ifrs 9 part ii classification & measurement cpd november 2015

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IFRS 9 Financial Instruments

Part II: Classification and measurement

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3Agenda

• Classification of financial assets and financial liabilities

• Derivatives• Embedded derivatives• Reclassification of financial assets• Measurement of financial assets and financial

liabilities• Estimates and other judgements

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Classification

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Classification Financial assets

Cash flows are solely payments of

principal and interest (SPPI)

Business model = hold

to collect

Business model = hold to collect and

sell

Other business models

Other types of cash flows

Amortised cost FVOCI*

FVTPL FVTPL

FVTPL

FVTPL

*Excludes investments in equity instruments. An entity can elect to present FV changes in OCI.

Step 1

Step 2

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Classification of financial assetsFair value through profit or loss (FVTPL)

Residual category

If a financial asset does not fit in

another category it is automatically FVTPL

Fair value option

Designated at initial recognition - eliminates or

reduces accounting mismatch

Note: the option to designate is irrevocable

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Classification of financial assets Fair value through other comprehensive income

Requirements for investments in equity instruments• Irrevocable election for particular investments in equity instruments that

would otherwise be measured at FVTPL• Condition: neither held for trading nor contingent consideration (IFRS 3)

Held for trading (definition)• Acquired or incurred principally for the purpose of selling or repurchasing

it in the near term• Part of a portfolio of identified financial instruments that are managed

together and for which there is evidence of a recent actual pattern of short-term profit-taking

• Derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument)

Election made on an instrument-by-instrument basis

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Contractual cash flow characteristics (step 1)• Financial assets with contractual cash flows that are solely payments of

principal and interest (SPPI) are measured at amortised cost or FVOCI depending on the business model in which the asset is held.

• Principal = amount transferred by holder (fair value at initial recognition)• Interest is consideration for:

– time value of money and credit risk;– other lending risks (for example, liquidity risk);– other associated costs (for example, administrative costs); and– a profit margin

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Contractual cash flow characteristics (step 1) (continued)• Exception for regulated rates

– government or regulatory authority sets interest rates where the time value of money (TVM) element does not provide consideration for only the passage of time

– the regulated interest rate may be a proxy for the TVM element if the rate provides consideration that is broadly consistent with the passage of time and does not provide exposure to risks or volatility that is inconsistent with a basic lending arrangement

• Simplified the test for a modified economic relationship:– the TVM element is not perfect, for example, the rate is periodically reset

to an average of short- and long-term rates– assess modification of the TVM element to determine whether contractual

cash flow represent SPPI– qualitative or quantitative assessment of TVM element

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Example 1:* contractual cash flow characteristicsSolely payments of principal and interest on the principal amount outstanding

• Instrument A 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.

* Refer to paragraph B4.1.13 of IFRS 9 Financial Instruments

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• Instrument B 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.


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• Instrument C is a bond with a stated maturity date and pays a variable market interest rate.

• That variable interest rate is capped.


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• Instrument D is a full recourse loan and is secured by collateral.


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• Instrument E is issued by a regulated bank with a stated maturity date.

– pays a fixed interest rate and all contractual cash flows are non-discretionary.

• Issuer subject to legislation that permits or requires a national resolving authority to impose losses on holders of particular instruments, including Instrument E, in particular circumstances.

• For example, the national resolving authority has the power to write down the par amount of Instrument E or to convert it into a fixed number of the issuer’s ordinary shares if the national resolving authority determines that the issuer is having severe financial difficulties, needs additional regulatory capital or is ‘failing’.


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Example 6:* contractual cash flow characteristicsNOT solely payments of principal and interest on the principal amount outstanding

• A bond that is convertible into a fixed number of equity instruments of the issuer.

Instrument F

• A loan that pays an inverse floating interest rate (ie the interest rate has an inverse relationship to market interest rates).

Instrument G

• A perpetual instrument but the issuer may call the instrument at any point and pay the holder the par amount plus accrued interest due.

• The instrument pays 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.

Instrument H


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Types of business model (step 2) Holding assets in order to collect

contractual cash flows

Realise cash flows by collecting contractual payments over the life

of the instrument

Typically involve lower frequency and value of

sales

Measurement: amortised cost

Both collecting contractual cash flows and selling financial assets

Both collecting contractual cash flows

and selling – sale integral to achieving the objective of the

business model

Typically involve greater frequency and

value of sales

Measurement: FVOCI

Other business models

Neither held to collect nor held to collect and

for sale

Collection of contractual cash flows

is incidental to the objective of the model

Measurement: FVTPL

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Example 7:* business modelHolding financial assets to collect the contractual cash flows

• Entity A holds investments to collect their contractual cash flows. • Entity A performs credit risk management activities – to minimise

credit losses. • In the past, sales have typically occurred when the financial assets’

credit risk has increased, ie credit criteria specified in the entity’s documented investment policy no longer met.

