IFRS 9: Financial Instruments. Background G20 Financial Stability Board Financial Crisis Advisory Group

IFRS 9: Financial Instruments

Background

G20

Financial Stability Board

Financial Crisis Advisory Group

EC Endorsement

ARC meeting 11 November 2009

Endorsement decision deferred

EFRAG draft endorsement advice deferred at least to January 2010

Outcome

Endorsement delayed until at least 2010

EC may wait until the whole package of changes has been completed

• Endorsement 2011?

Project phase Exposure draft Finalisation

Classification and measurement

July 2009 November 2009

Amortised cost and impairment

October 2009 2010

Hedge accounting Q1 2010 2010

IASB Project Timetable

Agenda

ScopeClassification and measurement Embedded derivativesPermitted optionsEffective date and transition

Scope

Unchanged from IAS 39

References to IAS 39 for:

Impairment

Hedge accounting

Agenda

ScopeClassification and measurement Embedded derivativesPermitted optionsEffective date and transition

Classification

Two measurement categoriesAmortised costFair valueIAS 39 categories eliminatedHeld to maturityAvailable for SaleLoans and receivables

Amortised cost measurement

Determined on the basis of:

Business model

Contractual terms

Business model

As determined by key management personnel (IAS 24)

Not an instrument by instrument focus

Hold financial assets to collect contractual cash flows

Do not need to hold assets to maturity

Business model - examples

Hold investments to collect contractual cash flows

Can sell in particular circumstances

• No longer meets investment policy

• Insurer adjusts portfolio to match expected timing of payouts

• Entity needs to fund capital expenditure


Business model is to purchase portfolios of financial assets

May or may not include financial assets with incurred losses

Seek to obtain payment of cash flows

Do not need to anticipate obtaining all contractual cash flows

Entity may also enter into interest rate swaps


Business model is to originate loans and sell them

Loans sold to a securitisation vehicle that is consolidated

Consolidated entity business model

• Hold loans and collect contractual cash flows

• May qualify for amortised cost measurement

Individual entity business model

• Originate and sell loans

• Do not qualify for amortised cost measurement

Contractual terms for cash flows

Assess on an instrument by instrument basis

Principal

Interest

Specified dates

Interest represents consideration for

Time value of money

Credit risk

Foreign currency

Assess payments on the basis of currency in which the instrument is denominated

Leverage

Amplifies variability of contractual cash flows

Leverage does not have economic characteristics of interest

Includes derivative contracts

• Option

• Forward

• Swap

Cannot qualify for measurement at amortised cost

Prepayment options

Debtor can prepay

Creditor can demand early repayment

Cash flows may be only principal and interest

Prepayment provision not contingent on future events except to protect holder against

• Credit deterioration of the issuer

• Changes in taxation or law

• Change in control of issuer

Prepayment represents

• Capital

• Interest

• Compensation for early termination

Extension options

Can result in cash flows of

Principal

Interest on principal outstanding

Conditions

Not contingent on future events

Cash flows in extension period are only

• Principal

• Interest on principal outstanding

Changes in the timing or amount of cash flows

Can result in cash flows of

Principal


Only if:

Variable interest rate – time value and credit risk only

Not contingent on future events except to protect holder against:• Credit deterioration of the issuer• Changes in taxation or law• Change in control of issuer

Cash flows in extension period are only• Principal• Interest on principal outstanding

Cash flows of principal and interest on principal - example

Bond with specified maturity date

Interest payments linked to inflation rate in currency of bond

Analysis

Contractual cash flows are payments of principal and interest on principal

Linkage to inflation rate resets time value to current level

What if linkage is to another variable (eg net income or equity index)?

Interest payments are not consideration for:

• Time value of money

• Credit risk of principal

Contractual interest payments inconsistent with market rates of interest


Variable rate bond

Borrower can choose one month or three month LIBOR on ongoing basis

Analysis

Key – does interest reflect• Time value• Credit risk

If able to choose one month LIBOR for three months• If reset each month – yes• If no reset – no

Term of instrument shorter than contractual interest rate• Constant maturity bond with periodically reset five year rate


Bond with capped rate

Stated maturity date

Variable market rate with cap

Analysis

Fixed rate bond

Variable rate bond

Combination can qualify

Cash flows of principal and interest on principal – examples that do not qualify

Convertible bond

Holder’s perspective

Principal and interest plus:

• Return linked to equity of issuer

Inverse floating rate loan

Interest is not consideration for time value

Cash flows of principal and interest on principal – examples that do not qualify

Perpetual instrument

Holder can call and pay par plus accrued interest

Market rate of interest

Cash payment of interest – solvency test

No accrued interest on deferred amounts

Analysis

Potential to defer interest with lack of interest accrual disqualifies

Features that do not disqualify

Perpetual

Callable

Cash flows of principal and interest on principal – examples that may not qualify

Full recourse loan

Secured by specified collateral

Analysis

Collateralisation does not affect classification

What if non recourse loan?

