IAS 32 & IFRS 9 Financial Instruments - Baker Tilly · IAS 32 & IFRS 9 Financial Instruments Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, ... Classification

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IAS 32 & IFRS 9

Financial Instruments

Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, Moldova


IAS 32

Financial Instruments: Presentation



Objective

• IAS 32 establishes principles for presenting

financial instruments.

• It applies to classification of financial assets, financial

liabilities and equity instruments from the issuer's

perspective;

• the classification of related interest, dividends, losses

and gains; and

• the circumstances in which financial assets and

liabilities can be offset;

3


Key concepts

• Financial instrument: A contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.

• Financial asset: Any asset that is:

• cash (i.e. cash, bank deposits);

• A contractual right to receive cash or a financial asset from another entity (i.e. trade receivables, loan receivables);

• A contractual right to exchange financial instruments with another entity under potentially favourable terms (i.e. derivative asset);

• A contract that will or may be settled in an entity’s own equity instruments (i.e. convertible corporate bonds);

• An equity instrument of another entity (i.e. investment in shares).

4


Key concepts

• Financial liability: is a contractual obligation to:

• Deliver cash or another financial asset to another entity (i.e. Bank overdraft, trade payables, loans payable, issued debt instruments (e.g. Bonds, loan notes), redeemable preference shares);

• Exchange financial instruments with another entity under potentially unfavourable terms i.e. Derivative liability);

• Be (or one that may be) settled in the entity's own equity instruments (i.e. Convertible corporate bonds).

• Equity instrument: is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (i.e. Ordinary shares irredeemable preference shares, share options / rights).

5


Compound Financial Instruments

• Compound instruments have both a liability and an equity component from the issuer's perspective. IAS 32 requires that the component parts, be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issue date and not revised for subsequent changes.

• For example, a convertible bond contains two components. One is a financial liability, which is the issuer's contractual obligation to pay cash, and the other is an equity instrument, which is the holder's option to convert into common shares.

• When the initial carrying amount of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component.

6


Compound Financial Instruments

• Step 1: The fair value of the consideration in respect of the liability

component is measured at the fair value of a similar liability that

does not have any associated equity conversion option (can be

done by discounting the future cash flows at the rate prevailing in

the market for similar non-convertible obligations). This becomes

the liability component's carrying amount at initial recognition.

• Step 2: The equity component (the equity conversion option) is

the residual amount after deducting from the fair value of the

instrument as a whole the amount separately determined for the

liability component.

Equity component Total Present Value Present Value

Of Financial = Proceeds - of Liability - of Interest

Instrument

7


Classification of financial

instruments

• The financial instrument should be classified as

either a financial liability or an equity instrument

according to the substance of the contract, not

its legal form. The entity must make the decision

at the time of initial recognition.

8


Examples

Financial

Assets

Financial

Liabilities

Equity

Instruments

- cash and cash

equivalents;

- bank deposits;

- Loans to customers;

- accounts receivable;

- notes receivable;

- bonds purchased;

- equity instruments

of another entity;

- derivatives.

- accounts payable;

- notes payable;

- loans received;

- bonds issued;

- derivatives;

- redeemable;

preference shares.

- own ordinary

shares;

- Warrants

issued;

- share options

issued;

- share rights

issued.

9


Interest, dividends, gains, and

losses

• Interest, dividends, gains, and losses relating to a

financial instrument classified as a liability should be

reported in the income statement. Example: Dividend

payments on redeemable preference shares (classified as liability)

would thus be classified as interest expense in the same way that

interest payments on a loan are classified as interest expense.

• On the other hand, interest, dividends, gains, and

losses relating to equity instruments are recognised

directly in equity. Example: Dividend payments on irredeemable

preference shares, ordinary shares etc., are treated as a deduction

from retained earnings in the Statement of Changes in Equity.

10


Offsetting

• Generally, it is inappropriate to net financial assets and financial liabilities and present only net amount in the Statement of Financial Position.

• IAS 32 requires a financial asset and a financial liability to be offset and the net amount reported when and only when, an entity: • Has a legally unconditional enforceable right to set off the

amounts “A right to set-off” ; and

• Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously “Intention to settle net or simultaneously” .

• When both conditions are met, net presentation reflects more appropriately the entity's expected future cash flows from settling the asset and the liability.

11


IFRS 9

Financial Instruments



Current development

• On 24 July 2014, the International Accounting Standards

Board (IASB) issued the final version of IFRS 9, bringing

together all three phases of the financial instruments

project:

• Phase 1: Classification and measurement of financial assets and

financial liabilities (completed 11/09 & 10/10)

• Phase 2: Impairment methodology (completed 07/14)

• Phase 3: Hedge accounting (completed 11/13)

• IFRS 9 will eventually replace IAS 39 in its entirety and is

effective for annual periods beginning on or after

1 January 2018, with early application permitted .

13


Content

• IFRS 9 contains requirements for financial

assets and liabilities:

• Initial recognition

• Classification

• Initial & subsequent measurement

• Recognition of gain or loss

• Derecognition

• Impairment of a financial asset

• Accounting rules for hedging

14


What changes under IFRS 9

• IFRS 9 main changes compared to IAS 39

include:

• Initial recognition;

• Classification

• Initial & subsequent measurement

• Recognition of gain or loss

• Derecognition

• Impairment of a financial asset

• Accounting rules for hedging

15


Financial Assets

16


Initial Measurement

• An entity shall recognise a Financial Asset at fair value of

consideration given plus, in the case of a financial asset not

at fair value through profit or loss, transaction costs that are

directly attributable to the acquisition of the financial asset.

• FVTPL = Fair Value

FVOCI and Amortised Cost = Fair Value +

transaction costs

17


Fair Value

Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (IFRS 13).

• The quoted price at the year end date where an active market exists (Level 1 disclosure).

• The price, adjusted if necessary, from the most recent transaction if a quoted price is not available (Level 2 disclosure).

• Price arrived at using discounted cash flow analysis or option pricing models, if an active market is not available (Level 3 disclosure).

