Accounting for Financial Instruments (IAS 39) Salzburg - Financial Instruments April 2018 - nur IAS 39.pdf · Accounting for Financial Instruments (IAS 39) Salzburg, April 4, 2018

Accounting for Financial Instruments

(IAS 39)

Salzburg, April 4, 2018

Martin Gehringer

2

Investment portfolio of insurers

Scope of IAS 39

Definitions

Categories of financial instruments

Derecognition

Measurement

Initial measurement

Subsequent measurement

Hedge Accounting

Embedded Derivatives

Agenda

Investment Portfolio (Europe)

3

Source: Insurance Europe European Insurance in Figures 2016, March 2018

Total

value Asset Allocation

The total

value of the

insurers

investment

portfolio in

Europe is

10.1 bn€

4

IAS 39 and IFRS 7 need to be considered together for the accounting of financial instruments. They cover different aspects of financial instruments accounting.

IAS 39 provides rules for recognition and measurement of financial instruments depending on whether the financial instruments are held inside or outside a hedging relationship. It provides rules for:

Recognition and Derecognition

Measurement

Hedge accounting

Disclosure requirements are covered by IFRS 7.

Also important: IFRS 13 Fair Value measurement

Scope of IAS 39 (I)

5

The scope of IAS 39 includes most types of financial instruments. Exceptions are (covered by other standards):

Interests in subsidiaries (IFRS 10)

Assets and liabilities found under employee benefit plans (IAS 19)

Contracts for contingent consideration in a business combinations (IFRS 3/IFRS 10)

Share-based payments (IFRS 2)

Insurance contracts (IFRS 4)

But: In the case of an embedded derivative, IAS 39 covers the embedded derivative

Scope of IAS 39 (II) Exceptions of the Scope

6

Financial instrument: Any contract that gives rise to a financial

asset of one entity and a financial liability or equity instrument

of another entity.

Derivatives are financial instruments or contracts with the

following characteristics:

Changes in value in response to changes in the specified underlying

Requires no or little initial net investment

Are settled at a future date.

Definition

7

Categories of financial assets (I)

(1a) At Fair Value through Profit or Loss

(4) Available-for-Sale

Financial Assets

(3) Loans and Receivables

(2) Held-to- Maturity

Investments

Financial Assets

(1b) Held for Trading

All financial assets have to be categorized on initial recognition.

8

Categories of financial assets (II) (1) At fair value through profit or loss

A financial asset at fair value through profit or loss is one that is either:

held for trading

designated at initial recognition, if: measurement or recognition inconsistencies are eliminated or significantly reduced,

OR

management and performance measurement of a group of financial assets, financial liabilities or both, is done on a fair value basis, in accordance with a documented risk management or investment strategy

A financial instrument must be classified as held for trading if it is:

acquired or incurred principally for the purpose of selling or repurchasing it in the near term

part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking, OR

a derivative (except for designated and effective hedging instruments)

9

Categories of financial assets (III) (2) Held-to-maturity

Held-to-maturity investments:

Financial assets with fixed or determinable payments and

fixed maturity, AND

that an entity has the positive intent and ability to hold to

maturity.

But not:

Those that are designated as fair value through profit or

loss or available-for-sale on initial recognition, OR

Those that meet the definition of loans and receivables

10

Categories of financial assets (IV) (2) Held-to-maturity - tainting -

An entity is not allowed to classify any financial assets

as held-to-maturity if it has:

Sold or transferred on more than an insignificant amount of

held-to-maturity investments before maturity

during the current financial year, OR

during the two preceding financial years

There are limited exceptions to the tainting rules

11

Loans and receivables:

financial assets with fixed or determinable payments, AND

not quoted in an active market

But not:

those that the entity intends to sell immediately

these are classified as fair value through profit and loss

those that are designated as fair value through profit or loss or available-for-sale on initial recognition

Categories of financial assets (V) (3) Loans and receivables

12

Available-for-sale financial assets are those financial

assets that are not classified as:

loans and receivables

held to maturity investments, OR

at fair value through profit or loss

It does not mean that these financial assets will be sold

Categories of financial assets (VI) (4) Available-for-sale

13

Categories of financial assets (VII) Summary

Categories of financial assets Knowledge check

An Insurance company purchases the following

investments:

Listed shares

Listed bearer bonds

Registered bond (not quoted in an active market)

Please explain how the investments can be categorized

14

Categories of financial assets (example) UNIQA 2016

15

Source: UNIQA Group Report 2016

pages 151 and 195

Categories of financial assets (example) Zurich 2017

16

Source: Zurich Group Report 2017

pages 6 and 31

17

(1a) At Fair Value through Profit or Loss

(2) Other Liabilities

(Financial Liabilities)

(1b) Held for Trading

Categories of financial liabilities (I)

18

A financial liability at fair value through profit or loss is one that is either: classified as held for trading, OR

designated at initial recognition, IF: measurement or recognition inconsistencies are eliminated or significantly

reduced, OR

management and performance measurement of a group of financial assets, financial liabilities or both, is done on a fair value basis, in accordance with a documented risk management or investment strategy.

