Regulatory Guidance Conversion to International Financial Reporting Standards (IFRS)

CREDIT UNION STABILIZATION FUNDS OF CANADA IFRS REGULATORS WORKING GROUP Regulatory Guidance Conversion to International Financial Reporting Standards (IFRS) May 2010 TABLE OF CONTENTS I. Introduction 1 II. Principles 3 III. Transition to IFRS... 4 IV. Securitizations/Syndications/Sales of Loans 4 V. Financial Instruments 6 VI. VII. VIII. IX. Loan Loss Provisioning 8 Property Plant & Equipment 10 Business Combinations 10 Joint Ventures 11 X. Lease Originations 11 XI. XII. XIII. Employee Benefits 12 Provisions & Contingencies 12 Disclosures....13 Regulatory Guidance Page 1

I. Introduction Purpose Credit unions are required to implement International Financial Reporting Standards (IFRS) for their fiscal year commencing in 2011. This final guidance outlines regulatory direction and requirements in implementing IFRS, and is intended to respond to specific accounting and regulatory capital issues highlighted by the National IFRS Readiness Initiative on behalf of credit unions. This document should be used by provincial regulators as a foundation for communication to their respective credit union system. The mandate of the RWG is to facilitate consistent communication across provinces. However, the RWG recognizes that individual regulators will incorporate provincially-specific perspectives, addressing challenges and feedback unique to their own jurisdiction. Background The Office of the Superintendent of Financial Institutions (OSFI) issued a Final Advisory on March 31, 2010 to federally regulated entities (FRE s) on requirements for the implementation of IFRS. This advisory may be reviewed at: http://www.osfi-bsif.gc.ca/app/docrepository/1/eng/guidelines/capital/advisories/ifrs_e.pdf The Credit Union Stabilization Funds of Canada IFRS Regulators Working Group (RWG) reviewed OSFI s Final Advisory as well as the issues raised by the National IFRS Readiness Initiative to develop relevant and consistent regulatory guidance for Canadian credit unions. The RWG believes this guidance aligns credit unions application of IFRS with other financial entities reporting under IFRS and is not to be interpreted in a way that is inconsistent with or contrary to IFRS. Applicable IFRSs Unless otherwise indicated, this guidance refers to IFRSs issued as at March 31, 2010 that are effective for fiscal years beginning on or after January 1, 2011. International Standards Board (IASB) projects that might result in a new or revised IFRS being effective on or before January 1, 2011 have been considered by the RWG. While the changes to IFRS resulting from these projects will require consideration when final, the likely outcomes (standards) of the IASB projects are not expected to require changes to this guidance. Early Adoption OSFI s Final Advisory states: The IASB is currently working on several projects that will be finalized in 2010 and 2011. Projects completed in 2010 an 2011 are likely to have mandatory effective dates no earlier than 2012, 2013 or 2014. Some of the projects on the IASB s work plan for the next two years have been identified by OSFI and the FRE s as having a potential material impact to financial reporting and / or regulatory capital. OSFI will consider Regulatory Guidance Page 2

allowing early adoption by FRE's on a standard by standard basis once a particular IFRS is issued in final form. After OSFI has completed an impact analysis and consultation on each new standard that is potentially relevant to FRE s, OSFI will separately communicate its decision on early adoption for that IFRS. Accordingly, unless otherwise communicated by OSFI, FRE s should not early adopt IFRS s. For IFRS 9 Financial Instruments, financial liabilities, impairment and hedging form an integral part of the comprehensive Financial Instruments standard. As these areas are still being developed by the IASB, OSFI will perform an analysis of the impacts of the comprehensive standard once all the components are issued and will decide at that time whether to permit early adoption. OSFI will communicate its decision once the analysis and consultation phases have been completed. In the meantime, the current IFRS 9, which addresses only the classification and measurement of financial assets, should not be adopted earlier than its mandatory effective date. The RWG will continue to monitor the IASB s progress on its various projects, and OSFI s communications in response. As a part of its own review of the upcoming changes to IFRS, the RWG will consider permitting early adoption, providing that the principles below are not compromised. II. Principles Broad principles were created to guide the RWG through the development of draft guidance on the issues raised by the National IFRS Readiness Initiative. These principles align with those of OSFI, and recognize the unique environment in which credit unions operate. The principles developed were: 1. Consistency with other Canadian regulatory bodies. A consistent regulatory response supports a level playing field for credit unions in the financial industry and facilitates leveraging the work and experience of regulators across the country. 2. Minimize additional regulatory requirements. Resources in the credit union system are under considerable pressure in meeting obligations under IFRS. Requirements will be minimized and issued only to support identified potential risks to prudential monitoring or regulatory capital. 3. Financial statements of different credit unions should be materially comparable. Comparable statements support prudential monitoring. Regulatory Guidance Page 3

