IFRS Update for Financial Institutions

IFRS Update for Financial Institutions

Markus Veith
Partner, McGladrey & Pullen, LLP

Table of Content

• Introduction
• Financial Instruments
• Amortized Cost and Impairment of Financial Assets
• Derecognition of Financial Instruments
• Financial Liabilities
• Liabilities – Replacement of IAS 37
• Hedge Accounting
• Offsetting Assets and Liabilities
• FI with Characteristics of Equity
• Fair Value Measurement and Disclosure
• Q&A

2 © 2011 Fiserv, Inc. or its affiliates.

IFRS and RSM
Introduction

IfrsE = E Tk2

IfrsE = IFRS excellence
E = expertise
Tk = technical accounting knowledge


Introduction

Markus K. Veith, Partner, McGladrey & Pullen, LLP

• Practice Leader, NY Financial Institutions
• IFRS Specialist and International Server
• Professional Background includes work as a banker and with a Big
4 firm

Contact Information:
• Telephone: (212) 372-1700
• markus.veith@mcgladrey.com

Footnote (Arial 8pt)


Financial Instruments



General Overview

Projects Overview

ED IFRS

Phase 1 – Classification and measurement of financial assets
(COMPLETED – IFRS 9) 12 Nov 2009
28 Oct 2010
Phase 1 – Classification and measurement of financial liabilities
(COMPLETED – IFRS 9)
Phase 2 – Impairment of financial assets
5 Nov 2009 H2/2011

Phase 3 – Hedge accounting Q3/2010 H2/2011

Asset and liability offsetting Q4/2010 Q3/2011

Derecognition (COMPLETED – IFRS 9)
7 Oct 2010 
FI with characteristics of equity
Q1/2011 H2/2011


General Overview

FI – What are the issues?

IFRS 7

Embedded derivatives

Hedge accounting
Liability or
accounting valuation equity?
measurement
IAS 39
IFRS 9
Derecognition IAS 32


IFRS 9

• IFRS 9 issued 12 November 2009
• A work in progress and will replace IAS 39
• Effective 1 January 2013 (EAP), early adoption in 2009 permitted

• Scope
• Classification and Measurement of financial assets (FA)

• Objective
• Facilitate assessment of amounts, timing and uncertainty of cash
flows arising from FA 
• Measurement of FA aligned with entity’s ‘business model’ and with
cash flow characteristics
• Single impairment method


IFRS 9

How is IAS 39 complexity reduced by IFRS 9?

• Number of classification and measurement categories reduced

• Clearer rationale for the new categories

• Bifurcation of embedded derivatives not required anymore

• ‘Tainting rules’ eliminated

• Single impairment method for all FA not at FV

• Impairment reversals permitted for all assets


Classification and Measurement of Financial Assets

IAS 39 IFRS 9

• Classification of FA into one of 4 • Classification of FA in one of 2 classes
classes, each having its own eligibility
criteria and different measurement • Classification based on assessment of
requirements the way in which the instrument is
managed (the entity’s business model)
• Eligibility criteria are a combination of and of its
the nature of the instrument, its manner contractual cash flow terms
of use and management choice
• The category into which the asset is
• ‘Tainting rules’ force reclassification to classified determines its measurement
FVTPL of all FA classified as HTM if on an ongoing basis: amortized cost or
more than an insignificant amount of the FV
FA in this class are sold before their
maturity date


Unquoted Equity Investments

IAS 39 IFRS 9

Unquoted equity instruments for which All equity investments must be
fair value cannot be measured reliably measured at fair value.
are measured at cost

Same exception applies to derivatives The fair value measurement project will
linked to such equity instruments that provide application guidance on
must be settled by delivery of such identifying circumstances where cost of
equity instruments equity instruments might be
representative of FV



IFRS 9 – Two-measurement-category Approach

• FI with highly variable cash flows or part of a trading operation
v/s
• FI with principal amounts held for collection or payment of contractual
cash flows rather than for sale or settlement with a third party

• Classification and measurement based on
• the entity’s business model (how it manages its FI) and
• the contractual CF characteristics of the FI



Reclassification after Initial Recognition?

• Reclassification of FA between the FV and AC categories
• Required if change in entity’s business model
• Prohibited in all other circumstances

• Expected to be rare

• Reclassification on the 1st day of the reporting period following the
change in business model -> prospectively only.