Financial liabilities held for trading consist of: derivative liabilities that are not hedging instruments, AND

obligations to deliver securities borrowed by a short seller (an enterprise that sells securities that it does not yet own)

The fact that a liability is used to fund trading activities does not make that liability one held for trading

Categories of financial liabilities (II)

19

Transfer of risks and rewards

Transfer the contractual rights to receive cash

flows or pass through settlement

Derecognition (I)

Derecognition of financial assets

Contractual rights to the cash flows from the financial asset expire

“Qualified” transfer

See next

slide

Derecognition

OR

AND

20

Derecognition (II) Retention and transfer of risks/rewards

Examples of retention of substantially all risks and rewards:

Repos, stock loans, total return swaps

Sales of short-term receivables where all credit risk is guaranteed

Examples of transfer of substantially all risks and rewards:

Sale with option to repurchase at fair value at time of repurchase

Sale of portfolio of assets but retain right to service the assets for a fee

21

Financial asset or financial liability

is initially recognised

at cost fair value of

consideration given

in case of asset

fair value of

consideration

received in case of

liability

Include: transaction costs on purchase (fees and commissions paid

to brokers, advisers and dealers, transfer taxes and duties)

Exclude: transaction costs that may be incurred on disposal

Transaction costs are not included in the case of a financial asset or financial liability at fair value through profit and loss

Initial measurement

22

Financial assets

are subsequently recognised

at amortised cost

Loans and

receivables

Held to maturity

investments

at fair value Financial assets held

for trading or designated as at fair

value through profit and loss

Available-for-sale

securities

Subsequent measurement (I) Financial assets

23

After initial recognition

Available-for-sale financial assets are measured at fair value

Fair value differences are taken to OCI recognised as a separate component in equity

recycled on disposal

Other points impairment loss shall go to profit or loss

impairment loss on equity investments cannot be reversed

interest recognition using effective interest rate

FX differences to profit or loss (debt instruments)

Subsequent measurement (II) Available-for-sale

24

An insurance company acquires 100 shares of entity X on

January 1, 2015 for € 20 each. During 2015, 2016 and 2017

the following happens:

For 2015, X pays a dividend of € 1 per share

On December 31, 2016 the quoted price of a share is € 24


In March 2017, the insurance company sells all of its shares for

€ 39

Assume that the shares are accounted for as

Held-for-trading

Available-for-sale

Booking entries?

Subsequent measurement (III) Example HfT / AfS

25

Gains and losses on financial assets and liabilities

at fair value through profit or loss (including all

derivatives) should be taken to the profit or loss

statement.

Gains and losses on available-for-sale financial

assets should be recognised in OCI (except for

impairment).

Different rules for hedging

Subsequent measurement (IV) Gains and losses

26

After initial recognition

Loans and receivables are carried at amortised

cost using the effective interest rate method

Held-to-maturity investments are carried at

amortised cost using the effective interest rate

method

Subsequent measurement (V) Held-to-maturity investments/Loans and receivables

27

Effective interest Rate that exactly discounts estimated future cash flows

through the expected life of the financial instrument (or when appropriate, a shorter period) to the net carrying amount of the instrument method of allocating the interest income or expense over the

relevant period, AND

of calculating the amortised cost

Example effective interest method: An insurance company buys a loan for € 9,500k as of December 31, 2012 and a face value of € 1,000k. The loan pays a coupon of 4.0 % p.a. The loan is repaid as of December 31, 2014 (face value). Booking entries?

Subsequent measurement (VI) Effective Interest Method

28

Example (cont.)

Cash Flows:

Book values:

Yield 5.87%

Subsequent measurement (VII) Effective Interest Method

29

Financial liabilities at fair value through profit or loss and derivatives that are financial liabilities are carried at fair value

Gains and losses are taken to the income statement

All other financial liabilities are carried at amortised cost

Again, different rules for hedging!!

Subsequent measurement (VIII) Financial liabilities

30

Fair value Amortised cost Transaction

costs

FV through profit or loss - adj. to

P&L Expensed

Held-to-maturity - Capitalized

Loans and receivables - Capitalized

Available-for-sale - adj. to

OCI Capitalized

Subsequent measurement (IX) Summary

31


pages 109/110

Measurement (example) UNIQA 2016

32


pages 127/128


33


pages 225/226


34

A company has to assign its investments to different levels depending on the liquidity and market activity of the respective financial instruments.

