new proposals for financial instruments at amortised cost

New proposals for financial instruments at amortised cost

ey.com/IFRS

Issue 61 / November 2009

Supplement to IFRS outlook

The International Accounting Standards Board (IASB) has reached another key milestone of its comprehensive project to replace IAS 39 Financial Instruments: Recognition and Measurement – the publication of a new Exposure Draft (ED) on Financial Instruments: Amortised Cost and Impairment.

The ED will apply to all financial assets and financial liabilities recorded at amortised cost in accordance with the first phases of the financial instruments project - IFRS 9 Financial Instruments1. The timeline for the IAS 39 replacement project is shown in Table 1 below. In this publication, we provide an overview of the proposals in the ED and discuss the impact this is likely to have on businesses.

Table 1: Timeline for IAS 39 replacement project

Summary of ED proposalsThe ED proposes an impairment methodology, based on expected credit losses and expected cash flows, for all financial assets measured at amortised cost. Since impairment is an integral part of amortised cost measurement, the ED also addresses the calculation of amortised cost and the computation of the effective interest rate, which are largely a restatement of the principles in IAS 39. The guidance on the use of the effective interest rate applies to both financial assets and financial liabilties measured at amortised cost.

In addition, a significant section of the ED is dedicated to new disclosure requirements.

Complete replacement of

IAS 39

Request for information: Impairment

Exposure draft: Classification and

measurement

Final standard Classification and

measurement (financial assets)

Exposure draft: Hedge accounting

Possible revised exposure draft: Derecognition

Final standard: Amortised cost and impairment

Exposure draft: Amortised cost and impairment

Final standard: Classification and measurement (financial liabilities)

Final standard: Hedge accounting

Final standard: Derecognition

June 2009 July 2009 Nov 2009 Jan-Mar 2010 Apr-June 2010 July-Dec 2010

1 The first phase of IFRS 9 Financial Instruments deals with classification and measurement of financial assets and is available for early adoption for 2009 year end financial statements, but application will not be mandatory before 2013. See Supplement to IFRS outlook Issue 60. A standard on financial liabilities is expected in the first quarter of 2010.

2 New proposals for financial instruments at amortised cost

Amortised costAmortised cost is defined in the ED as a cost-based measurement of a financial instrument that uses amortisation to allocate interest revenue or interest expense over the life of the instrument. It is calculated as the present value of expected cash flows discounted at the effective interest rate.

Current requirements of IAS 39 Currently, entities take into account estimated cash flows when setting the effective interest rate. Subsequent revisions to estimates do not change the effective interest rate, which is kept constant for a fixed rate instrument. Instead, there is a ‘catch-up’ adjustment to profit or loss so that the adjusted carrying amount continues to be recorded at the net present value of the remaining expected cash flows, discounted at the original effective interest rate. On the other hand, for a floating rate instrument, the effective interest rate will change to reflect movements in market interest rates. IAS 39 does not require a catch-up adjustment for floating rate instruments solely due to changes in market interest rates.

Changes from IAS 39 The ED proposes an effective interest rate calculation similar to IAS 39. For financial assets, the primary difference is that estimates of cash flows in the proposed model are to be made net of expected credit losses (described further, below). While IAS 39 was silent about the reflection of non-performance risk in the determination of expected cash flows for financial liabilities, the ED indicates that non-performance risk shall not be reflected in them.

In addition, the ED proposes that the amounts and timing of the cash flows shall be the probability-weighted possible outcomes, rather than the most likely outcome.

As movements in market interest rates result in changes to the effective interest rate for a floating rate instrument, the ED proposes a catch-up adjustment for such instruments when the contractual rate changes. Each expected cash flow is discounted at a rate equal to the sum of the initial effective spread and the zero coupon rate2 (applicable to that cash flow) on the benchmark yield curve3 at the measurement date, in order to determine the adjustment. The initial effective spread is derived from the carrying amount, the expected cash flows and their corresponding benchmark rates at inception, and is kept constant. The requirement to take into account future expected changes in the benchmark rate differs from current requirements and would considerably complicate the accounting for floating rate instruments.

2 The zero coupon rate is theoretically the interest rate of a zero coupon bond with the same timing and risk characteristics as the cash flow.

