1. S.R. BATLIBOI & CO. LLP KIRTANE & PANDIT LLP Institute of Actuaries of India Ind AS 109 Financial Instruments October, 2016

2. 1. Introduction1. Classification and Measurement 3. Derivatives and Hedge Accounting 2. Impairment and Derecognition Agenda - Ind AS 109 Financial Instruments

3. Classification and Measurement

4. 1. Introduction 4. Reclassification 6. Subsequent Measurement Contents 1. Meaning of Financial Instruments 2. Classification of Financial Assets 5. Initial Measurement 3. Classification of Financial Liabilities

5. Financial Asset of one entity Financial Liability or Equity Instrument of Another Entity A contract that gives rise to both Meaning of Financial Instruments

6. ► An asset that is: ► Cash ► An equity instrument of another entity ► A contractual right: ► To receive cash or another financial asset; or ► To exchange financial assets or financial liabilities under potentially favourable conditions; or ► A contract that will or may be settled in 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 Financial Assets

7. ► Any liability that is ► a contractual obligation: ► to deliver cash or another financial asset to another entity; ► to exchange financial assets/ liabilities under potentially unfavourable conditions; or ► 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 deliver 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 Financial Liability

8. ► Any contract that evidences a residual interest in the net assets of an entity ► Examples: ► Equity shares ► Preference shares (if certain criteria are met) ► Warrants ► Written call options to issue fixed number of equity shares for a fixed price Note: Detailed criteria for classification of instruments as liability or equity is covered under separate session. Equity Instruments

9. Classification of Financial Assets

10. Financial instruments in the scope of Ind AS 109 Financial assetsFinancial liabilities New classification criteria New categories that use OCI New presentation: ‘own credit’ related FV changes in OCI (for liabilities under the FVO) Ind AS 109 Classification and Measurement Model - Changes from Ind AS 39

11. ► Financial assets has been classified into three categories as per Ind AS 109: ► Financial assets shall be classified on the basis of both: (a) the entity’s business model for managing the financial assets and (b) the contractual cash flow characteristics of the financial assets. Financial Assets Amortised CostFair Value through other comprehensive income (FVTOCI) Fair Value through profit or loss (FVTPL) Classification of Financial Assets : Overview

12. Debt (including hybrid contracts) Pass No Neither (1) nor (2) BM with objective that results in collecting contractual cash flows and selling FA 1 3 2 No Yes DerivativesEquity No Yes Amortised cost FVTPL FVOCI (with recycling) FVOCI (no recycling) ‘Contractual cash flow characteristics’ test (at instrument level) Fail Hold-to-collect contractual cash flows Conditional fair value option (FVO) elected? Fail Held for trading? YesNo FVOCI option elected ? ‘Business model’ test (at an aggregate level) Classification and Measurement Model of Financial Assets

13. ► The business model assessment should refer to how an entity manages its financial assets in order to generate cash flows and create value for the entity. ► The entity’s business model for managing financial assets is often observable through particular activities that are undertaken to achieve the objectives of that business model. ► Sales do not drive the business model assessment and information about past sales should not be considered in isolation. ► Business activities usually reflect the way in which the performance of financial assets is evaluated and reported, as well as the risks that typically affect the performance of the business model and how those risks are managed. Overall Business Model Assessment

14. Sales made close to maturity and proceeds approximate the collection of remaining cash flows Infrequent sales (eg unanticipated stressed scenarios) even if significant Sales due to deterioration in credit quality in line with a documented investment policy In significant sales, both individually and in aggregate, even if frequent The fact that the requirement to sell the financial asset is imposed by a third party (e.g., a regulator) is not relevant for assessment of business model Examples of sales that would be consistent with a hold to collect business model: Amortised Cost Business Model

15. 1.To hold Contractual cash flows and 2.Sell Financial Assets This Category is:- 1.Neither a Free Choice 2.Nor a residual category FVOCI measurement applies under a business model whose objective results in both is Not Only Financial Asset s with Contractual Cash Flows that are solely Profit and Loss will qualify for FVOCI FVOCI Business Model (hold to collect and sell)

