IFRS Update for Financial Institutions

Markus VeithPartner, 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

IfrsE = E Tk2

IfrsE = IFRS excellence

E = expertise

Tk = technical accounting knowledge

IFRS and RSM

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 Big4 firm

Contact Information:• Telephone: (212) 372-1700

• markus.veith@mcgladrey.com

Footnote (Arial 8pt)

Financial Instruments

Financial InstrumentsGeneral Overview

ED IFRS

Phase 1 – Classification and measurement of financial assets(COMPLETED – IFRS 9) 12 Nov 2009Phase 1 – Classification and measurement of financial liabilities(COMPLETED – IFRS 9) 28 Oct 2010Phase 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

Projects Overview

accountingvaluation

measurement

IAS 39IFRS 9

IAS 32

IFRS 7

Hedgeaccounting

Derecognition

Liability orequity?

Embedded derivatives

Financial InstrumentsGeneral Overview

FI – What are the issues?

Financial InstrumentsIFRS 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 cashflows arising from FA

• Measurement of FA aligned with entity’s ‘business model’ and withcash flow characteristics

• Single impairment method

Financial InstrumentsIFRS 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

Financial InstrumentsClassification and Measurement of Financial Assets

IAS 39 IFRS 9

• Classification of FA into one of 4classes, each having its own eligibilitycriteria and different measurementrequirements

• Eligibility criteria are a combination ofthe nature of the instrument, its mannerof use and management choice

• ‘Tainting rules’ force reclassification toFVTPL of all FA classified as HTM ifmore than an insignificant amount of theFA in this class are sold before theirmaturity date

• Classification of FA in one of 2 classes

• Classification based on assessment ofthe way in which the instrument ismanaged (the entity’s business model)and of itscontractual cash flow terms

• The category into which the asset isclassified determines its measurementon an ongoing basis: amortized cost orFV

Financial InstrumentsUnquoted Equity Investments

IAS 39 IFRS 9

Unquoted equity instruments for whichfair value cannot be measured reliablyare measured at cost

Same exception applies to derivativeslinked to such equity instruments thatmust be settled by delivery of suchequity instruments

All equity investments must bemeasured at fair value.

The fair value measurement project willprovide application guidance onidentifying circumstances where cost ofequity instruments might berepresentative of FV

IFRS 9 – Two-measurement-category Approach

• FI with highly variable cash flows or part of a trading operation

• FI with principal amounts held for collection or payment of contractualcash 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 thechange 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 assetat fair value through profit or loss if, and only if, that designationeliminates or significantly reduces an accounting mismatch

AMORTIZED COST

FAIR VALUE

Unless

New model for classification of FA

Financial InstrumentsImpairment

IAS 39 IFRS 9

• Impairment assessment required forFA- measured at FV through OCI- measured at amortized cost

• Several different models

• Some impairments cannot be reversed

• Only FA at AC subject to impairment

• All impairments eligible for reversal

Amortized Cost and Impairment of Financial Assets

Impairment – Project Overview

• Project’s objective

• Improve the amortized cost measurement, in particular thetransparency of

• provisions for losses on loans

• the credit quality of financial assets

ED IFRS

5 November 2009 H2 / 2011

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 duewill be under default due to death of credit card holders (historically,this pattern has been observed and is expected to continue in thefuture)

• 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 creditlosses, over the life of the instrument

• Build up a provision over the life of the instrument for the expectedcredit 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 balancesheet activities.

• The amendments will allow users of financial statements toimprove their understanding of transfer transactions of financialassets (for example, securitizations), including understanding thepossible effects of any risks that may remain with the entity thattransferred the assets.

• The amendments also require additional disclosures if adisproportionate amount of transfer transactions are undertakenaround the end of a reporting period.

Final standard on improved disclosures about derecognition(continued)

• The IASB had originally proposed to replace the existingderecognition model in IAS 39 Financial Instruments: Recognition andMeasurement and the associated disclosure requirements in IFRS 7.However, in light of the feedback received, the IASB decided to retainthe existing derecognition requirements and to finalize improveddisclosure requirements.

• The amendments also broadly align the relevant disclosurerequirements of IFRSs and US GAAP.