3 The yield curve applicable to the contractual variable rate of the instrument, e.g., if the contractual variable rate of the instrument is LIBOR, the benchmark yield curve would be based on LIBOR.

3New proposals for financial instruments at amortised cost

Impairment and the expected cash flow approachIAS 39 currently requires impairment of financial instruments that are recorded at amortised cost to be determined using an incurred loss model, where an impairment loss is only recognised when a loss event has occurred.

The ED proposes one impairment model for all financial assets recorded at amortised cost (as determined under IFRS 9) that includes all accounts receivables, based on

an expected cash flow approach. In this approach, impairment losses are recognised over the life of the financial asset, by including expected losses in the computation of the effective interest rate when the asset is first recognised. Changes in credit loss expectations are reflected in catch-up adjustments to profit or loss.

Table 2 below, highlights the key features of the incurred loss model currently required by IAS 39 and how the proposed expected cash flow approach would differ.

Expected cash flow examplesWe have included in the Appendix examples to illustrate:

The differences in allocation of credit • losses over the lives of financial instruments between the current approach and the proposed approach

The catch-up adjustment required when • credit loss expectations change

The catch-up adjustment required for • floating rate instruments when market interest rates change.

Guidance set out in the ED on the expected cash flow approach to impairmentThe guidance contained in the ED includes the following:

‘Point-in-time’ estimates ‘Point-in-time’ estimates of future cash flows should be used rather than ‘through-the-cycle’ estimates, which are based solely on historical credit loss data over a full economic cycle or several economic cycles.

Collective versus individual assessment In calculating the amortised cost, entities may estimate the expected cash flows either on a collective or an individual basis. This basis may be changed during the life of a financial asset (e.g., after a default). Entities should use the approach that provides the best estimate and which does not result in double-counting of credit losses. Also, entities should group financial assets that have similar credit risk characteristics (e.g., asset type, industry, geographical location, collateral type and past-due status) when estimating expected cash flows on a collective basis.

Table 2: Incurred loss versus expected cash flow approach

Current incurred loss approach Proposed new expected cash flow approach

Interest revenue for financial assets • is recognised on the basis of expected cash flows excluding expected credit losses.

Interest revenue for financial assets is • recognised on the basis of expected cash flows including expected credit losses.

Impairment is recognised only when • a loss event occurs (i.e., an impairment trigger).

Expected credit losses are continuously • re-estimated, hence, there are no loss events or impairment triggers.

Losses that are expected to arise • from future events are not recognised.

Impairment is recognised from an • adverse change in credit loss expectations and can be reversed by subsequent favourable changes.

Interest revenue can be viewed as • ‘overstated’ in periods before a loss event occurs.

Interest revenue reflects the total net • return expected at inception.

There is a complex interplay between • individual and collective impairment (e.g., incurred but not reported losses).

Individual or collective assessment only • depends on what better facilitates the cash flow estimate.


Sources of data Entities may use internal and external sources of data to estimate credit losses and expected cash flows. In the absence of entity-specific data, entities may use peer group experience for comparable financial assets. Historical data used should be adjusted to reflect current conditions.

Back-testing Entities should review, on a regular basis, the methodology and assumptions to estimate credit losses to ensure that such estimates are reliable.

CollateralEntities should consider the cash flows from possibly obtaining and selling collateral in their estimates of expected cash flows.

Practical expedientsEntities can use practical expedients to calculate amortised cost if they result in materially appropriate amounts. However, such practical expedients should comply with the following principles:

The time value of money is included in • the calculation (except for short-term receivables where the effect of discounting is not material)

The expected cash flows for all of the • remaining life of the financial instrument are included in the calculation

The present value of expected cash flows • equals the initial measurement of the financial instrument so that no losses are recorded on initial recognition.

Trade receivables and similar assetsThe ED suggests that an entity would not need to impute interest for a trade receivable. The undiscounted trade receivable amount would be recorded net of expected credit losses at initial recognition. Subsequent to initial recognition, the entity would analyse its trade receivables to determine if the estimates of credit losses need to be changed.

TransitionThe ED proposes that adoption would be retrospective, by adjusting the effective interest rate to approximate the rate that would have been determined at inception as if the entity has always used the expected cash flow approach.