III. Transition to IFRS IFRS 1, First-time Adoption of International Financial Reporting Standards, sets out the procedures that an entity must follow when it adopts IFRS for the first time. In the absence of IFRS 1, retrospective application of all standards would be required upon transition. IFRS 1 instead provides a set of optional and mandatory exceptions and exemptions to IFRS that are designed to provide entities some relief from full retrospective application. The choices made by credit unions with respect to the IFRS 1 exemptions will impact opening retained earnings and/or Accumulated Other Comprehensive Income, which may, in turn, have an impact on regulatory capital. The RWG requires that, except for own use property as noted in Section VII: Property Plant & Equipment, in the absence of a systemically material impact on capital, the net impact to retained earnings from IFRS 1 be recognized in regulatory capital. The RWG acknowledges that the net impact on credit unions varies significantly across the country. Therefore, it will be left to the discretion of individual Regulators on the appropriate phase-in period, if necessary, for net impact on regulatory capital. The regulatory financial reporting forms and related guidance will be revised over the coming months so that final versions of all documentation are available in advance of the IFRS transition date. IV. Securitization/Syndications/Sales of Loans International Standard (IAS) 27, Consolidated and Separate Financial Statements and Standard Interpretations Committee (SIC) 12 Consolidated Special Purpose Entities, and IAS 39, Financial Instruments: Recognition and Measurement provide guidance on de-recognition of financial instruments and principles on consolidation of subsidiaries and special purpose entities. These standards may require many Canadian securitizations and off balance sheet structures to be reported on the balance sheet and permits fewer assets to be derecognized compared to current CGAAP. If so, adoption of these standards will likely increase the risk weighted assets and secured financings of credit unions. Regulatory Guidance Page 4

RWG recommendation: OSFI has advised that certain securitizations will be grandfathered and excluded from capital requirements. The following is taken from OSFI s final guidance: Insured mortgages securitized through the Canada Mortgage and Housing Corporation s (CMHC s) National Housing Act Mortgage-Backed Securities (NHA MBS) and Canada Mortgage Bond (CMB) Programs, as well as the Insured Mortgage Purchase Program (IMPP), collectively referred to hereafter as the CMHC Programs, are unlikely to achieve derecognition, and if so, will therefore be brought on balance sheet under IFRSs. To facilitate compliance with the ACM (Asset to Capital Multiple) under IFRS s and permit an orderly transition, OSFI will permit mortgages sold through CMHC Programs, up to and including March 31, 2010 to be excluded from the ACM calculation under IFRSs. For CMB/IMPP transactions completed up to and including March 31, 2010, all existing and future reinvestments newly reported on the balance sheet as a result of IFRSs will also be excluded from the ACM upon conversion to IFRSs. Credit unions operating in provinces that include an asset to capital ratio in their regulatory framework will have the same grandfathering available to them as the FRE s noted above. Credit unions should review the documentation and substance of all securitizations, syndications, and sales of loans (mortgage pools). In the event that these agreements are recognized on the balance sheet, credit unions will be required to apply the appropriate risk-weight for these assets in accordance with the current regulatory capital framework. There may also be a reduction in retained earnings and regulatory capital as a result of any reversal of any prior period gains or losses on sales associated with CMHC programs as well as gains or losses resulting from bringing back assets on balance sheet when securitized assets are no longer derecognized. Regulatory Guidance Page 5