Three levels are defined by IFRS 13: Level 1: Quoted prices (unadjusted) in active markets for identical

assets or liabilities that the entity can access at the measurement date

Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly

Level 3: Unobservable inputs for the asset or liability

Fair Value hierarchy Levels

Levels IFRS 13 (example) UNIQA 2016

35


pages 131/133 (extract)

Levels IFRS 13 (example) UNIQA 2016

36


page 196/198 (extract)

37

A financial asset is impaired when

Carrying amount is greater than estimated recoverable amount

At each balance sheet date, an entity must assess if there is objective evidence of impairment; evidence includes (incurred loss approach): financial difficulty of issuer

default or delinquency, or concessions by lender

high probability of bankruptcy or financial reorganisation, OR

disappearance of active market in investment due to financial problems

In addition, for equity investments: significant changes in technological, market, economic or legal

environment

significant or prolonged decline in fair value

Impairment (I)

38

Assessment

The existence of objective evidence of impairment

is assessed:

Individually for individually significant financial assets

Individually or collectively for financial assets that are

not individually significant

If there is no objective evidence of impairment at an individual level, the asset is grouped with assets of similar credit risk characteristics for collective assessment

Impairment (II)

39

Measurement

Impairment loss is the difference between the carrying amount and the Present Value of expected future cash flows discounted at original effective rate

Recognition

The carrying amount of the asset must be reduced to its estimated recoverable amount, and the loss is included in profit or loss for the period

Reverse impairment through income statement only if change causing the reversal can be related objectively to an event occurring after the write-down

Impairment (III) Assets carried at amortised cost

40

Financial assets carried at fair value

This section applies only to available-for-sale financial assets.

Financial assets held for trading

fair value adjustments are to net income

impairment loss is recognised automatically

A decline in value may have been recognised in equity as part

of the usual measurement process

When there is objective evidence of impairment, the

cumulative net loss that had been recognised in OCI is

reversed in OCI and recognised in profit or loss for the period

Impairment (IV) Assets carried at fair value

41

The amount is measured as the difference

between acquisition cost and:

current fair value (for equity instruments), OR

recoverable amount (for debt instruments)

Recoverable amount is the present value of expected future

cash flows discounted at the current market rate of interest

for a similar financial asset

Impairment (V) Assets carried at fair value

42

An insurance company acquires 100 shares of entity X on

January 1, 2015 for € 20 each. During 2015, 2016 and 2017

the following happens:

For 2015, X pays a dividend of € 1 per share



In March 2017, the insurance company sells all of its shares for

€ 39

Assume that the shares are accounted for as

Available-for-sale and the decline in the fair value as at

December 31, 2017 is an impairment

Booking entries?

Impairment/Subsequent measurement Example HfT / AfS (continued)

43


pages 129/130

Impairment (example) UNIQA 2016

44

Source: Zurich Group Report 2017

page 25

Impairment (example) Zurich 2017

45

Fair value - Something is

already locked in and you

need to protect it

Cash flow - You are

locking in something

Definition

Hedging the exposure to changes in the fair

value of an asset or liability due to a particular

risk or a firm commitment to buy or sell an asset

at a fixed price.

Definition

Hedging the exposure in the cash flows of an

asset, liability, forecasted transaction or the

FX risk of an unrecognised firm commitment.

Hedge Accounting (I) Major types of hedges

46

Examples of fair value hedges Fixed rate debt issued by the entity and hedged using a receive fixed/pay

floating interest rate swap

Available-for-sale equity security hedged with a purchased put option

Hedge of the variability in the price of a firm commitment to acquire a product in 2 months

A firm commitment to buy a machine in 6 months time for a fixed USD foreign currency amount hedged by a USD/GBP forward contract

Examples of cash flow hedges Floating rate debt issued by the entity and hedged using a receive

floating/pay fixed interest rate swap

Forecast USD foreign currency sales of fuel in September hedged by a USD/Euro forward contract

Hedge Accounting (II)

On April 8, 2015 an insurance company buys a bond with a 5 year maturity and a

fixed interest rate coupon of 2% p.a. The face value is € 1,000k and the purchase

price is 100 %. To avoid volatility due to fair value changes the insurance

company buys a payer swap with a nominal value of € 1,000k where it pays the

2% coupon to the counterparty of the swap and receives interest payments based

on the LIBOR. The fair value of the swap is zero.

Swap

counterparty Insurance

company Bond issuer

LIBOR

2%

2%

Hedge Accounting (III) Example of a Fair Value Hedge

47

On April 8, 2015 an insurance company buys a bond with a 5 year maturity and a

fixed interest rate coupon of 2% p.a. The face value is € 1,000k and the purchase

price is 100 %.