The effective date is expected to be around three years from the issue of the final standard (probably no earlier than 2014), as responses from the Request for Information and feedback from extensive outreach activities indicated that a longer-than-normal period will be necessary to allow preparers to modify their systems and collect the data required to estimate expected cash flows.

Presentation and disclosuresThe ED proposes extensive qualitative and quantitative disclosures to enable users to decipher what happened and why in relation to the expected cash flow approach, as well as providing information on the credit quality of financial assets. These proposed disclosures are in addition to the credit risk related disclosure currently required in IFRS 7.

The majority of the proposed disclosures are required by ‘class’ of financial asset or financial liability.

Presentation and disclosures on the face of the statement of comprehensive income Gross interest revenue; allocation of initial expected credit losses; net interest revenue; gains and losses from changes in estimates; and interest expense using effective interest rate methodAn example of the proposed disclosures is shown in Table F in the Appendix.

The ED proposes that only gains or losses on hedging transactions that qualify for hedge accounting should be included in the same line as the gross interest revenue or expense for the hedged financial instruments.


Disclosures in the notes to the financial statements A reconciliation of the allowance account for each class of financial assets The ED proposes the use of a provision account for expected credit losses and prohibits direct write-offs, even when a financial asset becomes impaired and is written-off in the same period.

See an example of this disclosure in Table G in the Appendix.

Entities will also be required to disclose their write-off policies.

Details of estimates and changes in estimates The proposed disclosures include the basis of inputs and the estimation technique used to determine the expected losses, changes in inputs resulting in significant increases or decreases in expected credit losses, changes in estimation technique, and quantitative and qualitative analysis of changes in estimates.

One of the most significant proposed disclosures is a comparison of the development of the credit loss allowance over time with cumulative write-offs by year of origination and a qualitative analysis of the effect of changes in credit loss estimates on this comparison if that effect is significant. This is required for each class of financial asset. The disclosure in Table 3 (based on the example in the ED) compares historical estimates (i.e., cumulative credit loss allowance) with actual outcomes for one class of loans in order to:

Track the development of losses over • time

Provide transparency of the accuracy of • management’s estimates (the table would not show a steady build up provision pattern if there are many significant changes to management expectations)

Provide back testing information on how • loss estimates develop over time.

Stress testing informationIf management performs stress testing for their internal risk management purposes, the entity should disclose the implications for the financial position and performance and the entity’s ability to withstand the stress scenario(s).

Credit quality for each class of financial assetsThe ED proposes a reconciliation of changes in non-performing financial assets during the period. It also proposes narrative explanation for changes in the allowance account and movement in non-performing financial assets if, according to the ED, the interaction between the two is significant. Financial assets are defined as non-performing when more than 90 days past due or considered uncollectible.

Origination and maturity (vintage) information for each class of financial assets Disclosure of the year of origination and maturity information based on nominal amounts, designed to allow users to assess

credit risk that is associated with particular vintages, which may be relevant for understanding the quality of the portfolios and the quality of the lending business.

Transition disclosuresEntities should provide what the ED describes as a “qualitative analysis” of:

The effect on profit or loss due to the • difference in the effective interest rate previously determined under the incurred loss approach and the expected effective interest rate determined under the expected cash flow approach

How the effect relates to the amount of • the transition adjustment to the amortised cost of financial assets.

Expert Advisory PanelThe IASB will establish an Expert Advisory Panel consisting of preparers of financial statements, credit risk professionals with a background in risk management, systems, operations or product development, as well as auditors and regulators.

Table 3: Comparison of loss allowance with cumulative write-offs for mortgage loans

Year of origination 20X1 CU

20X2 CU

20X3 CU

20X4 CU

Total CU

Credit loss provision (cumulative)

At the end of the origination year 50 70 80 300

One year later 100 150 150

Two years later 200 200

Gross provision for credit losses (before write-offs)

200 200 150 300 850

Total cumulative write-offs (100) (100) (50) (0) (250)

Net provision for credit losses (gross provision for credit losses less cumulative write-offs)(a)

100

100

100

300

600

(a) The ‘net provision for credit losses’ should equal the carrying amount of the provision account. (b) At the end of the life of the instrument, the cumulative write offs and the cumulative provisions should be equal.(c) The cumulative write-offs are divided by the ED into two sub-categories: write-offs as a result of delinquencies and

write-offs as a result of foreclosures. We have not reflected this in the table.


