www.pwc.com Financial instruments Financial instruments Disclosures Hedging Impairment Derecognition Accounting for financial assets and financial liabilities Compound Instruments Equity or liability Definitions Fair values under IFRS 13 1
Financial instruments IFRS 9 development Project phase Exposure draft Status / next steps 1a. Classification & measurement of financial assets 1b. Classification & measurement of financial liabilities 2. Impairment Original ED in Nov 2009 Jul 2009 IFRS 9 published in Nov 2009 Redeliberations on-going May 2010 Added to IFRS 9 in Oct 2010 Supplement in Jan 2011 Second ED in Mar 2013 Finalised deliberations in Feb 2014 Added to IFRS 9 in July 2014 3a. General hedge accounting Dec 2010 Added to IFRS 9 in Nov 2013 3b. Macro hedge accounting De-coupled from IFRS 9 project in May 2012 Transition When does IFRS 9 become mandatory? Annual periods beginning on or after 1 January 2018 Full retrospective application on adoption but Discussion paper issued in April 2014 (Comments by Oct 2014) - Restatement of comparatives is not required but is permitted if it can be done without the benefit of hindsight - If comparatives are not restated the opening balance of its retained earnings should be adjusted Operational simplifications exist to ease retrospective application 2
Definitions Financial assets Financial instruments Financial liabilities (a) Cash (a) Contractual obligation to: (b) Equity instrument of (i) deliver cash/ another entity another FA (c) Contractual right to: (ii) exchange FA/FL - receive cash/another FA under conditions - exchange FA/FL under potentially conditions potentially unfavourable favourable (b) Contract that may/will be (d) Contract that may/will be settled in entity s own settled in entity s own equity equity Contents Accounting for financial assets and financial liabilities Compound Instruments Equity or liability Definitions Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity Equity instruments Any contract that evidences a residual interest in the net assets of an entity 3
Financial assets new model summary Contractual cash flow characteristics + Business model test All other instruments Equities, derivatives & some hybrid contracts Amortised cost (Original exposure draft) Fair value through P&L No bifurcation Fair value option Accounting mismatches only Option to take gains & losses to OCI for equities No recycling Reclassification required where business model changes Financial assets new model summary Contractual cash flow characteristics + Business model test All other instruments Equities, derivatives & some hybrid contracts Hold to collect Hold to collect and sell Amortised cost Fair value through OCI Fair value through P&L No bifurcation Fair value option Accounting mismatches only Option to take gains & losses to OCI for equities No recycling Reclassification required where business model changes 4
Contractual cash flows Contractual cash flow characteristics Business model test + Business model Contractual cash flow characteristics + Business model test Do contractual cash flows represent solely payments of principal and interest (SPPI)? Principal Interest in principal outstanding Time value of money Credit risk P P Leverage / multiples Non-financial variables Conversion features Factors to consider: P O O O The way assets are managed How performance is reported How management are compensated P Frequency, timing and volume of sales in prior periods Expectations of future sales activity Why past and future sales have or will be made Sales in stress case scenarios do not disqualify hold to collect Entity forced by regulator to routinely sell significant volumes to demonstrate liquidity of assets will fail hold to collect business model 5
Business model test Hold to collect Hold to collect and sell Fair value through profit or loss Subsequent measurement Most financial liabilities Amortised cost Objective to hold the asset until redeemed Sales themselves do not determine the business model and cannot be considered in isolation This can apply to situations where the objective is to manage everyday liquidity needs, maintain a particular interest yield profile and match the duration of assets to liabilities The default category of business model if fail to meet the hold to collect or the hold to collect and sell Decisions are made to hold or sell based on the fair value of the instrument FINANCIAL LIABILITIES FL at FV through P/L Fair Value (changes in P/L) IAS 12 39 6
