Financial assets

Typical coverage of US GAAP Scope Definitions Measurement bases Classification categories and related measurement and reporting Derecognition Impairment Transfers between categories of financial assets Disclosures

Executive summary Under IFRS, the accounting standards in this area have evolved in a cohesive fashion and are contained in three pronouncements (IFRS 7, IAS 32 and IAS 39) with a fourth pronouncement, IFRS 9, Financial Instruments, to take effect in 2018. Under US GAAP, the accounting standards in this area have evolved (cost to fair value) with numerous pronouncements spanning approximately 20 years. These standards have now been codified. Loans and receivables are included in the scope of IAS 39 even if they are not securities, whereas the scope of ASC 320 only addresses loans and receivables that are securities. Fair value has been converged in ASC 820, Fair Value Measurement and IFRS 13, Fair Value Measurement. IFRS allows securities that are not marketable to be classified as AFS and measured at fair value, if determinable. US GAAP generally records these securities at cost.

Executive summary IFRS requires equity-method (significant influence) investments to be accounted for under the equity method while US GAAP also allows the fair value option (FVO). IFRS has a comprehensive derecognition model, covering both assets and liabilities, and looks at whether risks and rewards and/or control have been transferred. US GAAP focuses on derecognition of financial assets only and uses a control and legal isolation test for derecognition. There are different impairment tests under both standards. IFRS allows reversals of impairments in debt securities classified as AFS and HTM to be recognized in income. This is not allowed under US GAAP.

Primary pronouncements US GAAP ASC 310, Receivables – Subsequent Measurement ASC 320, Investments – Debt and Equity Securities ASC 820, Fair Value Measurement ASC 825, Financial Instruments – Recognition and Disclosures ASC 860, Transfers and Servicing ASC 948, Financial Services – Mortgage Banking IFRS IFRS 7, Financial Instruments: Disclosures IAS 32, Financial Instruments: Presentation IAS 39, Financial Instruments: Recognition and Measurement IFRS 9, Financial Instruments (effective January 1, 2018) IFRS 13, Fair Value Measurement

Progress on convergence The accounting for financial instruments has been an ongoing convergence project for a number of years. The FASB is still deliberating certain portions of the financial instruments project with a standard expected in 2015. In July 2014, the IASB issued a final version of IFRS 9, Financial Instruments, which addresses classification and measurement, impairment methodology and hedge accounting. The statement applies to annual periods beginning on or after January 1, 2018, although earlier application is permitted. Retrospective application is required. Note: Reference should be made to the appendix for a synopsis of IFRS 9 as it pertains to this topic. Upon issuance of the FASB standard, this module will be updated and IFRS 9 will be compared with the new FASB standard.

Scope US GAAP IFRS Financial assets include cash, receivables, investments and derivatives. Similar

Scope US GAAP Accounting for financial assets has been an evolutionary process (cost to fair value) with numerous pronouncements spanning approximately 20 years. These standards have now been codified together. ASC 320 focuses on investments in marketable securities. IFRS Accounting for financial assets has evolved in a more cohesive fashion and is contained in three pronouncements (IFRS 7, IAS 32 and IAS 39) with a fourth pronouncement, IFRS 9, to take effect in 2018. IAS 39 includes marketable securities as well as other instruments, such as loans and receivables (which may not be marketable securities).

Definitions US GAAP IFRS Financial assets are defined. Similar

Definitions US GAAP IFRS A financial asset, per the ASC Master Glossary is defined as “cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to do either of the following: Receive cash or another financial instrument from a second entity, or Exchange other financial instruments on potentially favorable terms with the second entity.” IFRS A financial asset, per IAS 32, paragraph 11) is “ … any asset that is: Cash An equity instrument of another entity; A contractual right: to receive cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity. A contract that will or may be settled in the entity’s own equity instruments and is a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.”

Definitions

Measurement bases US GAAP IFRS Amortized cost or fair value can be used as a measurement basis depending on the classification of the financial instrument. Similar Upon initial recognition of the instrument, an irrevocable accounting policy choice is allowed to measure instruments at fair value with gains/losses recognized in income. This is referred to as the FVO. Similar The definition of fair value. Similar

Measurement bases FVO US GAAP There are no criteria for using the FVO, although there are certain financial assets that may not be revalued under the FVO. Equity-method investments may use the equity method of accounting or the FVO. IFRS An entity must prove either of the following to use the FVO. The use of FVO reduces measurement or recognition inconsistencies. The assets in question are managed by the entity and performance is evaluated on a fair-value basis. Equity-method investments must use the equity method of accounting.

