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IFRS 9 - Financial Instruments Dr Rajesh Dalmia - October 2011

Agenda

►Timeline

► IFRS 9 Financial Instruments

► Classification and measurement

► Business Model + Financial Characteristic Test

► Reclassification

► Challenges

►

Oct-11 IFRS Seminar – Institute of Actuaries of India

IASB timeline

2009

2010

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012 2013 2015

Mandatory effective date IFRS 9 ED MA

Classification and measurement IFRS MA

Impairment ED ED IFRS? MA?

General hedge accounting ED IFRS? MA?

Macro hedge accounting ED? MA?

Asset and liability offsetting ED IFRS? MA?

IFRS 7: Derecognition disclosures IFRS MA

IFRS 7: Credit risk disclosures IFRS MA

Fair value measurement ED IFRS MA

Insurance contracts ED/RD IFRS? MA?

ED Exposure draft IFRS Final standard MA Mandatory adoption


IFRS 9 mandatory effective date to move to 2015 ► The IASB has tentatively decided to move the mandatory effective

date of IFRS 9 to annual periods beginning on or after 1 January

2015, with earlier application permitted

► Exposure Draft has been issued, comment deadline: 21 October

2011

► The proposed change will also potentially align the effective date of

IFRS 9 with the effective date of other new standards such as those

already mentioned


IFRS 9: Financial instruments


Classification and measurement Financial assets

Debt Derivative Equity

‘Business model’

test?

‘Characteristics of

the financial asset’

test?

Fair Value Option

(FVO)?

Held-for-trading?

Fair value through

OCI option?

Yes

No

No

Yes No

No

Yes

Yes

Yes

No

Amortised

cost

Fair value through

profit or loss

Fair value

through OCI


Classification and measurement Financial assets - Overview Amortised cost

► If business model is to hold instruments to collect contractual cash flows (the

„business model test‟); AND

► The contractual terms of the financial asset give rise, on specified dates, to

cash flows that are solely payments of principal and interest („characteristics

of the financial asset test‟)

Fair value

► FVTPL (fair value through profit or loss) all other instruments, except where FVTOCI option is used

► FVTOCI (fair value through OCI) non trading equity investments (by choice), but dividends through profit or loss

► No cost exception for unquoted equity investments

Securitised debt holder to „look-through‟ to underlying pool of assets

Embedded derivatives no bifurcation for hybrids with financial hosts

Reclassifications only when business model changes

No recycling between OCI or profit or loss


The business model test


Business model test

► The objective of the entity‟s business model must be to hold

instruments to collect contractual cash flows

► Some sales may be permitted, for example:

► If asset no longer meets investment policy (e.g., decline in credit

rating)

► If entity adjusts its investment portfolio to match the duration of its

liabilities

► If to fund unexpected cash outflows

► Amortised cost may not be appropriate if “more than infrequent” sales

► Disclosures required

► On derecognition of amortised cost assets, gains or losses are to be

disclosed on the face of the income statement

► Additional qualitative disclosures of the reasons for the sale


‘Business model’ test : Example

Scenario:

► Entity A holds investments to collect contractual cash flows but would

sell the investment in particular circumstances, e.g., if

(a) An instrument no longer meets Entity A‟s investment policy (e.g.,

the credit rating declines below that required);

(b) The entity is an insurer and adjusts its portfolio to reflect a change

in expected duration (expected timing of payouts); or

(c) Entity A needs to fund capital expenditures


‘Business model’ test Example (continued)

Analysis:

► While Entity A may consider the assets‟ fair value from a liquidity

perspective, Entity A‟s objective is to hold the instruments and collect

contractual cash flows

► Some sales would not contradict that objective

► However, if more than an infrequent number of sales are made out of

a portfolio, the entity needs to assess whether and how such sales

are consistent with an objective of collecting contractual cash flows

► Note: Gains or losses on sale of such instruments will need to be disclosed

as a separate line item in the statement of comprehensive income


Business model test

Key questions/considerations:

► Level at which business model test is applied – is an entity allowed to

stratify portfolios to maximise the use of amortised cost?

► Accounting for loan syndications and sub-participations – more than

one business model?

► What happens if a sub-participation fails?

► A business model initially meets amortised cost, but subsequent sales

are “more than infrequent” – should the portfolio continue to be at

amortised cost? And how should any newly acquired assets be

accounted for?

► When assessing the business model, should an entity have regard to

whether it legally „sells‟ assets or whether it derecognises them for

accounting purposes?