18


Amortised cost

• Amortised cost is the cost of an asset or liability adjusted to achieve a constant effective interest rate over the life of the asset or liability.

• The effective interest rate is the discount rate that will give a present value of future cash flows that equals the purchase price.

• The effective interest rate method determines how much interest income or expense will be reported in the income statement in each period.

19


Financial Assets - Classification and

measurement model under IAS 39

20

Financial Assets

Fair value through

profit or loss

(FVTPL)

Loans and

receivables

Held to

maturity

(HTM)

Available

for sale

(AFS)

Amortised cost Amortised cost Fair value

Note:

- Investments in unquoted equity instruments whose fair value cannot be reliably measured shall

be measured at cost

- The measurement of an asset/ liability may be adjusted because of a designated hedging

relationship.

Fair value gains and

losses are taken to

income statement

Take amortisation

charges and

impairment losses to

income statement

Take amortisation

charges and

impairment losses to

income statement

Fair value gains and

losses are taken to

equity

Fair value


Financial Assets – Classification

under IAS 39

Fair

value

through

profit or loss

(FVTPL)

►Assets that are held for trading and derivatives (except for a

derivative that is a designated hedging instrument).

► Assets are held for trading if there is frequent buying or selling

or if they were acquired for the purpose of reselling in the near

future.

►This category includes any assets designated upon initial

recognition at fair value through profit or loss (the “fair value

option”)

Loans and

receivables

►Assets with fixed or determinable payments that are not

quoted in an active market, including:

►Loans receivable

►Trade receivables

► Investments in unquoted debt instruments

►Deposits held with banks

21


Financial Assets – Classification

under IAS 39

Held to

Maturity (HTM)

► Assets with fixed or determinable payments and fixed maturity, that are quoted in an active market and the entity has the intention and ability to hold to maturity.

► e.g. Investment in quoted debt instruments such as government bonds

► If the entity sells or reclassifies any HTM investments prior to maturity, the entity is not allowed to use the HTM classification during the following 2 year period except when the sale or reclassification:

► is due to an isolated event beyond the entity’s control

► occurred less than 3 months before maturity

Available

for sale (AFS)

► Investments in debt and equity securities that do not fall into any other category e.g.

► An investment in shares that has a quoted price, and that is not held-for-trading

► An investment in an equity instrument that is not quoted, and for which there is no intention to sell

► The entity has the option to classify certain other assets into this category.

22



measurement model under IFRS 9

• The following diagram summarises the overall structure of the

classification and measurement model in IFRS 9.

• Under IFRS 9, there are 3 measurement categories:

• Amortised cost

• FVOCI (with recycling / without recycling), and

• FVTPL

• FVTPL catches all the instruments which are not measured in one

of the other categories. As opposed to IAS 39, where AFS is the

distinct residual category. In order for a financial asset to qualify for

one of the other two measurement categories, it has to pass both,

the contractual cash flow characteristics test and the business

model test.

23




24

Debt (including hybrid contracts)

Pass

No

Neither (1)

nor (2) BM with objective that

results in collecting

contractual cash flows and

selling financial assets

1 3 2

No

Yes

Derivatives

No

Yes

Amortised cost

FVTPL FVOCI

(with recycling)

FVOCI

(no recycling)

Fail

Hold-to-collect

contractual

cash flows

Conditional fair value

option (FVO) elected?

Fail Fail

Held for

trading?

Yes No

FVOCI option

elected?

‘Business model’ test (at an aggregate level)

‘Contractual cash flow characteristics’ test

(at instrument level)

Equity




25


Pass

No

Neither (1)





1 3 2

No

Yes

Derivatives

No

Yes

Amortised cost

FVTPL FVOCI

(with recycling)

FVOCI

(no recycling)

Fail

Hold-to-collect

contractual

cash flows



Fail Fail

Held for

trading?

Yes No

FVOCI option

elected?




Equity


Contractual cash flow test

• The entity has to assess, whether the cash flows resulting

from the financial asset are solely payments for principal and

interest (SPPI) on specified dates. That test has to be

performed on an instrument-by-instrument basis.

• ‘Interest’ is consideration for the time value of money and the

credit risk associated with the principal amount outstanding

during a particular period of time.

• Note that derivatives and Equity instruments fail that test as

the cash flows from those instruments are not SPPI.

26


SPPI Test – Example 1

Scenario:

• Instrument A is a full recourse loan given to a customer.

• The loan facility is secured by a collateral.

Question:

Are the contractual cash flows Solely Payments of Principal and

Interest (SPPI)?

27



Solution:

YES

The fact that a full recourse loan is collateralised does not in

itself affect the analysis of whether the contractual cash flows

are solely payments of principal and interest on the principal

amount outstanding.

28



Scenario:

• Instrument B is a bond with a stated maturity date.

• Payments of principal and interest on the principal amount

outstanding are linked to an inflation index of the currency in

which the instrument is issued.

• The inflation link is not leveraged and the principal is protected.

Question:


Interest (SPPI)?

29



Solution:

YES

Linking payments of principal and interest on the principal

amount outstanding to an unleveraged inflation index resets the

time value of money to a current level. In other words, the

interest rate on the instrument reflects ‘real’ interest. Thus, the

interest amounts are consideration for the time value of money

on the principal amount outstanding.

If however, the interest payments were indexed to another

variable such as the debtor’s performance (e.g. the debtor’s net

income) or an equity index, the test would fail the SPPI test

(unless the indexing to the debtor’s performance results in an

adjustment that only compensates the holder for changes in the

credit risk of the instrument). 30



Scenario:

• Instrument C is issued by a regulated bank and has a stated

maturity date. The instrument pays a fixed interest rate and all

contractual cash flows are non-discretionary.

• However, the issuer is subject to legislation that permits a

national resolving authority to impose losses on holders of

Instrument C in particular circumstances. For example, it has

the power to write down the par amount of Instrument C or to

convert it into a fixed number of the issuer’s ordinary shares if it

determines that the issuer is having severe financial difficulties,

needs additional regulatory capital or is ‘failing’.