Measurement bases Day-one gains A gain may arise at the time of purchase (e.g., when the asset is purchased in one market but normally sold in another). These gains are called “day-one gains” since they result immediately on the day of the transaction (i.e., day one). US GAAP Day-one gains and losses may be recognized even when all inputs to the fair value model are not observable. This means that instruments may be measured at initial recognition at a value that differs from the transaction price. IFRS Day one gains or losses on financial assets are recognized only when fair value is evidenced by a quoted price in an active market for an identical assets (i.e. level 1 or level 2 input) or based on a valuation technique that used only data from observable markets.

Day-one gains example Example 1 Heli-Ski Inc. (Heli) purchased a financial instrument in the marketplace (dealer market) for $1,000 cash consideration. Heli immediately determined that it could sell the exact same asset in another market with no modifications for $1,100 (retail market). How would Heli account for the financial asset under US GAAP and IFRS? How would Heli account for the financial asset under US GAAP and IFRS if there was no observable market or market inputs?

Day-one gains example Example 1 solution: Observable market inputs Under both US GAAP and IFRS, Heli would record the financial asset at $1,100 as follows: Financial asset $1,100 Cash $1,000 Unrealized gain 100

Day one gains example Unobservable market inputs For US GAAP, if there was no observable market or market inputs, Heli might estimate the fair value. The financial asset would be recorded at $1,100, as long as the entity could support the value. Under IFRS, it would be valued at $1,000. US GAAP: Financial asset $1,100 Cash $1,000 Unrealized gain 100 IFRS: Financial asset $1,000 Cash $,1000

Classification categories and related measurement and reporting US GAAP IFRS Financial assets are required to be sorted into specific categories for classification and measurement purposes (not including FVO as discussed earlier) as follows: Trading: This classification includes debt and marketable equity assets with no significant influence that are intended to be traded. These assets are measured at fair value with unrealized holding gains/losses reported in income. Available-for-sale (AFS): This classification includes debt and marketable equity assets with no significant influence that are not classified as trading/FVPL or held to maturity (HTM). These assets are measured at fair value with unrealized holding gains/losses reported in OCI. HTM: This classification includes debt assets intended to be HTM. These assets are measured at amortized cost using the effective interest method. Similar, although trading is part of the category referred to as FVPL

Classification categories and related measurement and reporting US GAAP IFRS Financial assets are required to be sorted into specific categories for classification and measurement purposes (not including FVO as discussed previously) as follows (continued): Other assets: This classification includes non-marketable equity assets with no significant influence. These assets are measured at cost. Loans/receivables: This classification includes conventional loans and receivables. These assets are generally measured at amortized cost. Equity-method investments: This classification includes equity assets with significant influence but no control These assets are measured at cost and adjusted thereafter with the investor’s share of post-acquisition earnings (equity method). Similar

Classification categories and related measurement and reporting US GAAP Non-marketable equity securities with no significant influence are classified as other assets and measured at cost. Financial assets classified as AFS with foreign exchange components report all unrealized holding gains/losses in OCI. Loans and receivables must be classified as loans and receivables and measured at amortized cost. IFRS Allows non-marketable equity securities with no significant influence to be classified as other assets and measured at cost or alternatively classified as AFS, if fair value is determinable, with unrealized holding gains/losses reported in OCI. Financial assets classified as AFS with foreign exchange components report unrealized holding gains/losses due to foreign exchange rates separately in income with the remaining unrealized holding gains/losses in OCI. Loans and receivables can be classified as loans and receivables and measured at amortized cost or alternatively classified as AFS and measured at fair value with unrealized holding gains/losses reported in OCI (even if not traded).