• Disclosure on effects of the reclassification



Fair Value Option?

An entity can elect, on initial recognition, to measure a financial asset
at fair value through profit or loss if, and only if, that designation
eliminates or significantly reduces an accounting mismatch



New model for classification of FA

FAIR VALUE

Unless

AMORTIZED COST


Impairment

IAS 39 IFRS 9

• Impairment assessment required for • Only FA at AC subject to impairment
FA
- measured at FV through OCI • All impairments eligible for reversal
- measured at amortized cost

• Several different models

• Some impairments cannot be reversed



Amortized Cost and Impairment of Financial Assets



Impairment – Project Overview

ED IFRS

5 November 2009 H2 / 2011

• Project’s objective
• Improve the amortized cost measurement, in particular the
transparency of
• provisions for losses on loans
• the credit quality of financial assets



What is the issue?

• Assume a credit card receivable balance of $100 at end of Y1
• $50 due end of Y1
• remaining $50 will remain outstanding at the end of Y2

• The entity estimates that at the end of each year, 5% of balance due
will be under default due to death of credit card holders (historically,
this pattern has been observed and is expected to continue in the
future)

• Any impairment to recognize for this financial asset end Y1?



Why is the ILM criticized?

• Expected future credit losses often recognized too late
• not permitted to be recognised until a trigger event has occurred

• High recognition of interest revenue until evidence of loss event
• accounting assumes that the loan will be repaid in full unless, at some
point during the loan’s life, evidence is provided to the contrary
• Abrupt adjustment in the P&L when trigger event occurs
• impairment is only then recorded

• Inconsistent impairment accounting between different entities
• for similar FAs, use of different trigger events or assessed differently



What is being proposed?

From Incurred Loss Model (ILM) to Expected Loss Model (ELM)

• Determine expected credit losses on a FA when first obtained
• Recognize contractual interest revenue, less initial expected credit
losses, over the life of the instrument
• Build up a provision over the life of the instrument for the expected
credit losses
• Reassess the expected credit loss each period
• Recognize immediately effects of changes in loss expectations



What is being proposed? (cont’d)

• ELM applied on a portfolio basis in many cases

• Application to all FA measured at amortized cost
• simplified approach for non-interest bearing assets

• Additional useful disclosure



What are the major benefits of the ELM?

• Expected losses recognized earlier
• Interest revenue reflects initial loss expectations
• Update of expected credit losses
• Enhanced transparency
• No loss recognition triggers  consistency in application
• Impairment method better reflects economic reality
• Improved information about credit quality of assets



Impairment – Issues under Consideration



Derecognition of Financial Instruments



Final standard on improved disclosures about derecognition

• On 7 October 2010, the International Accounting Standards Board
(IASB) issued amendments to IFRS 7 Financial Instruments:
Disclosures as part of its comprehensive review of off balance
sheet activities.
• The amendments will allow users of financial statements to
improve their understanding of transfer transactions of financial
assets (for example, securitizations), including understanding the
possible effects of any risks that may remain with the entity that
transferred the assets.
• The amendments also require additional disclosures if a
disproportionate amount of transfer transactions are undertaken
around the end of a reporting period.



Final standard on improved disclosures about derecognition
(continued)

• The IASB had originally proposed to replace the existing
derecognition model in IAS 39 Financial Instruments: Recognition and
Measurement and the associated disclosure requirements in IFRS 7.
However, in light of the feedback received, the IASB decided to retain
the existing derecognition requirements and to finalize improved
disclosure requirements.
• The amendments also broadly align the relevant disclosure
requirements of IFRSs and US GAAP.
• Entities shall apply the amendments for annual periods beginning on
or after 1 July 2011. In the first year of application, comparative
information are not required.



Continuing Involvement in a Transferred Asset?



