Financial Assets and Liabilities
Overview for Banks
David Cairns
© 2006 David Cairns
www.cairns.co.uk
Financial Instruments
Equity instrument
Bank deposit
Bank loan
Debt security
Financial liability/
equity instrument of …
Issuer
Bank
Borrower
Borrower/issuer
Financial asset of …
Investor
Depositor
Bank
Investor
© 2006 David Cairns
www.cairns.co.uk
Financial Instruments: Derivatives
Corporate entity• obligation to deliver
$1.3m (financial liability)
• right to receive €1m (financial asset)
Bank• obligation to deliver €1m
(financial liability)
• right to receive $1.3m (financial asset)
Corporate entity enters into contract with bank to
pay $1.3m and receive €1m in three months time
© 2006 David Cairns
www.cairns.co.uk
Financial Instruments• When does a bank recognise financial assets and financial
liabilities on its balance sheet?
• How does a bank classify financial assets and financial liabilities on its balance sheet?
• When does a bank remove (derecognise) financial assets and financial liabilities from its balance sheet?
• How does a bank measure financial assets and financial liabilities:– on initial recognition?
– at subsequent balance sheet dates?
• How does a bank report the resulting income and expenses?
© 2006 David Cairns
www.cairns.co.uk
Derecognition
• Risk & rewards approach– transfer, and test of
transfer, of substantially all risks and rewards
• Control and continuing involvement approach– possible reacquisition of
contractual rights and/or
– exposure to performance
© 2006 David Cairns
www.cairns.co.uk
(1)
(2)
(3) Derecognise
(4)
(5) No derecognition
(6) Derecognise
(7)
(8) Derecognise
No derecognition
Continuing involvement
Y
Y
YY
Y
Y
N
N
N
N
NN
1) Consolidate all subsidiaries2) All or part of an asset?3) Has right to cash expired?4) Transfer of right to collect cash?5) Pass-through conditions met?6) Substantially all risks/rewards
transferred?7) Substantially all risks/rewards
retained?8) Control retained?
Derecognition: Financial Asset
© 2006 David Cairns
www.cairns.co.uk
Derecognition: Financial Liability
• Remove a financial liability when it is extinguished– when the obligation is discharged, cancelled or expires
• Extinguishment occurs through:
– entity repays the creditor or
– entity is legally released from primary responsibility for the liability
© 2006 David Cairns
www.cairns.co.uk
Measurement
• How does a bank measure financial assets and financial liabilities:– on initial recognition?
– at subsequent balance sheet dates?
• How does a bank report the resulting income and expenses?
© 2006 David Cairns
www.cairns.co.uk
MeasurementFair Values – the Myth
• Under IAS 39– a bank must measure all financial assets and financial
liabilities at each balance sheet date at fair value
– a bank must include all the resulting gains and losses in profit and loss
© 2006 David Cairns
www.cairns.co.uk
MeasurementFair Values – the Truth
• Under IAS 39– a bank must measure all transactions in financial assets and
financial liabilities at fair value
– a bank must measure all derivatives, other held-for-trading financial assets/financial liabilities and available-for-sale financial assets at fair value at each balance sheet date
– a bank may measure all other financial assets and most financial liabilities at historical cost-based amounts at each balance sheet date
© 2006 David Cairns
www.cairns.co.uk
Subsequent MeasurementFair Values – the Truth
• The Fair Value Option– under IAS 39, a bank has the option to measure many
financial assets and most financial liabilities that would otherwise be measured at historical cost-based amounts at fair value
© 2006 David Cairns
www.cairns.co.uk
The Fair Value Option
• Measurement– fair value
• Income and expenses– profit or loss
Fair value option without hedge accounting
• How does the fair value option work?– on initial recognition, the bank classifies a financial
asset or financial liability as fair value through profit or
loss
© 2006 David Cairns
www.cairns.co.uk
Profit or loss Profit or loss
Loans and Receivables
Fair value option
(fair value through
profit and loss)
Amortised Cost
Fair value
Loans, Receivables etc.
Category
Measurement
Gains and losses
© 2006 David Cairns
www.cairns.co.uk
Profit or loss Profit or loss
Other Liabilities
Fair value option
(fair value through
profit and loss)
Amortised Cost
Fair value
Deposits and Other Financial Liabilities
Category
Measurement
Gains and losses
© 2006 David Cairns
www.cairns.co.uk
The Fair Value Option• When is a bank allowed to use the fair value option?