• 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.

• Entity A also monitors fair values of the financial assets, among other information.

* Refer to Example 1 in paragraph B4.1.4 of IFRS 9 Financial Instruments

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Example 8:* business modelHolding financial assets to collect the contractual cash flows

• Assume that the loans continue to be recognised in the consolidated statement of financial position because they are not derecognised by the securitisation vehicle.

Entity Customers Originates loan

Securitisation vehicle

Sells loan

Investors Issues instrument


Controls → consolidate

Transfer of contractual cash flows

Payment of contractual cash flows

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Example 9:* an entity’s business modelObjective may be to hold financial assets to collect the contractual cash flows.

• A financial institution holds financial assets to meet liquidity needs in a ‘stress case’ scenario.

– No sale is anticipated except in such scenarios.• Credit quality of the financial assets is monitored• Objective in managing the financial assets: collect the contractual

cash flows. • Financial assets are monitored on the basis of their fair value from

a liquidity perspective – Objective: cash amount that would be realised 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.


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Example 10:* an entity’s business modelBoth collecting contractual cash flows and selling financial assets

• 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.

• Return = collecting contractual payments + gains and losses from the sale of financial assets.

• 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 of significant value.

• This activity is expected to continue in the future.

* Refer to Example 6 in paragraph B4.1.4C of IFRS 9 Financial Instruments

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ClassificationFinancial liabilities

1. At fair value through profit or loss

• Held for trading, including derivative liabilities that are not accounted for as hedging instruments

• Derivative liabilities that are accounted for as hedging instruments

• Fair value option — designated at inception

2. Amortised cost

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Definition of derivative

Settled at a future date

Requires little or no initial

net investment

Value changes in response to

the change in the underlying

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Examples of derivatives and underlyingsType of contract Main pricing-settlement variable

(underlying variable)Interest rate swap Interest rates

Currency swap (foreign exchange swap) Currency rates

Commodity swap Commodity prices

Equity swap Equity prices (equity of another entity)

Purchased or written treasury bond option (call or put)

Interest rates

Interest rate futures linked to government debt (treasury futures)

Interest rates

Currency futures Currency rates

Currency forward Currency rates

Commodity forward Commodity prices

Equity forward Equity prices (equity of another entity)

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Embedded derivatives

What is an embedded derivative?

A component of a hybrid contract that also includes a non-derivative host – with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative

Example: equity kickerVenture capital entities providing subordinated loans agree that if and when the borrower lists its shares on a stock exchange, the venture capital entity is entitled to receive shares of the borrowing entity free of charge or at a very low price (an ‘equity kicker’) in addition to the contractual payments.

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Accounting for embedded derivativesDoes the hybrid contract contain a host that is an asset within the scope of IFRS 9?

Apply the requirements for classification of financial assets in IFRS 9 to the entire hybrid contract

economic characteristics and risks of the

embedded derivative are not closely related to

the economic characteristics and risks of the

host

Yes NoSeparate embedded derivative from host and account for as a derivative under IFRS 9 if the following three conditions are satisfied:

a separate instrument with the same terms

as the embedded

derivative would meet the

definition of a derivative

the hybrid contract is not measured at FVTPL (ie a

derivative that is embedded in

a financial liability at

FVTPL is not separated)

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ReclassificationConditions

Financial assets• When, and only when, an entity changes

its business model for managing financial assets – expected to be very infrequent

Financial liabilities• An entity shall not reclassify any financial

liability

Reclassification shall be applied prospectively from the reclassification date.

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Changes in business modelExamples of change in business model: Not a change in business model

• 1. An entity has a portfolio of commercial loans that it holds to sell in the short term. o The entity acquires a company that manages

commercial loans and has a business model that holds the loans in order to collect the contractual cash flows.

o The portfolio of commercial loans is no longer for sale, and the portfolio is now managed together with the acquired commercial loans and all are held to collect the contractual cash flows.

• 2. A financial services firm decides to shut down its retail mortgage business - no longer accepts new business and the financial services firm is actively marketing its mortgage loan portfolio for sale.