IAS 39 Decision Tree Sequence – Example

• A has a portfolio of listed securities for which a liquid market exists
• A sells the portfolio to B for 10 million with agreement to repurchase it
in 2 years time for 10 million plus interests and less dividends

• Risk and rewards model: the repurchase agreement involves that A
has retained the risk relating to dividends paid in the portfolio and the
fair value of securities. A continues to recognize the portfolio
• Control model: Since the securities are traded in a liquid market, B
can easily sell the securities to third parties and then repurchase them
to deliver back to A. B has control over the portfolio. A derecognizes
the portfolio



IAS 39 Decision Tree Sequence – Example (cont’d)

• IAS 39 decision tree has to be strictly applied in sequence
• First “risk and rewards” model
• Second “control” model

• A retained substantial risks and rewards. As a result, B’s ability to
control the portfolio is irrelevant. A continue to recognize the portfolio



What are the Disclosure Requirements?

Transferred assets Transferred assets
NOT derecognized derecognized
(On-balance sheet) (Off-balance sheet)

Relationship between Nature of and risks from
transferred Continuing involvement
(but not derecognized) assets
and associated liabilities

Users’
concern!



Financial Liabilities



Final standard on financial liability accounting

• On 28 October 2010, the IASB issued requirements on the
accounting for financial liabilities. These requirements were added to
IFRS 9 Financial Instruments and complete the classification and
measurement phase of the IASB's project to replace IAS 39.
• New requirements address volatility in the P&L caused by changes in
the credit risk of a financial liability (‘own credit’) - affects primarily
entities that choose to apply the FV option to their financial liabilities.
• Maintains the existing amortized cost measurement for most
liabilities, limiting change to that required to address the own credit
problem.
• If an entity elects to measure a liability at fair value, it has to present
the portion of the change in its fair value due to changes in the entity's
own credit risk in other comprehensive income (OCI).



What is the Own Credit Issue?

Changes in a financial liability’s credit risk affect its fair value

If entity’s creditworthiness deteriorates, FV of its issued debt will
decrease (and vice versa)

For FL measured using the FVO, gain (or loss) recognized in OCI



Liabilities – Replacement of IAS 37


Liabilities
Overview

Project Overview
ED IFRS

January 5, 2010 H2 / 2011

• Project’s objectives
• Address inconsistencies with other IFRSs
• Achieve global convergence of accounting standards
• Improve measurement of liabilities in IAS 37

• Project status
• 1st ED in June 2005 to replace IAS 37
• 2nd ED in January 2010 related to guidance on measurement


Liabilities
Why a New Standard (1/3) ?

To address inconsistencies with other IFRSs

• IAS 37 - liability recorded only if it is probable (i.e. > 50% likely) that the
obligation will result in an outflow of cash or other resources

• IFRS 3, IAS 39 – no such ‘probability of outflows’ criterion


Liabilities

To achieve global convergence of accounting standards

• IAS 37 - liability for the total costs of restructuring a business recorded
when restructuring plan announced or starts to be implemented

• US GAAP - liability for only individual costs of a restructuring recorded
when the entity has incurred that particular cost


Liabilities

To improve measurement of liabilities in IAS 37

• What is ‘best estimate’ of the expenditure required to settle the
obligation?

• What costs should be included in the measurement of a liability?


Liabilities
Scope of the New IFRS

• Included - All liabilities not in the scope of other standards
• Liabilities arising from legal disputes
• Statutory asset decommissioning obligations
• Other environmental obligations
• Liabilities arising under contracts that have become onerous

• Excluded – Liabilities within the scope of other standards
• Financial liabilities (IAS 39)
• Pension liabilities (IAS 19)
• Income tax liabilities (IAS 12)
• Insurance liabilities (IFRS 4)


Liabilities
Key Amendments

• The new IFRS will not include the ‘probability of outflows’
criterion
• Instead, uncertainty about the amount and timing of outflows will be
accounted for by using a measurement that reflects their expected
value (i.e the probability-weighted average of the outflows for the
range of possible outcomes)

• The new IFRS will require an entity to record a liability for each
individual cost of a restructuring only when the entity incurs that
particular cost


Liabilities
Key Amendments (cont’d)

• The new IFRS will require measurement at the amount the entity
would rationally pay at the measurement date to be relieved of the
liability, i.e estimate of the PV of resources required to fulfil the liability
considering
• expected outflows of resources
• time value of money
• risk that actual outflows might differ from expected outflows

• Liability to pay cash v/s liability to undertake a service


Liabilities

Existing Recognition Criteria New Recognition Criteria
• Entity has a present obligation • Entity has a present obligation

• Probable (more likely than not) • Probable (more likely than
that an outflow of resources not) that an outflow of
required to settle the obligation resources required to settle
the obligation

• Amount of the obligation can
be reliably estimated • Amount of the obligation can
be reliably estimated



Hedge Accounting


Hedge Accounting

What is a Derivative?