– for most financial instruments that contain embedded derivative(s)
• for example, structured loans
– to eliminate, or reduce significantly, measurement or recognition inconsistency (accounting mismatch)
• for example, when assets are measured at fair value but matching liabilities would be measured at amortised cost
– for financial assets/financial liabilities managed and evaluated on a fair value basis
© 2006 David Cairns
www.cairns.co.uk
Profit or loss Equity
Held for Trading
(Fair value through profit and loss)
Available-for- sale financial
assets
Fair value Fair value
Investments in Equity Securities
Category
Measurement
Gains and losses
© 2006 David Cairns
www.cairns.co.uk
IAS 27SIC 12IFRS 3
Control
Subsidiary
IAS 31SIC 13
IAS 28
JointControl
Significant Influence
Joint Venture Associate
Investments in Equity Securities
© 2006 David Cairns
www.cairns.co.uk
Special Purpose Entities• A special purpose entity (SPE) is a subsidiary when
the substance of the relationship indicates control, for example when:– the bank
• predetermines the SPE’s activities• makes decisions about the SPE or the SPE’s net assets• has right to majority of the SPE’s benefits• guarantees interests of other parties in the SPE
– the SPE conducts activities on behalf of the bank
• Consider SPEs used for securitisations, other off-balance sheet financing etc.
© 2006 David Cairns
www.cairns.co.uk
Venture Capital Investments• Investments held by a venture capital entity, mutual
fund, unit trust, private equity or similar entity– if investor controls the investee, consolidate
– if the investor has significant influence over the investee, classify investment as either
• associate and use equity method or
• held for trading financial asset (IAS 39) and measure at fair value with changes in fair value included in the profit or loss
– in all other cases, apply IAS 39
© 2006 David Cairns
www.cairns.co.uk
Loans and Receivables• Financial assets with fixed or determinable payments
except – loans and receivables that the bank intends to sell
immediately
– derivatives
– debt securities quoted in active market
– loans and receivables for which the bank may not recover substantially all initial investment (other than because of credit deterioration)
© 2006 David Cairns
www.cairns.co.uk
Loans and Receivables
Measurement at recognition
Transaction price plus
Transaction costsminus
Origination and commitment fees charged to borrower
Without fair value option
© 2006 David Cairns
www.cairns.co.uk
Financial Service Fees• Origination fees and most commitment fees
charged to borrower on creation or acquisition of loans and receivables carried at amortised cost deduct from amount of loan or receivable recognise as income through application of effective
interest rate
© 2006 David Cairns
www.cairns.co.uk
Loans and Receivables
• Subsequent measurement– amortised cost using effective interest rate method
• Gains and losses– profit or loss
Without fair value option
© 2006 David Cairns
www.cairns.co.uk
Amortised Cost of Loan or Receivable
Amount at which measured at recognitionminus
Repayments of principalplus or minus
Cumulative amortisation of premium or discount on settlement, origination and commitment fees,
transaction costs, etc.less
Impairment losses
© 2006 David Cairns
www.cairns.co.uk
Interest Income on Loan or Receivable
• Under the effective interest rate method, interest income is: – interest plus or minus
– amortisation of any premiums, discounts, origination and commitment fees, transaction costs etc.
© 2006 David Cairns
www.cairns.co.uk
Impairment of Assets
• If the carrying amount of an asset exceeds the amount that the entity expects to recover from the sale or use of that asset– the asset is impaired
– write down asset to amount that expect to recover
• Applies to all measurement models• Applies to all assets
© 2006 David Cairns
www.cairns.co.uk
Impairment: Loans and Receivables
• Loan or receivable is impaired only when:– there is objective evidence of impairment as a result of
one or more events before balance sheet date that has impact on future cash flows
• Incurred, not expected, loss model
© 2006 David Cairns
www.cairns.co.uk
Impairment: Loans and Receivables
• Impairment – carrying amount of loan or receivable exceeds – present value of expected future cash flows discounted at
original effective interest rate
Carrying Present value of Impaired amount future cash flows
Loan 1,000 1,000 No
Loan 1,000 200 Yes
Loan 1,000 - Yes
© 2006 David Cairns
www.cairns.co.uk
Evidence of Impairment• Significant financial difficulty of borrower • Breach of contract by borrower• Special concessions by lender to borrower• Probable borrower will enter bankruptcy etc.• Measurable decrease in estimated future cash flows
since initial recognition – even though decrease cannot be identified with individual
loans and receivables
© 2006 David Cairns
www.cairns.co.uk
Assessment of Impairment• Separately for individually significant loans and
receivables• Collectively for other loans and receivables with
similar credit risk– include significant loans which are not identified
separately as impaired
© 2006 David Cairns
www.cairns.co.uk
Assessment of Impairment
• General provisions – must reflect objective evidence of impairment as a result
of one or more events before balance sheet date that has impact on future cash flows
© 2006 David Cairns
www.cairns.co.uk
Impairment: Loans and Receivables
• Ignore: – losses that arise from events between balance sheet date
and date of approval of financial statements
– losses that may arise from other future events
– effect of changes in market rate of interest on fair value of loan or receivable carried at amortised cost
– additional requirements of banking supervisors or regulators
© 2006 David Cairns
www.cairns.co.uk
Interest Income on Loan or Receivable
• Under the effective interest rate method, interest income is: – interest plus or minus– amortisation of any premiums, discounts, origination
and commitment fees, transaction costs etc.
