a financial instrument have been renegotiated or modified and the financial instrument was not derecognized, an entity must assess whether there has been a significant increase in the credit risk by comparing the following: The risk of a default occurring at the reporting date (based on the modified contractual terms) The risk of a default occurring at initial recognition (based on the original contractual terms) However, if the modification of an instrument results in derecognition, the modified financial instrument is considered to be a new instrument and the date of modification is treated as the date of initial recognition. Credit-impaired assets Very high credit risk In some cases, financial assets are considered credit-impaired at initial recognition because the credit risk is very high and in the case of a purchase it is acquired at a deep discount. For such assets, IFRS 9 contains special rules for measuring the loss allowance and recognizing interest revenue. A financial asset is credit-impaired when one or more events have occurred that have an unfavorable impact on the estimated future cash flows. The following are examples: Significant financial difficulty of the issuer or the borrower A breach of contract (e.g. a default or past-due event) The lender has granted a concession to the borrower (for economic or contractual reasons related to the borrower s financial difficulty) that the lender would not otherwise consider It is likely that the borrower will enter bankruptcy or other financial reorganization The disappearance of an active market for that financial asset because of financial difficulties The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses Initial measurement Subsequent measurement At initial recognition, no impairment allowance is recognized for purchased or originated credit-impaired financial assets. Instead, a credit-adjusted effective interest rate is applied to the amortized cost of the instrument. Thus, the initial expected credit losses are included in the estimated cash flows. At the reporting date, the cumulative changes (not the total amount) in lifetime expected credit losses since initial recognition are recognized as a loss allowance. Favorable changes in lifetime expected credit losses are recognized as an impairment gain, even if the lifetime expected credit losses are less than the amount of expected credit losses that were included in the estimated cash flows on initial recognition. UniCredit Research page 13 See last pages for disclaimer.

14 Probability-weighted estimate Measurement of expected credit losses Expected credit losses are probability-weighted estimates of credit losses over the expected life of the instrument. Credit losses are the present value (PV) of cash shortfalls. The measurement of expected credit losses should reflect: An unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes The time value of money Reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions IFRS 9 does not specify a method to measure expected credit losses. The methods used may vary based on the type of instrument and the information available. However, the impairment loss (or reversal) recognized in profit or loss is the amount required to adjust the loss allowance to the appropriate amount at the reporting date. Period of expected credit losses Financial assets Loan commitments and financial guarantee contracts The maximum period over which expected credit losses are measured is the contractual period over which the entity is exposed to credit risk on the instrument. For loan commitments and financial guarantee contracts, this is the maximum contractual period over which an entity has a present contractual obligation to extend credit. However, certain financial instruments include both a loan and an undrawn commitment component and the entity s contractual ability to demand repayment and cancel the undrawn commitment does not limit its exposure to credit losses to the contractual notice period. For such instruments, the expected credit losses are measured over the period for which an entity is exposed to credit risk and for which expected credit losses would not be mitigated by credit risk management. Cash shortfall For financial assets a cash shortfall is defined as the difference between the cash flows that are due in accordance with the contract and the cash flows an entity expects to receive. Because expected credit losses consider the amount and timing of payments, a credit loss arises even if the entity expects to be paid in full but later than when contractually due. Hence, the term cash shortfall refers to the overall shortfall against contractual terms and not just to a shortfall on particular dates when cash is received or due. The definition of a cash shortfall for undrawn loan commitments and financial guarantees is slightly different to that for financial assets. For undrawn loan commitments, the credit loss is the PV of the difference between: the contractual cash flows that are due to the entity if the holder of the loan commitment draws down the loan; and the cash flows that the entity expects to receive if the loan is drawn down. For financial guarantee contracts, the credit loss is the PV of the difference between: the expected payments to reimburse the holder for a credit loss that it incurs; and any amounts that the entity expects to receive from the holder, debtor or any other party. UniCredit Research page 14 See last pages for disclaimer.