A derivative is a FI with the following 3 characteristics:

• Its value changes in response to the change in a specified variable
(financial or possibly non-financial, the ‘underlying’)

• It requires no or a relatively small initial net investment

• It is settled at a future date


Hedge Accounting

Embedded Derivative - What is it?

Hybrid instrument
Host contract Embedded
derivative

An embedded derivative is a component of a hybrid (combined) instrument,
that also includes a non-derivative host contract, with the effect that some of
the cash flows of the combined instrument vary in a way similar to a stand-
alone derivative (IAS 39.10)


Hedge Accounting

Embedded derivatives – Split accounting?

Is the hybrid Would a freestanding Is the embedded
instrument measured No instrument with the Yes derivative closely No
Split out the
at fair value with same term and related to the host
changes recognized condition meet the contract? embedded
in profit or loss? definition of a derivative
derivative?

Yes No Yes

Do not split out the embedded derivative


Hedge Accounting

Embedded Derivatives

IAS 39 IFRS 9

Mixed requirements for a hybrid • If host contract is a financial asset, no
contract: split  classification criteria applied to
the contract in its entirety
• measured at FVTPL in its entirety
• If host contract is a financial liability or
• split into 2 components a non-financial item no change to the
- the ED measured at FVTPL accounting for hybrid contracts under
- the non-derivative host contract IAS 39
measured at AC or as an executory
contract using accrual accounting

• management’s choice: either as a
single contract or on a split basis


Hedge Accounting

Embedded Derivatives – Proposals

Hybrid contracts

Host not w/in Host w/in
IFRS 9 scope IFRS 9 scope

No separation
Apply IAS 39
Potential
bifurcation

Hedge Accounting

Embedded Derivatives – Proposals (cont’d)

Bifurcation

Derivative Host

Asset Otherwise IAS 39 or others

Apply Apply
IFRS 9 IAS 39


Hedge Accounting

Project Overview

ED IFRS

9 December 2010 H2 / 2011

• Fundamental reconsideration of current hedge accounting
requirements of both financial and non-financial hedged items


Hedge Accounting

Hedge Accounting - What is it?

• “Hedge accounting recognizes the offsetting effects on profit or
loss of changes in the fair values of the hedging instrument and
the hedged item”

• Once a hedging relationship is entered into, the hedged item is
accounted for following the hedging rules and no longer the
general rules for financial instruments


Hedge Accounting

What are Hedging Instruments?

Single hedging
item
Derivative

Hedging instruments
Proportions of a
Non-derivative for hedging item (only in
foreign currency terms of notional)
risk only


Hedge Accounting

What are Hedged Items?

Highly
probable Single item
forecast
transactions

Assets Group of similar
Firm Hedged items
Liabilities items
commitments

Net Portions/proportions of an
investments
item (time and amount)
in foreign
operations


Hedge Accounting

When can Hedge Accounting be Applied?
Hedge accounting criteria

Reliable
measurement of
effectiveness

Formal hedge The hedge is expected to
documentation in
Formal be and is highly effective
place at inception designation

Risk
management
policy


Hedge Accounting

How is Effectiveness Assessed?

IAS 39 does not specify a single method for assessing hedge
effectiveness. The method an entity adopts for assessing hedge
effectiveness depends on its risk management strategy

• Correlation and regression analysis
• Dollar-offset method
• The “hypothetical derivative” method
Use Specialists!
• The “change in fair value” method
• The critical terms method
• US GAAP literature



Offsetting Assets and Liabilities



Offsetting - Project Overview

ED IFRS
28 January 2011 Q3 / 2011

• Address IFRSs / US GAAP differences on balance sheet netting of
derivative contracts and other financial instruments that can result
in material differences in financial reporting by financial institutions

• Project’s progress
• ED published 28 January 2011
• Comment deadline on ED 28 April 2011
• Final IFRS expected third quarter of 2011



Offsetting – What are the Issues?