Summary chart for financial assets classification and measurement Assets included Measurement basis and related reporting (not including FVO) US GAAP IFRS Trading FVPL Debt and marketable equity assets (no significant influence) intended to be traded Fair value with unrealized holding gains/losses reported in income AFS Debt and marketable equity assets (no significant influence) not classified as trading/FVPL or HTM Fair value with unrealized holding gains/losses reported in OCI Non-marketable equity securities (no significant influence) are not permitted to be classified as AFS See other assets Non-marketable equity securities (no significant influence) can be alternatively classified here if fair value is determinable. Otherwise, see other assets. N/A – see other assets Fair value with unrealized holding gains/losses reported in OCI Financial assets with foreign exchange components. Fair value with unrealized holding gains/losses reported in OCI. Fair value with unrealized holding gains/losses due to foreign exchange separately reported in income and the remaining unrealized holding gains/losses reported in OCI Conventional loans and receivables are not permitted to be classified as AFS. See loans/receivables Conventional loans and receivables can be alternatively classified here. Otherwise, see loans/receivables. N/A – see loans/receivables Fair value with unrealized gains/losses reported in OCI HTM Debt assets intended to be held to maturity Amortized cost using the effective-interest method Other assets (investment in investee) Non-marketable equity assets (no significant influence) See AFS above for alternative classification for IFRS Cost Loans/receivables Conventional loans and receivables (held for investment) Amortized cost Equity-method investment Equity assets with significant influence but not control These assets are measured at cost and adjusted thereafter with the investor’s share of post-acquisition earnings (equity method)

Use of the FVO example Example 2: Extreme Surf (Extreme) has recently raised financing by issuing $1,000 of fixed-rate bonds (5%) to institutional investors. The bonds would otherwise be carried at amortized cost. Assume that the bonds were issued at par. The money was used to invest in $1,000 of fixed rate (6%) corporate bonds. These bonds are classified as AFS with fair value gains/losses being recorded in OCI. Assume by year-end, interest rates have declined to 5.45%, resulting in the fair value of the bond to be $1,100. Assuming no use of the FVO, provide the journal entries for how Extreme would record these transactions in year one under US GAAP and IFRS? Discuss whether the FVO is allowed under US GAAP and IFRS in this situation. Assuming that the FVO was selected upon initial recording of the bonds, provide the journal entries for how Extreme would record these transactions in year one under US GAAP and IFRS assuming that by year end, interest rates have declined to 4.35%, resulting in the fair value of the issued bonds to be $1,150 and the fair value of the bonds acquired to be $1,380.

Use of the FVO example Example 2 solution: Bond issuance: Cash $1,000 Bonds payable $1,000 Year-end: Interest expense $50 Cash $50 Bond acquisition: Investment in corporate bonds (AFS) $1,000 Cash $1,000 Investment in corporate bonds (AFS) $100 Unrealized gain – OCI $100 Cash $60 Interest income $60

Use of the FVO example The debt and investment are linked since one was used to finance the other. Because they are both fixed rate, the economic gains on one will offset the losses on another. This is a natural hedge. However, for accounting purposes, there will be a mismatch because the loans on the liability side are carried at amortized cost and not revalued, whereas the bonds on the asset side are classified as AFS, and are, therefore, valued at fair value with unrealized holding gains/losses being reported in OCI. If the FVO is used, both the asset and liability will be measured at fair value with unrealized holding gains/losses being reported in income. Under US GAAP, Extreme may designate any financial asset under the FVO. Under IFRS, this would also be allowed since there is an accounting mismatch if the FVO is not chosen. Thus, the FVO reduces recognition inconsistencies.

Use of the FVO example Bond issuance: Cash $1,000 Bonds payable $1,000 Year-end: Interest expense $50 Cash $50 Unrealized loss – income $150 Bonds payable $150 Bond acquisition: Investment in corporate bonds $1,000 Cash $1,000 Investment in corporate bonds $380 Unrealized gain – income $380 Cash $60 Interest income $60

Equity assets that are non-marketable example The Mountain Climbing Company (MCC) invests in shares of the Everest Company (Everest), whose shares do not trade on the stock exchange and are closely held by entities that have strategic alliances with Everest. MCC purchased Everest shares for $150 and at year-end, MCC is able to determine that the fair value of the shares is $199. MCC valued the shares using a valuation technique. The shares are not held for trading, MCC does not have significant influence and the FVO has not been utilized. Assume the shares are sold January 1 of the following year for $199 per share. What classifications and related measurement are available to MCC for this investment under US GAAP and IFRS? Provide the journal entries for this investment assuming MCC classifies this investment in other assets for US GAAP and AFS for IFRS. Now assume that the shares are marketable securities. How would the investment be accounted for under both US GAAP and IFRS?

Equity assets that are non-marketable example Example 3 solution: Classification and measurement Under US GAAP, as the securities are not marketable, they would be classified as an investment in an investee in other assets and would be recorded at cost. Under IFRS, the securities could be classified and measured similar to US GAAP or, if fair value is determinable, the securities can be classified as AFS with unrealized holding gains/losses being recognized in OCI or cost in AFS.