Question:


Interest (SPPI)? 31



Solution:

YES

The holder would analyse the contractual terms of the

financial instrument to determine whether the SPPI test is met.

The analysis would not consider the payments that arise as a

result of the national resolving authority’s power to impose

losses on the holders of Instrument C. That is because that

power, and the resulting payments, are not contractual terms of

the financial instrument.

In contrast, SPPI test would not be met if the contractual terms

of the financial instrument permit or require the issuer or

another entity to impose losses on the holder even if the

probability is remote that such a loss will be imposed.

32



Scenario:

• Instrument D is a variable interest rate instrument with a stated

maturity date that permits the borrower to choose the market

interest rate on an ongoing basis.

• For example, at each interest rate reset date, the borrower can

choose to pay three-month LIBOR for a three-month term or

one-month LIBOR for a one-month term.

Question:


Interest (SPPI)?

33



Solution:

YES

The contractual cash flows are solely payments of principal and

interest on the principal amount outstanding as long as the

interest paid over the life of the instrument reflects

consideration for the time value of money, for the credit risk

associated with the instrument and for other basic lending risks

and costs, as well as a profit margin.

The fact that the LIBOR interest rate is reset during the life of

the instrument does not in itself disqualify the instrument.

34



Scenario:

• Instrument E is a bond that is convertible into a fixed number of

equity instruments of the issuer.

Question:


Interest (SPPI)?

35



Solution:

NO

The holder would analyse the convertible bond in its entirety.

The contractual cash flows are not payments of principal and

interest on the principal amount outstanding because they

reflect a return that is inconsistent with a basic lending

arrangement (i.e. the return is linked to the value of the equity

instrument of the issuer).

36



Scenario:

• Instrument F is a loan that pays an inverse floating interest rate

(i.e. the interest rate has an inverse relationship to market

interest rates).

Question:


Interest (SPPI)?

37



Solution:

NO

The contractual cash flows are not solely payments of principal

and interest on the principal amount outstanding.

The interest amounts are not consideration for the time value of

money on the principal amount outstanding.

38



Scenario:

• Instrument G is a perpetual instrument but the issuer may call

the instrument at any point and pay the holder the par amount

plus accrued interest due.

• It pays a market interest rate but payment of interest cannot be

made unless the issuer is able to remain solvent immediately

afterwards.

• Deferred interest does not accrue additional interest.

Question:


Interest (SPPI)?

39



Solution:

NO

The contractual cash flows are not payments of principal and

interest on the principal amount outstanding. That is because

the issuer may be required to defer interest payments and

additional interest does not accrue on those deferred interest

amounts. As a result, interest amounts are not consideration for

the time value of money on the principal amount outstanding.

If interest accrued on the deferred amounts, the contractual

cash flows could be payments of principal and interest on the

principal amount outstanding.

40




41


Pass

No

Neither (1)





1 3 2

No

Yes

Derivatives

No

Yes

Amortised cost

FVTPL FVOCI

(with recycling)

FVOCI

(no recycling)

Fail

Hold-to-collect

contractual

cash flows



Fail Fail

Held for

trading?

Yes No

FVOCI option

elected?




Equity


Business model test

• Each portfolio has to undergo the business model test.

The business model under which the portfolio is

managed results in the classification of all the financial

assets in that portfolio.

• The three possible outcomes of this test, with the

corresponding classification, are:

• Hold-to–collect contractual cash flows (CCF)

• Hold-to–collect CCF and sell

• Neither of the above two

42

Amortised cost

FVOCI

(with recycling)

FVTPL


Business model test

Amortised cost:

• The business model leading to amortised cost is relatively

simple. If the objective of the business model is to hold the

financial assets to collect contractual cash flows, then the

financial assets are held at amortise cost. This is similar to the

HTM category under IAS 39, but does not preclude infrequent

or insignificant sales, and there is not tainting effect on the

remainder of the AMC portfolio if some assets are sold.

• Deciding on business model test is a matter of facts, that is how

an entity actually manages its financial assets, rather than

management’s intent.

43


Business model test – Example 1

Scenario:

• An entity holds investments to collect their contractual cash flows. The

funding needs of the entity are predictable and the maturity of its financial

assets is matched to the entity’s estimated funding needs.

• The entity performs credit risk management activities with the objective of

minimising credit losses. In the past, sales have typically occurred when the

financial assets’ credit risk has increased such that the assets no longer

meet the credit criteria specified in the entity’s documented investment

policy. In addition, infrequent sales have occurred as a result of

unanticipated funding needs.

• Reports to key management personnel focus on the credit quality of the

financial assets and the contractual return. The entity also monitors fair

values of the financial assets, among other information.

Question:

How shall the above portfolio be classified?

44



Solution:

Amortised Cost

Although the entity considers, among other information, the financial assets’

fair values from a liquidity perspective (i.e. the cash amount that would be

realised if the entity needs to sell assets), the entity’s objective is to hold the

financial assets in order to collect the contractual cash flows.

Sales would not contradict that objective if they were in response to an

increase in the assets’ credit risk, for example if the assets no longer meet

the credit criteria specified in the entity’s documented investment policy.

Infrequent sales resulting from unanticipated funding needs (e.g. in a stress

case scenario) also would not contradict that objective, even if such sales

are significant in value.

45



Scenario:

• An entity’s business model is to purchase portfolios of financial assets, such

as loans. Those portfolios may or may not include financial assets that are

credit impaired.

• If payment on the loans is not made on a timely basis, the entity attempts to

realise the contractual cash flows through various means - for example, by

contacting the debtor by mail, telephone or other methods. The entity’s

objective is to collect the contractual cash flows and the entity does not

manage any of the loans in this portfolio with an objective of realising cash

flows by selling them.

• In some cases, the entity enters into interest rate swaps to change the

interest rate on particular financial assets in a portfolio from a floating

interest rate to a fixed interest rate.

Question:


46



Solution:

Amortised Cost

The objective of the entity’s business model is to hold the financial assets in

order to collect the contractual cash flows.