V. Financial Instruments Although the accounting concepts under IFRS are closely aligned with CGAAP there are a number of differences. The differences require institutions to carefully review the details in the standards. For example, CGAAP requires all changes in fair value of Available for Sale securities (including foreign exchange gains/losses) to be recorded in Other Comprehensive Income. IFRS requires the foreign exchange gains/losses to be recorded in Income. (This may have an impact where Accumulated Other Comprehensive Income is excluded from regulatory capital) The National IFRS Readiness Project Webinar on Financial Instruments identified high priority areas for credit unions to focus on, including: 1. Fair Value Option ( FVO ) 2. Changes in Classifications of Financial Instruments 3. Presentation of Member Shares 4. Hedging 1. Fair Value Option (FVO): IAS 39 Financial Instruments: Presentation and Measurement allows entities an option to designate a financial asset or financial liability at fair value through profit or loss upon initial recognition. This is similar to the option available in CGAAP but provides more criteria or limitations on when the FVO can be selected. Before making a decision to use the FVO it is important to consider: the reliability of estimated fair values when observable market prices are not available, and the prerequisite for a documented risk management strategy and the ability to demonstrate that significant financial risks are eliminated or significantly reduced. Reference to industry guidance and practices with respect to the FVO is an important consideration for credit unions in making a decision on using the FVO. OSFI Guideline D-10 [http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?articleid=3297] for federally regulated institutions is generally consistent with IAS 39 criteria. It identifies an industry recognized restriction that FVO is not to be used for loans to individuals or loans to companies with annual gross revenue less than $62.5 million. Regulatory Guidance Page 6

The RWG is not providing additional regulatory guidance or clarification on this issue. 2. Changes in Financial Instruments Classification (at opening balance sheet date) Upon the transition to IFRS there is a one-time opportunity to reclassify financial instruments from Held for Trading (HFT) to either Available for Sale (AFS) or Fair Value Through Profit and Loss (FVTPL), provided that the criteria are met. A reclassification of the financial asset previously designated as HFT to AFS may be considered to obtain a better matching and/or eliminate the volatility in earnings. All financial instruments should be reviewed prior to the transition to IFRS to determine if it is appropriate to reclassify them to AFS or FVTPL. Depending on the reclassifications made, any adjustments may impact opening Retained Earnings or Accumulated Other Comprehensive Income. The RWG is not providing additional regulatory guidance or clarification on this issue. 3. Presentation of Member Shares Under IAS 32 Financial Instruments: Presentation and IFRIC 2 Member shares in Co-operative Entities all credit union shares will need to be reviewed to confirm correct financial statement presentation. Refer to the Decision Tree in the Financial Instruments Toolkit posted on Canadian Central s site to assist in determining the classification of member shares as liability or equity under IFRS [http://www.cucentral.ca/ifrs]. Shares currently presented as equity which are determined to be classified as liabilities under IFRS will affect the financial statement presentation but will not change the calculation of regulatory capital on the regulatory financial reporting forms submitted by credit unions. For clarification, members equity includes member shares required for membership as well as other member shares that qualify for regulatory capital. Regulatory Guidance Page 7