Equity assets that are non-marketable example US GAAP: Investment $150 Cash $150 To record the purchase of the securities Cash $199 Investment $150 Realized gain on sale 49 To record the sale of the securities IFRS: AFS securities $150 Available-for-sale securities $49 Unrealized gain – OCI $49 To revalue the securities to fair value Unrealized gain – OCI 49 AFS securities $199 Realized gain on sale 49 Marketable securities If the shares were marketable securities and the fair values were available, the journal entries under US GAAP would be the same as for AFS under IFRS.

Equity-method investments and the FVO example The Rope Climbing Company (Rope) buys 40% of the common shares of Carabiner Company, resulting in significant influence. The investment cost is $200 and at year-end, Rope’s share of the post-acquisition earnings is $20. The fair value of the investment at that time is $240. There are no dividends. Explain the choices that Rope has when determining how to account for the investment. Consider both US GAAP and IFRS. Prepare journal entries.

Equity-method investments and the FVO example Example 4 solution: Under US GAAP, the entity may elect to use the FVO or use the equity method. If the equity method is used, the entries would be the same as under IFRS. Under IFRS, the equity method of accounting is required and Rope would recognize its share of post-acquisition earnings. US GAAP: FVO IFRS: Purchase date Purchase date Equity investment $200 Equity investment $200 Cash $200 Cash $200 Year-end Year-end Equity investment $40 Equity investment $20 Unrealized gain on investment $40 Equity investment income $20

AFS debt assets and foreign exchange translation example The White Water Rafting Company (White Water) buys a bond denominated in a foreign currency (FC) for 100 FC at par value (with no discount or premium). The exchange rate at the purchase date is 1 FC = $1.1 US. At year-end, the fair value of the bond in the marketplace is 150 FC and the exchange rate is 1 FC = $1.2 US. Prepare the journal entries that White Water should record for the purchase and subsequent change in value assuming that the investment is classified as AFS under both US GAAP and IFRS.

AFS debt assets and foreign exchange translation example Example 5 solution: US GAAP: IFRS: Purchase date Purchase date AFS investment $110 AFS investment $110 Cash $110 Cash $110 Year-end Year-end AFS investment $ 70 AFS investment $ 70 Unrealized gain – OCI $ 70 Unrealized gain – OCI $ 60 Unrealized exchange gain – income 10 The cost is translated to US dollars at the date of purchase. Under IFRS, the exchange gain is bifurcated into two parts with the exchange portion recognized in income ($1.2 – $1.1 = $0.1 x 100 FC = $10) and the rest in OCI (150 FC – 100 FC) X $1.2 = $60.

Loans receivable example Skydivers Inc. (Skydivers) recently loaned $1,000 to a customer on January 5, 2012. The loan is interest bearing at 10% (which equals the market interest rate). The loan is due in three years. Skydivers plans to hold the loan until it matures. Assume all criteria for the FVO are met. The fair value of the loan is as follows: December 31, 2012 – $1,010 December 31, 2013 – $1,005 December 31, 2014 – $1,000 How would Skydivers account for the loan in 2012 through 2014 under US GAAP and IFRS?

Loans receivable example Example 6 solution: US GAAP: Skydivers may elect to use the FVO to measure and report this loan. This means that the loan would be measured at fair value at each balance sheet date with unrealized holding gains/losses being recognized in income along with interest. There would be no need to test for impairment. Otherwise, given that Skydivers plans to hold onto the asset and since it is clearly not a marketable security (this is a loan to a customer, not an instrument that trades on a stock exchange), the loan could be recorded at the amortized cost of $1,000 with interest recognized as interest income. Note that in this case, since market interest is equal to the interest rate on the receivable, there would be no discount and amortized cost would be equal to cost. The instrument would be tested for impairment.

Loans receivable example Amortized cost Fair value option January 5, 2012 Loan receivable $1,000 Loan receivable $1,000 Cash $1,000 Cash $1,000 December 31, 2012 Cash $100 Cash $100 Interest income $100 Interest income $100 Loan receivable $10 Unrealized gain – income $10 December 31, 2013 Cash $100 Cash $100 Interest income $100 Interest income $100 Unrealized loss – income $5 Loan receivable $5 December 31, 2014 Cash $100 Cash $100 Interest income $100 Interest income $100 Cash $1,000 Cash $1,000 Loan receivable $1,000 Unrealized loss - income 5 Loan receivable $1,005

Loans receivable example IFRS: Similar to US GAAP, Skydivers can elect to use the FVO or carry the loan at amortized cost. However, an additional option is open to Skydivers. The receivable may be classified as AFS (even though the intent is not to sell or dispose of it). This means that it would be measured at fair value at each balance sheet date with gains and losses recognized in OCI.