The same analysis would apply even if the entity does not expect to receive

all of the contractual cash flows (e.g. some of the financial assets are credit

impaired at initial recognition).

Moreover, the fact that the entity enters into derivatives to modify the cash

flows of the portfolio does not in itself change the entity’s business model.

47



Scenario:

• An entity has a business model with the objective of originating loans to

customers and subsequently selling those loans to a securitisation vehicle.

• The securitisation vehicle issues instruments to investors.

• The originating entity controls the securitisation vehicle and thus

consolidates it.

• The securitisation vehicle collects the contractual cash flows from the loans

and passes them on to its investors.

• It is assumed for the purposes of this example that the loans continue to be

recognised in the consolidated statement of financial position because they

are not derecognised by the securitisation vehicle.

Question:

How shall the above portfolio be classified on a group level?

48



Solution:

Amortised Cost

The consolidated group originated the loans with the objective of holding

them to collect the contractual cash flows.

However, the originating entity has an objective of realising cash flows on

the loan portfolio by selling the loans to the securitisation vehicle, so for the

purposes of its separate financial statements it would not be considered to

be managing this portfolio in order to collect the contractual cash flows.

49



Scenario:

• A financial institution holds financial assets to meet liquidity needs in a

‘stress case’ scenario (e.g., a run on the bank’s deposits). The entity does

not anticipate selling these assets except in such scenarios.

• The entity monitors the credit quality of the financial assets and its objective

in managing the financial assets is to collect the contractual cash flows. The

entity evaluates the performance of the assets on the basis of interest

revenue earned and credit losses realised.

• However, the entity also monitors the fair value of the financial assets from a

liquidity perspective to ensure that the cash amount that would be realised if

the entity needed to sell the assets in a stress case scenario would be

sufficient to meet the entity’s liquidity needs. Periodically, the entity makes

sales that are insignificant in value to demonstrate liquidity.

Question:


50



Solution:

Amortised Cost (The objective of the entity’s business model is to hold the

financial assets to collect contractual cash flows).

The analysis would not change even if during a previous stress case

scenario the entity had sales that were significant in value in order to meet

its liquidity needs. Similarly, recurring sales activity that is insignificant in

value is not inconsistent with holding financial assets to collect contractual

cash flows.

In contrast, if an entity holds financial assets to meet its everyday liquidity needs

and meeting that objective involves frequent sales that are significant in value,

the objective of the entity’s business model is not to hold the financial assets to

collect contractual cash flows.

Similarly, if the entity is required by its regulator to routinely sell financial assets

to demonstrate that the assets are liquid, and the value of the assets sold is

significant, the entity’s business model is not solely to hold financial assets to

collect contractual cash flows. Whether a third party imposes the requirement to

sell, or that activity is at the entity’s discretion, is not relevant to the analysis.

51


Business model test

FVOCI:

• The IASB introduced FVOCI as a measurement category in

order to overcome cases where the business model objective is

achieved by both collecting contractual cash flows and selling

financial assets. For example, a bank holds a portfolio as a

liquidity buffer as required by the regulator (i.e. Central Bank).

That portfolio consists of plain-vanilla bonds which are intended

to be held until maturity. However, the regulator also requires

the bank to churn that portfolio on an annual basis to

demonstrate that the assets are in fact liquid. Such a portfolio

could not qualify for AMC (see example 4).

52


Business model test

FVOCI:

• In this category, fair value changes are recognised in OCI while

interest income and possible impairment are recognised

through P&L as if the asset were recorded at AMC. This means

that on initial recognition, a 12-month expected loss will need to

be recorded in profit or loss with an offsetting credit to OCI.

Changes in fair value for reasons other than credit (e.g. a

liquidity discount) will not be recorded in profit or loss until

derecognition. The amounts accumulated in OCI are recycled

to P&L on sale.

• The assessment of the business model is performed on a

portfolio level.

53



Scenario:

• An entity anticipates capital expenditure in a few years. The entity invests its

excess cash in short and long-term financial assets so that it can fund the

expenditure when the need arises. Many of the financial assets have

contractual lives that exceed the entity’s anticipated investment period.

• The entity will hold financial assets to collect the contractual cash flows and,

when an opportunity arises, it will sell financial assets to re-invest the cash in

financial assets with a higher return.

• The managers responsible for the portfolio are remunerated based on the

overall return generated by the portfolio.

Question:


54



Solution:

Fair Value through Other Comprehensive Income (FVOCI).

The objective of the business model is achieved by both collecting

contractual cash flows and selling financial assets. The entity will make

decisions on an ongoing basis about whether collecting contractual cash

flows or selling financial assets will maximise the return on the portfolio until

the need arises for the invested cash.

In contrast, consider an entity that anticipates a cash outflow in five years to

fund capital expenditure and invests excess cash in short-term financial

assets. When the investments mature, the entity reinvests the cash in new

short-term financial assets. The entity maintains this strategy until the funds

are needed, at which time the entity uses the proceeds from the maturing

financial assets to fund the capital expenditure. Only sales that are

insignificant in value occur before maturity (unless there is an increase in

credit risk). The objective of this contrasting business model is to hold

financial assets to collect contractual cash flows.

55



Scenario:

• A financial institution holds financial assets to meet its everyday liquidity

needs. The entity seeks to minimise the costs of managing those liquidity

needs and therefore actively manages the return on the portfolio. That return

consists of collecting contractual payments as well as gains and losses from

the sale of financial assets.

• As a result, the entity holds financial assets to collect contractual cash flows

and sells financial assets to reinvest in higher yielding financial assets or to

better match the duration of its liabilities. In the past, this strategy has

resulted in frequent sales activity and such sales have been significant in

value. This activity is expected to continue in the future.

Question:


56



Solution:


The objective of the business model is to maximise the return on the

portfolio to meet everyday liquidity needs and the entity achieves that

objective by both collecting contractual cash flows and selling financial

assets. In other words, both collecting contractual cash flows and selling

financial assets are integral to achieving the business model’s objective.