Characteristics of the financial asset test


Characteristics of the financial asset test

► Contractual terms of the financial asset give rise, on specified dates,

to cash flows that solely represent principal and interest payments

► Features that will still qualify for amortised cost:

► Prepayment options, extension options

► Fixed/variable interest rates

► Caps, floors, collars

► Unleveraged inflation index linked

► Features/assets that will not qualify:

► Leverage (options, forwards and swaps)

► Inverse floaters

► Convertible bonds, constant maturity rate bonds

► Catastrophe bonds


Characteristics of the financial asset test Features that require further analysis

► Inflation indexed Euro bonds e.g. indexed to the local inflation

rate

► Constant maturity type bonds - 15 year floating rate JGB,

coupons are reset every 6 months by referencing to the 10

year rate

► Products with a time lag in setting interest rates

► e.g. mortgage is indexed to the average 2 year Libor rate over the

last 2 years plus a fixed spread

► Restructured bank loans, for e.g. with an equity kicker

► Step up features: spread above benchmark rate increases if

borrower‟s EBITDA or debt to equity ratio deteriorates

► Dual currency bonds

► Investments in units issued by money market or debt funds


‘Characteristics of the financial asset’ test Examples Instruments that will qualify Instruments that will NOT qualify

A bond with a stated maturity date.

Principal and interest are linked to

an inflation index that is not

leveraged.

A convertible bond that is convertible

into equity instruments of the issuer.

A variable interest rate loan with a

stated maturity date that permits

the borrower to change the period

of the market interest rate at each

interest reset date on an ongoing

basis.

A loan that pays an inverse floating

rate, i.e. the interest rate has an

inverse relationship to the market

interest rates.

A bond with a stated maturity date

and pays a variable market interest

rate which is capped.

A constant maturity bond with a five-

year term that pays a variable rate

that is reset periodically but always

reflects a five-year maturity. A full recourse loan secured by

collateral.


Non-recourse loans

► Some financial assets may have cash flows described as

„principal and interest‟ but may not, in fact, represent such

payments. Guidance is not clear, but

► A non-recourse instrument may still qualify for amortised

cost, but holder must look through to the underlying assets

or cash flows

► Amortised cost not appropriate if cash flows are linked to the

performance of underlying assets/project, etc, e.g., „interest‟

based on traffic on toll road


Non-recourse loans : Example

► Entity Q gives a loan to an SPE that invests in equities. There are no

contractual linkages between the loan and the equities

► Assume Entity Q does not consolidate the SPE

► Does Entity Q‟s loan to the SPE qualify for amortised cost?

► Analysis:

► In substance the loan is taking the equity risk, although without

contractual linkage. The upside or downside would only be

apparent on liquidation of the SPE.

► This extreme, no-equity, example would fail amortised cost

accounting as the pricing of the loan would surely reflect the

implicit put option and so not reflect only time value and credit risk

► It would, of course be, difficult to apply this logic to situations

where there is only a little equity, since at what point do you draw

the line?


Contractually linked instruments

NO

Yes

NO

Yes

Yes

NO

NO

Yes

Yes

NO

Fair value

Cash flows of underlying pool are solely principal and interest?

Practicable to look through to underlying pool of instruments?

Cash flows of tranche are solely principal and interest?

All other instruments in the underlying pool (i) reduce cash flow

variability or (ii) align with the cash flows of the tranches?

Can instruments in the underlying pool change, in a way the pool does

not meet the conditions above?

? Amortised cost

NO

Credit risk of tranche < credit risk of the underlying pool?


Contractually linked assets (cont.)

► Calculate comparative risks, based on conditions at original

recognition

Considerations:

► What would be the effect on the look through test for

contractually linked instruments if the SPE benefits from credit

enhancement through the purchase of a credit default swap?

► What about where the linkage is in substance rather than by

contract?

Practical difficulties in applying the look-through for:

► Synthetic CDOs

► CDO squared or cubed

► Blind pools


Application of the look through test Step 1 – calculate probability weighted expected loss

►Bank A is sponsor and junior noteholder of an SPE

►SPE holds residential mortgages and no derivatives

►Total notional amount of mortgage assets and notes issued is CU 1000.

►Table shows a range of expected credit losses for the portfolio of mortgages as

at inception and the estimated probability that scenarios will occur:

Probability weighted expected loss of underlying assets is 12.3%


Application of the look through test Step 2 – compare credit risk tranche vs underlying pool

Useful for determining treatment of intermediary notes


Equity

► Presentation of FV changes in OCI

► Available for all equity instruments that are not held for trading

► Free choice for each holding of an instrument at initial recognition

► Irrevocable for that holding (no reclassification)

► Currently puttable instruments do not meet the definition

► Equity derivatives do not qualify

► Costs to sell recorded in profit or loss?