15 Definition of default IFRS 9 provides no definition Side note Default is not defined in IFRS 9. Instead, IFRS 9 requires entities to define default themselves. However, the definition must be consistent with the definition used for internal credit risk management purposes for the relevant financial instruments and consider qualitative indicators, e.g. financial covenants. Moreover, there is a rebuttable presumption that default has occurred when a financial instrument is 90 days past due unless an entity has reasonable and supportable information to demonstrate that a more lagging default criterion is more appropriate. Some definitions of default used in practice focus only on failure to make contractual payments; others are broader and take into account the likelihood of future contractual payments being carried out in full before payments are actually past due and consider, among other things, breaches of covenants. However, entities must define default themselves. This, in turn, can affect the amount of expected losses recognized. For example, the earlier an asset is considered to be in default, the more likely it is that the default event would be possible within the 12 months after the reporting date. Probability-weighted outcome Range of possible outcomes The estimation of expected credit losses reflects an unbiased and probability-weighted amount, based on a range of possible outcomes (not on a best or worst-case scenario). Under IFRS 9, and, as opposed to IAS 39, entities are no longer allowed to measure the expected credit loss using the most likely outcome or the best estimate of the ultimate outcome. The estimation must always reflect the following: The probability that a credit loss occurs, even if this probability is very low The probability that no credit loss occurs In any case, there is no mandatory need for a large number of detailed simulations of scenarios. For example, the average credit losses of a large group of financial instruments with shared risk characteristics may be a reasonable estimate of the probability-weighted amount. Time value of money The estimation of expected credit losses must reflect the time value of money. The following discount rates have to be used: DISCOUNT RATES Instrument Instruments with a variable interest rate Purchased or originated credit-impaired financial assets Lease receivables Loan commitments Loan commitments for which the effective interest rate cannot be determined and financial guarantee contracts Discount rate Current effective interest rate for floating-rate financial assets Credit-adjusted effective interest rate determined at initial recognition Discount rate used in measuring the lease receivable in accordance with IAS 17 Effective interest rate or an approximation thereof that will be applied to discount the financial asset resulting from the loan commitment Discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows but only if, and to the extent that, the risks are taken into account by adjusting the discount rate instead of adjusting the cash shortfalls being discounted Source: UniCredit Research, IFRS 9 UniCredit Research page 15 See last pages for disclaimer.

16 Exhaustive searches are not required Reasonable and supportable information IFRS 9 requires the estimate of expected credit losses to reflect reasonable and supportable information that is available without undue cost or effort. As examples of potential data sources, the standard lists internal historical credit loss experience, internal and external ratings, credit loss experiences of other entities and external reports and statistics. The standard acknowledges that the degree of judgment required to estimate expected credit losses depends on the availability of information. As the forecast horizon increases, the availability of information decreases, and the degree of judgment required increases. The estimate of expected credit losses does not require a detailed estimate for periods that are far in the future (for such periods, an entity may extrapolate projections from available information). To estimate expected credit losses, entities are not required to undertake exhaustive searches for information but they should consider all reasonable and supportable information that is available and relevant. Collateral Cash flows from collateral Side note The estimation of expected cash shortfalls must reflect the cash flows expected from collateral and other credit enhancements that are part of the contractual terms and are not recognized separately. The estimate of expected cash shortfalls on a collateralized financial instrument reflects the amount and timing of cash flows that are expected from foreclosure on the collateral less the costs of obtaining and selling the collateral. Any cash flows that are expected from the realisation of the collateral beyond the contractual maturity of the contract should be included in the analysis. Under IAS 39, instead of expected cash flows, an entity can measure the fair value of the collateral on the reporting day to assess whether impairment has incurred; future changes in fair value are not considered in this assessment. IFRS 9 states that the focus is on cash flows that are expected to be received in the future. Moreover, expected cash flows are probabilityweighted and, thus, include possible scenarios. UniCredit Research page 16 See last pages for disclaimer.