On December 31, 2015 the yields on a comparable bond have risen to 3% and

the price of the bond decreased to 95% while the fair value of the swap increased

to €40k.

What are the booking entries as of December 31, 2015?

48

Fair value hedges

1. Gain or loss on hedging instrument is recognised immediately in P&L

2. Hedged item is adjusted for change in fair value due to the hedged risk and the gain or loss recognised immediately in the P&L

3. By default, hedge ineffectiveness is captured immediately in P&L

Cash flow hedges

1. Gain or loss on hedging instrument that is fully effective is recognised in a separate component of equity (through OCI)

2. No adjustment is made to the hedged item

3. Gain or loss on the hedging instrument that is not effective is recognised immediately in the P&L

Hedge Accounting (IV) Accounting treatment for qualifying hedges

49

Key Steps to achieving a qualifying hedge Identify the type of hedge

fair value OR

cash flow

Identify the hedged item or transaction

Identify the nature of the risk being hedged

Identify the hedging instrument

Demonstrate that the hedge has and will continue to be effective

Document the hedging relationship above, including the risk management objectives and strategy for undertaking the hedge

Hedge Accounting (V)

50

Hedge effectiveness

Demonstrate that the hedge has and will continue to

be highly effective

At inception, effective means flows fully offset

(stronger than 80-125%)

Ongoing, effectiveness only needs to show 80-125%

Please calculate the hedge effectiveness in the

example.

Hedge Accounting (VI) Hedge effectiveness

51

Please explain the three key features of a derivative according

to IAS 39?

How are derivatives categorized?

How must derivatives be measured?

Embedded Derivatives (I) Knowledge check

52

A component of a hybrid financial instrument that includes both

a derivative and a host contract – with the effect that some of

the cash flows of the combined instrument vary in a similar way

to a stand-alone derivative.

An embedded derivative should be separated from the host

contract and accounted for (separately) as a derivative if

the economic characteristics and risks of the embedded derivatives are

not closely related to those of the host

a separate instrument with the same terms as the embedded item

satisfies the definition of a derivative, AND

the hybrid instrument is not already measured at fair value with changes

taken to the income statement

Embedded Derivatives (II) Definitions

53

Embedded Derivatives (III) Identification and measurement

Hybrid contract host contract + embedded derivative

Host contract is an element which is left had the embedded

derivative been eliminated from the hybrid contract

Host contract does not have to be a financial instrument

What is a host contract?

Any financial asset or liability

Measurement

Separation of derivative (at fair value through profit or loss) and host

contract (depending on the category)

Otherwise, hybrid is accounted for at fair value through profit or loss

in its entirety

Embedded Derivatives (IV) Examples

Reverse Convertible Bond Is a bond linked to an underlying stock. The security offers a

steady stream of income due to the payment of a high coupon

rate. In addition, at maturity the owner will receive either 100%

of the par value or, if the stock value falls, a predetermined

number of shares of the underlying stock.

Credit Linked Note Is a structured security which allows the issuer e.g. a bank to

transfer a specific credit risk e.g. of a government or

company to investors. The issuer is not obliged to repay the

debt if a specified event occurs.

54

The two main categories of disclosures required by IFRS 7 are:

1. Information about the significance of financial instruments

Accounting policies

Financial position: Categorization of the financial instruments, including

fair values for those financial instruments valued at amortized cost

Income statement: income, expense, gains, and losses by category

including impairments

Others: Hedging, embedded derivatives, reclassifications, collaterals,

credit losses

2. Information about the nature and extent of risks arising from financial

instruments

Description of the risk management system (qualitative information)

Quantitative information on market risk including a sensitivity analysis

as well as credit and liquidity risk

55

Disclosure requirements

Summary IAS 39

Categorization: Financial Instruments have to be categorized

according to IAS 39.

Measurement: The category determines whether a financial

instrument is measured at fair value or amortized cost; changes in

the fair value are recognized through P&L or OCI.

Impairment: An impairment test has to be performed for all

categories except for Fair Value through profit or loss.

Hedging: An effectiveness of 80%-125% is a precondition for hedge

accounting.

Embedded derivatives: Where a financial instrument contains not

closely related risks the host contract and the embedded derivative

have to be separated or fully accounted at fair value through P&L.

56

Thank you for your attention!

57

Martin Gehringer

Ernst & Young GmbH

Wirtschaftsprüfungsgesellschaft

Mergenthalerallee 3-5

65760 Eschborn

Telefon +49 6196 996 12427

Mobile +49 160 939 12427

[email protected]

Accounting for Financial Instruments (IAS 39) Salzburg - Financial Instruments April 2018 - nur IAS 39.pdf · Accounting for Financial Instruments (IAS 39) Salzburg, April 4, 2018

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