Financial Instruments: Measurement Risk and Accounting Financial Instruments: Measurement Marco Venuti 2019

Agenda Classification of financial assets Subsequent measurement of financial assets Financial assets measured at amortised cost Amortised cost and effective interest method Financial assets measured at fair value Impairment requirements Expected credit loss model Impairment of financial assets Subsequent measurement of financial liabilities

Classification IAS 39 requires that financial assets are classified in 3 categories and financial liabilities in 2 categories. The classification of financial instruments dictates measurement bases to apply. Classification is decided at initial recognition. Upon initial recognition, reclassification is allowed only for Financial assets in rare circumstances (if the entities changes its business model for managing financial assets).

Classification and Subsequent Measurement of financial assets Step 1 Business model = hold to collect Business model = hold to collect and sell Other business models Step 2 Cash flows are solely payments of principal and interest (SPPI) Amortised cost FVOCI* FVTPL Other types of cash flows FVTPL FVTPL FVTPL *Excludes investments in equity instruments (other than held for trading). An entity can elect this kind of investment to present FV changes in OCI.

Which statements are correct? Equity securities held may be measured at amortised cost Fair value changes of derivatives are recognised in profit or loss Fair value changes of debt securities held to collect and sell are recognised in OCI Debt securities held to collect may be measured at amortised cost

Subsequent measurement of financial assets There are 2 measurement criteria: 1) amortised cost 2) fair value

Financial assets measured at amortised cost The amortised cost is the amount at which they are measured at initial recognition (fair value), plus or minus cumulative amortisation using the effective interest method to calculate any difference between that initial amount and the maturity amount. Effective interest rate is the rate that exactly discounts the stream of principal and interest cash flows (estimated future cash flows), over the expected life of the financial instrument, to the initial net carrying amount. Effective interest rate corresponds to Internal Rate of Return. When applying the effective interest method, an entity generally amortises any fees, points paid or received, transaction costs and other premiums or discounts included in the calculation of the effective interest rate over the expected life of the instrument

Amortised cost and effective interest method Effective interest method calculates amortised cost and allocates interest income or expenses (as well as transaction costs and other initial differences) over relevant period Effective interest rate is calculated on initial recognition. It is not modified subsequently Effective interest rate exactly discounts estimated future cash flows, without taking account of future credit losses, to the net carrying amount Interest is recognised on an effective yield basis, which means that the coupon is adjusted for any fees, transactions costs, premiums, discounts and any steps in interest rate, where appropriate

Which statements are correct? Applying the amortised cost, the transaction costs and other initial differences are allocated over the life of the financial instruments? Applying the amortised cost, the transaction costs and other initial differences are recognised in profit and loss immediately? Effective Interest rate corresponds to internal rate of return? Effective Interest rate is calculated only for initial recognition?

Amortised cost: example 1 this example is focused on a case of a financial liability Nominal amount: (capital borrowed) 100.000 euro Maturity: 5 years Transaction costs: 4.100 euro Coupons: 6% (postponed) Initial value (amount received) = 100.000 – 4.100 = 95.900 euro Effective Interest Rate = IRR = ? (solve the equation) The capital is paid only at maturity The effective interest rate (at initial recognition) is estimated as the rate that discounts exactly estimated future cash payments (over the expected life of the financial instrument) to the net carrying amount of the financial instrument on initial recognition. IV=  CF · (1+i)-t IV= Initial Value (net present value) CF = Cash Flow (the stream of principal and interest cash flows) t = number of time periods

Amortised cost: example 1 Initial value: 95.900 Time periods Future Cash flows Discounting factor Discounted cash flows 1 6.000 (1,07)-1 5.607 2 (1,07)-2 5.241 3 (1,07)-3 4.898 4 (1,07)-4 4.577 5 106.000 (1,07)-5 75.577 95.900

Amortised cost: example 2 This example is applicable to financial assets/liabilities nominal amount: 1.000 amount paid/received: 1.000 maturity: 5 years coupons: 6% No transaction cost IRR evaluation: ? (solving the equation)

Amortised cost: example 3 This example is applicable to financial assets/liabilities nominal amount: 1.250 amount paid/received : 1.250 maturity: 5 years coupons: 6%, 8%, 10%, 12%, 16,3% IRR evaluation: 10% (solving the equation)