57



Scenario:

• An insurer holds financial assets in order to fund insurance contract

liabilities. The insurer uses the proceeds from the contractual cash flows on

the financial assets to settle insurance contract liabilities as they come due.

To ensure that the contractual cash flows from the financial assets are

sufficient to settle those liabilities, the insurer undertakes significant buying

and selling activity on a regular basis to rebalance its portfolio of assets and

to meet cash flow needs as they arise.

Question:


58



Solution:


The objective of the business model is to fund the insurance contract

liabilities. To achieve this objective, the entity collects contractual cash flows

as they come due and sells financial assets to maintain the desired profile of

the asset portfolio. Thus both collecting contractual cash flows and selling

financial assets are integral to achieving the business model’s objective.

59


Business model test

FVTPL:

• The rest of the financial assets go into the FVTPL category.

Also, derivatives and instruments held for trading are

mandatorily in this category.

60


Business model test

FVTPL:

• One business model that results in measurement at fair value through profit

or loss is one in which an entity manages the financial assets with the

objective of realising cash flows through the sale of the assets. The entity

makes decisions based on the assets’ fair values and manages the assets to

realise those fair values. In this case, the entity’s objective will typically result

in active buying and selling.

• Even though the entity will collect contractual cash flows while it holds the

financial assets, the objective of such a business model is not achieved by

both collecting contractual cash flows and selling financial assets. This is

because the collection of contractual cash flows is not integral to achieving

the business model’s objective; instead, it is incidental to it.

61




62


Pass

No

Neither (1)





1 3 2

No

Yes

Derivatives

No

Yes

Amortised cost

FVTPL FVOCI

(with recycling)

FVOCI

(no recycling)

Fail

Hold-to-collect

contractual

cash flows



Fail Fail

Held for

trading?

Yes No

FVOCI option

elected?




Equity


Conditional fair value option

• Conditional fair value option means that an asset which would

otherwise be measured at Amortised Cost or FVOCI can be

designated, at initial recognition only, to be measured at FVTPL

if this eliminates or significantly reduces a measurement or

recognition inconsistency (‘accounting mismatch’) that would

otherwise arise from measuring any assets or liabilities and

recognising any gains or losses on them on different bases.

For example, an entity holds a fixed-rate loan receivable that it hedges with

an interest rate swap. Measuring the loan asset at amortised cost and the

interest rate swap at FVTPL, creates a measurement mismatch. In this case,

the loan receivable could be designated at FVTPL under the Fair Value

Option.

63




64


Pass

No

Neither (1)





1 3 2

No

Yes

Derivatives

No

Yes

Amortised cost

FVTPL FVOCI

(with recycling)

FVOCI

(no recycling)

Fail

Hold-to-collect

contractual

cash flows



Fail Fail

Held for

trading?

Yes No

FVOCI option

elected?




Equity


Equity investments

• Equity investments (i.e. investments in shares) can only be measured at Fair Value since contractual cash flow on specified dates is not a characteristic of equity instruments. Thus FVTPL classification is used.

• If however, an equity investment is not held for trading, the entity has the irrevocable option, at initial recognition only, to classify it at FVOCI, with only dividend income recognised in I/S. Such designation is done on an instrument-by-instrument basis.

• This sounds similar to the AFS category for equity instruments under IAS 39 but with the differences that the amounts in OCI never get recycled to P&L (on disposal it is reclassified in equity (R/E)). Consequently, no impairment testing is required.

65


Reclassification of Financial Assets

between AMC & FVTPL

• Reclassification is required when, and only when, an entity changes its business model for managing them.

• Any reclassification is to be accounted for prospectively from the Reclassification date:

• Which is the first day of the first reporting period following the change in business model that results in an entity reclassifying financial assets

• Reclassification from amortised cost to fair value measure instrument at fair value on that date; recognise difference between carrying amount and fair value in a separate line in profit or loss

• Reclassification from fair value to amortised cost fair value of the instrument on the date of reclassification becomes its new carrying amount

• Detailed disclosures will be required in interim reports and annual financial statements

• Reclassification not allowed where:

• The FVOCI option has been exercised, or

• The ‘Fair Value option’ has been exercised.

66


Financial Liabilities

67


Initial Measurement

• An entity shall recognise a Financial Liability at fair value

of consideration received minus, in the case of a financial

liability at amortised cost, transaction costs that are directly

attributable to the issue of the financial liability.

• FVTPL = Fair Value

Amortised Cost = Fair Value - transaction costs

68


Financial Liabilities - Classification

and measurement model under IAS 39

69


Fair Value through profit or loss

(FVTPL) All other liabilities

Fair

value Amortised

cost

Fair value

gains and losses are

taken to the income statement

Take amortisation

charges and impairment

losses to the income statement

Note:

- The measurement of an asset/ liability may be adjusted because of a designated hedging

relationship.



under IAS 39

70

Fair value through profit or loss (FVTPL)

►Liabilities that are held for trading and derivatives (except for a derivative that is a designated hedging instrument).

► e.g. an issued debt instrument that the entity intends to repurchase soon to make a gain from short-term movement in interest rates.

►This category includes any liabilities designated upon initial recognition at fair value through profit or loss (the “fair value option”)

Other liabilities - Amortised cost

►This is the default category for financial liabilities that do not meet the definition of financial liabilities at fair value through profit or loss. For many companies, most financial liabilities will fall into this category. e.g. accounts payable, loan payable, issued debt instruments (e.g. redeemable preference shares), deposits from customers



and measurement model under IFRS 9

• Financial liabilities are measured at amortised cost, unless

they are required or elected (fair value option) to be measured

at FVTPL.

• Required

• Financial liabilities held for trading

• Derivatives

• Elected (‘Fair Value Option’)

This designation can only be made upon initial recognition and is

irrevocable. Criteria for exercising the fair value option include:

• the liability is managed on a fair value basis

• electing fair value will eliminate or reduce an accounting mismatch or

• the instrument is a hybrid that would require separation of an embedded

derivative.