The Board will use the Panel as a forum to address the operational challenges, provide concise application guidance, facilitate field testing and identify simplifications to the expected cash flow approach.

Business impactIncreases subjectivity More judgment will be needed in assessing expected future credit losses. One of the main challenges in transitioning from an incurred loss approach to an expected cash flow approach will be to obtain the expected cash flow data and make forecasts about future cash flows. While historical data can be useful, history is not necessarily a good guide to the future. The estimation of future expected cash flows and credit losses will, inevitably, be subjective.

Significant systems changes and operationally challengingSince estimates of the amount and timing of cash flows are required at different points in time over the entire lives of the financial assets, forecasting expected cash flows could require significant new processes to be introduced and changes to information systems, procedures and controls. Some entities that currently determine expected credit losses (e.g., financial institutions which do so to meet Basel II capital requirements), do so over shorter projection periods, and may have access to some, but not all, of the necessary expected cash flow information. In addition, there are added complexities in computing the effective interest rates, especially for variable rate instruments, and in calculating catch-up adjustments.

Complexity in back-testing The ED indicates that the methodology and assumptions shall be reviewed regularly to reduce any differences between estimates and actual credit loss experiences. Back-testing is one way to achieve this. To meaningfully perform back-testing, it is necessary to track different categories of loans at a sufficiently granular level to

determine how the expected cash flows for each category translate into losses. Note that this level of detail is also needed to present the vintage disclosures described earlier.

Migration of loans between fixed and variable rate portfolios It is possible that a loan will be reset from an initial fixed rate to a variable rate after a number of years. Forecasting the cash flows for such products and keeping track of the effective interest rate and accumulated loan loss allowances, will be particularly challenging.

May be more pro-cyclical Although the expected loss provision is accrued over time, the expected cash flow approach may result in larger losses in periods with significant changes in credit loss expectations and therefore be more pro-cyclical. (This is illustrated by Table C in the Appendix.) On the other hand, the adoption of the expected cash flow approach would, potentially, reduce profitability for expanding loan books in earlier years due to the inclusion of expected credit losses in the computation of interest revenue.

Transition impact As adoption is retrospective, entities would have to estimate the new effective interest rates of all existing financial instruments recorded at amortised cost on the date of adoption. This is likely to be a difficult and time-consuming exercise.

Extensive disclosure requirements Entities will need to gather large amounts of data and change their systems significantly in order to comply with the extensive disclosure requirements, in particular, as most of the disclosures require analysis by class of financial asset.

Comments on this ED are due by 30 June 2010


Expected cash flow examplesIn order to illustrate the effects of the new impairment model, we have extended some examples that were originally prepared by the IASB staff.

Fixed rate instrument example Table A below highlights the differences between the incurred loss and the expected cash flow models, based on the following assumptions:

A portfolio of 1,000 loans totalling CU • 2,500,000 matures in 10 years at a contractual interest rate of 16%

Management estimates that no loans will • default in years X1 or X2

From X3 onwards, loans will default at an • annual rate of about 9%, with 100% loss on default

If defaults occur as expected, the rate of • return from the portfolio will be approximately 9.07%

The example is for a fixed number of • loans, without any new lending or prepayments or transaction costs, or any collective impairment provisions.

In Table A, the total net return (interest less loan loss) over the life of the instrument is the same under both models. However, the incurred loss model results in loan losses being recognised later in the life of the instrument while the expected cash flow model has the effect of smoothing the reported income.

Table A: Fixed rate example with no change in credit loss expectations

Incurred loss Expected cash flow

Coupon Loans, net of allowance

Loan loss expense

(incurred)