Amortised cost: example 4 (financial liability) CF's -970 50 1.050 IRR 5,71% Loan amount (received): 1.000 € Maturity: 5 years Nominal interest rate: 5% Other initial difference (up-front fee paid): 3% Effective interest rate: 5,71% (calculated) Opening balance Effective interests Cash flows Amortised cost (end of year) Year 1 970,0 55,3 50,0 975,3 Year 2 55,7 981,0 Year 3 56,0 987,0 Year 4 56,3 993,3 Year 5 56,7 1.050,0 TOTAL 280,00 1.250,00

Definition of fair value: basic elements the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. . Comments: It specifies that the entity is selling the asset It refers to the transfer of a liability It is not a forced or distressed sale It is clear it is market-based It states explicitly when the sale or transfer takes place

Financial assets measured at fair value Financial assets at fair value through profit or loss . Fair value changes are recognised in profit and loss Assume that the carrying amount of the financial asset is 100 (purchased during the year) the fair value at the end of the year is 120 In the financial statement the company records a profit of 20. If the fair value were 80, the company would record a loss equal to 20. Dr Financial asset 20 Cr Profit and loss

Investments in debt instruments Hold to collect and Sell Fair Value Through Other Comprehensive Income (FVOCI) Investments in debt instruments Equity investments FVOCI Option (Irrevocable election) FVPL Meet SPPI Hold to collect and Sell FV changes are recognised in OCI No recycling to PL FVOCI Variazioni di FV a OCI Recycling al momento della derecognition Irrevocable election at initial recognition. Only Investments not held for trading Election on an instrument-by-instrument basis Election

Equity instrument measured at fair value Financial assets at fair value through OCI . Fair value changes are recognised in OCI (see IAS 1). Subsequently the amount recognised is reclassified in an equity reserve. known as AFS reserve. This reserve can be either positive or negative. Assume that the carrying amount of the financial asset is 100 (purchased during the year) the fair value at the end of the year is 120 In the financial statement the company records a equity reserve of 20. Dr Financial asset 20 Cr Other comprehensive income Dr Other comprehensive income 20 Cr Reserve OCI

Financial assets measured at fair value Financial assets at available for sale . Fair value changes are recognised in OCI (see IAS 1). Subsequently the amount recognised is reclassified in an equity reserve, known as OCI reserve. This reserve can be either positive or negative. Assume that the carrying amount of the financial asset is 100 (purchased during the year) the fair value at the end of the year is 80 Dr Other comprehensive income 20 Cr Financial asset Dr Reserve OCI 20 Cr Other comprehensive income

Which statements are correct? Financial assets that meet both hold to collect test and SPPI test are measured at amortised cost All equity investments to be measured at fair value For equity investments that are not held for trading, entities can make an irrevocable election at initial recognition to classify the instruments as at FVOCI When an equity instrument measured at is derecognised as a result of a disposal, the cumulative change in fair value is required to remain in OCI IFRS 9 required that derivative embedded within a financial asset (embedded derivatives) is to be measured at amortised cost

Impairment: an overview 21 Change in credit risk since initial recognition Stage 1 Stage 2 Stage 3 Impairment recognition 12-month expected credit losses Lifetime expected credit losses Lifetime expected credit losses When significant increase in credit risk occurs Interest revenue Gross basis Gross basis Net basis IMPAIRMENT RECOGNITION Stage 1 Para 5.5.5: if, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses. Stage 2 and 3 Para 5.5.4: The objective of the impairment requirements is to recognise lifetime expected credit losses for all financial instruments for which there have been significant increases in credit risk since initial recognition — whether assessed on an individual or collective basis — considering all reasonable and supportable information, including that which is forward-looking. Para 5.5.3: at each reporting date, an entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased significantly since initial recognition. Para 5.5.7: If an entity has measured the loss allowance for a financial instrument at an amount equal to lifetime expected credit losses in the previous reporting period, but determines at the current reporting date that paragraph 5.5.3 is no longer met, the entity shall measure the loss allowance at an amount equal to 12-month expected credit losses at the current reporting date. INTEREST REVENUE Para 5.4.1: Interest revenue shall be calculated by using the effective interest method. This shall be calculated by applying the effective interest rate to the gross carrying amount of a financial asset except for: (b)financial assets that are not purchased or originated credit-impaired financial assets but subsequently have become credit-impaired financial assets. For those financial assets, the entity shall apply the effective interest rate to the amortised cost of the financial asset in subsequent reporting periods. ‘Performing’ ‘Under-performing’ ‘Non-performing’ © IFRS Foundation