• A change in intention related to particular financial assets (even in circumstances of significant changes in market conditions).

• The temporary disappearance of a particular market.

• A transfer of financial assets between parts of the entity with different business models.

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Measurement

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Measurement at Initial Recognition 29

Initial carrying amount

Measured at FVTPL


Measured at other

than FVTPL

Fair value

Adjusted for transaction Costs

Asset Asset or Liability Liability

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=

Measured at other

than FVTPL

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Example 11:* accounting for transaction costsInitial and subsequent measurement - FVOCI

An entity acquires a financial asset for CU100 plus a purchase

commission of CU2.

The reporting period ends one day later, when the quoted market price of the asset is CU100.

If the asset were sold, a commission of CU3 would be

paid.


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Fair value versus transaction price• Best evidence of the fair value of a financial instrument at initial recognition is normally

the transaction price.• If fair value at initial recognition differs from transaction price:

– If fair value is evidenced by a quoted price in an active market for an identical asset or liability or based on valuation technique that uses only data from observable markets

– Recognise the difference between the fair value at initial recognition and the transaction price as a gain or loss

– In all other cases: o At initial recognition: defer the differenceo After initial recognition: recognise that deferred difference as a gain or loss only to

the extent that it arises from a change in a factor that market participants would take into account

• If part of the consideration might not be for the financial instrument itself, eg– ‘Interest free’ loan to a subsidiary– Providing below-market interest rate loan for rebates or minimum purchase volume

regarding other itemso In the cases above, an entity measures the fair value of the financial instruments

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Subsequent measurement of financial assetAmortised cost

Statement of financial position

Amortised cost

Profit or loss

Interest revenue using effective interest method

Impairment

Foreign exchange gains & losses

Gain or loss on derecognition

Other Comprehensiv

e Income

Nil

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Subsequent measurement of financial assetFair value through OCI (debt instruments)

Statement of

financial position

Fair value

Profit or loss

Interest revenue using effective interest method

Impairment

Foreign exchange gains & losses

Other Comprehensiv

e Income

Fair value change other than those

recognised in profit or loss

(amounts accumulated are recycled to P&L

upon derecognition)

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Example 12:* Subsequent measurement of financial asset Debt instrument measured at FVOCI

• FV of debt instrument = CU1,000 on 15 December 20X0 (measured at FVOCI). • 5% interest rate over the contractual term of 10 years. • Effective interest rate = 5%• At initial recognition the entity determines that the asset is not purchased or

originated credit-impaired.

* Refer to Example 13 in paragraphs IE78-IE81 of IFRS 9 Financial Instruments

Debit Credit Financial asset – FVOCI CU1,000Cash CU1,000(To recognise the debt instrument measured at its FV)

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FVOCI means fair value through other comprehensive income.

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• 31 December 20X0 (the reporting date) – FV decreased to CU950 as a result of changes in market interest rates.

• The entity determines that there has not been a significant increase in credit risk since initial recognition and that expected credit losses should be measured at an amount equal to 12-month expected credit losses (ECL), which amounts to CU30. (Note: refer to Part III of the IFRS 9 CPD for how to calculate 12-month ECL).


Debit Credit Impairment loss (P&L) CU30Other comprehensive income (a) CU20Financial asset - FVOCI CU50(To recognise 12-month expected credit losses and other FV changes on the debt instrument)

(a) cumulative loss in OCI at the reporting date = CU20 which consists of the total FV change of CU50 (ie CU1,000 – CU950) offset by the change in the accumulated impairment amount representing 12‐month expected credit losses that was recognised (CU30).

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• 1 January 20X1: the entity sells the debt instrument for CU950, which is its FV at that date.


Debit Credit Cash CU950Financial asset—FVOCI CU950Loss (profit or loss) CU20Other comprehensive income CU20To derecognise the FVOCI asset and recycle amounts accumulated in OCI to P&L)

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Subsequent measurement of financial assetFair value through OCI (investments in equity instruments)

Statement of financial

position

Fair Value

Profit or loss

Dividends

Other Comprehensive

Income

Changes in fair value and foreign exchange

component

(amounts accumulated never reclassified to

P&L → may be transferred within

equity)

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Subsequent measurement of financial assetFair Value through Profit or Loss

Statement of financial position

Fair value

Profit or loss

Changes in Fair value

Gain or los on

derecognition

Other Comprehensiv

e Income

Nil

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Dividends

• the entity’s right to receive payment of the dividend is established;

• it is probable that the economic benefits associated with the dividend will flow to the entity; and

• the amount of the dividend can be measured reliably.