71




Where an entity opts the fair value option, any change in fair

value of the liability must be separated into two elements as

follows:

• Changes in fair value due to own credit risk, which are taken

to other comprehensive income (not recycled).

• Other changes in fair value, which are taken to profit or loss.

One possible approach is to separate the interest rate charged

on the financial liability into a benchmark rate (e.g. such as

LIBOR) and an instrument-specific rate. Any change in fair

value which is not wholly due to the change in LIBOR is a

change in own credit risk.

72




73

Amortised cost

• Financial Liabilities not held for trading

FVTPL

• Derivatives

• Liabilities held for trading

• Fair value option

FVOCI

(No recycling)

Note:

Reclassification is

not allowed!!!


Changes in fair

value due to own

credit risk


Own credit risk - Example

On 1 January 20X8 ABC issues a 7 year bond at par value of

$300,000 and annual fixed coupon rate of 9%, which is also the

market rate, when LIBOR is 6%. Therefore the instrument-specific

element of IRR = (9% - 6%) is 3%.

At 31 December 20X8, LIBOR has moved to 5.5%, thus making the

benchmark interest rate (5.5% + 3%) 8.5% (i.e. LIBOR plus the

instrument-specific element of IRR). If the fair value of the liability is

consistent with a market interest rate of, say, 8.3%, then any change

in the fair value of the liability from the benchmark rate to fair value

must be due to something other than the change in the benchmark

rate – i.e. it must be due to the change in the liability’s credit risk.

Required:

Calculate the amounts to be included within the financial

statements for the year ended 31 December 20X8.

74


Own credit risk - Solution

PV at benchmark rate 8.5% Cash flow Factor PV

Year $ $

1-6 27,000 4.5533 122,939

6 300,000 0.6129 183,870

306,809

PV at market rate 8.3% Cash flow Factor PV

Year $ $

1-6 27,000 4.5808 123,684

6 300,000 0.6197 185,910

309,594

75


Own credit risk - Solution

Therefore, the change in the fair value of the liability which

is not due to the change in the benchmark rate must be due

to the change in the liability’s credit risk.

$

PV of liability at market rate of 8.3%

(on SOFP at reporting date) 309,594

PV of liability at benchmark rate of 8.5% 306,809

Other comprehensive income ‘ 2,785

76


Impairment of financial instruments

77


Impairment of financial instruments

under IAS39

• All financial assets, except for those measured at FVTPL, are subject to an impairment review.

• IAS 39 requires that an assessment should be made, at each reporting date, as to whether there is any objective evidence that a financial asset is impaired, (i.e. whether a loss event has occurred that has had a negative impact on the expected future cash flows of the asset).

• The loss event causing the negative impact must have already happened. An event expected to cause impairment in the future should not be anticipated (incurred loss model).

• The treatment of any impairment loss differs according to the type of financial asset.

78


Financial assets carried at amortised cost

• Impairment loss = Carrying Value – PV of the estimated future cash flows of the asset, discounted at the original effective interest rate (not the current market interest rate).

• Any impairment loss is recognised as an expense in profit or loss.

• Interest on impaired assets is accrued at the original effective interest rate.

79


Financial assets carried at cost

• Unquoted equity investments that cannot be reliably measured at fair value are included in the statement of financial position at cost.

• Impairment loss = Carrying Value - PV of estimated future cash flows of the asset, discounted at the current market rate of return for a similar financial asset.

• Any impairment loss is recognised as an expense in profit or loss.

80


Financial assets carried at FVOCI

• If the fair value of a financial asset has been

recognised in other comprehensive income

(FVOCI) and there is evidence that the asset is

impaired, the cumulative loss that had been

recognised as other comprehensive income

must be removed from equity and recognised as

an expense in profit or loss, even though the

asset has not been derecognised.

81


Objective of IFRS 9 impairment model

• The objective of the impairment requirements is that at

each reporting date, an entity shall measure and

recognise the loss allowance at an amount equal to the

lifetime expected credit losses of all financial

instruments for which there have been significant

increases in credit risk since initial recognition.

• An entity shall recognise in profit or loss, as an

impairment gain or loss, the amount of expected credit

losses (or reversal).

82


Variation of the expected credit loss

model

83

Scope of ECL requirements General approach

Simplified approach

IFRS 9 Financial Instruments

Trade receivables that do not contain a significant financing component Trade receivables that contain a significant financing component

Policy election at entity level

Other debt financial assets measured at AMC or at FVOCI Loan commitments and financial guarantee contracts not accounted for at FVTPL IFRS 15 Revenue from Contracts with Customers

Contract assets that do not contain a significant financing component Contract assets that contain a significant financing component

Policy election at entity level

IAS 17 Leases

Lease receivables Policy election at entity level


General Approach

Stage 1 Stage 2 Stage 3

Loss allowance updated at each reporting date

12-month expected credit losses

Lifetime expected credit losses

Lifetime expected credit losses

Lifetime expected credit losses criterion

When and how

As soon as a financial asset is originated or purchased, 12-month expected credit losses are recognised in profit or loss and a loss allowance is established.

If the credit risk has increased significantly since initial recognition, full lifetime expected credit losses are recognised.

The resulting credit quality is not considered to be low credit risk.

If the credit risk of a financial asset increases to the point that it is considered credit-impaired.

Interest revenue Interest revenue is calculated using the effective interest rate on the gross carrying amount (without adjustment for expected credit losses).

Interest revenue is calculated using the effective interest rate on amortised cost (gross carrying amount adjusted for the loss allowance)

Change in credit risk since initial recognition

Improvement Deterioration

Start here

30 DPD 90 DPD


General Approach

• As a general approach, expected credit losses are required to

be measured through a loss allowance at an amount equal to:

• the 12-month expected credit losses (expected credit losses that

result from default events on financial instrument that are possible

within 12 months after the reporting date); or

• Full lifetime expected credit losses (expected credit losses that result

from all possible default events over the expected life of the financial

instrument).