12-month & lifetime expected credit losses Definitions Credit loss - difference between all contractual cash flows that are due to a company in accordance with the contract and all the cash flows that the company expects to receive (ie all cash shortfalls), discounted at the original effective interest rate. In order to estimate expected cash flow, the company take in consideration: past events., current conditions and future economic conditions (forward-looking information) Expected credit losses (ECL) - weighted average of credit losses with the respective risks of a default occurring as the weights What are 12-month ECL? What are lifetime ECL? Appendix A, Defined terms: credit loss - The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (ie all cash shortfalls), discounted at the original effective interest rate (or credit-adjusted effective interest rate for purchased or originated credit-impaired financial assets). An entity shall estimate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument. The cash flows that are considered shall include cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. There is a presumption that the expected life of a financial instrument can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the expected life of a financial instrument, the entity shall use the remaining contractual term of the financial instrument. expected credit losses - The weighted average of credit losses with the respective risks of a default occurring as the weights. 12-month expected credit losses - The portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. lifetime expected credit losses - The expected credit losses that result from all possible default events over the expected life of a financial instrument. Para B5.5.43: For lifetime expected credit losses, an entity shall estimate the risk of a default occurring on the financial instrument during its expected life. 12-month expected credit losses are a portion of the lifetime expected credit losses and represent the lifetime cash shortfalls that will result if a default occurs in the 12 months after the reporting date (or a shorter period if the expected life of a financial instrument is less than 12 months), weighted by the probability of that default occurring. Thus, 12-month expected credit losses are neither the lifetime expected credit losses that an entity will incur on financial instruments that it predicts will default in the next 12 months nor the cash shortfalls that are predicted over the next 12 months. ECL comprise all possible default events that will result if a default occurs in 12 months ECL that result from all possible default events over the expected life of a financial instrument © IFRS Foundation

IFRS 9 – Expected Credit Loss Model Recognition credit expected losses (loss allowance) At the reporting date, credit risk of the portfolio has increased significantly since initial recognition ? yes NO 12-month expected credit losses (ECL) – Stage 1 Lifetime expected credit losses (ECL) - Stage 2 (eg more than 30 days past due)

Example 1: assessing significant increase in credit risk on a collective basis Bank ABC provides mortgages to finance residential real estate in a specific area The area includes a mining community - largely dependent on the export of coal and related products Significant decline in coal exports occurs and the closure of several coal mines is expected The risk of a default occurring on mortgage loans to borrowers who are employed by the coal mines is determined to have increased significantly There has been a significant increase in credit risk as can be seen from the comparison between Risk of default at reporting date and Risk of default at initial recognition

Example 2: assessing significant increases in credit risk since initial recognition Significant increase in credit risk Bank X provides a loan to Company Y. At the time of origination of the loan: It was expected that Company Y would be able to meet the covenants for the life of the instrument. Generation of revenue and cash flow was expected to be stable in Company Y’s industry over the term of the loan. Subsequent to initial recognition: Company Y has underperformed on its business plan for revenue generation and net cash flow generation due to macroeconomic changes. Company Y has increased its leverage ratio Company Y is now close to breaching its covenants Trading prices for Company Y’s bonds have decreased, market spreads have increased, not explained by changes in the market environment Bank X expects a further deterioration in the macroeconomic environment

Example 3: assessing significant increases in credit risk since initial recognition No significant increase in credit risk Bank X provides a loan to Company Y. At the time of origination of the loan: It was expected that Company Y would be able to meet the covenants for the life of the instrument. Generation of revenue and cash flow was expected to be stable in Company Y’s industry over the term of the loan. Subsequent to initial recognition Sales of Company are stable There are not macroeconomic changes. Company Y has increased its leverage ratio in non meaningful way Company Y is not close to breaching its covenants © IFRS Foundation