17 Hedge Accounting IFRS 9 implements a principle-based standard that aligns hedge accounting more closely with risk management. The hedge accounting model under IAS 39 is often described as too complex, impractical and excessively rule-based. The three types of hedge accounting remain the same: cash flow hedge accounting, fair value hedge accounting and hedge of a net investment in a foreign operation. However, there have been changes to the types of transactions that are eligible for hedge accounting (hedging instruments as well as hedged items). The IAS 39 effectiveness test was replaced with a principle of an economic relationship and the assessment of the hedge effectiveness is no longer required to be retrospective. Moreover, a voluntary discontinuation of a hedging relationship that met the qualifying criteria is not permitted any longer under IFRS 9. Macro hedge accounting The IASB has decided to separately develop guidance for macro hedge accounting. IAS 39 contains a hedge accounting model for portfolio fair value hedges of interest rate risk. While the project on macro hedging is ongoing, the IASB decided that the IAS 39 requirements on fair value hedges of interest rate risk would be maintained for macro hedge accounting. Eligible instruments Hedging instruments Under IAS 39, only instruments that meet the definition of derivatives are eligible to be hedging instruments. The only exception is non-derivative financial instruments that can be used to hedge foreign currency risks. IFRS 9 expands the eligible hedging instruments by nonderivative financial instruments measured at FVTPL. Written options and embedded derivatives are still excluded from hedge accounting. Designation A hedging instrument must generally be designated in its entirety as a hedging instrument. The only exceptions are the following: Only the change in the intrinsic value of an option can be designated as the hedging instrument. Only the change in the value of the spot element of a forward contract can be designated as the hedging instrument; similarly, the foreign currency basis spread can be separated and excluded from the designation of a financial instrument as the hedging instrument. A proportion of the entire hedging instrument (e.g. 50% of the notional amount) can be designated as the hedging instrument. However, a hedging instrument may not be designated for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding. UniCredit Research page 17 See last pages for disclaimer.

18 Intrinsic and time value can be separated Time value of a purchased option Under IFRS 9, an entity can separate the intrinsic value and time value of a purchased option and designate only the change in the intrinsic value as the hedging instrument. The intrinsic value is the difference between the underlying's price and the strike price. Any premium that is in excess of the option's intrinsic value is referred to as time value. However, the time value of an option decreases over time as the option approaches expiry. Under IAS 39, the change of the time value of an option is recognized in profit and loss, which can lead to volatilities in earnings. Under IFRS 9, if only the intrinsic value of an option is designated as the hedging instrument, the change in the fair value of the time value of the option is recognized in OCI to the extent that it relates to the hedged item (this is not a choice, but a requirement). The time value of a purchased option is considered to be a cost of obtaining protection against unfavorable changes in prices, similar to an insurance premium. However, an entity must determine whether a purchased option hedges a transactionrelated or a time-period-related hedged item, based on the nature of the hedged item. This, in turn, determines how and when fair value changes are recognized in OCI or affect profit and loss. Transaction-related hedged items The accumulated amount recognized in OCI has to be reclassified as follows: The hedged item may subsequently result in the recognition of a non-financial asset or liability. In this case, the amount is removed and included directly in the initial cost or carrying amount of the hedged item. In other cases, the amount is reclassified to profit or loss in the same period(s) during which the hedged expected future cash flows affect profit or loss. Any portion of the time value recognized in OCI that is not expected to be recovered in future periods will be immediately reclassified in profit or loss. Time-period-related hedged items The accumulated amount recognized in OCI has to be reclassified as follows: The time value at the date of designation of the hedging relationship is amortized over the period during which the hedge adjustment for the option s intrinsic value could affect profit or loss. In each reporting period, the amortization amount is reclassified from equity to profit and loss as a reclassification adjustment. If the hedging relationship is discontinued, the net amount that has been accumulated in OCI is reclassified immediately in profit and loss. Forward contracts and foreign currency basis spreads Excluded portion is treated as a cost of hedging An entity can separate the forward element and the spot element of a forward contract and designate only the change in the spot element as the hedging instrument. The forward element of a forward contract represents the difference between the forward price and the current spot price of the underlying. Also, the foreign currency basis spread of a financial instrument can be separated and excluded from the designated hedging instrument. Foreign currency basis spreads are usually found in cross-currency swaps and can be seen as a charge to convert one currency into another. UniCredit Research page 18 See last pages for disclaimer.