the future of financial instruments accounting

The Future of Financial Instruments Accounting

30 October 2014

IFRS 9Financial Instruments

Publication of the final standard

Impairment

Hedge Accounting

Classification and Measurement

3© 2014 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a member of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss legal entity. All rights reserved. The KPMG name, logo and “cutting through complexity” are registered trademarks.

Publication of the final standard

The complete standard also amends IFRS 7 “Financial Instruments: Disclosures“ to introduce new or amended disclosures.

Principle-instead of rules-based standard for accounting for financial instruments

IAS 39 has been revised in stages as follows:

IFRS 9 (2009)

IFRS 9 (2010)

IFRS 9 (2013)

New requirements for the classification and measurement of financial assets and financial liabilities

IFRS 9 (Final Standard)

New requirements for general Hedge Accounting

Amendments to classification and measurement requirements for financial assets published in IFRS 9 (2009) and IFRS 9 (2010).

New expected credit loss model for calculating impairment.

Requirements for the recognition and de-recognition of financial instruments (merely small adjustments)

Version What’s includedRetained from

IAS 39

The standard will be effective for annual periods beginning on or after 1 January 2018, and will be applied retrospectively with some exemptions.

Early adoption is permitted.

Restating comparatives not required, and permitted only if information is available without use of hindsight.

EU-Endorsement is outstanding.

Effective date and transition


Classification and Measurement of financial assets (1/2)

Verification of the business model and the cash flow criteria are the essential steps for classifying financial assets in accordance with IFRS 9

no

no

yes

Fair Value through Other

Comprehensive Income (No Recycling)

FVOCI

Fair Value OptionFVO

Fair Value through Other

Comprehensive Income (with Recycling)

FVOCI

no

Debt Instruments

Business ModelHeld to Collect

Business ModelHeld to Collect

and to Sell

SPPI criteria

Fair ValueOption

Amortised CostAC

SPPI criteria

DerivativesEquity

instruments

Held for Trading

OCI Option

yes

no noyes

Fair ValueOption

Business ModelTrading

Fair Value through

Profit and LossFV

yesyes

Classification of debt instruments is driven by the entity’s business model.

Possible to apply existing classification if debt instruments meet SPPI Test.

SPPI – Test: Assessmet whether asset’s contractual cash flows represent solely payments of principal and interest.

Equity instruments must be measured at fair value. If no trading intention exist then the OCI option is applied.

Focus topics


Classification and Measurement of financial assets (2/2)

The contractual terms may only give rise to cash flows that are solely payments of principal and interest

Payment of interest Payment of principal

Interest consists of consideration for: Time value of money. The associated credit risk.

The basis is the the principal amount outstanding during a particular period of time.

Payment of principal consists of: Contractual repayments. Unscheduled repayments. Mandatory unscheduled

repayments.

Verification of the SPPI Criteria is to be made for the currency in which the financial asset is denominated.

Cash Flows = Interest and Principal Cash Flows ≠ Interest and Principal

AC FVOCI FV

Examples fo featrues that needs to be considered:

- Prepayment and extension rights.

- Exposure to risks or volatility unrelated to a lending arrangement.

- Leverage.

- Modified time value of money.

Focus topics


Determin business models (level of business model) to be used and allocate investments to business models. particular focus on portfolios that are held for liquidity or investment purposes and other non-trading portfolios from which varying degrees of sales may be expected.

Implementing and operationalising SPPI test and benchmark test (integrate in new loan application and approval process e.g. apply lending tool)

Performance evaluation targets and measures may need to be updated.

Classification and Measurement - Practical Application Challenges

Need for system enhancements to support classification.

Verification of the SPPI criteria is a major challenge for the operationalisation of the classification process.

Constraints on ability to sell investments under business model test: Management wants the flexibility to sell assets (active management of portfolio, arbitrage, asset/liability matching).

Volatility in equity from OCI adjustments (eg,, EPS, regulatory capital) and profit or loss.

The classification and the resulting impact on measurement, may have a significant impact on the way an entity calculates its capital resources and requirements.

Business Impacts Our Approach


Classification and Measurement of financial liabilities

no

yes

Amortised Cost (AC)

Fair Value through

Profit and Loss(FV)

Fair Value Option

FVO

Debt Instruments

Held for Trading

Fair Value Option

yesEmbedded Derivatives that require bifurcation

yes

no

no

Derivative

Host Contract

(Bifurcation)

Derivatives

The classification of financial liabilities remains substantially unchanged in comparison to IAS 39

Measurement of financial liabilities remains substantially unchanged in comparison to IAS 39.