• After impairment loss– interest income is determined based on rate used to
determine impairment loss
© 2006 David Cairns
www.cairns.co.uk
Hedge Accounting• How does a bank measure financial assets and
financial liabilities at subsequent balance sheet dates if it uses hedge accounting?
• How does a bank report the resulting income and expenses?
© 2006 David Cairns
www.cairns.co.uk
Fair Value Hedge Accounting
• Hedging instrument (usually derivative)– fair value
• Hedged item– adjust carrying amount for gain or loss attributable to
hedged risk
• Gains and losses on hedging instrument and hedged item– profit or loss
© 2006 David Cairns
www.cairns.co.uk
Cash Flow Hedge Accounting
• Hedging instrument (usually derivative)– fair value
• Hedged item– no change
• Gains and losses on hedging instrument– equity (effective portion)
– profit or loss (ineffective portion)
© 2006 David Cairns
www.cairns.co.uk
Hedge Accounting
• A bank is allowed to use hedge accounting only when the hedging instrument is a – derivative (other than a written option)
– written option when used to hedge purchased option
– non-derivative financial asset or liability used to hedge foreign currency risks
© 2006 David Cairns
www.cairns.co.uk
Hedge Accounting
• A bank is allowed to use hedge accounting only when the hedged item is a – recognised asset
– recognised liability
– unrecognised firm commitment
– highly probable forecasted transaction
– net investment in foreign operation
• Single items or groups of items with similar risk characteristics
© 2006 David Cairns
www.cairns.co.uk
Hedge Accounting• A bank is allowed to use hedge accounting only
when: – it formally designates and documents the hedging
relationship, objective and strategy
– it expects the hedge to be highly effective
– hedge effectiveness can be measured reliably
– it assesses hedge effectiveness on an ongoing basis
– for a cash flow hedge, any forecasted transaction is highly probable and must ultimately affect profit
© 2006 David Cairns
www.cairns.co.uk
Disclosure
• IFRS 7 applies to:
– all entities – not just banks or financial institutions
– all financial instruments except those covered by more specific standard
• interests in subsidiaries, associates and joint ventures
• interests in post employment benefits
• share-based payments
• insurance contracts
© 2006 David Cairns
www.cairns.co.uk
Disclosure
• Application of IFRS 7 depends on an entity’s use of financial instruments
Manufacture
r – only
has
rece
ivables &
payables
Bank – extensive use of FI
© 2006 David Cairns
www.cairns.co.uk
Disclosure
• Accounting– significance of
financial instruments to financial position and performance
• Risk– extent of exposure to
risks arising from financial instruments
© 2006 David Cairns
www.cairns.co.uk
Accounting Disclosure
• Financial assets and financial liabilities– measurement categories– fair value through profit
or loss– reclassifications– compound instruments
with multiple embedded derivatives
– fair value
• Financial assets– transfers not qualifying
for derecognition– collateral– allowance for credit
losses– defaults and breaches
© 2006 David Cairns
www.cairns.co.uk
Accounting Disclosure
• Income, expenses, gains, losses
• Accounting policies
• Hedge accounting– types of hedges
– hedging instruments
– risks being hedged
• Fair value– methods and valuation
techniques
– non-market based assumptions
© 2006 David Cairns
www.cairns.co.uk
Risk Disclosure
• Qualitative information– exposures to risk and
how they arise
– objectives, policies and process for managing risk
– methods used to measure risk
– changes from previous period
• Quantitative information– based on information
provided to key management personnel
– concentrations
© 2006 David Cairns
www.cairns.co.uk
Risk Disclosure
• Credit risk– maximum exposure to credit risk, past due and
impaired financial assets, collateral
• Liquidity risk– maturity analysis and how liquidity risk is managed
• Market risk– sensitivity analysis
© 2006 David Cairns
www.cairns.co.uk
Capital Disclosures
• IAS 1 (revised 2005)
– objectives, policies and processes for managing capital
– description and quantification of what bank regards as capital
– if subject to externally imposed capital requirement
• nature of requirements
• whether complied with requirements and, if not, the consequences
Financial Assets and Liabilities
Overview for Banks
David Cairns