Dividends are recognised in profit or loss only when:

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Investments in equity instrumentsMeasurement

All investments in equity instruments must be measured

at FV.

In limited circumstances cost may be an appropriate

estimate of FV, eg insufficient more recent information is available to measure FV, a wide range of possible FV measurements and cost

represents the best estimate of FV within that range.

Cost is never the best estimate of

FV for investments in quoted equity

instruments

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Cost not representative of fair valueIndicators

Significant change in investee’s performance compared with budgets, plans or milestones.

Changes in expectation, eg investee’s technical product milestones will be achieved.

Significant change in the market for the investee’s equity or its products or potential products.

Significant change in the global economy or the economic environment in which the investee operates.

Significant change in the performance of comparable entities, or in the valuations implied by the overall market.

Internal matters of the investee, eg commercial disputes, litigation, changes in management or strategy.

Evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties.

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MeasurementFinancial liabilities

MEASUREMENT AT INITIAL RECOGNITION

Fair value*—the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date.

SUBSEQUENT MEASUREMENTIt depends: - amortised cost using the effective interest method; - fair value through profit or loss: derivatives, liabilities accounted for under the fair value option and other financial liabilities

*Fair value is defined as follows: ‘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, Appendix A)

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Financial liabilities – ‘own credit’ Designated as at fair value through profit or loss (fair value option, ie FVO)

* Not recycled to P&L

Financial statements – IFRS 9Balance sheet P&L

Financial liabilities –FVO Full FV Gain and loss all FV ∆ except own credit

OCI

Gain and loss FV ∆ due to ‘own credit’*

• Otherwise, P&L gain when ‘own credit’ deteriorates, loss when it improves• Required by IFRS 9 for liabilities under the FVO

Own credit = FV changes in the liability arising from changes in the risk that the issuer will fail to perform on that particular liability

IFRS 9 allows the ‘own credit’ requirements to be early applied before the rest of IFRS 9

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Amortised cost

• Effective interest method is the method that is used in the calculation of the amortised cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period.

• Effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability.

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Amount at initial

recognition

Principal repayments

Cumulative amortisation using effective interest method of any

difference between initial amount and

maturity amount

Gross carrying amount

- +/- =Loss

allowance for financial

assets

Amortised cost

=-

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Reclassification of financial assets Measurement

Reclassification toFair value through

profit or lossFair value through OCI Amortised cost

Reclassification

from

Fair value through

profit or loss

• Continue to measure at FV • FV at reclassification date = new gross carrying amount

• The effective interest rate is determined on the basis of the fair value of the asset at the reclassification date

Fair value through OCI

• Continue to measure at FV

• Cumulative gain or loss in OCI → reclassified to profit or loss at reclassification date

• Reclassify the financial asset at its FV at the reclassification date

• Cumulative gain or loss in OCI → removed from equity and adjusted against FV at reclassification date

• Effective interest rate and expected credit losses → not adjusted

Amortised cost

• FV measured at reclassification date

• Difference between previous amortised cost and FV → recognised in profit or loss

• Difference between previous amortised cost and FV → recognised in OCI

• Effective interest rate and expected credit losses → not adjusted

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Example 13:* reclassification of financial assets• Entity A purchases a portfolio of bonds: FV (gross carrying amount)

= CU500,000.• Business model for managing the bonds changes.• FV of the portfolio of bonds at the reclassification date =

CU490,000.• If the portfolio was measured at amortised cost or at FVOCI

immediately prior to reclassification: – Loss allowance recognised at the date of reclassification would be CU6,000

(reflecting a significant increase in credit risk since initial recognition and thus the measurement of lifetime expected credit losses).

• 12-month expected credit losses at reclassification date = CU4,000.• For simplicity, journal entries for the recognition of interest revenue

are not provided.* Refer to Example 15 in paragraph IE104 of IFRS 9 Financial Instruments

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Example 13:* reclassification of financial assets (continued)

Debit Credit Bonds (FVOCI assets) CU490,000

Bonds (FVPL assets) CU490,000

Impairment loss (profit or loss) CU4,000

Other comprehensive income CU4,000

(To recognise the reclassification of bonds from FVTPL to FVOCI including commencing accounting for impairment. The OCI amount reflects the loss allowance at the date of reclassification (an accumulated impairment amount relevant for disclosure purposes) of CU4,000.)

