FINICS - Financial Instruments - IFRS9

Digital Automation of Accounting Compliance Services

FINICS - Financial Instruments - IFRS9

IFRS 9 was announced on 24th July 2014 with the mandatory effective date as 1st Jan 2018. IFRS 9 is more objective than IAS 39. The classification criteria of financial assets as per IFRS 9 are conceptually different from that of IAS 39. All the entities that are within the IAS/IFRS regulatory regime have no choice other than to follow IFRS 9 with effect from 1st Jan 2018

IFRS 9 Challenges

  • IFRS 9 – Financial Instruments is built on a logical, single classification and measurement approach.
  • The classification reflects the business model in which they are managed and their cash flow characteristics.
  • IFRS 9 requires financial institutions to move from an incurred loss model to an expected loss model. For the first time, financial institutions will have to recognize not only credit losses that have already occurred but also losses that are expected in the future that will result in more timely recognition of loan losses and is a single model that is applicable to all financial instruments subject to impairment accounting.
  • IFRS 9 will also include an improved hedge accounting model to better link the economics of risk management with its accounting treatment.

How our solution – FINICS – helps

Classification

  • Amortized cost
  • FOVCI
  • FVTPL
  • SPPI Test
  • Business Model Objective Test
  • ERI Computation

Measurement

  • Valuation of Securities
  • Support for custom model
  • Mark to model
  • Financial guarantees
  • Prepayment Option
  • Amortization schedule

?

Impairment

  • Staging of FA
  • Provision matrix for recievables
  • Impairment model
  • PD/LGD/EAD
  • Recovery rate
  • Transition matrix
  • Impairment policy
  • Credit risk analysis

Hedge Accounting

  • Micro hedge
  • Interest rate / FX risk
  • Fair value/Cash flow hedge
  • Macro hedge as per IAS 39
  • Cost of hedging
  • Effectiveness testing analysis

Report

  • CVA/DVA
  • EIR
  • IFRS 7 – Financial instruments
  • PD/LGD/EAD
  • IFRS 13 fair value

FINICS – IFRS 9 Service offering

  • Repository Services – Out of the box support for indicative information/Market data from industry standard data providers like Bloomberg/Reuters/Markit is available.
  • Transaction Uploader –
    Provides the ability to upload all transactions across different asset classes.
  • Static data – Users can provide their own version of product definitions for example Bonds/Debentures or loans. For listed products, we support Static data provided by Bloomberg (client licenses apply)
  • Model service – We provide the flexibility to integrate with in house models of customers for valuation/ EIR/ECL
  • API – Entire solution can be accessed through API if the client wants STP integration with their systems/processes.

  • Configuration – Configuration to suit the client requirements is provided depending upon the requirements. For example, account level configuration / market data configuration / access control for internal users / audit are provided.
  • Report framework – The outputs can be generated for down-stream processing out of the box support available for standard packages like Oracle Financials.

Adversary – Stage Transferring Criteria

The key feature is that the classification is now based on sound objective criteria as opposed to IAS 39 wherein it was based on subjective criteria. While there is a choice given for the entities to classify an investment in equity instrument as either FVOCI or FVTPL, there is no such choice for the classification of debt instrument as it is exclusively based on certain very rigid and objective criteria.

The key feature is that the classification is now based on sound objective criteria as opposed to IAS 39 wherein it was based on subjective criteria. While there is a choice given for the entities to classify an investment in equity instrument as either FVOCI or FVTPL, there is no such choice for the classification of debt instrument as it is exclusively based on certain very rigid and objective criteria.

A financial asset is classified as one of the three as follows:

  1. Amortized Cost (AC)
  2. Fair Value through OCI (Equity Instruments) – FVOCI – Equity Instruments
  3. Fair Value through OCI (Debt Instruments) – FVOCI – Debt Instruments
  4. Fair Value through Profit & Loss (FVTPL)

The key feature of Ind AS 109 is that the classification is now based on sound objective criteria as opposed to IAS 39 wherein it was based on subjective criteria. While there is a choice given for the entities to classify an investment in equity instrument as either FVOCI or FVTPL, there is no such choice for the classification of debt instrument as it is exclusively based on certain very rigid and objective criteria. The following diagram gives an overview of the classification process of a financial asset within the purview of Ind AS 109.