The RWG is not providing additional regulatory guidance or clarification on this issue. 4. Hedging IAS 39 Financial Instruments Classification and Measurement identifies three types of hedging relationships and specifies their accounting treatment. The three types of hedging relationships are fair value hedge; cash flow hedge; and hedge of a net investment. Unlike CGAAP, IFRS prohibits the use of the critical terms match approach or the short cut method for demonstrating hedge effectiveness. A quantitative method must be developed, documented and employed. All hedging transactions should be reviewed prior to the IFRS transition date to assess whether hedging strategies are eligible or not and to document and test the effectiveness at transition in order to maintain hedge accounting treatment under IFRS. If they do not meet the effectiveness test, they will be de-designated as an eligible hedging strategy on the IFRS transition date. The RWG is not providing additional regulatory guidance or clarification on this issue. VI. Loan Loss Provisioning IAS 39 Financial Instruments: Recognition and Measurement outlines the requirements for impairment of financial assets including the principles and requirements for determining loan loss provisions. While IFRS is somewhat more detailed in its requirements and measurement of loss provisions, IAS 39 is considered to be similar to CGAAP Section 3025 as both are based on incurred loss models. Also, the two standards incorporate consideration of similar events (e.g. financial difficulty, delinquency, probable bankruptcy and economic conditions such as an increase in unemployment rates, a decrease in property values etc.). IAS 39 requires a detailed documented provision methodology that incorporates historical loan loss experience. However, credit unions may apply experienced judgment to estimate the amount of any impairment where observable data is not available or is limited, or is no longer fully relevant to current circumstances as outlined in paragraph 62. In fact, as indicated the use of reasonable estimates is an essential part of the preparation of financial statements. Additionally, credit unions should note that IAS 39 subparagraph 59(f)(ii) provides good examples of objective evidence relating to national or local economic conditions that correlate with defaults on the Regulatory Guidance Page 8

assets in the group (e.g. an increase in the unemployment rate in the geographical area of the borrowers, a decrease in property prices for mortgages in the relevant area, a decrease in oil prices for loan assets to oil producers, or adverse changes in industry conditions that affect the borrowers in the group) for incorporation into collective provisions. Credit unions will need to develop an appropriate methodology that fully recognizes IAS 39 requirements for determining loan loss provisions based on their own individual circumstances and the complexity of their loan portfolio. In determining an appropriate methodology we encourage credit unions to refer to industry guidelines and best practices. For example: OSFI o Guideline C-1, Impaired Loans [http://www.osfibsif.gc.ca/app/docrepository/1/eng/guidelines/accounting/guidelines/loan s/c1_e.pdf] outlines a number of indicators of impairment which are considered to be within the principles outlined in IAS 39. o Guideline C-5, General Allowance for Credit Risk [http://www.osfibsif.gc.ca/app/docrepository/1/eng/guidelines/accounting/guidelines/loan s/c5_e.pdf] provides additional guidance for establishing the collective (general) provision to ensure that the provision appropriately reflects the inherent loss in an institution s loan portfolio. The guideline also reinforces OSFI s expectation for a robust loan loss provisioning model that incorporates the Basel Committee on Banking Supervision principles in the paper issued June 2006 entitled Sound credit risk assessment and valuation for loans [http://www.bis.org/publ/bcbs126.pdf]. National IFRS Readiness Initiative Loan Loss Provisioning Toolkit Information provided by credit union external auditors Other provincial guidance Regulators should ensure terminology within legislation is consistent with IFRS 39. Regulatory Guidance Page 9

VII. Property, Plant & Equipment IAS 16, Property, plant and equipment, permits property being held for an entity s own use to be valued at cost or using the revaluation model at the time of transition, and on an ongoing basis. IAS 40, Investment Property, permits investment property to be valued at cost or fair value at the time of transition, and on an ongoing basis. There is an IFRS 1 election available for property, plant and equipment called the deemed cost exemption. An entity is allowed to re-measure an item on the date of transition to fair value or a revalued amount, and deem that amount to be the new cost basis going forward. The offsetting adjustment is recorded in as a revaluation surplus in equity as at the transitional date. For own-use property, any fair value gains or losses upon transition and subsequent revaluation gains and losses to be excluded in determining regulatory capital, as these assets are not easily sold without disrupting the operations of the entity. This exclusion from capital will be addressed in credit unions regulatory financial reporting forms. For investment property, any fair value gains or losses upon transition and subsequent revaluation gains and losses to be recognized in determining regulatory capital. For mixed-use property, the regulatory capital treatment will be based on the IFRS reporting requirements, unless legislation defining own-use and investment property exists. VIII. Business Combinations IFRS 3, Business Combinations, requires the acquisition method of accounting to be used for all business combination transactions, creating the possibility of increased levels of goodwill. IAS 36, Impairment of Assets, requires goodwill to be assessed for impairment at least annually, with negative goodwill being recognized immediately in profit and loss. IFRS 1, First-time Adoption, permits a credit union to either apply IFRS 3 retrospectively from a date of its choosing or to choose not to restate any prior business combinations under IFRS 3. However, credit unions must still comply with the requirements of Appendix C of IFRS 1. Regulatory Guidance Page 10