16. ► A Insurance Company holds financial assets to meet its everyday liquidity needs. ► The company seeks to minimise the costs of managing its liquidity needs and therefore actively manages the return on the portfolio. ► The company typically holds some financial assets to collect contractual cash flows and sells others to reinvest in higher yielding assets or to better match the duration of liabilities. ► This strategy has resulted in significant and recurring sales activity in the past, which is expected to continue. FVOCI Business Model – Example 1

17. ► An insurer holds financial assets in order to fund insurance contract liabilities. ► The insurer uses the proceeds from the contractual cash flows on the financial assets to settle insurance contract liabilities as they come due. ► The insurer also undertakes significant buying and selling activity to rebalance the portfolio of financial assets on a regular basis as estimates of the expected cash flows needed to fulfil the insurance contract liabilities change to ensure that the contractual cash flows from the financial assets are sufficient to settle those liabilities. FVOCI Business Model – Example 2

18. ► FVTPL is the residual measurement category applicable to all instruments failing either the contractual cash flow or the business model test (this includes instruments held for trading, derivatives and equity instruments) FVTPL Business Model

19. XYZ an Insurance Company holds a portfolio of debt instruments whose value is approximately INR 10 million. XYZ has appointed a separate employee to manage the portfolio. The employee has mandate to optimise long term yield on the portfolio. For this purpose, the employee regularly sells the assets and reinvests proceeds in new assets having similar maturity and risk profile, but a higher yield. The entity typically generates insignificant gains or losses in the process of sale. Fair value gains or losses are not considered for this purpose. The management is evaluating whether it can measure the portfolio at the amortized cost? Example Response Based on the factors mentioned, it may be argued that the objective of the entity is not to realise fair value gains or losses on the portfolio. However, this may not be sufficient basis to conclude that measurement at amortised cost is appropriate. This is because the business model objective for the portfolio is not only to hold financial assets for collecting contractual cash flows but, it also results in frequent sales which are significant in value. The business model objective results in both holding the financial assets to collect contractual cash flows and selling the financial assets. Hence, measuring the portfolio as at FVTOCI may be more appropriate. Example

20. Difference between IRDA accounting guidelines and Ind AS IRDA*Ind AS ► All contracts are accounted as insurance contracts ► Ind AS 104 require every contract issued needs to be classified in insurance contract or investment contract based on the risk assumed by such contract. ► Once a contract is classified as an Insurance contract it cannot be reclassified to investment contract however for contracts which are classified as investment contract, based on any change in benefits or rider acquired it may be reclassified to insurance contract. * IRDA – Insurance Regulation and Development Authority

21. Difference between IRDA accounting guidelines and Ind AS IRDA*Ind AS ► Investments need to be classified into the following categories : ► Schedule 8 – Shareholders investments ► Schedule 8A – Policyholders investments (Non Linked) ► Schedule 8B – Assets held to cover linked liabilities. ► Ind-AS 109 prescribes the classification of financial assets into three different categories: ► Amortised cost ► Fair value through other comprehensive income (FVOCI) o ► Fair value through profit or loss (FVTPL), Based on the business model of the entity for managing the financial assets and the contractual cash flow characteristics of the financial asset. * IRDA – Insurance Regulation and Development Authority

22. Classification of Financial Liabilities

23. CategoryMain use Fair value through profit or loss ► Financial liabilities that are held for trading (including derivatives) ► Financial liabilities that are designated as FVTPL on initial recognition ► Contingent consideration recognised by an acquirer in a business combination Amortised Cost ► All liabilities not in the above category Financial liabilities have been classified into two categories: Classification of Financial Liabilities

24. Difference between IRDA accounting guidelines and Ind AS IRDA*Ind AS ► Shadow accounting : No such concept ► Per Ind AS 104 If any of the insurance liability is linked with realised gains or losses of the insurer’s asset than insurer is permitted to change its accounting policies so that a recognised but unrealised gain or loss on an asset affects those measurements in the same way that a realised gain or loss ► The related adjustment to the insurance liability shall be recognised in other comprehensive income if, and only if, the unrealised gains or losses are recognised in other comprehensive income.. * IRDA – Insurance Regulation and Development Authority