Loans receivable example AFS January 5, 2012 Loan receivable (AFS) $1,000 Cash $1,000 December 31, 2012 Cash $100 Interest income $100 Loan receivable (AFS) $10 Unrealized gain – OCI $10 December 31, 2013 (assuming no impairment) Unrealized loss – OCI $5 Loan receivable $5 December 31, 2014 Cash $1,000 Unrealized loss – OCI 5 Loan receivable (AFS) $1,005

Derecognition US GAAP IFRS Guidance stipulates when a financial asset should be recognized and derecognized. Similar

Derecognition US GAAP IFRS Requires derecognition of financial assets where effective control has been surrendered. This would normally be the case when there is legal isolation (i.e., the assets are physically and legally separate from the entity). There are three criteria that must be met before an asset is derecognized: There is legal isolation of the instruments from the transferor. The transferee has the right to pledge or exchange receiving assets. Transferor does not maintain effective control over the transferred assets. IFRS Derecogntion of financial assets is based on a mixed model that considers transfer of risks and rewards and control. Transfer of control is considered only when the transfer of risks and rewards assessment is not conclusive. If the transferor has neither retained nor transferred substantially all of the risks and rewards, there is then an evaluation of the transfer of control. Control is considered to be surrendered if the transferee has the practical ability to unilaterally sell the transferred asset to a third party without restrictions. There is no legal isolation test.

Derecognition example Scuba Divers Inc. (Scuba) has receivables from an unrelated party with a face value of $1,000. Scuba transfers these receivables to the Fin Company (Fin) for $900. The difference reflects the credit risk. The receivables will continue to be collected by Scuba and deposited to Scuba’s bank account with the cash flows being remitted in total each month-end to Fin. Embedded in the $100 discount is a fee for providing this service. Scuba is not allowed to sell or pledge the receivables to anyone else and there is no agreement to repurchase. Fin does have the right to transfer the asset to an unrelated third party. How should Scuba account for the receivables under US GAAP and IFRS?

Derecognition example Example 7 solution: US GAAP: The first question is whether legal isolation exists. The receivables remain with Scuba which will continue to collect them (legal entitlement to collect rests with Scuba). In addition, if Scuba went bankrupt, would creditors have access to the cash flows related to the receivables? Since the cash collected on the receivables is initially deposited to Scuba’s bank account, it is commingled with Scuba’s other operating cash flows. It is likely that the legal isolation test may not have been met, although likely that a lawyer would have to provide an opinion. In addition, while it is clear that Scuba is not allowed to pledge the assets, it is not clear that Fin is allowed to pledge them. Therefore, the second test is not met. Because there are no repurchase obligations for Scuba, the third test is met. The assets are, therefore, not derecognized and this would be accounted for as a secured borrowing. Cash $900 Expense 100 Liability $1,000

Derecognition example IFRS: The first question is whether the risks and rewards of ownership have passed. Since the selling price is fixed, Scuba is no longer at risk for any credit losses. In fact, it has received $900 already and is under no obligation to repay no matter what happens. Therefore, the risks and rewards have passed. Since Scuba has passed the risks and rewards test, there is no need for an evaluation of control. In this situation, since the asset has passed to Fin and Fin has the right to sell the asset to a third party, control over the asset has passed from Scuba to Fin. Therefore, it would appear that this would be accounted for as a sale, under both criteria and thus derecognized. Cash $900 Loss on sale 100 Accounts receivable $1,000

Impairment US GAAP IFRS Similar Similar but FVPL Similar Similar Financial assets must be reviewed for impairment at the end of each reporting period. Similar Trading: There is no need to test for impairment on trading debt and equity securities since all gains and losses are regularly recognized in income. Similar but FVPL AFS debt assets: Impairment is measured as the difference between the amortized cost basis and fair value, and impairment related to credit losses is reported in income. Similar HTM debt assets: Impairment related to credit losses is reported in income. Similar AFS equity assets: Impairment is measured as the difference between the cost basis and fair value and is reported in income. No reversal is permitted. Similar

Impairment AFS debt assets US GAAP An entity determines impairment exists if the fair value is less than the amortized cost basis and it is determined to be other than temporary. Impairment losses are bifurcated between those related to credit losses which are reported in income and those related to all other factors reported in OCI. There is no reversal of impairment due to credit losses but reversal of impairment losses due to other factors is reported in OCI. IFRS An entity looks for objective evidence of impairment. Impairment losses are reported in income. If an impairment reversal can be objectively related to an event occurring after the impairment was recognized, it can be reported in income.