► Dividends will be recognised in profit or loss, if return on investment (not return of investment)

► No recycling of fair value changes to profit or loss on impairment, disposal or in any other circumstances

► No impairment testing required

► Additional disclosures

► Unquoted Equities are at fair value – cost may be a measure of fair value under certain conditions


Fair Value Option (FVO) for financial assets*

Fair value option available, if…

Accounting

mismatch

Managed on

fair value basis

Embedded

derivative(s)

Not managed to

collect contractual

cash flows FV

Hybrid contracts

with financial host

classified in entirety

* FVO unchanged for financial liabilities at this stage


Financial liabilities Changes to the Fair Value Option

► Maintain IAS 39, except when Fair Value Option is used:

► Record effect of changes in own credit risk in OCI, without

recycling

► Other fair value changes in profit or loss

► Or record in profit or loss if creates a mismatch

► Retain existing rules for embedded derivative separation

► The three eligibility criteria in IAS 39 will remain for use of FVO

► Cannot revoke previous designations or make new ones, except when adopting phase 1 of IFRS 9 for assets

► Standard clarifies that credit risk is not the same as asset-specific performance risk

► Transition – similar to financial assets


IFRS 9: Reclassification


Reclassifications (between amortised cost and FVTPL) ► Reclassification will be required when an entity changes its business

model

► Prohibited in all other circumstances

► 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 Examples from application guidance

Reclassification required Reclassification prohibited

An entity has a portfolio of commercial

loans that it held to sell in the short term.

However, the entity acquires a company

that manages commercial loans and has a

business model that holds the loans to

collect the contractual cash flows.

A change in intention related to

specific financial assets (even in

circumstances of significant

changes in market conditions)

A financial services firm decides to shut

down its retail mortgage business, and is

no longer accepting new business. The

firm actively market its mortgage loan

portfolio for sale.

A temporary disappearance of a

particular market for financial

assets

A transfer of financial assets

between existing business models


IFRS 9: Main Challenges


► To qualify for amortised cost, entities need to demonstrate that

financial assets are held and managed within an appropriate

„business model‟ (management intent is not sufficient)

► Entities need to assess instruments impacted due to the new

measurement criteria and make changes to accounting systems

► A number of areas will require judgment and interpretation by

preparers and auditors

► Classification of tranches of securitised debt will be complex, as they

are subject to „look-through‟

► If a financial asset is reclassified from FVTPL to amortised cost, it is

not possible to amend hedge accounting retrospectively

► Restated information may be difficult to explain if fair value gains and

losses on those assets had been previously been offset by the change in

value of derivatives

Classification and measurement Main challenges


► Additional transition disclosures will be required upon adopting

IFRS 9

► Depending on the choices exercised, there could be a change in

the geography of where certain gains and losses are recognised

► Entities need to determine regulatory and tax consequences

► Adopting IFRS 9 would mean changes to the measurement model, with a

consequential impact on the net profit or loss for the reporting period

► As financial liabilities and hedge accounting have been scoped out

of the current phase, there may be some difficulties in

understanding the overall implications

Classification and measurement Main challenges (continued)


Financial Instruments: Impairment


IASB/FASB three-bucket approach

Bucket 1

Bucket 2

Bucket 3

Assets that do not meet the criteria

for the other two buckets i.e., assets

perform

Assets for which possible future

defaults may occur i.e., credit

deterioration – individually or

collectively identified

Definition Impairment allowance

Losses expected to arise in the next

12 or 24 months (no final decision

yet)

Full lifetime expected loss

Calculation at the portfolio or

individual level

Individual assets, available

information indicates that credit

losses are expected to occur, or

have occurred i.e., credit

deterioration – individually identified

Full lifetime expected loss

Calculation at the individual asset

level


IFRS 9 Hedge accounting


Key features of the proposed standard

Align hedge accounting with risk management objectives

► Identify risks that are eligible as hedged items

► Designate hedges with qualifying hedging instruments and

hedged items

► Perform prospective hedge effectiveness assessment

► Rebalance the hedge relationship, when necessary

► De-designate when risk management objective changes;

voluntary de-designation is not permitted

► Provide additional disclosures

Measure ineffectiveness retrospectively, recognise in P&L


Hedge effectiveness and rebalancing

Deliberate mismatch

between hedged quantity

and designated quantity? Yes

No

Effective hedge

Economic relationship

between hedged item and

hedging instrument?

Hedging objective

remains unaltered? Rebalancing

Discontinuation

No

No

Yes

Yes


Thank you Contact details

Dr. Rajesh Dalmia

Associate Director, Ernst & Young

+91 99 2092 6693

[email protected]

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