25. Reclassification of Financial Assets & Liabilities

26.  Reclassification of financial liability is prohibited  For Financial Assets: Only When Business Model Is changed Financial Assets From FVTPL to amortized cost, fair value at reclassification date become new carrying amount From FVOCI to amortized cost, fair value at reclassification date become new carrying amount From Amortized cost to FVOCI Fair value is determined at reclassification date and gain/loss is recognized in OCI From Amortized cost to FVTPL Fair value is determined at reclassification date and gain/loss is recognized in profit and loss Reclassification

27. Original category New categoryBalance sheet impact P&L impactOCI impact Amortised costFVTPLFV is measured at RD*Gain/loss = difference between previous amortised cost and FV None FVTPLAmortised costFV at RD becomes new gross carrying amount None Amortised costFVTOCIFV is measured at RDNoneGain/loss = difference between previous amortised cost and FV FVTOCIAmortised costFV at RD becomes new gross carrying amount NoneGain/loss previously in OCI reclassified as an adjustment to FV at RD FVTPLFVTOCIFV at RD becomes new carrying amount None FVTOCIFVTPLAssets continue to be measured at fair value Gain/loss previously recognised in OCI is reclassified from equity to profit or loss *RD = Reclassification Date Reclassification – Accounting Treatment

28. Initial Measurement

29. “The fair value of a financial instrument on initial recognition is normally the transaction price.” However, if fair value differs from transaction price, an entity shall account for that instrument as follows (Application Guidance): (a) If fair value is evidenced by quoted price in an active market (i.e. Level 1 input) or based on valuation technique that uses only data from observable markets, entity shall recognise difference between fair value at initial recognition and transaction price as gain or loss (Day 1 gain or loss). (b) In all other cases, difference is deferred. After initial recognition, entity shall recognise deferred difference as gain or loss only to extent that it arises from change in factor (including time) that market participants would take into account when pricing asset or liability. Initial Measurement

30. “The fair value of a financial instrument on initial recognition is normally the transaction price.” Please advice on initial measurement of following transactions: a) A Ltd lends to B Ltd loan of 10 million for 5 years and classify as asset under loans and receivable. The Loan carries no interest. Market rate of interest is 10% b) A ltd grants interest free loan of 10 Lac to a employees for a period of two years. Market rate of interest is 10% Initial Measurement Eliminated: IAS 39 exception to measure unquoted equity instruments whose fair value cannot be determined reliably

31. Difference between IRDA accounting guidelines and Ind AS IRDA*Ind AS ► Deferred Acquisition Costs (‘DAC’). E.g. Commission, underwriting expenses and policy issuance costs. However, they are not defined by Ind-AS 104. Acquisition costs are recognised as expense for the period in which it is incurred. No deferment of acquisition costs is allowed ► In case of investment contracts without DPF, Ind-AS 109 provides that Incremental costs that are directly attributable to securing an investment management contract are recognised as an asset if they can be identified separately and measured reliably and if it is probable that they will be recovered. ► Such costs need to defer over the period of investment contract ► If the entity has a portfolio of investment management contracts, it may assess their recognition on a portfolio basis. * IRDA – Insurance Regulation and Development Authority

32. Subsequent Measurement

33. Recognition of fair value changes Financial assets Measurement Fair value Amortised cost Not relevant Profit or loss FVTPL ♦OCI except for dividends/interest ♦Dividends in income statement ♦Interest in income statement through EIR ♦No recycling from OCI to P&L (except for debt instruments classified as FVOCI) ♦OCI except for dividends/interest ♦Dividends in income statement ♦Interest in income statement through EIR ♦No recycling from OCI to P&L (except for debt instruments classified as FVOCI) FVTOCI Subsequent Measurement – Financial Assets