Impairment AFS equity assets US GAAP An entity determines impairment exists if the fair value is less than the cost basis and it is determined to be other than temporary. IFRS An entity looks for objective evidence of impairment.

Impairment HTM debt assets US GAAP An entity determines impairment exists if the fair value is less than the amortized-cost basis and it is determined to be other than temporary. Impairment losses are measured as the difference between the amortized cost basis and fair value. Impairment losses are bifurcated between those related to credit losses which are reported in income and those related to all other factors reported in OCI. There is no reversal of impairment due to credit losses, but reversal of impairment losses due to other factors is accreted in income up to the new carrying amount of the asset. IFRS An entity looks for objective evidence of impairment. Impairment losses are measured as the difference between the carrying amount and the present value of estimated future cash flows, discounted at the original effective interest rate. Impairment losses are reported in income. If an impairment reversal can be objectively related to an event occurring after the impairment was recognized, it can be reported in income.

Impairment determination Impairment measurement Summary chart for impairment determination, measurement, reporting and reversal Summary of impairment Impairment determination Impairment measurement Impairment reporting Impairment reversal Category US GAAP IFRS AFS – debt If fair value is less than the amortized cost basis and other-than- temporary impairment If objective evidence of impairment Amortized cost basis less fair value Income for impairment due to credit losses Income Not permitted Permitted in income if the reversal can be objectively related to an event occurring after the impairment was recognized OCI for impairment due to other factors OCI AFS – equity If fair value is less than the cost basis and other-than- temporary impairment Cost basis less fair value HTM – debt Amortized cost basis less fair value Amortized cost basis less the present value of estimated future cash flows discounted at the original interest rate Accreted in income up to the new carrying amount of the asset

Impairment of AFS debt and equity assets due to credit losses example The Jumpin’ Jones Company (Jones) has the following investments: Common shares of Bungee Inc. – accounted for as AFS (carrying value equal to cost of $100) Bonds of Bridge Inc. – accounted for as AFS (carrying value equal to cost of $100) At year-end December 31, 2012, the shares are valued at $90 and the bonds at $80. Both are considered to be impaired for both US GAAP and IFRS. At year-end December 31, 2013, the shares are worth $100 and the bonds $95. Assume the values reflect incurred credit losses only and are equal to fair value. How should Jones account for these investments at both year-end dates under US GAAP and IFRS?

Impairment of AFS debt and equity assets due to credit losses example Example 8 solutions: US GAAP: 2012 Loss $30 Investments – AFS equity $10 Investments – AFS debt 20 The loss is recognized in income since this is considered to be an impairment. Otherwise, the decline in value would be reported in OCI. 2013 Investments – AFS debt 15 Unrealized gain – OCI $25 The recovery of the value on both the debt and equity are never reflected in income. The impairment establishes a new cost base. Since the assets are valued at fair value, the recovery is recognized in OCI.

Impairment of AFS debt and equity assets due to credit losses example IFRS: 2012 Loss $30 Investments – AFS equity $10 Investments – AFS debt 20 The loss is recognized in income since this is considered to be an impairment. Otherwise, the decline in value would be reported in OCI. 2013 Investments – AFS equity $10 Investments – AFS debt 15 Unrealized gain – OCI (equity) $10 Reversal of impairment loss – income (debt) 15 The recovery in value of the debt instrument (only) may be reported in income. Since the assets are valued at fair value, the recovery on the equity investment is reported in OCI.

Impairment of HTM debt assets example The Marvelous Mountain Bike Company (Marvelous) invested in a 5%, $100 bond at par. The bond is classified as HTM and at year-end has a fair value of $50. This is partially due to the fact that interest rates have risen to 7% and also due to the fact that the interest and principal may not be collected under the terms of the bond. The present value of the estimated cash flows at year-end using a 5% discount rate is $70. For US GAAP impairment testing purposes, there is a potential impairment since the fair value is less than the carrying value. Marvelous establishes that there is objective evidence of impairment for IFRS impairment testing purposes. The company determines that the decline in value is other than temporary. Marvelous has no intent to sell the bond. Prepare the journal entries to reflect any impairment at year-end under both US GAAP and IFRS.