Scenario 1: Reclassification out of FVTPL and into FVOCI measurement category

* Refer to Example 15 in paragraph IE104 of IFRS 9 Financial Instruments

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Debit Credit Bonds (gross carrying amount of the amortised cost assets)

CU490,000

Bonds (FVTPL assets) CU490,000Impairment loss (P&L) CU4,000Loss allowance CU4,000(To recognise reclassification of bonds from FVTPL: to amortised cost including commencing accounting for impairment.)

Scenario 2: Reclassification out of FVTPL and into amortised cost measurement category


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Debit Credit Bonds (FVPL assets) CU490,000

Bonds (FVOCI assets) CU490,000

Reclassification loss (profit or loss) CU4,000

Other comprehensive income(a) CU4,000

(To recognise the reclassification of bonds from FVOCI to FVTPL.)

Scenario 3: Reclassification out of FVOCI measurement category and into FVTPL measurement category

(a) The cumulative loss in OCI at the reclassification date was CU4,000. That amount consists of the total FV change of CU10,000 (ie CU500,000 – 490,000) offset by the loss allowance that was recognised (CU6,000) while the assets were measured at FVOCI


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Debit Credit Bonds (gross carrying value of the amortised cost assets) CU490,000

Bonds (FVOCI assets) CU490,000

Bonds (gross carrying value of the amortised cost assets) CU10,000

Loss allowance CU6,000

Other comprehensive income (a) CU4,000

(To recognise the reclassification from FVOCI to amortised cost including the recognition of the loss allowance deducted to determine the amortised cost amount. The measurement of expected credit losses is however unchanged.)

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Scenario 4: Reclassification out of FVOCI and into amortised cost measurement category

(a) The cumulative loss OCI at the reclassification date was CU4,000. That amount consists of the total FV change of CU10,000 (ie CU500,000 – 490,000) offset by the accumulated impairment amount recognised (CU6,000) while the assets were measured at FVTOCI


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Debit Credit Bonds (FVTPL assets) CU490,000Bonds (gross carrying amount of the amortised cost assets)

CU500,000

Loss allowance CU6,000Reclassification loss (profit or loss) CU4,000(To recognise the reclassification of bonds from amortised cost to FVTPL and to derecognise the loss allowance.)

Scenario 5: Reclassification out of amortised cost and into FVTPL measurement category


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Debit Credit Bonds (FVOCI assets) CU490,000

Bonds (gross carrying amount of amortised cost assets)

CU500,000

Loss allowance CU6,000

Other comprehensive income(a) CU4,000

(To recognise the reclassification from amortised cost to FVOCI. The measurement of expected credit losses is however unchanged.)

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Scenario 6: Reclassification out of amortised cost and into FVOCI measurement category

(a) For simplicity, the amount related to impairment is not shown separately. If it had been, this journal entry (ie DR CU4,000) would be split into the following two entries: DR OCI CU10,000 (FV changes) and CR OCI CU6,000 (accumulated impairment amount).


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Main judgements and estimates in applying IFRS 9

Classification and measurement •An entity will need to use judgement when it assesses its business model for managing financial assets and that assessment is not determined by a single factor or activity (B4.1.2B). •Sometimes judgement is required to assess whether contractual cash flows meet the solely payment of principal and interest criteria to ensure the correct classification of financial assets. •Consideration for the time value of money – an entity will need to apply judgement to assess whether the element provides consideration for only the passage of time (B4.1.9A).

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• Retrospective application with certain transition reliefs• Date of initial application = date when an entity first applies IFRS 9• ‘Own credit’ requirements can be early applied in isolation, until the mandatory effective

date. • Specific transition requirements for the following items:

– Classification: business model assessment, solely payment of principal and interest assessment, investments in equity instruments, fair value option designations, own credit risk on liabilities designated as at FVTPL

– Measurement: hybrid contracts, effective interest method, unquoted equity investments

• Previous versions of IFRS 9 phased out: – An entity may elect to apply earlier versions of IFRS 9 if , and only if, the entity’s

relevant date of initial application is before 1 February 2015• ‘Impracticable’ exemption for interim periods prior to the date of initial application

Effective date and transitionAnnual periods beginning on or after 1 January 2018

(early application of completed (whole) version permitted)

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ifrs 9 part ii classification & measurement cpd november 2015

Documents

financial instruments

financial liabilitiesestimates

financial statements

ifrs foundationsource

following chapters of

contractual cash flows

entitys business model

classification paragraph