Classification of Financial Assets

FINICS – Financial Instrument Modules

Conversion at a fixed price
Where the conversion into equity shares is at a fixed price, there is no further obligation on the part of the entity to part with either cash or any other financial asset of the company, as the number of equity shares to be issued in lieu of preference shares is also known.

Similar to the facts discussed above, neither the issuer nor the holder has the discretion of not converting the preference shares into equity shares. The conversion takes place only on a fixed-for-fixed ratio and as such, these will also be classified as equity instruments.

Prepayment Option
Prepayment is the early repayment of a loan by a borrower, in part or in full, often as a result of optional refinancing to take advantage of lower interest rates. An entity would prepay an existing fixed rate loan if there is a reduction in the interest rate and the prepayment penalty is less than the fair value of the prepayment option.

There are four types of loans that call for an analysis as to whether prepayment option exists in such loans.

1. Floating rate plus fixed spread: Floating rate loans based on a benchmark rate plus or minus a fixed spread. An example of such a loan will be PLR + Defined %. While the PLR might change, the defined spread will not change during the tenor of the loan. These loans are variable rate loans and the spread reflect the extra risk applicable to the entity. Consequently, there will no advantage of prepaying the loan.
2. Floating rate plus variable spread: Floating rate loans based on a benchmark rate plus or minus a fixed spread, the reset of which happens on a periodical basis. In this case the defined spread can change during the tenor of the loan. If there is a history of change in the spread when the loan is reset, then there could be prepayment option, which needs to be evaluated. In respect of such loans it should be analyzed if there is any history of change in the spread whenever the loan is reset. If not then the volatility of interest rate is zero, which effectively means that there is no value of prepayment option for such loans.

3. Fixed rate with prepayment clause: The third is fixed rate loans, which provide a prepayment clause. For this type of loans value of prepayment option should be computed.

4. Fixed rate without prepayment clause: The fourth is also fixed rate loans, which does not provide for prepayment clause. These loans can never be prepaid and hence there is no question of any value of prepayment option.

Preference Shares
Compulsorily convertible preference shares give the shareholders a fixed rate of re-turn plus the opportunity for capital appreciation. These can be viewed as fixed in-come securities that an investor can expect to get a fixed or variable number of shares of the company either at a pre-determined price or at the market price of the shares of the company.

The option to convert the securities into stock exists in the case of convertible preference shares. However, in the case of compulsorily convertible preference shares, the preference shares would be compulsorily converted into equity shares and there is no option left to the investor.

The option, if any, may be relating to the time at which the investor may elect to exercise the option. The compulsorily convertible preference shares may have a fixed rate of dividend either on a cumulative basis or a non-cumulative basis. If the profits of the company are insufficient to meet the liability relating to the dividends on such preference shares, the same would be accumulated and treated as a liability to be settled using the equity shares of the entity at the pre-determined rate or at the fair value (market price) of the company as per the terms of issue of the preference shares.

Compulsorily convertible cumulative preference shares
To the extent of the preference dividend that is not paid, the same would be accumulated and becomes the liability for the issuer in the cases where there are insufficient profits in the company. The accumulated unpaid preference shares dividends become payable only on liquidation of the company if it is not paid by then.

Where the preference shares are to be compulsorily converted into equity shares, as per the terms of the issue, the preference shares would be converted along with the unpaid preference shares dividends.

Normally, the preference dividends should be paid in cash and hence constitutes a liability on the part of the company to part with cash. But where the preference dividend is not paid, then the company uses its equity shares as a currency to settle its obligation of payment of dividend.

The number of shares to be issued for settling the liability is not known even though the quantum of liability is known. This is because, the shares would be issued based on the fair value of the equity shares. So, the unpaid accumulated preference dividend would be regarded as a liability and should be bifurcated at the time of issue and shown as a liability component.

The present value of the dividend liability will have to be computed by discounting the projected cash outflows using the interest rate that is applicable for similar preference shares which does not have the compulsorily convertible option.

Unquoted Equity Instruments
Financial Liabilities are classified as Amortized cost category usually unless it is a derivative or a liability held for trading purpose. Entities have an option to designate a financial liability at fair value by exercising the ‘Fair Value Option’ choice which is available at the inception of the financial liability. Once the choice is exercised it is irrevocable. FVO is considered to be an alternative for hedge accounting, albeit laden with several limitations.
Debt Securities [Fixed Income Securities]
A debt instrument would be classified as Amortized cost asset if it satisfies SPPI test. Further the Business Model Objective should be holding the asset for collecting contractual cash flows only.