The difference in comparison to IAS 39 relates to liabilities that are designated at Fair Value through Profit or Loss. A change in fair value that is attributable to changes in credit risk is presented in OCI. Any other change in fair value is presented in Profit or Loss.

Focus topics


Impairment – Overview (1/2)

Criticism of the Incurred Loss-Model (IAS 39) Objective of the Expected Loss-Model (IFRS 9)

■ Loan loss allowance does not consider expected losses (“too little too late“)

■ Front loading of interest

■ Comparability is limited due to heterogenous impairment techniques

■ Loan loss allowance considers expected losses

■ Credit-adjusted effective interest rate for financial assets that are credit-impaired on initial recognition

■ Increased comparability of financial statements

Incurred but not reported (portfolio)

Impaired Portfolio (Default Portfolio):

Non impaired Portfolio:

Impaired Portfolio (Default Portfolio): No material impact

expected

Add

ition

ally

to b

e co

nsid

ered

Non impaired Portfolio:■ Consideration of EL for all assets

■ The model relies on robust estimates of:

- Expected credit losses- The point at which there is a significant

increase in the credit risk since initial recognition

Incurred Loss (specific identification) Incurred Loss = Expected Loss

Credit risk is at the heart of bank’s business, so IFRS 9 is likely to have a significant impact on banks and similar institutions

üü


Impairment – Overview (2/2)

Three Stage Approach

Definition of “significant increase in credit risk” requires degree of judgment

Assessment based on change in risk of default since initial recognition

Consideration of all reasonable and supportable information, including forward-looking info, available without undue cost or effort such as:

- Actual/expected internal/external credit rating changes

- Actual/forecast macroeconomic data

- Actual/expected changes in operating results/environment of borrower

Use 1yr EL if credit risk is low (e.g. if rated IG)

Potential impact on Basel 3 capital ratios; deduction of provision shortfall (vs. EL) from CET 1 capital

Focus topics

Definition of “significant increase in credit risk” requires robust data analysis and judgement

STAGE 3

EL

Lifetime

1yr

Transfer if significant increase in credit risk

STAGE 2

EL

Lifetime

1yr

STAGE1

EL

Lifetime

1yr

IAS 39

Objective evidence of impairmentMove back if

transfer criteria no longer met

Move back if transfer criteria no longer met


Impairment – Sensitivity analyses

1-year vs. lifetime expected loss Interpretation

Significant P&L volatility likely when switching between 1-year and lifetime EL

Assumptions made

S&P rating migration matrices to generate lifetime PDs (data: S&P Global Corporates, 1981-2013)

LGD and EAD assumed constant over time, EIR = 3%

EL multiple: Size of lifetime EL relative to 1-year EL

Example: BB-rated loan, maturity 7 years has EL multiple of around 10, i.e. lifetime EL is 10 times as big as 1-year EL

Further characteristics of lifetime expected loss:

- Can be significant portion of total exposure for lower rated, long-term credit exposures

- High P&L volatility when switching between 1-year and lifetime EL

- Sensitive to EIR choice

Observations

EL multiple is large for high rated (IG) exposures

Comparably small EL multiple for non-IG, but high EL in % of total exposure

1 2 3 4 5 6 7 8 9 10 11 120

10

20

30

AA A BBB IG Non-IG

Years

EL m

ult

iple

1 2 3 4 5 6 7 8 9 10 11 120%

5%

10%

15%

AA A BBB IG Non-IG

Years

EL in %

of

exposure


Impairment – Expected loss modelling framework

Modelling of lifetime expected losses Focus topics

Approach 1 – “Expected Loss”Probability weighted sum of exposure at

default („EAD“)

Appproach 3 – “Loss Rate”Expected loss approximation using

(portfolio) loss rate estimates

iii

T

iiT EADLGDDPPDEL

)

~1( 1

1

Year i forward PDYear i-1 cumulative PD

EADLRELT Year T cumulative Loss Rate („LR“)

Lifetime Average EAD

Approach 2 – “Cashflow”Probability weighted sum of potential

future cashflow shortfalls

Remarks:

EL calculations can be performed either at single credit exposure or (sub-) portfolio level

Requires definition of homogeneous sub-portfolios and justification of chosen approach

Data quality & granularity; missing internal data / inclusion of external data

Requires 1-year and multi-year estimates for PD, LGD, EAD, LR

Similar to Basel 2 A-IRB approach for credit risk; some key differences however (point-in-time PDs, No downturn LGDs, etc.)