• A loss allowance for full lifetime expected credit losses is

required for a financial instrument if the credit risk of that

financial instrument has increased significantly since initial

recognition.

• Definition of ‘default’ is not defined by the standard and there is

a 90 days past due rebuttable presumption.

85


Lifetime and 12-month

Expected Credit Losses

• ECL are expected shortfalls in the contractual cash flows.

• Lifetime ECL reflect the expected shortfalls over the entire life of a financial instrument i.e. in assessing credit risk, the entity considers the likelihood of not collecting some or all of the contractual cash flows over the remaining maturity of the financial instrument (i.e. the probability of a default occurring over the remaining life).

• 12 month ECL are the lifetime losses that would arise on an asset weighted by the probability of a default occurring in the next 12 months. It isn’t just expected cash shortfalls in the next 12 months or the losses on those assets that are expected to default in the next 12 months.

86


Assessing significant increases in

credit risk

• An entity, at each reporting date, should compare:

• The risk of a default occurring as at the reporting date, with

• The risk of a default occurring as at the date of initial recognition.

• Generally a financial instrument would have a significant increase

in credit risk before there is objective evidence of impairment and

before default occurs.

• There is a rebuttable presumption that:

• The credit risk on a financial asset has increased significantly since

initial recognition when contractual payments are 30 dpd or more.

• Default does not occur later than when a financial asset is 90 dpd.

• If reasonable and supportable forward-looking information is

available without undue cost or effort, an entity cannot rely solely

on past due information.

87


Operational simplifications in assessing

significant increases in credit risk

88

Low credit risk

For financial instruments that are equivalent to ‘investment grade’

quality, an entity would continue to recognise 12-month ECL

More than 30 days past due (DPD)

Rebuttable presumption that there is a significant increase in credit

risk when contractual payments are more than 30 DPD

► An entity can assume that a financial instrument has not significantly increased in credit risk if it has low credit risk at the reporting date

► The low credit risk notion is not a bright-line trigger and that financial instruments are not required to be externally rated

► The more than 30 DPD rebuttable presumption is intended to serve as a backstop and should identify significant increases in credit risk before default or objective evidence of impairment.


Low vs high credit risk financial

instruments: how would the model work?

89

Probabilities of default (PD) are based on S&P Global Corporate Average Cumulative Default Rates By Rating Modifier (1981-2011)

Threshold Investment grade Non-investment grade

S&P AA+ A BBB+ BBB- BB B+ B B- CCC/C D

12-mth PD* 0% 0.08% 0.15% 0.37% 0.76% 2.50% 5.46% 8.64% 26.82% 100%

Allowance 12-month 12-month or lifetime

Implementation challenges

► Tracking credit risk measures from origination

► Developing practical ‘absolute’ credit risk thresholds

► Mapping internal grading to external rating and/or probabilities of default (PD)

► Using delinquency-based approaches and the ‘more than 30 DPD’ rebuttable presumption

► Segmenting the portfolios by shared risk characteristics


Measuring expected credit losses

• An entity shall measure expected credit losses of a

financial instrument in a way that reflects:

• An unbiased and probability-weighted amount that is determined

by evaluating a range of possible outcomes (calculation

incorporates Probabilities of Default – PDs);

• The time value of money (present value of all cash shortfalls). A

cash shortfall is the difference between the contractual cash flows

that are due to an entity and the cash flows that the entity expects

to receive. Note that a credit loss arises even if the entity expects

to be paid in full but at a later stage than when contractually due.;

• 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.

90


Measuring expected credit losses:

Implementation Challenges

91

The time value of money

► Choice of discount rate

Best available information

Past Current

Future

► Area of

judgement

► Availability of data

► Reliability of forecasts

+ +

Unbiased and probability-weighted estimate

► No prescribed approaches ► Not best estimate

► Defining default

► Determining 12-month and lifetime ECL


Illustrative example: PD approach

► Correlating PD and LGD ► Relying on rating agencies’ data ► Individual vs collective assessment

Challenges

0.15% x 25% x $1 m = $375

► Loan originated at $1 million, i.e., exposure at default (EAD)

► 25% gross carrying amount irrecoverable if loan defaults, i.e., loss given default (LGD)

► 0.15% probability of a default (PD) in next 12 months

12-month ECL

allowance

PD x LGD x EAD

92


Gross carrying amount

Lifetime expected credit loss allowance (gross carrying amount x lifetime expected credit loss rate)

Current

15,000,000 @ 0,3% =

45,000

1-30 days past due

7,500,000 @ 1,6% =

120,000

31-60 days past due

4,000,000 @ 3,6% =

144,000

61-90 days past due

2,500,000 @ 6,6% =

165,000

>90 days past due

1,000,000 @ 10,6% =

106,000

30,000,000

580,000

Illustrative example: Provision Matrix

Trade receivables from the large number of small customers amount to $30 million divided into groups with common risk characteristics.

Current

1-30 days past due

31-60 days past due

61-90 days past due

> 90 days past due

Probability of Default

0.3% 1.6% 3.6% 6.6% 10.6%

93


Simplified approach and purchased

or originated credit-impaired assets

94

Simplified approach

Purchased or originated credit-impaired assets

► Scope: financial assets that are credit-impaired on purchase or origination

► ECL on initial recognition reflected in credit-adjusted EIR (no ‘day one’ 12-month ECL) Loss allowance based on subsequent changes in lifetime ECL

► Scope: trade receivables, contract assets under IFRS 15 and lease receivables under IAS 17

► Loss allowance based on lifetime ECL (Stage 1 is omitted)

► No tracking of changes in credit risk


Measuring expected credit losses

95

Expected credit losses

Present value of all cash shortfalls over the

remaining life, discounted at the

original EIR

Numerator: Cash shortfalls

► The period over which to estimate ECL: maximum contractual period (for revolving credit facilities, this extends beyond contractual period)

► Probability-weighted outcomes: possibility that a credit loss occurs, no matter how low that possibility is

► Reasonable and supportable information: reasonably available information about the past, current and future forecasts

Denominator: Discount rate

► Discounting period: from cash flows date to reporting date

► Assets: EIR or approximate (if credit-impaired on initial recognition, then use credit-adjusted EIR)

► Commitments and guarantees: EIR of resulting asset (if not determinable, then use current rate representing risk of the cash flows)


Deterioration in credit quality (stage 2)

• Initially an asset is assessed for impairment based on

12-month expected credit losses.