Financial liabilities Retain IAS 39 measurement requirements Held for trading Vanilla liabilities Hybrid instruments Fair value through P&L Amortised cost Bifurcation Maintain fair value option but with one amendment regarding own credit risk Implementation challenges The new classification and measurement requirements will represent a challenge, especially for financial institutions, as management will need to assess their financial assets classification in light of the new business model requirements This new model is substantially different Business model assessment is a highly judgmental area Requirement to document the reasons behind the assessment Monitor sales to determine impact The business model assessment is also dependent on the history of how the entity has achieved the objective in the business model This process might take a significant amount of time, so it is advisable that entities should start planning their transition to IFRS 9 in order to make sure that they are ready for when the new standard becomes effective. 7
Classification and measurement Summary of impact on corporates! Equities measured at FVTPL unless FVOCI election taken up for non trading assets. Entities need to assess debt instruments under the business model and SPPI tests to determine whether the measurement basis is amortised cost or FVOCI. Instruments that do not meet one of the two tests are measured at FVTPL. No bifurcation of embedded derivatives for financial assets Likely to impact AFS assets which could previously be voluntarily measured at FVOCI. Contents Impairment Derecognition Accounting for financial assets and financial liabilities Compound Instruments Equity or liability Definitions 8
Impairment Incurred loss model Currently used by IAS 39 Credit losses are recognised only if an event has occurred that has a negative effect on future cash flows & that effect can be reliably estimated An entity is not permitted to consider the effects of future expected losses The challenge Financial meltdown Too big to fail Cliff effect Risk taking Unrealised v realised profits Complex disclosures G20, Governments and politics Bonus culture Expected loss model The way forward Requires an entity to make an ongoing assessment of expected credit losses Will require earlier recognition of credit losses in many cases Difference between IFRS and US GAAP in approach Impact on impairment losses fear or reality? IASB fieldwork in 2013: Expectation of an increase of 25-60% on portfolios excluding mortgages and an increase of 30-250% on mortgages (caveat only 15 banks from around the world responded!) 2014 survey of 54 major banks including 11 of the 17 GISIFIs reporting under IFRS: Expected increase in recognition of impairment losses of around 50% as a result to expected loss model 9
Impact on impairment losses fear or reality? Analysts at Barclays have calculated how 27 of Europe s biggest banks would fare under new global rules governing how much lenders should set aside for potential bad loans. They found that the rules would trigger an increase of about 34 per cent in loan loss provisions across the group, as well as lower bank valuations and more volatile earnings. Spain s Caixa, Italy s UBI and the UK s Standard Chartered are the most affected by the change in the IFRS 9 rules. Caixa s common equity tier one ratio would fall by about 1.7 per cent as a result of the higher loan losses triggered by the rules, Barclays said, while Standard Chartered s and UBI s would fall by about 1.3 per cent. Impact on impairment losses fear or reality? IASB fieldwork in 2013: Expectation of an increase of 25-60% on portfolios excluding mortgages and an increase of 30-250% on mortgages (caveat only 15 banks from around the world responded!) 2014 survey of 54 major banks including 11 of the 17 GISIFIs reporting under IFRS: Expected increase in recognition of impairment losses of around 50% as a result to expected loss model 2016 survey of 91 major banks including 14 of the 17 GISIFIs reporting under IFRS: Expected increase in recognition of impairment losses of up to 25% as a result of adopting IFRS 9 ECL model 10
Scope exclusions Financial assets credit impaired on initial recognition Trade receivables without a significant financing component Low credit risk Includes both originated and purchased credit-impaired assets Outside of scope of the above model Use credit adjusted effective interest rate No day 1 allowance balance No day 1 impairment loss recognised Allowance balance represents changes in lifetime loss expectations Consistent with IAS 39 (AG5) Practical expedient to enable entities to calculate losses using certain current practices eg, group receivables by age and applying historical loss rates Implied application to non-financial services entities Recognition of full lifetime expected loss on a matrix model basis If the credit risk is determined to be low at the reporting date Impairment can be measured using 12-month ECL Presumption that no significant increase in credit risk has occurred There is a low risk of default Borrower has strong capacity to meet obligations in the short term Adverse changes in economic or business conditions in the longer term wont necessarily reduce ability to fulfil obligations 11