• Entities shall apply the amendments for annual periods beginning onor after 1 July 2011. In the first year of application, comparativeinformation 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 itin 2 years time for 10 million plus interests and less dividends

• Risk and rewards model: the repurchase agreement involves that Ahas retained the risk relating to dividends paid in the portfolio and thefair value of securities. A continues to recognize the portfolio

• Control model: Since the securities are traded in a liquid market, Bcan easily sell the securities to third parties and then repurchase themto deliver back to A. B has control over the portfolio. A derecognizesthe 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 tocontrol the portfolio is irrelevant. A continue to recognize the portfolio

What are the Disclosure Requirements?

Transferred assetsNOT derecognized(On-balance sheet)

Transferred assetsderecognized

(Off-balance sheet)

Relationship betweentransferred

(but not derecognized) assetsand associated liabilities

Nature of and risks fromContinuing involvement

Users’concern!

Financial Liabilities

Final standard on financial liability accounting

• On 28 October 2010, the IASB issued requirements on theaccounting for financial liabilities. These requirements were added toIFRS 9 Financial Instruments and complete the classification andmeasurement phase of the IASB's project to replace IAS 39.

• New requirements address volatility in the P&L caused by changes inthe credit risk of a financial liability (‘own credit’) - affects primarilyentities that choose to apply the FV option to their financial liabilities.

• Maintains the existing amortized cost measurement for mostliabilities, limiting change to that required to address the own creditproblem.

• If an entity elects to measure a liability at fair value, it has to presentthe portion of the change in its fair value due to changes in the entity'sown 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 willdecrease (and vice versa)

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

Liabilities – Replacement of IAS 37

Liabilities – Replacement of IAS 37Overview

Project Overview

• 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

ED IFRS

January 5, 2010 H2 / 2011

Liabilities

To address inconsistencies with other IFRSs

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

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

Liabilities

Liabilities – Replacement of IAS 37Why a New Standard (1/3) ?

To achieve global convergence of accounting standards

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

• US GAAP - liability for only individual costs of a restructuring recordedwhen 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 theobligation?

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

Liabilities

Liabilities – Replacement of IAS 37Scope 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

Liabilities – Replacement of IAS 37Key Amendments

• The new IFRS will not include the ‘probability of outflows’criterion

• Instead, uncertainty about the amount and timing of outflows will beaccounted for by using a measurement that reflects their expectedvalue (i.e the probability-weighted average of the outflows for therange of possible outcomes)

• The new IFRS will require an entity to record a liability for eachindividual cost of a restructuring only when the entity incurs thatparticular cost

Liabilities

Liabilities – Replacement of IAS 37Key Amendments (cont’d)

• The new IFRS will require measurement at the amount the entitywould rationally pay at the measurement date to be relieved of theliability, i.e estimate of the PV of resources required to fulfil the liabilityconsidering

• 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

• Entity has a present obligation

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

• Amount of the obligation canbe reliably estimated

New Recognition Criteria

• Entity has a present obligation

• Probable (more likely thannot) that an outflow ofresources required to settlethe obligation

• Amount of the obligation canbe reliably estimated

Liabilities

Liabilities – Replacement of IAS 37

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

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

alone derivative (IAS 39.10)

Host contract Embeddedderivative

Hybrid instrument

Hedge Accounting

Embedded Derivative - What is it?

Do not split out the embedded derivative

Split out theembeddedderivative

Is the hybridinstrument measured

at fair value withchanges recognized

in profit or loss?

NoWould a freestandinginstrument with the

same term andcondition meet the

definition of aderivative?

Is the embeddedderivative closelyrelated to the host

contract?

Hedge Accounting

Embedded derivatives – Split accounting?

Hedge Accounting

IAS 39 IFRS 9

Mixed requirements for a hybridcontract:

• measured at FVTPL in its entirety

• split into 2 components- the ED measured at FVTPL- the non-derivative host contract

measured at AC or as an executorycontract using accrual accounting

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

• If host contract is a financial asset, nosplit classification criteria applied tothe contract in its entirety

• If host contract is a financial liability ora non-financial itemno change to theaccounting for hybrid contracts underIAS 39

Embedded Derivatives

Hedge Accounting

Embedded Derivatives – Proposals

Hybrid contracts

Apply IAS 39Potential

bifurcation

Host w/inIFRS 9 scope

No separation

Host not w/inIFRS 9 scope

Hedge Accounting

Embedded Derivatives – Proposals (cont’d)

Bifurcation

Derivative

IFRS 9

IAS 39 or others

IAS 39

Asset Otherwise

Hedge Accounting

Project Overview

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

ED IFRS

9 December 2010 H2 / 2011

Hedge Accounting - What is it?