IX. Joint Ventures IAS 31, Interests in Joint Ventures requires the use of the equity method of accounting or the proportionate consolidation method. X. Lease Originations IAS 17, Leases, sets out detailed guidance with respect to the classification, recognition, measurement and disclosure of both finance leases and operating leases. Leases are classified at the inception of a lease as either a finance lease or an operating lease, based on whether or not substantially all the risk and rewards incidental to ownership are transferred. Both IFRS and CGAAP provide the same criteria for determining the appropriate classification of a lease: transfer of ownership, bargain purchase, lease term vs. economic useful life, present value vs. fair value of minimum lease payments. However, IAS 17 requires the assessment to be based on all facts and circumstances and requires more judgment than CICA 3065. IAS 17 provides that for leased assets of a highly specialized nature, where only the lessee can use them without major modifications, the lease could be classified as a finance lease. IAS 17 also includes other considerations that are not explicitly set out in CGAAP. Regulatory Guidance Page 11

XI. Employee Benefits IAS 19, Employee Benefits, provides accounting and reporting standards for employee benefits which includes short term as well as long term benefits. This standard covers defined contribution plans, defined benefit plans and short term benefit plans as well as providing guidance for treatment of termination benefits, actuarial gains and losses and treatment of past service costs. IAS 19 requires that the actuarial gains / losses be recognized by using one of the four alternative accounting policies; Recognized in income immediately Recognized directly in other comprehensive income 10% corridor approach Another systematic method as long as it is faster than corridor approach XII. Provisions & Contingencies IAS 37, Provisions, Contingent Liabilities and Contingent Assets, introduces different thresholds for financial reporting of provisions and contingencies, relative to current CGAAP. These thresholds may recognize assets or liabilities presently not on a credit union s balance sheet, derecognize existing assets or liabilities, or create the need for additional disclosure. The result is a potential impact to regulatory capital with the change in assets, liabilities, and gains or losses being recognized through profit and loss. Regulatory Guidance Page 12

XIII. Disclosures IAS 1, Presentation of Financial Statements, sets out the overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content. The recognition, measurement and disclosure requirements for specific transactions and other events are dealt with in other IFRS. Under IFRS, disclosures tend to be more detailed and require credit unions to disclosure judgments when applying an accounting policy that would significantly affect amounts recognized in the financial statements. Paragraph 24 of IFRS 1 requires credit unions to prepare a number of reconciliations explaining how the transition from CGAAP to IFRS affected its reported financial position, financial performance and cash flows. These reconciliations include the following: (a) Reconciliation of Equity reported in accordance with previous CGAAP to Equity in accordance with IFRS for both of the following dates: (i) The date of transition to IFRS for December year-end credit unions, January 1, 2010 or for September year-end credit unions, October 1, 2010; and (ii) The end of the latest period presented in the entity s most recent annual financial statements in accordance with previous CGAAP for December year-end credit unions, December 31, 2010 or for September year-end credit unions, September 30, 2011; and (b) A reconciliation of Total Comprehensive Income in accordance with IFRS for the latest period in the credit union s most recent annual financial statements for December year-end credit unions, December 31, 2010 or for September year-end credit unions, September 30, 2011. These reconciliations are required to provide users of financial statements with a link between the previous CGAAP amounts and those prepared in accordance with IFRS. The RWG acknowledges that data collection related to the impacts of IFRS varies among the individual Regulators. Therefore, content and timing of data collection will be left to the discretion of individual Regulators. Regulatory Guidance Page 13