Expected credit losses General model Change in credit quality since initial recognition Recognition of expected credit losses 12 month expected credit losses Interest revenue Effective interest on gross carrying amount Stage 1 Stage 2 Stage 3 Performing (Initial recognition*) Lifetime expected credit losses Effective interest on gross carrying amount Underperforming (Assets with significant increase in credit risk since initial recognition*) *Except for purchased or originated credit impaired assets Regulatory v standards Regulatory PD vs IFRS 9 PD Regulatory PD Through the cycle ( TTC ) Hard to reconcile both! Lifetime expected credit losses Effective interest on amortised cost carrying amount Non-performing (Credit impaired assets) IFRS 9 PD Point in time ( PiT ) 12
Significant increase in credit risk The following indicators were identified: Change in internal price indicators of credit risk - Change in credit spread, rates, terms, collateral, guarantees or covenants if issued now Changes in market indicators of credit risk - Change in credit spread, credit default swap price, fair values below amortised cost value, changes in the prices of borrowers other instruments Change in externally or internally derived credit rating of borrower Change in general economic or market conditions, regulatory or technology environment of the borrower Change in actual or expected performance of the borrower Values of underlying collateral Changes in guarantee quality Change in the loan documentation Change in credit risk management Significant increase in credit risk The following indicators were identified: Change in internal price indicators of credit risk - Change in credit spread, rates, terms, collateral, guarantees or covenants if issued now Changes in market indicators of credit risk Rebuttable - Change in credit spread, credit default swap price, fair values below amortised cost value, changes in the prices ofpresumption borrowers other instruments Credit risk has increased Change in externally or internally derived credit rating of borrower significantly when Change in general economic contractual or market payments conditions, are regulatory or technology environment of the borrower more than 30 days past due Change in actual or expected performance of the borrower Values of underlying collateral Changes in guarantee quality Change in the loan documentation Change in credit risk management 13
Indications for a significant increase in credit risk what the banks say One missed payment is most likely trigger with more than 30 days late indicating significant increase in credit risk Change in PD is next most likely trigger with relative change in PD being used rather than absolute change Other triggers include management review committee thresholds exceeded and changes in the economic return Measurement of expected credit losses Expected credit losses are a probability weighted estimate of the present value of all cash shortfalls discounted at the original effective interest rate over the expected life of the financial instrument An entity should measure in a way that reflects: An unbiased and probability weighted amount that is determined by evaluating a range of possible outcomes; The time value of money; and 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 14
Key challenges Data Parallel running System selection Finance and Risk The quality of data especially historical credit information is a major issue for banks, especially smaller ones Due to the slow response banks will not have the time to test IFRS 9 systems before go live date. Banks will require some system capabilities to implement the changes. In our experience, this aspect has not been thought through yet. Still tendency with some banks that one or the other department dominates projects. Both departments need to work together and align approaches. And in other news 70% of banks believe that there will be a reduction of up to 50 bps in core tier 1 capital ratio with the vast majority unsure as to how regulators will incorporate IFRS 9 numbers into regulatory capital Price makers expect that adopting an ECL model will impact product pricing whilst price takers believe that it is unlikely to have an impact on price Half of all banks believe they have insufficient technical resources Half of all banks do not plan to disclose quantitative data before 2018 Availability of the origination lifetime PD is the biggest data concern 75% of IFRS 9 programme budgets are as yet unspent 15
Contents Key points Types of hedging relationship, accounting mechanics and presentation requirements largely unchanged Rules on using nonderivative financial instruments and purchased options as hedging instruments relaxed Hedging Impairment Derecognition Accounting for financial assets and financial liabilities Compound Instruments Equity or liability Definitions New requirements to achieve, continue and discontinue hedge accounting Extensive new disclosures required Additional exposures may now be hedged items Transition generally prospective 16