34. Fair value ♦FV change attributable to own credit risk in OCI except if this creates or enlarges an accounting mismatch ♦Remainder in profit or loss ♦FV change attributable to own credit risk in OCI except if this creates or enlarges an accounting mismatch ♦Remainder in profit or loss Amortised cost Not relevant Amortised cost FVTPL Recognition of fair value changes Financial liabilities Measurement Subsequent Measurement – Financial Liabilities

35. Impairment and Derecognition

36. 1. Introduction 4. Derecognition of Financial Assets Contents 1. Impairment of Financial Instruments 2. Expected Credit Loss Model 3. Measurement of Expected Credit Loss 5. Derecognition of Financial Liabilities

37. Impairment- Financial instruments

38. ► The impairment requirements would apply to: ► Debt instruments measured at amortised cost ► Debt instruments measured at fair value through other comprehensive income ► Loan commitments and financial guarantee contracts not measured at fair value through profit or loss ► Trade receivables and contract assets ► Lease receivables Scope

39. Expected Credit Loss Model

40. Scope of ECL requirements General approach Simplified approach Ind AS 109 Financial Instruments Trade receivables that do not contain a significant financing component Trade receivables that contain a significant financing component Policy election at entity level Other debt financial assets measured at AC or at FVOCI Loan commitments and financial guarantee contracts not accounted for at FVPL Ind AS 115 Revenue from Contracts with Customers Contract assets that do not contain a significant financing component Contract assets that contain a significant financing component Policy election at entity level Ind AS 17 Leases Lease receivables Policy election at entity level Scope and Variation of Expected Credit Loss Model

41. Stage 2Stage 3Stage 1 Loss allowance updated at each reporting date 12-month expected credit losses Lifetime expected credit losses Lifetime expected credit losses criterion Credit risk has increased significantly since initial recognition (individual or collective basis) + Credit-impaired Interest revenue calculated based on Effective interest rate on gross carrying amount Effective interest rate on amortised cost Change in credit risk since initial recognition Improvement Deterioration Lifetime expected credit losses Start Here Scope and Variation of Expected Credit Loss Model

42. Interpretation of ‘significant’ Original credit risk at initial recognition Expected life or term structure  Change in absolute probability of default (PD) occurring is more significant for financial instruments with lower initial credit risk as compared to financial instrument with higher initial risk of default occurring  Risk of a default occurring increases with the expected life of the financial instrument  PD will decrease less quickly over time for instrument with significant payments obligations close to maturity What is significant increase in Credit Risk

43. Credit spread (e.g., credit default swap) Rates or terms (e.g., covenants, collateral) Credit rating (internal or external) Business, financial or economic conditions Operating results Regulatory, economic or technological environment Collateral, guarantee or financial support, if this impacts the risk of a default occurring Credit risk management approach Payment status and behaviour Factors or indicators of change in the risk of a default occurring

44. Use change in 12-month risk as approximation for change in lifetime risk Assessment at counterparty level Set transfer threshold by determining maximum initial credit risk 30 days past due ‘backstop’ ‘Low’ credit risk – equivalent to ‘investment grade’ Assessing significant increases in credit risk General Approach- simplifications and presumptions for assessing credit deterioration

45. Low credit risk For financial instruments that are equivalent to ‘investment grade’ quality, an entity would continue to recognise 12- month ECL More than 30 days past due (DPD) Rebuttable presumption that there is a significant increase in credit risk when contractual payments are more than 30 DPD ► An entity can assume that a financial instrument has not significantly increased in credit risk if it has low credit risk at the reporting date ► Low credit risk notion is not a bright-line trigger and financial instruments are not required to be externally rated More than 30 DPD rebuttable presumption is intended to serve as a backstop and should identify significant increases in credit risk before default or objective evidence of impairment. Operational simplifications in assessing significant increase in credit risk