Impairment of HTM debt assets example Example 9 solutions: US GAAP: Impairment loss – income $30 Impairment loss – OCI 20 Bond (HTM) $50 The impairment loss is measured at carrying value less fair value. The amount related to credit losses of $30 (amortized cost basis of $100 less the year end estimated cash flows of $70) is recognized in income. The impairment loss due to the change in interest rate of $20 ($70-$50) is charged to OCI as Marvelous has no intent to sell the bond. IFRS: Bond (HTM) $30   The impairment loss under IFRS is measured at the carrying value less discounted cash flows. The impairment loss under US GAAP is measured at the carrying value less fair value. Under the new impairment rules, however, only the part of this related to the incurred credit loss is recognized in income.

Transfers between categories US GAAP IFRS Generally, transfers of financial assets between categories are not allowed, except in limited circumstances. Similar FVO: Transfers into and from the FVO categories of assets are not permitted in any circumstances. Similar Trading: May not be reclassified to other categories except in limited circumstances, such as an asset no longer being held for sale or classification to loans and receivables. Similar but FVPL AFS: Not permitted to be reclassified, except for loans and receivables that meet the same criteria as trading. Similar HTM: May be transferred in limited circumstances, but may trigger the “tainting rule,” which could result in the entire portfolio being transferred out of the category and the inability to use the HTM category for two years (SEC registrants only). Similar Similar Loans and receivables: Permitted in limited circumstances.

Summary of transfers between categories of financial assets Category Reclassification into category allowed? Reclassification out of category allowed? FVO No Trading/FVPL Yes – in limited circumstances AFS HTM Yes – may trigger tainting rules Loans and receivables

Disclosures US GAAP IFRS Requires fairly detailed footnote disclosures, including: Significance of financial assets for financial position and performance: Statement of financial position (categories of assets, fair value through profit or loss, reclassification, derecognition, collateral, allowance for credit losses, compound instruments, defaults and breaches) Statement of comprehensive income (amounts recognized through income and OCI) Other disclosures (accounting policies, fair value): The fair value disclosures have basically been converged and the disclosures required are specified in ASC 820 and IFRS 13 (See Fair Value Basics module). These include the three levels of fair value applied to financial assets, transfers between levels and rollforwards of level 3 valuations, among other disclosures. Nature and extent of risks arising from financial assets: Qualitative disclosures Quantitative disclosures (credit risk, liquidity risk, market risk) IFRS Similar

Disclosures US GAAP A moderate level of qualitative disclosures is required. Disclosures are more generally included in the management discussion and analysis. Very specific in what information must be included. IFRS A detailed level of qualitative disclosures is required within the body of the financial statements and related footnotes. Tends to allow more judgment in how much is disclosed.

IFRS 9, Financial Instruments In July, 2014, the IASB issued the final version of IFRS 9, Financial Instruments, bringing together the classification and measurement, impairment and hedge accounting phases of the ISAB’s project to replace IAS 39, Financial Instruments: Recognition and Measurement and all previous versions of IFRS 9. The standard applies to annual periods on or after January 1, 2018, although early application is permitted. Retrospective application is required however, transition relief is provided (including no restatement of comparative period information) Entities will only be permitted to early adopt a previous version of IFRS 9 if their date of initial application is before February 1, 2015 However, if an entity has early adopted a previous version of IFRS 9 before February 1, 2015, the entity is permitted to continue to apply that version until IFRS 9 becomes mandatorily effective on January 1, 2018.

IFRS 9, Financial Instruments Classification of financial assets The standard introduces principles-based requirements for classification and measurement The classification and measurement depends on two assessments: the financial asset’s contractual cash flows and the entity’s business model for managing financial assets The contractual cash flow characteristics test identifies financial assets for which amortized cost information would be relevant, With interest revenue or expense allocated over a relevant period, using the effective interest method Such instruments potentially qualify for measurement at amortized cost or at fair value through other comprehensive income (OCI) All other financial assets are measured at fair value through profit or loss (FVPL)

IFRS 9, Financial Instruments The business model assessment determines whether financial assets held in a portfolio must be measured at amortized cost, FVOCI or FVPL. The first two categories, amortized cost and FVOCI, only apply to portfolios of instruments which have also passed the contractual cash flow characteristics test. The business model assessment is dependent on the particular objective of the business model under which those portfolios of assets are held.