Hedging Hedged item An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that exposes the entity to risks of changes in fair value or future cash flows and is designated as being hedged Hedging instrument Designated derivative or other financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value of the designated hedged item Most often a derivative Gains and losses on hedged items and hedged instruments can be accounted for under hedge accounting rules provided the hedging relationship is formally designated & documented and expected to be highly effective. Risk management strategy The risk management strategy is the highest level at which an entity determines how it manages its risk Typical documentation includes Governance of the risk management activities Description of the risks Risk appetite Time period over which a risk is managed List of instruments that could be used to hedge Risk limits 17
Hedging types Fair Value Hedge Cash Flow Hedge Hedging types Fair Value Hedge Cash Flow Hedge Hedge of fair value of a recognised asset or liability Hedge of cash flow volatility associated with a recognised asset or liability Hedge of fair value of a recognised asset or liability or unrecognised firm commitment Hedge of cash flow volatility associated with a recognised asset or liability or highly probable forecast transaction 18
Hedging types Fair Value Hedge Cash Flow Hedge Hedge of fair value of a recognised asset or liability or unrecognised firm commitment Hedge of cash flow volatility associated with a recognised asset or liability or highly probable forecast transaction Hedged item & hedging instrument re-measured to fair value via profit or loss Effective gain or loss on hedging instrument to equity until hedged item affects profit or loss Outcome is that gains & losses on hedged item and hedged instrument matched in P/L in same period Hedging a recognised asset fair value hedge XYZ plc owns stocks of 12,500 barrels of oil which cost $500,000 on 1.12.2016. In order to hedge the fluctuation in the market value of the oil the company signs a futures contract to deliver 12,500 barrels of oil on 31.3.2017 at the futures price of $42.10 per barrel. The market price of oil on 31.12.2016 is $42 per barrel and the futures price for 31.3.2017 delivery is $44.05 per barrel. How would this be accounted for if the derivative did not qualify for hedge accounting? What if it did qualify for hedge accounting? 19
Hedging a recognised asset fair value hedge Inventory no hedge accounting Measure at cost Gain recognised when sold Derivative Re-measure to fair value Loss 31.12.16 Loss of 12,500 * ($44.05-$42.10) = $24,375 Inventory with hedge accounting Re-measure to fair value Gain of (12,500 x $42) 500,000 = $25,000 Loss 31.12.16 Mismatch Gain Hedging a recognised asset fair value hedge Gain Net profit or loss impact is Derivative a gain of $625. Re-measure to fair value Loss of 12,500 * ($44.05-$42.10) = $24,375 20
Hedging a highly probable forecast transaction An entity expects to have to undertake repairs to a ship next year due to changing regulations. It is uncommitted to this transaction but it is highly probable that the work will be undertaken. The repair work will be undertaken in Singapore at a cost of S$60 million and therefore the entity is exposed to movements in the exchange rate. It therefore enters into a futures contract, buying forward S$60 million at a rate of US$1 = S$3. The futures price on 31.12.16 (the company s year end) is S$3.25. How would this be accounted for if the derivative did not qualify for hedge accounting? What if it did qualify for hedge accounting? Hedging a highly probable forecast transaction Highly probable forecast transaction Not on statement of financial position Gain recognised when paid Loss 31.12.16 Derivative no hedge accounting Re-measure to fair value Loss of S$60m/3.00 - S$60m/3.25 = US$1,538,462 Mismatch Gain 21
Hedging a highly probable forecast transaction Highly probable forecast transaction Not on balance sheet Gain recognised when paid Derivative with hedge accounting Loss 31.12.16 Re-measure to fair value but gain or loss deferred in OCI Loss of S$60m/3.00 - S$60m/3.25 = US$1,538,462 Main benefits relate to hedge accounting! Gain and loss recognised in the same accounting period. Gain Hedge Accounting- How will corporates benefit from IFRS 9? Simplification of hedge accounting and brings it in line with an entity s risk management strategy Effectiveness testing is now more relaxed Removes many of the provisions that made it difficult to apply hedge accounting under IAS 39 Exposures permitted to be hedged have expanded. For eg risk components of non financial items Better accounting treatment available for options 22
IFRS 9 for corporates 23