Lender entitled to repayment only from specific assets or cash flows

• ‘look through’ to specific assets to determine characteristics

Subordinated instruments

May still have contractual cash flows

Principal


Conditions:

Issuer’s non payment is breach of covenant

Holder has right to unpaid amounts even if issuer bankrupt

• Unsecured trade receivable when debtor has collateralised loans

‘Waterfall’ structures

Example

SPE purchases a portfolio of mortgage receivables

Finance raised through issue of tranches of debt

Tranches have subordination ranking for payment

Cash flows of principal and interest on principal if:

Contractual terms of the tranche itself qualify

Underlying pool of financial instruments have specified characteristics

Credit risk of tranche is equal to or lower than average

If cannot ‘look through’

Fair value measurement

‘Waterfall’ structures

Underlying pool of financial instruments

Some required to have cash flows of principal and interest on principal

May also have:

Instruments that change the cash flow variability

• Interest rate swap that changes rate on underlying assets from floating to fixed

Instruments that align cash flows of tranches and underlying instruments

• Foreign exchange contract

Reclassification and ‘tainting’

Reclassification

Required on change of business model

• ‘Very infrequent’

Not changes

• Changes in intentions (even if significant market changes)

• Temporary disappearance of market

• Transfer of financial assets between existing business models

IAS 39 HTM ‘tainting’ eliminated

Reclassification

Examples

Entity has portfolio of commercial loans – intention to sell in short term

• Acquires a company that manages commercial loans

• Portfolio of commercial loans no longer for sale

Financial services firm

• Decision to close retail mortgage business

• No new business accepted

• Existing loan portfolio now actively marketed for sale

Measurement

Initial recognition

Fair value

Add transaction costs if amortised cost

Subsequent measurement

Definition of amortised cost in appendix

Reference to IAS 39 for impairment of assets at amortised cost, fair value measurement and hedge accounting

Agenda

Scope


Embedded derivatives

Permitted options

Effective date and transition


Financial host asset (within scope)?

Yes: no separation

Does the instrument as a whole give rise to payments of principal and interest?

Yes – amortised cost, no – fair value of entire instrument

No: apply existing IAS 39 rules

Potential separation

Financial liability, financial asset (outside scope of IFRS 9), and non-financial asset host contracts

Existing guidance for embedded derivatives retained

Agenda

Scope



Permitted options


Fair value option

Election available to designate at FVTPL

Initial recognition and irrevocable

Eliminates/substantially reduces an accounting mismatch

Other IAS 39 options obsolete

Managed on a fair value basis


Equity instruments

Do not have cash flows that are solely principal and interest

Fair value measurement

Optional recognition in OCI

Not held for trading

Irrevocable election on initial recognition of each investment

All changes in fair value in OCI

No recycling to income statement

Dividends recognised in profit or loss

Agenda

Scope



Permitted options


Effective date

Periods beginning 1 January 2013

Linked to effective date for impairment and hedge accounting

Early adoption permitted for December 2009 year ends

Transition

Retrospective application with exceptions

IAS 8 applies

Date of initial application

Date on which the requirements of the new standard are first applied

Date of initial application

Any date between:

Date of issue of IFRS 9; and

Before 1 January 2011

Beginning of first reporting period if adopt on/after 1 January 2011

If date of initial application not beginning of a reporting period:

Disclose that fact and reasons for using that date

Transition - exceptions

Assessment of whether hold to collect contractual cash flowsDate of initial applicationRetrospective applicationDesignation as at FVTPL – applies to financial assets AND liabilitiesCircumstances as at date of initial applicationRetrospective application of FVPrevious optional designation as at FVTPLMay revoke based on facts/circumstancesRequired to revoke if eligibility criteria not metBased on facts at date of initial application


Hybrid contracts that are required to be at fair value, if fair value not determined in prior periodsMeasure at sum of fair value of componentsMeasure at fair value in entirety at date of initial applicationTreatment of differences in fair value of components and wholeOpening retained earnings (if apply at start of reporting period)Profit or loss (if apply during reporting period)Designation of equity instruments as at FVTOCIOptional if not held for tradingAssessment at date of initial applicationRetrospective application


Hedge accounting

Apply IAS 39 hedge cessation rules if no longer qualify

Instruments previously measured at fair value that are restated to amortised cost

If impracticable to apply effective interest rate method, amortised cost and impairment based on previous period end fair values

Fair value at date of initial application is deemed amortised cost


Unquoted equity instruments measured at cost under IAS 39Remeasure to fair value at date of initial applicationDifference between fair value and previous carrying amount to opening retained earningsInterim financial reportsComparatives not required to be restated if impracticable (IAS 8)


Comparative information – annual financial statements

Adopt in reporting period beginning before 1 January 2012Not required to restate comparativesDifferences between previous carrying amount and fair value on initial application recognised in opening retained earnings

Adopt in reporting period beginning on/after 1 January 2012Restate comparatives

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Documents

IFRS 9: Financial Instruments. Background G20 Financial Stability Board Financial Crisis Advisory Group