Example 4: Provision matrix A provision matrix is used to determine the expected credit losses for the portfolio, based on its historical observed default rates over the expected life of the trade receivables and is adjusted for forward-looking estimates Current 1–30 days past due 31–60 days past due 61–90 days past due More than 90 days past due Default rate 0.4% 1.3% 3.6% 6.0% 11.1% *

A question for you Which elements are taken into consideration for impairment test? Modified expected cash flows as a consequence of expected losses Current effective interest rate Original effective interest rate Modified expected cash flows as a consequence of Incurred losses at stage 1

Credit-Impaired Financial Assets: evidence A company Transfers an exposure from Stage 2 to Stage 3 whether there is an objective evidence of impairment for an asset or group of financial assets Significant financial difficulty of the issuer/obligor Default or breach of contract Granting of a concession that the creditor would not otherwise consider Bankruptcy or financial reorganisation of the borrower

Which statements are correct? Effective Interest rate is calculated only at initial recognition? A financial asset shall be transferred from stage 2 to stage 1 when there is a significant decrease in credit risk? Financial asset shall be partially written off whether it is transferred from stage 2 to stage 3? Financial asset shall be partially written off whether it is transferred from stage 1 to stage 2?

Financial assets at amortised cost Amortised cost: example 5 Loan amount provided nominal amount: 1.000 maturity: 5 years coupons: 10% Other initial difference: up-front 5% IRR evaluation ? Effective interest rate (IRR) is the rate that exactly discounts estimated future cash flows to the net carrying amount (net carrying amount is: 1.000 – 50 = 950). IRR is 11.37%

Amortised cost: example 5 Financial assets at amortised cost Amortised cost: example 5 The company amortised, using the effective interest rate, the up-front (cost transactions) over the expected life of the instrument (a loan). Applying the cost amortisation, the transaction costs and other initial differences are allocated gradually over the life of the instrument (using an accrual basis of accounting). At the initial recognition, the company shall recognise a loss allowance (a provision) equal to 20.

Amortised cost: example 5 Financial assets at amortised cost Amortised cost: example 5 At year 2, the company assesses that there has been a significant increase in credit risk. The loan is transferred from stage 1 to stage 2. The company shall measure the loss allowance at an amount equat to life time expected credit losses. Subsequently the initial recognition, the company shall recognise a loss allowance equal to 50 (an increase of the provision equal to 30)

Impairment of financial instruments measured at amortised cost Example 5.1 Suppose that the company: The interest of the year 3 is not paid The Company expects to collect only the payment of the principal at the end of the year 5. The company transfer the loan (receivable) from stage 2 to stage 3. The company shall derecognise the allowance and recognise direcly a credit impairment. (At the end of the year 3, the amortised cost of the receivable is 806 (present value of the expected cash flows using the IRR calculated on initial recognition). 806 is less than 977 such that it is necessary to recognise a loss.

Impairment of financial instruments measured at amortised cost Example 5.1 271 is the difference between: 1077 (original amortised cost) and 806 (adjusted amortised cost). 806 is the present value of the expected cash flows using the IRR calculated on initial recognition In the subsequent years the company shall used the original IRR applied to the adjusted amortised cost (see above example ).

Measurement of expected credit loss Expected credit losses (ECL) - weighted average of credit losses with the respective risks of a default occurring as the weights PD is the probability that a loan will not be repaid. LGD is the fraction of the exposure at default that will not be recovered in the case of a default event. EAD represents the expected exposure in the event of insolvency. D is the discount factor (only in case of lifetime credit losses). IFRS 9 Probability-weighted approach EL EAD PD LGD Discount factor (1 yr at 5% p.a. discount rate) x x x = 10,500 0.5% 25%

Classification of financial liabilities Category Definition Financial liabilities at fair value through profit or loss (FVTPL) Financial liabilities held for trading Derivatives, other than some hedging instruments Financial liabilities designated to this category at initial recognition (fair value option) Other financial liabilities (OFL) All financial liabilities that are not classified as FVTPL

Subsequent measurement of financial instruments Value changes Financial liabilities at fair value through profit or loss or designated as such Fair value P&L Other liabilities Amortised cost