Interest less loan loss

Return, net of loan loss

Loans, net of allowance

Expected cash flow

adjustment


Return, net of

loan loss

(a) CU

(b) CU

(c) CU

(a)-(c) CU

(f) %

(d) CU

(e) CU

(a)-(c)-(e) CU

(f) %

31/12/X1 400,000 2,500,000 0 400,000 16.00 2,326,689 173,311 226,689 9.07

31/12/X2 400,000 2,500,000 0 400,000 16.00 2,137,662 189,026 210,974 9.07

31/12/X3 364,000 2,275,000 225,000 139,000 5.56 1,967,496 (54,834) 193,834 9.07

--- --- --- --- --- --- --- --- --- ---

--- --- --- --- --- --- --- --- --- ---

31/12/X9 208,000 1,300,000 127,500 80,500 5.64 1,260,320 (41,572) 122,072 9.07

31/12/X0 189,600 0 115,000 74,600 5.74 0 (39,680) 114,280 9.07

1,634,600 1,634,600

(a) Interest income computed at 16% contractual rate.(b) Contractual amount of outstanding loans, reduced by cumulative incurred

losses in (c).(c) Amount incurred as a result of events that happened during the period.

(d) Present value of expected future cash flows discounted at the effective interest rate including expected losses of 9.07%.

(e) Expected cash flow adjustment.(f) The return, net of loan loss, is the interest less loan loss divided by the opening

loan balance net of allowance.

Appendix


Change in expected credit losses It is interesting to see how the two models reflect changing circumstances. Assume that, in X2, there is a loss event and an additional 100 loans default (with a 100% loss on default). At 31/12/X2, management expects the default rate after X2 to increase to approximately 10%. The additional defaults and change in expectations alter the expected cash flows from the entire portfolio. A catch-up adjustment is necessary in X2 to increase the estimate of defaults and restate the net carrying amount of the loans to the new expected cash flows, discounted at the original 9.07%. This is shown in Table C.

The impairment loss in X2 is measured as the difference between the carrying amount and the present value of the revised expected cash flows of the financial instrument. As described previously, for fixed rate instruments, the effective interest rate is determined at inception and kept constant throughout the life of the instrument. The catch-up adjustment of CU 319,624 (the difference between CU 210,974 in Table A and CU (148,650) in Table C less the CU 40,000 of interest income not received on the loans which have defaulted) is computed according to the application guidance in the ED, as illustrated in Table B.

Table B: Calculation of catch-up adjustment for change in credit loss expectations

Carrying amount Less Present value of future cash flows

Equals Catch-up adjustment

2,137,662 4 1,818,038 319,624

Discounted at original effective interest rate at inception using initial expected credit spread

Recognised in income statement

4 The carrying amount is the expected cash flow closing loan balance as at 31/12/X2 in Table A.


Table C: Fixed rate example with a change in credit loss expectations



Loan loss expense

(incurred)

Interest less loan

loss



Expected cash flow

adjustment



(a) CU

(b) CU

(c) CU

(a)-(c) CU

(f) %

(d) CU

(e) CU

(a)-(c)-(e) CU

(f) %

31/12/X1 400,000 2,500,000 0 400,000 16.00 2,326,689 173,311 226,689 9.07

31/12/X2 360,000 2,500,000 250,000 110,000 4.40 1,818,038 258,650 (148,650) (6.39)

31/12/X3 324,000 2,275,000 225,000 99,000 4.40 1,658,890 (65,852) 172,335 9.07

--- --- --- --- --- --- --- --- --- ---

--- --- --- --- --- --- --- --- --- ---

31/12/X9 172,500 1,076,500 119,500 52,740 4.41 1,030,591 (47,260) 100,000 9.07

31/12/X0 155,040 0 107,500 47,540 4.42 0 (45,909) 93,449 9.07

1,074,600 1,074,600

Variable rate instrument example As mentioned earlier, for a variable rate instrument, movements in market interest rates result in changes to the effective interest rate. A catch-up adjustment is required in such circumstances.

We have adapted the example shown in Table A to a variable rate instrument, as set out in Table E below. To simplify the example, we have used a flat yield curve. Assume the following further assumptions and changes in interest rates:

At inception of the loans, the contractual • interest rate of 16% is made up of LIBOR at 7% and a credit spread of 9%.Therefore, the effective interest rate of 9.07% consists of LIBOR at 7% and the initial effective spread of 2.07%.

In Table C, while the incurred loss approach still reports a net profit for X2, the expected cash flow approach reports a net loss in X2 as a consequence of continuing to discount the revised cash flows at the originally computed 9.07% effective interest rate. Although the expected cash flow model is generally more conservative, in X2 it results in a loss and so, in this example, is more pro-cyclical than the incurred loss model.

