BE130 – Lecture 5 - IFRS9 PDF

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10/11/BE130 – Current IssuesLecture 5 – IFRS9, Financial InstrumentsOverview of IFRS 9  Initial measurement of financial instruments  All financial instruments are initially measured at fair value plus or minus, in the case of a financial asset or financial liability not at fair value through prof...

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10/11/17

BE130 – Current Issues Lecture 5 – IFRS9, Financial Instruments Overview of IFRS 9  Initial measurement of financial instruments  All financial instruments are initially measured at fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs. [IFRS 9, paragraph 5.1.1] Subsequent Measurement IFRS 9 splits all types of financial assets currently within scope IAS39 into two classifications: 1. Those measured at amortised cost 2. Those measured at fair value Where assets are measured at FV, any gains/losses are either recognised in P/L (i.e. FVTPL) or recognised in other comprehensive income (i.e. FV changes through OCI). Debt Instruments A debt instrument that meets the following two conditions MUST be measured at amortised cost (net of any write down for impairment): 1. Business Model Test 2. Cash Flow Characteristics Test Business Model Test The objective of the business model to hold the FA to collect the contractual cash flows (rather than to sell the instrument before its contractual maturity to realise its fair value changes)? Cash Flow Characteristics Test Does the contractual terms of the FA give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding? However…  A debt instrument that meets the following two conditions must be measured at FVTOCI (unless the asset is designated at FVTPL under the fair value option)  All other debt instruments not meeting the above tests must be measured at fair value through profit or loss (FVTPL) Mis-Match Rule  Even if debt instrument meets the two tests to use amortised cost or FVTOCI then IFRS 9 has an option to designate, at initial recognition, a financial asset at FVTPL. If doing so ‘eliminates or significantly reduces a measurement or recognition inconsistency.

10/11/17

Equity – Financial Instruments ALL equity investments: are measured at FV in the SOFP (BS), with any value changes recognised in P/L [except for those equity investments for which the entity has elected to present value changes in ‘OCI'. There is no 'cost exception' for unquoted equities.] Financial Liabilities IFRS 9 NOT change the basic accounting model for financial libs under IAS 39. Still uses: FVTPL and Amortised cost. [Financial liabilities held for trading are measured at FVTPL, and all other financial liabilities are normally measured at amortised cost.] Unless the FV option applies IF there is a mismatch. Mis-match: Libs IFRS 9 contains an option to designate a financial liability as measured at FVTPL if it eliminates or significantly reduces a measurement or recognition inconsistency (i.e. an 'accounting mismatch'). Reclassification For financial assets, reclassification is required between FVTPL, FVTOCI and amortised cost, if and only if the company’s business model objective for its financial assets changes so its previous model assessment would no longer apply – but done prospectively from the reclassification date. Two Major Reforms 1. Incurred loss to expected loss model 2. ‘Own credit adjustment’ (sometimes termed ‘Debt Valuation Adjustment’) 1. Incurred loss to expected loss model Impairment Model The impairment model in IFRS 9 is based on the premise of providing for expected losses and not incurred losses. Largely applies to financial assets measured at amortised cost. I.e. Loans/Debt. In practice, this meant the INCURRED LOSS MODEL used by banks only entered provisions for impairment of their loans when customers actually missed loan interest or debt repayments. Banks were only able to recognise losses when they were actually incurred – even though they could often foresee additional losses heading their way. ‘Expected Loss’ Model  The reforms in IFRS9 now require banks to switch from an ‘incurred loss’ to an ‘expected loss’ model.  In future – this means banks will be required to not only recognise credit losses that have already arisen but also now include potential losses that are expected to occur in the future. These new rules will be based on a continuous assessment of the level of credit risk.

10/11/17

Time Frame The new IFRS rules even introduce a time frame for the estimation of the future expected losses. The revised IFRS9 will now require banks to normally provide for any credit losses in their financial statements for the coming 12-month period. [But can be extended if a bank believes the risks of credit losses to be increased significantly then the time horizon is correspondingly increased to encompass up to the lifetime of the expected credit losses. Implications Some analysts have predicted that the impact of the changes could be significant on the balance sheets of banks. These analysts forecast that banks might have to increase provisions for loan losses by up to 50% of current levels. 2. Own Credit Adjustment Often counter  intuitive accounting  Under IAS39, banks were subject to almost counter- intuitive accounting treatment for their own debt.  If a bank issued its own debt, which then falls in value on the capital markets  then this reduction in value could be credited back to reported earnings. So if a bank issued £100 worth of debt, but at the end of the financial year, the fair value of this debt fell to £80, (perhaps because the bank’s creditworthiness deteriorates), the £20 reduction is taken as a credit to the income statement. Example: Under the former rules, banks were subject to a quaint and almost counter- intuitive accounting treatment for their own debt. If a bank issued its own debt, which then falls in value on the capital markets  then this reduction in value could be credited back to reported earnings. So if a bank issued £100 worth of debt, but at the end of the financial year, the fair value of this debt fell to £80, (perhaps because the bank’s creditworthiness deteriorates), the £20 reduction is taken as a credit to the income statement. However,  IFRS9 still requires these financial liabilities to be recognised at fair values BUT  Significantly, the changes in these fair values caused by movements in the bank’s creditworthiness will NOT affect reported earnings.  Changes will now be reported in the Statement of Other Comprehensive Income – and so have no direct bearing on reported earnings...