IFRS 9, Financial Instruments Classification and measurement diagram

IFRS 9, Financial Instruments Debt securities The new FVOCI measurement category is aimed at portfolios of debt instruments for which amortized cost information, as well as fair value information, is relevant and useful. This will be the case if their performance is affected by both contractual cash flows and the realization of fair values through sales. The FVOCI measurement category is mandatory when a portfolio of debt instruments: Consists of debt instruments that pass the contractual cash flow characteristics test (i.e. the contractual cash flows of the instruments consist of solely payments of principal and interest) Is held within a business model in which assets are managed to achieve a particular objective by both collecting contractual cash flows and selling financial assets For debt financial instruments at FVOCI, fair value changes are recognized in other comprehensive income. Interest revenue, foreign exchange revaluation and impairment losses or reversals are recognized in profit or loss. Interest revenue and expected credit losses are computed and recognized in the same manner as financial assets measured at amortized cost. Upon derecognition, the net cumulative fair value gains or losses recognized in OCI are recycled to profit or loss.

IFRS 9, Financial Instruments Equity securities, derivatives and fair value option Equity securities are measured at FVPL, unless the entity choses, on initial recognition, to present fair value changes in OCI This option is irrevocable and applies only to equity instruments which are not held for trading Unlike debt instruments, gains and losses in OCI are not recycled on sale and there is no impairment accounting Derivatives Derivatives are also measured at FVPL In comparison to IAS 39, there is no bifurcation of embedded derivatives for financial assets recorded at amortized cost or FVOCI Fair value option The fair value option in IFRS 9 applies to financial assets that would otherwise be mandatorily measured at amortized cost of FVOCI An entity is permitted to measure these financial assets at FVPL if doing so would eliminate or significantly reduce a measurement or recognition inconsistency (sometimes referred to as an “accounting mismatch”) The fair value option for financial liabilities remains unchanged The designation to measure financial assets or liabilities at FVPL is irrevocable and only permitted at initial recognition

IFRS 9, Financial Instruments Impairment The IASB has addressed the key concern that arose as a result of the financial crises, which is that the incurred loss model in IAS 39 contributed to the delayed recognition of credit losses, by issuing the new impairment requirements that are based on a more forward-looking expected credit loss model The expected credit loss model (ECL) requirements would apply to: Financial assets measured at amortized cost or at fair value through OCI under IFRS 9 (which includes debt instruments such as loans, debt securities and trade receivables) Loan commitments and financial guarantee contracts that are not accounted for at FVPL Contract assets under IFRS 15, Revenue from contracts with Customers Lease receivables under IAS 17, Leases

IFRS 9, Financial Instruments General approach Under the general approach for impairment, entities must recognize ECL’s in two stages: For credit exposures where there has not been a significant increase in credit risk since initial recognition (i.e. “good exposures”), entities are required to provide for credit losses that result from default events “that are possible” within the next 12-months (a 12-month ECL – Stage 1 in the diagram that follows) For those credit exposures where there has been a significant increase in credit risk since the initial recognition, a loss allowance is required for credit loses expected over the remaining life of the exposure regardless of the timing of the default (a lifetime ECL – Stage 2 and 3 in the diagram that follows) If the financial assets become credit-impaired (Stage 3 in the diagram that follows), interest revenue would be calculated by applying the effective interest rate (“EIR”) to the amortized costs (net of the allowance) rather than the gross carrying amount. Financial assets are assessed as credit-impaired using the same criteria as for the individual asset impairment under IAS 39 Examples of events to assess as to whether a financial asset is credit-impaired are provided in paragraph 59 of IAS 39 and Appendix 39 of IFRS 9

IFRS 9, Financial Instruments General approach

EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About the Ernst & Young Academic Resource Center The Ernst & Young Academic Resource Center (EYARC) is an innovative collaboration between faculty and professionals to support higher education. The EYARC develops and provides free curriculum resources and other educational support to address leading-edge issues impacting the accounting profession. The EYARC is yet another example of the commitment of the global EY organization and the Ernst & Young Foundation to the academic community. The Ernst & Young Foundation is a 501(c)(3) tax exempt corporation associated with Ernst & Young LLP, which funds the Foundation, together with its present and former partners, principals and staff. © 2014 Ernst & Young Foundation (US). All Rights Reserved. SCORE No. MM4177C. www.ey.com/us/arc