Note: (a) to (f) have the same meaning as noted in Table A..


Table D: Calculation of catch-up adjustment for change in contractual variable rate

Carrying amount Less Present value of future cash flows

Equals Catch-up adjustment

2,137,662 5 2,144,685 7,023

Discounted at revised effective interest rate using initial expected spread

Recognised in income statement

5 The carrying amount is the expected cash flow closing loan balance as at 31/12/X2 in Table A.

On 31/12/X2, LIBOR increases by 3% to • 10%. Therefore, the contractual interest rate becomes 19%. There is no change in credit loss expectations. The entity revises the effective interest rate by the 3% increase in LIBOR, keeping the initial effective spread frozen, to 12.07% (i.e., 10% plus 2.07%).

The change in LIBOR increases the expected cash flows for the entire portfolio. An adjustment is necessary in X2 to revise the effective interest rate and restate the net carrying amount of the loans to the new value of expected cash flows, discounted at the revised effective interest rate of 12.07%.

Both the incurred loss and expected cash flow models report an increase in interest revenue net of loan losses over the life of the loans. However, for the year ended 31/12/X2, there is no impact on the income statement under the incurred loss model, whilst there is a catch-up adjustment of CU 7,023 (the difference between CU 210,974 in Table A and CU 217,997 in Table E) recognised under the expected cash flow model, as illustrated in table D below. The catch-up adjustment arises because the effect of the change in the expected cash flows is not the same as the effect of the change in the discount rate.


Table E: Variable rate example with a change in contractual variable interest rate



Loan loss expense

(incurred)

Interest less loan

loss



Expected cash flow

adjustment



(a) CU

(b) CU

(c) CU

(a)-(c) CU

(f) %

(d) CU

(e) CU

(a)-(c)-(e) CU

(f) %

31/12/X1 400,000 2,500,000 0 400,000 16.00 2,326,689 173,311 226,689 9.07

31/12/X2 400,000 2,500,000 0 400,000 16.00 2,144,685 182,004 217,997 9.37

31/12/X3 432,250 2,275,000 225,000 207,250 8.29 1,971,245 (51,561) 258,811 12.07

--- --- --- --- --- --- --- --- --- ---

--- --- --- --- --- --- --- --- --- ---

31/12/X9 247,000 1,300,000 127,500 119,500 8.37 1,258,304 (42,593) 162,093 12.07

31/12/X0 225,150 0 115,000 110,150 8.47 0 (41,696) 151,846 12.07

2,037,650 2,037,650

If the yield curve is not flat, the ED proposes the use of forward rates to forecast expected cash flows for variable rate instruments and zero coupon rates to discount them. This will further complicate the calculation of the catch-up adjustment for a variable rate instrument. Note that the catch-up adjustment would often not be material if the yield curve is not steep.

Example disclosures We have included in Tables F and G examples of certain disclosures proposed by the ED, based on the figures for year X2 shown in Tables A and C. Please refer to the Presentation and Disclosures section for more details of the proposed disclosures.

Table F: Extract of statement of comprehensive income 20X2 CU

Gross interest revenue 400,000

Less:

Allocation of initial expected credit losses (189,026)

Net interest revenue 210,974

Gains and losses due to changes in expectations (319,624)

Interest expense (xxx)

Table G: Reconciliation of provision account 20X2 CU

Opening balance of provision account for credit losses 173,311

Additions:

Allocation of initial expected credit losses in the current period 189,026

Increase in expected credit losses for the current period 319,624

Subtractions:

Decrease in expected credit losses for the current period —

Write-offs (250,000)

Closing balance of provision account for credit losses 431,961

Note: (a) to (f) have the same meaning as noted in Table A..

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About Ernst & YoungErnst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.

For more information, please visit www.ey.com

Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.

About Ernst & Young’s International Financial Reporting Standards GroupThe move to International Financial Reporting Standards (IFRS) is the single most important initiative in the financial reporting world, the impact of which stretches far beyond accounting to affect every key decision you make, not just how you report it. We have developed the global resources — people and knowledge — to support our client teams. And we work to give you the benefit of our broad sector experience, our deep subject matter knowledge and the latest insights from our work worldwide. It’s how Ernst & Young makes a difference.

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