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

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

Hedge Accounting

What are Hedging Instruments?

Derivative

Non-derivative forforeign currency

risk only

Single hedgingitem

Proportions of ahedging item (only in

terms of notional)

Hedging instruments

Hedge Accounting

Single item

Group of similaritems

Portions/proportions of anitem (time and amount)

Highlyprobableforecast

transactions

Firmcommitments

Assets

Liabilities

Netinvestments

in foreignoperations

Hedged items

Hedge Accounting

What are Hedged Items?

Reliablemeasurement of

effectiveness

The hedge is expected tobe and is highly effective

Riskmanagement

policy

Formaldesignation

Formal hedgedocumentation inplace at inception

Hedge Accounting

When can Hedge Accounting be Applied?

IAS 39 does not specify a single method for assessing hedgeeffectiveness. 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

• The “change in fair value” method

• The critical terms method

• US GAAP literature

Use Specialists!

Hedge Accounting

How is Effectiveness Assessed?

Offsetting Assets and Liabilities

Offsetting - Project Overview

• Address IFRSs / US GAAP differences on balance sheet netting ofderivative contracts and other financial instruments that can resultin 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

ED IFRS

28 January 2011 Q3 / 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 andexpenses, unless required or permitted by an IFRS (IAS 1.32).

• A financial asset and a financial liability shall be offset and the netamount presented in the statement of financial position when, andonly 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 settlethe liability simultaneously.

IFRSs and Offsetting – What is Proposed in the ED?

• An entity would be required to offset a recognized FA and arecognized FL if, and only if, it has an enforceable unconditional rightof set-off and intends either to settle the asset and liability on a netbasis or to realize the asset and settle the liability simultaneously (theoffsetting criteria).

• Offsetting criteria apply whether the right of set-off arises from abilateral arrangement or from a multilateral arrangement (i.e. between3 or more parties). The proposals also clarify that a right of set-offmust be legally enforceable (incl. default by or bankruptcy of acounterparty) and its exercisability must not be contingent on a futureevent.

• Require disclosure of information about offsetting and relatedarrangements (such as collateral agreements).

FI with Characteristics of Equity

Financial instruments - Liability or Equity?

That is the question…

Project Overview

• Project’s objectives

• Address some practice issues in current guidance

• Eliminate current rules-based approaches

• Achieve convergence with US GAAP

DP ED IFRS

February 28, 2008 H2 / 2011 Q4 / 2011 - ???

What is Proposed?

• A model where classification is based on the form of an instrument’ssettlement 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 separatedinto liability and equity components

Instruments that the Issuer Settles with Assets

• Classify as equity if asset-settlement occurs because of the followingreasons• 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 ownequity 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 orshareholder

• Classify as liability all other equity-settled instruments

Fair Value Measurement Guidance

Project Overview

• Project’s objectives• 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

DP ED IFRS

November 2006May 28, 2009June 29, 2010 Q2/2011

Project Overview (cont’d)

IAS 39 IAS 41 IFRS 3 IFRS 5 …When?

How? IFRS on fair value Measurement guidance

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

Future FVM Guidance v/s Other IFRSs

How should the entity recognize andmeasure the asset or liability?

Refer to the appropriate IFRS

Does the IFRS use fair value?

Refer to Fair Value Measurement for:• definition of fair value• measurement• disclosure

If adopted theproposed standardwould apply onlywhen an existingIFRS alreadyrequires an asset ofliability to bemeasured at fairvalue.

Current definition – The amount for which an asset could be exchanged, aliability settled, or an equity instrument granted, between knowledgeable,

willing parties in an arm’s length transaction

New Definition of Fair Value – Exit Price

Fair Value of a Liability

Fair Value at Initial Recognition

The Fair Value Hierarchy

Thank you

Any Questions?

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IFRS Update for Financial Institutions

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