• Usefulness and appropriateness of offsetting
• Why FA and FL shall or can be offset in the SoFP?
• When offsetting in the SoFP might provide useful information?

• Basis of offsetting
• How FA and FL should be offset (basis of offsetting)?

• Approach to offsetting
• Legal enforceability of the right in bilateral arrangements



IFRSs and Offsetting – What is the Current Situation?

• An entity shall not offset assets and liabilities or income and
expenses, unless required or permitted by an IFRS (IAS 1.32).

• A financial asset and a financial liability shall be offset and the net
amount presented in the statement of financial position when, and
only when, an entity (IAS 32.42):
• (a) currently has a legally enforceable right to set off the recognized
amounts; and
• (b) intends either to settle on a net basis, or to realize the asset and settle
the liability simultaneously.



IFRSs and Offsetting – What is Proposed in the ED?

• An entity would be required to offset a recognized FA and a
recognized FL if, and only if, it has an enforceable unconditional right
of set-off and intends either to settle the asset and liability on a net
basis or to realize the asset and settle the liability simultaneously (the
offsetting criteria).
• Offsetting criteria apply whether the right of set-off arises from a
bilateral arrangement or from a multilateral arrangement (i.e. between
3 or more parties). The proposals also clarify that a right of set-off
must be legally enforceable (incl. default by or bankruptcy of a
counterparty) and its exercisability must not be contingent on a future
event.
• Require disclosure of information about offsetting and related
arrangements (such as collateral agreements).



FI with Characteristics of Equity



Financial instruments - Liability or Equity?

That is the question…



Project Overview

DP ED IFRS
February 28, 2008 H2 / 2011 Q4 / 2011 - ???

• Address some practice issues in current guidance
• Eliminate current rules-based approaches
• Achieve convergence with US GAAP



What is Proposed?

• A model where classification is based on the form of an instrument’s
settlement  distinction between
• Instruments that the issuer settles with assets (e.g. cash)
• Instruments that the issuer settles with its own equity instruments
(e.g. shares)

• Instruments with both liability and equity features will be separated
into liability and equity components



Instruments that the Issuer Settles with Assets

• Classify as equity if asset-settlement occurs because of the following
reasons
• on distribution of all of its assets (such as bankruptcy)
• the issuer chooses to pay a dividend or repurchase shares
• redemption allows existing holders to maintain control of the entity
• the holder ceases to participate in the activities of the entity

• Classify as liability all other asset-settled instruments



Instruments Settled with Own Equity Instruments

• Classify as equity a contract for a specified number of issuer’s own
equity instruments in exchange for a specified price
• specified number must be fixed or vary as an anti-dilution measure
• specified price must be in the functional currency of the reporting entity or
shareholder

• Classify as liability all other equity-settled instruments



Fair Value Measurement Guidance



Project Overview
DP ED IFRS
May 28, 2009
November 2006 June 29, 2010 Q2/2011

• Establish a single source of guidance for all FV measurements
• Clarify the definition of FV and related guidance
• Enhance disclosures about FV measurements
• Increase convergence between IFRS and US GAAP

• Project status
• Re-exposed measurement uncertainty analysis disclosure + consideration of
the effect of correlation between inputs
• Develop educational material to accompany the IFRS



Project Overview (cont’d)

When? IAS 39 IAS 41 IFRS 3 IFRS 5 …

How? IFRS on fair value Measurement guidance

Does not introduce new fair values
Does not change the measurement objective in existing IFRSs

© 2011 Fiserv, Inc. or its affiliates.


Future FVM Guidance v/s Other IFRSs

How should the entity recognize and If adopted the
measure the asset or liability? proposed standard
would apply only
when an existing
Refer to the appropriate IFRS
IFRS already
requires an asset of
liability to be
Does the IFRS use fair value? measured at fair
value.
Refer to Fair Value Measurement for:
• definition of fair value
• measurement
• disclosure

© 2011 Fiserv, Inc. or its affiliates.


New Definition of Fair Value – Exit Price

Current definition – The amount for which an asset could be exchanged, a
liability settled, or an equity instrument granted, between knowledgeable,
willing parties in an arm’s length transaction



Fair Value of a Liability



Fair Value at Initial Recognition



The Fair Value Hierarchy


IFRS for SMEs - Update

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IFRS Update for Financial Institutions

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