Robust justfication for use of approximations such as:- Constant LGDs and CCFs- Usage of rating migration

matrices from external providers as e.g. Moody’s or S&P

Different approach with varying degree of sophistication possible – Each requiring in-depth understanding of limitations and key assumptions made

)(~

11

iii

T

iiT EADEADLGDDPEL

cashfow at risk in year i

Year i cumulative PD


Impairment – Practical Application Challenges (1/2)

Transition from IAS 39 to IFRS 9 impairment model Application of the new requirements will be

retrospective and hence cover all existing in-scope credit portfolios and committments

Assets are expected to attract significantly higher loss provisions compared to current IAS 39 incurred loss model

After go-live

Significant P&L volatility to be expected, due to

- Moving between stages 1 and 2- Changes in expectations over long-term PDs will

impact the stage 2 loss provisions significantly

Increased pro-cyclicality of loss provisions (worsening of overall economic condition will both shift more exposures to stage 2 and increase lifetime EL)

Business Impact

IFRS 9 impairment readiness

Assessment of status quo regarding

- Quality and granularity of internal data, use of external data

- Availability and quality of existing internal credit risk models (PD, LGD, EAD, credit portfolio models, etc)

Gap analysis regarding availability/quality of internal data and credit risk models

Impact and sensitivity analyses

Impact estimation of transition from IAS 39 to IFRS 9 model

Sensitivity analyses of IFRS 9 model after go-live

identification of key P&L volatility drivers

Our Approach


Impairment – Practical Application Challenges (2/2)

Operational and infrastructure challenges

Requires close collaboration of Risk (credit risk management) and Finance (accounting, reporting) units

Data quality and granularity matters

- Transfer criteria („significant increase in credit risk“)- Calculation of the expected losses, calibration of

parameters, justification of chosen approach (e.g. backtesting, stress testing)

Significant enhancements to Risk and Finance IT infrastructure likely to be required

Implementation of IFRS 9 impairment model

Detailed analysis, comparison and discussion of different alternative definitions for “transfer criteria” between stages 1 to 3

Implementation of IFRS 9 expected credit loss modelling framework (EL methodology, IT implementaion, updates to existing policy, processes and controls framework, etc.)

Our apporach takes the following key aspects into account:

- Ambition level desired by management- Review of your internal credit processes to

determine leverage / reliance on existing processes

- Applicability of simplifications- P&L volatility minimzation

Our ApproachBusiness Impact


Hedge Accounting (1/2)

Eligible hedged items Eligible hedging instruments

Recognised asset or liabilities (except if measured at FVtPL). Unrecognised firm commitment. Highly probable forecast transaction. Net investment in a foreign operation. Separately identifiable and reliably measurable risk components

(also relating to non-financial items). Net positions and layer components of items. Aggregated exposures (a combination of a non-derivative

exposure and a derivative).

Derivatives. Non-derivative items that are measured at FVtPL (except for

financial liabilities designated at FVtPL). Risks components. Combination of hedging instruments.

Hedge of a Net Investment in a

Foreign Operation Fair Value Hedge Cash Flow Hedge

Fair value changes of the hedged item is recognized

in profit or loss

Fair value changes of the hedging instrument is

recognized in OCI

Cash Flow Hedge:Hedge of exposure to variability in cash flows

Fair Value Hedge:Hedge of exposure to changes in fair value of hedged item

Scope of application

Hedged items and hedging instruments

Hedge accounting models


Hed

ged

It

ems

Hed

gin

g

Inst

rum

ents

Hed

ge

Eff

ecti

ve-

nes

s

Inef

fect

ive-

nes

sA

cco

un

tin

g

IFRS 9

Risk components of financial and non-financial items.

Aggregated exposures (combination of a non-derivative exposure and a derivative).

Increase in eligible hedging instruments, e.g. all financial instruments measured at FVtPL can be designated at hedging instrument.

Prospective assessment of hedge effectiveness only.