• If there is a deterioration in credit quality from initial

recognition, then it is assessed for impairment on lifetime

expected credit losses. \

• Interest income is calculated on the gross carrying

amount (the amount before deducting the allowance

balance) until there is a significant deterioration in credit

risk, when it is calculated on the net carrying amount.

96


Deterioration in credit quality (stage 3)

• If the asset deteriorates to the point that it is essentially non-performing (i.e. there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset), interest is calculated by applying the effective interest rate to the carrying amount net of the allowance balance to better reflect the yield on the asset.

• The point where this occurs is when an incurred loss would arise under IAS 39 (i.e. when there is objective evidence of impairment) using that concept in IAS 39.

97


Impairment Indicators

Indicators that credit risk has increased significantly may include:

• Significant adverse changes in the expected performance and behaviour of the borrower;

• An actual or expected internal credit rating downgrade for the borrower;

• Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or in unemployment rates;

• An actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased balance sheet leverage, etc;

• Significant increases in credit risk on other financial instruments of the same borrower;

• An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations;

• Significant changes, such as reductions in financial support from a parent entity or other affiliate.

98


Uncollectability (write-off)

• An entity would write off a financial asset, or part of a

financial asset, in the period in which the entity has no

reasonable expectation of recovery of the financial asset

(or part of the financial asset)

• The gross carrying amount of a financial asset would be

reduced as a result of the write-off

• A write-off constitutes a derecognition event

99


Reversal of impairment losses

• If an entity has measured the loss allowance for a

financial instrument at an amount equal to lifetime

expected credit losses in the previous reporting period,

but determines at the current reporting date that

condition about ‘significant increase of credit risk since

initial recognition’ is no longer met, the entity shall

measure the loss allowance at an amount equal to 12-

month expected credit losses at the current reporting

date.

• Any impairment loss reversal is recognised in the Profit

or Loss.

100


Transition and effective date

• IFRS 9 is effective for annual periods beginning on or after 1

January 2018, with early application permitted

• Retrospective application with transition reliefs permitted

101

► Approximated based on reasonable and supportable information available without undue cost or effort

► May apply low credit risk or more than 30 days past due

► If undeterminable, recognise lifetime expected credit losses

► Restatement of prior periods not required (permitted to do so unless this requires the use of hindsight)

► Cumulative impairment loss allowance is recognised in the opening retained earnings

The same transition reliefs apply for first-time adopters

Comparatives

Initial credit risk


How will IFRS 9 impact entities?

► Greater judgement and diversity of application ► Estimating ECL

► Assessing when lifetime ECL are required

► Likely to result in earlier recognition of credit losses ► May increase the credit loss allowance depending on:

► Duration and quality of financial instruments

► Application of the current IAS 39 model

► Potential volatility due to change in estimates ► ‘Cliff effect’ when financial instruments move between 12-

month ECL and lifetime ECL and vice versa

► Modification of current credit risk management and financial reporting systems

102


Contact us:

Marios E. Maltezos Senior Manager

Technical Advisory Services

Baker Tilly in South East Europe

Tel. +357 22 458 500, Fax. +357 22 751 648

Email: [email protected]

This presentation has been prepared for general guidance on matters of interest only, and does not constitute professional advice. Do not act upon the

information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the

accuracy or completeness of the information contained in this publication. Τo the extent permitted by law, Baker Tilly Klitou and Partners Ltd (Baker Tilly in

Cyprus), its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of anyone acting, or

refraining to act, in reliance on the information contained in this publication or for any decision based on it.

©2017 Baker Tilly in Cyprus. All rights reserved. Baker Tilly in Cyprus is an independent member of Baker Tilly International. Baker Tilly International Limited is

an English company. Baker Tilly International provides no professional services to clients. Each member firm is a separate and independent legal entity and

each describes itself as such. Baker Tilly in Cyprus is not Baker Tilly International’s agent and does not have the authority to bind Baker Tilly International or

act on Baker Tilly International’s behalf. None of Baker Tilly International, Baker Tilly in Cyprus, nor any of the other member firms of Baker Tilly International

has any liability for each other’s acts or omissions. The name Baker Tilly and its associated logo is used under licence from Baker Tilly International Limited.


Marios E. Maltezos FCCA, ACIB

Our Experts’ CVs

Senior Manager, Technical Advisory Services Baker Tilly in South East Europe

[email protected]

Competencies

• Extensive experience in IFRSs

• IFRS implementation practitioner

• 14-year experience in IFRS training and seminars

Relevant project experience (12 years)

• Implementation of IFRSs in Financial sector

• Evaluation of provisioning methodology and implementation of IAS39 and IFRS9 requirements to Banks

• In-house and open public IFRS training in Europe and Middle East

Experience

Marios has a long experience in the Banking and

Professional services sectors. He specialises in providing

high quality IFRS advisory services and training to both

large and medium sized clients of Baker Tilly in South

East Europe. He is a Senior Manager heading the

Technical Advisory Services of the firm and his clients are

engaged in a range of sectors including manufacturing,

trading, professional services and financial services.

Prior to joining Baker Tilly in SEE, Marios worked for 20

years in a leading financial institution in Cyprus, serving

the organisation from the positions of Group Senior

Accountant and Group Senior Internal Auditor. He is also a

lecturer for various ACCA examinations.

Marios has delivered repeatedly IFRS courses and

seminars to more than fifteen different countries in Europe

and Middle East during the past 14 years.

IAS 32 & IFRS 9 Financial Instruments - Baker Tilly · IAS 32 & IFRS 9 Financial Instruments Baker Tilly in South East Europe Cyprus, Greece, Romania, Bulgaria, ... Classification

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