46. ► Under the general model of Ind AS 109, all assets need to have a loss allowance. ► Allowance covers either 12-month or lifetime expected credit losses depending on whether the asset’s credit risk has increased significantly. ► Since the loan has just been granted and there has not been a significant increase in credit risk, an allowance equal to 12-month expected credit losses is appropriate. B. 12-month expected credit losses Loss Allowance Recognition: Response

47. Feature According to the simplified approach, for trade receivables and contract assets that do not contain a significant financing component, an entity shall always measure loss allowance at an amount equal to lifetime expected credit losses. A provision matrix could be used to estimate ECL for these financial instruments. Example An entity may set up the following provision matrix based on its historical observed default rates, which is adjusted for forward-looking estimates. Same will appear in the Ind AS compliant financial statement of the entity. Probability of Default Non Past due0.3% of carrying value 30 days past due1.6% of carrying value 31-60 days past due3.6% of carrying value 61-90 days past due6.6% of carrying value more than 90 days past due 10.6% of carrying value Simplified Approach: Provision Matrix

48. Derecognition of Financial Instruments

49. ► An entity should recognize ECL in statement of financial position as: ► a loss allowance for financial assets measured at amortized cost and lease receivables; and ► a provision (that is, a liability) for loan commitments and financial guarantee contracts. ► Accumulated impairment amount for debt instruments measured at fair value through OCI is presented as 'accumulated impairment amount' in OCI rather than presenting ECL as an allowance to financial asset Derecognition of Financial Asset

50. Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) Continue to recognise the asset to the extent of the entity’s continuing involvement Has the entity transferred its contractual rights to receive the cash flows from the asset? Has the entity assumed an obligation to pay the cash flows from the asset under pass-through arrangement? Has the entity transferred substantially all risks and rewards? Has the entity retained substantially all risks and rewards? Has the entity retained control of the asset? Continue to recognise the asset Derecognise the asset Continue to recognise the asset Derecognise the asset No Yes No Yes No Yes No Yes Have the rights to the cash flows from the asset expired? No Yes Derecognise the asset Note: The Above tree assumes that the consolidation has been already done Derecognition of Financial Assets (contd..)

51. When the entity’s continuing involvement takes form of guaranteeing the transferred financial asset, Ind AS 39 states the extent of the entity’s continuing involvement is lower of:  Amount of the asset; and  Maximum amount of the consideration received that the entity could be required to repay (“guarantee amount”) Additionally, when an entity continues to recognize an asset to the extent of its continuing involvement, Ind AS 39 also requires entity to recognize an associated liability initially measured at guaranteed amount plus the fair value of the guarantee (which is normally consideration received for guarantee) For example, Entity has loan portfolio carried at $10 million with fair value of $10.5 million. The entity sells the rights to 100% of cash flows to a third party for a payment of $10.55 million, which includes a payment of $50K in return for the transferor agreeing to absorb first $1 million of default losses on portfolio. Treatment under Ind AS Derecognition of Financial Assets (contd..)

52. Derecognise Financial liability is extinguished Is the obligation in the contract discharged, cancelled or expired? yes Derecognition of Financial Liabilities

53. Qualitative assessment: Are there substantial differences in terms that by their nature are not captured by the quantitative assessment? Continue to recognise Substantial modification of terms Quantitative 10% assessment: D oes net present value of the cash flows under the new terms (including any fees paid / received), discounted using original effective interest rate, differ at least 10% from the present value of the remaining cash flows under the original terms? Yes Derecognise No Yes No Modification of Terms

54. Any new financial liability recognised is measured initially at fair value The consideration paid includes non-financial assets transferred and the assumption of liabilities, including the new modified financial liability Any costs or fees incurred are recognised as part of the gain or loss on extinguishment A gain or loss is recognised based on the difference between the carrying amount of the financial liability extinguished and the consideration paid Accounting for Extinguishment

55. Fees, transaction costs and difference in present value due to modification amortised over remaining new life of the liability Carrying amount of liability is adjusted for fees and transaction costs Any difference in present value arising as a result of the modification is recognised as an adjustment to effective interest rate No gain or loss is recognised Accounting for modification of terms that is not substantial

56. Thank You