IFRS First Impressions: IFRS 9 Financial Instruments September 2014 kpmg.com/ifrs Contents Fundamental changes call for careful planning 2 7.3 Host contracts that are not financial assets in the scope of IFRS 9 38 Setting the standard 3 8 Reclassification 39 1 Key facts 4 8.1 Conditions for reclassification of financial assets 39 2 How this could impact you 6 8.2 Timing of reclassification of financial assets 40 8.3 Measurement on reclassification of financial 3 Scope 8 assets 41 3.1 Overview 8 9 Measurement on initial recognition 42 3.2 Own-use exemption 8 3.3 Loan commitments and contract assets 8 10 Subsequent measurement 44 4 Recognition and derecognition 9 10.1 Financial assets 44 10.2 Financial liabilities 45 5 Classification of financial assets 10 10.2.1 General principles 45 5.1 Introduction 10 10.2.2 Measurement of changes in credit risk 45 5.1.1 Overview of classification 10 11 Amortised cost and the effective interest method 50 5.1.2 Amortised cost measurement category 13 11.1 Calculating amortised cost 50 5.1.3 FVOCI measurement category 13 11.2 Calculating the EIR 51 5.1.4 FVTPL measurement category 13 11.2.1 General approach 51 5.1.5 FVOCI election for equity instruments 14 11.2.2 Credit-adjusted EIR 52 5.2 Contractual cash flows assessment – the SPPI criterion 14 11.3 Calculating interest revenue and expense using the EIR 53 5.2.1 Meaning of ‘principal’ and ‘interest’ 15 11.3.1 General approach 53 5.2.2 Time value of money 17 11.3.2 Approach for credit-impaired financial 5.2.3 Contractual provisions that change the assets 53 timing or amount of contractual cash flows 19 11.4 Revisions to estimated cash flows 53 5.2.4 De minimis or non-genuine features 22 11.5 Modifications of financial assets 54 5.2.5 Non-recourse assets 22 11.5.1 Overview 54 5.2.6 Contractually linked instruments 23 11.5.2 Gains or losses on modifications of financial assets 55 5.2.7 Examples of instruments that may or do not meet the SPPI criterion 25 12 Impairment 58 5.3 Business model assessment 27 12.1 Scope of the impairment requirements 58 5.3.1 Overview of the business models 27 12.1.1 General requirements 58 5.3.2 Assessing the business model 28 12.1.2 Equity investments 60 5.3.3 Held-to-collect business model 30 12.2 Overview of the new impairment model 60 5.3.4 Both held to collect and for sale 12.3 The general approach to impairment 61 business model 32 12.3.1 The expected credit loss concept 61 5.3.5 Other business models 33 12.3.2 12-month expected credit losses and 6 Classification of financial liabilities 34 lifetime expected credit losses 64 6.1 Overview of classification 34 12.3.3 When is it appropriate to recognise 12-month expected credit losses or 6.2 Fair value option for financial liabilities 35 lifetime expected credit losses? 65 6.2.1 Would split presentation create or 12.3.4 Significant increase in credit risk 66 enlarge an accounting mismatch? 36 12.4 Measurement of expected credit losses 78 6.3 Deletion of the cost exception for derivative financial liabilities 37 12.4.1 Overview 78 12.4.2 Definition of ‘cash shortfall’ 80 7 Embedded derivatives 38 12.4.3 The estimation period – the expected 7.1 Overview 38 life of the financial instrument 82 7.2 Host contracts that are financial assets in the 12.4.4 Probability-weighted outcome 84 scope of IFRS 9 38 12.4.5 Time value of money 84 15.2.2 Transition requirements for classification 12.4.6 Reasonable and supportable information 86 and measurement 119 12.4.7 Collateral 88 15.2.3 Transition requirements for impairment 123 12.4.8 Individual or collective basis of 15.2.4 Previous versions of IFRS 9 124 measurement 89 15.3 Disclosures on initial application of IFRS 9 126 12.4.9 Financial guarantee contracts and loan 15.3.1 Classification and measurement 126 commitments 89 15.3.2 Impairment 127 12.4.10 Example of measurement of expected 15.4 First-time adopters of IFRS 127 credit losses 91 16 FASB proposals and US GAAP convergence 129 12.5 Write-offs 92 16.1 Classification and measurement of financial 12.6 Special approach for assets that are assets and financial liabilities 129 credit-impaired at initial recognition 94 16.2 Impairment 129 12.6.1 Definition of ‘credit-impaired’ asset 94 16.3 Hedge accounting 129 12.6.2 Initial measurement 95 12.6.3 Subsequent measurement 95 About this publication 130 12.6.4 Modifications 97 Acknowledgements 132 12.7 Simplified approach for trade and lease receivables and contract assets 97 12.7.1 Overview 97 12.7.2 Definitions 98 12.7.3 Specific measurement issues 98 12.8 Presentation of expected credit losses in the financial statements 100 12.8.1 Assets measured at amortised cost, lease receivables and