Removal of the quantitative effectiveness thresholds.

Re-balancing if hedge effectiveness is not fulfilled.

No changes compared to IAS 39.

IAS 39

Several restrictions; e.g. non-derivative financial asset or liability may only be designated as hedged item in its entirety and only for a hedge of foreign currency risk.

Derivatives may not be designated as hedged items.

Several restrictions in respect of eligible hedging instruments depending on the hedge accounting model.

Two step approach: prospective and retrospective assessment of hedge effectiveness (range: 80% - 125%).

Discontinuation of hedge accounting if hedge effectiveness criteria is not fulfilled.

Retrospective determination of hedge ineffectiveness and recognition in profit or loss.

Fair Value Hedge: fair value changes of hedging instrument and hedged item are recognised in profit or loss.

Cash flow Hedge: effective (ineffective) portion of fair value changes of hedged instrument is recognised in OCI (profit or loss).

No changes compared to IAS 39.

Hedge Accounting (2/2)


Hedge Accounting – Practical Application Challenges

Potentially no impact if current hedge relationships meet criteria in IAS 39.

Review of existing and designation of new hedge relationships.

It is a long-term decision – no de-designation possible.

Implementation of rebalancing requirement.

Potential cost savings by streamlining routine internal hedge accounting processes.

Business Impact

Identify and document rebalancing strategies.

Document new hedge relationships.

Implement controls to ensure actual hedge outcomes are in line with risk management strategy.

Disclosure requirements to be addressed.

Our Approach


Open discussion

Questions ?

Feedback?

Your views?

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Contact details

Patricia Bielmann

Partner

IFRS Financial Services

KPMG AGBadenerstrasse 172

8026 Zurich

Phone +41 58 249 41 88

Fax +41 58 249 48 64

[email protected]

Dr. Matthias Degen

Senior Manager

Financial Services Quantitative Finance Group

KPMG AGBadenerstrasse 172

8026 Zurich

+41 58 249 40 36

+41 58 249 48 64

[email protected]

mailto:[email protected]

mailto:[email protected]


KPMG IFRS 9 Accelerators

KPMG IFRS 9 Accelerators

IFRS 9 Lending Tool

The IFRS 9 Lending Tool supports you by providing an analysis of loan contracts under the requirements of IFRS 9 for financial instruments, supporting the efficient assessment and documentation of the solely payments of principal and interest (SPPI) criteria for loans.

1

iRADAR

The iRADAR tool offers a robust solution for appropriate classification of securities under the IFRS 9 SPPI criteria. It utilises an ever expanding database of security information, sourced from five professional databases such as Bloomberg and Reuters, and an IFRS 9 SPPI algorithm to facilitate accurate classification of security portfolios.

2

gCLAS

An IFRS 9 web based modular accounting software package which includes a cash flow engine designed to risk adjust contractual cash flows for fixed and floating rate loans and includes residential and commercial mortgage loans, consumer loans, syndicated loans and revolving loans

3

IFRS 9 Interactive Data Dictionary

The data dictionary is a standalone tool which will help organisations identify the data and data flows required to produce IFRS 9 compliant quantitative disclosures. It highlights the disclosures that require judgement and/or data objects and the underlying processes which are required to calculate the data items. It will also highlight which data items and disclosure requirements are new and are not being reported under current IFRS 7 rules.

4


Glossary

A-IRB CCF EAD EIR EL IG LGD LR PD

Advanced Internal Ratings Based approach (Basel 2 / Basel 3)

Cash Conversion Factor (term frequently used in the context of EAD estimation)

Exposure At Default

Effective Interest Rate

Expected Loss

Investment Grade

Loss Given Default

Loss Rate

Probability of Default

Publications

For KPMG’s Newsletter:https://www.kpmgnews.ch/en/index.htm

For KPMG’s IFRS Publications:http://www.kpmg.com/global/en/topics/global-IFRS-institute

First Impressions: IFRS 9 Financial Instruments

This First Impressions provides our detailed analysis on the complete

version of IFRS 9 Financial Instruments, issued in July 2014.

.

Insights into IFRS 2014/15

KPMG’s updated publication explains the requirements of IFRS and provides extensive interpretative and application

guidance.

Disclaimer:

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2014 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss legal entity. All rights reserved. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.

the future of financial instruments accounting

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