contract assets 100 12.8.2 Loan commitments and financial guarantee contracts 101 12.8.3 Debt instruments measured at FVOCI 101 12.9 Interaction between expected credit losses and interest revenue 102 12.10 Comparison with Basel regulatory model 102 13 Hedge accounting 106 14 Presentation and disclosures 107 14.1 Presentation 107 14.2 Disclosures 107 14.2.1 Overview 107 14.2.2 Classification and measurement of financial assets and financial liabilities 107 14.2.3 Credit risk and expected credit losses 109 15 Effective date and transition 117 15.1 Overview 117 15.2 Transition 118 15.2.1 General principle 118 2 | First Impressions: IFRS 9 Financial Instruments Fundamental changes call for careful planning On 24 July 2014, the IASB issued the fourth and final version of its new standard on financial instruments accounting – IFRS 9 Financial Instruments. This completes a project that was launched in 2008 in response to the financial crisis. After long debate about this complex area, the implementation effort can begin in earnest. The new standard includes revised guidance on the classification and measurement of financial assets, including impairment, and supplements the new hedge accounting principles published in 2013. In the past, concerns have been raised about ‘too little, too late’ provisioning for loan losses. The new expected credit loss model for the recognition and measurement of impairment aims to address these concerns, and accelerates the recognition of losses by requiring provisions to cover both already-incurred losses and some losses expected in the future. The new standard will have a massive impact on how banks account for credit losses on their loan portfolios. Provisions for bad debts will be bigger and are likely to be more volatile, and adopting the new rules will require a lot of time, effort and money. A major issue for banks and investors in banks will be how adoption of the new standard will affect regulatory capital ratios. Banks will need to factor this into their capital planning, and users are likely to be looking for information on the expected capital impact. Insurers will also be significantly impacted by IFRS 9. The industry has to plan for the adoption of new standards on both financial instruments and insurance contracts over the next few years. The overall effect cannot be assessed until the insurance standard is finalised over the next 12 months, but we can expect a sea-change in financial reporting for most insurers. Other corporates should not automatically assume that the impact of the classification, measurement and impairment requirements of the new standard will be small, as this depends on the exposures they have and how they manage them. Planning for IFRS 9 adoption – including implementation of the new hedge accounting requirements published in 2013 – is likely to be an important issue for corporate treasurers and accountants generally. The new standard has a mandatory effective date of 1 January 2018, but may be adopted early. As the standard has been completed in stages, the relatively few entities that have adopted a previously released version of IFRS 9 can continue to use it until then. In addition, entities can adopt in isolation the part of the standard that allows them to reflect the effects of changes in credit risk on certain marked-to-market liabilities outside of profit or loss. Entities need to think about when they plan to adopt the new standard. Many banks may need the whole three and a half years up to 2018 to prepare for adoption of the expected credit loss requirements. However, the possibility of early adopting only the ‘own credit’ amendment would provide some welcome relief from profit or loss volatility caused by fluctuations in an entity’s own credit risk. Chris Spall (Leader) Enrique Tejerina (Deputy leader) Terry Harding (Deputy leader) Ewa Bialkowska KPMG’s global IFRS financial instruments leadership team KPMG International Standards Group © 2014 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. First Impressions: IFRS 9 Financial Instruments 3 Setting the standard Setting the standard A phased approach to completing IFRS 9 Since November 2008, the IASB has been working to replace its standard on financial instruments, IAS 39 Financial Instruments: Recognition and Measurement. The IASB structured the project in three phases: ● Phase 1: Classification and measurement of financial assets and financial liabilities ● Phase 2: Impairment ● Phase 3: Hedge accounting. The issuance in July 2014 of the complete version of IFRS 9: Financial Instruments, hereafter referred to as IFRS 9, marks the culmination of this project.