For debt securities, the accumulated profit or loss that is parked in the other comprehensive income should be reclassified to the profit and loss account. The reason for recognizing the fair value changes of a debt security in the other comprehensive income is two-fold – one, the balance sheet should reflect the fair value of the asset at any point of time and two – the fair value changes are not really profits or losses at that point of time as it is not yet crystallized.

The profit /loss gets crystallized on liquidation of the asset and at that point of time it should be reported in the profit and loss account. And hence the requirement that the accumulate profit or loss should be reclassified to the profit and loss account when the asset is liquidated.

Interest Free Deposits

The fair value of the interest free deposit would be arrived by discounting the principal amount of interest free rental deposit with the effective interest rate which is the risk-free rate of interest for the same tenor as deposit as increased by the credit risk of the counter party. The imputed interest income for the various years till maturity date of the deposit should be computed.

Financial Guarantees
A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.

Financial liabilities are measured at amortized cost, except for financial guarantee contracts. After initial recognition, financial guarantee contract should be measured subsequently at the higher of (i) the amount of the loss allowance as per the expected credit loss criteria and (ii) the amount initially recognized less any cumulative amount of income recognized on such financial guarantee contract.
A loss allowance for expected credit losses in respect of a financial guarantee contract should be recognized by the entity. If the financial guarantee contract was issued to an unrelated party in a stand-alone arm’s length transaction, its fair value at inception is likely to equal the premium received, unless there is evidence to the contrary. Subsequently, unless the financial guarantee contract was designated at inception as at fair value through profit or loss.

Expected credit losses on financial guarantee contracts for which the effective interest rate cannot be determined shall be discounted by applying a discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows but only if, and to the extent that, the risks are taken into account by adjusting the discount rate instead of adjusting the cash shortfalls being discounted.

Effective Interest Rate [EIR]
  • The EIR is calculated at initial recognition of a financial asset or a financial liability. It is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the gross carrying amount of the financial asset.
  • At initial recognition, the gross carrying amount of a financial asset, or the amortized cost of a financial liability, is generally equal to the fair value of the instrument, adjusted for transaction costs. The estimate of expected cash flows should consider all contractual terms (e.g. prepayment, call and similar options) but should not consider expected credit losses (i.e. the contractual cash flows are not reduced by expected credit losses.)Transaction Costs
  • Transaction costs include fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and security exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.
  • Financial assets measured not at FVTPL: For financial assets not measured at fair value through profit or loss, transaction costs are added to the fair value at initial recognition. For financial liabilities, transaction costs are deducted from the fair value at initial recognition.
  • Financial assets at amortised cost: For financial instruments that are measured at amortised cost, transaction costs are subsequently included in the calculation of amortised cost using the effective interest method and, in effect, amortised through profit or loss over the life of the instrument.
  • Financial assets at FVOCI: For financial instruments that are measured at fair value through other comprehensive income transaction costs are recognised in other comprehensive income as part of a change in fair value at the next re-measurement. If the financial asset is measured those transaction costs are amortised to profit or loss using the effective interest method and, in effect, amortised through profit or loss over the life of the instrument.
Foreign Currency Convertible Bonds
Contracts that will be settled by an entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of foreign currency are treated as a liability as per IFRS 9.

Accordingly, contracts, which include a conversion option in a foreign currency denominated convertible bond, are liabilities. A derivative contract which involves an entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of foreign currency fails the “fixed for fixed test” and be classified as liability.

Indian Standard: However as per the carve out mentioned in Ind AS 32, an exception is provided to the definition of ‘financial liability’. Accordingly, equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of entity’s own equity instruments is considered an equity instrument if the exercise price is fixed in any currency.

A convertible bond denominated in foreign currency to acquire a fixed number of entity’s own equity instruments may result in issuing a variable number of its own equity instrument depending upon the foreign exchange rate at the time of conversion. In spite of this, such FCCB would be considered as equity instrument only pursuant to the carve out provided as mentioned above.

Classification of Financial Liabilities

Financial Liabilities are classified as Amortized cost category usually unless it is a derivative or a liability held for trading purpose. Entities have an option to designate a financial liability at fair value by exercising the ‘Fair Value Option’ choice which is...

Business Model Test

The investors’ key management personnel determine the business model, as defined in Ind AS 24 ‘Related Policy Disclosures’. The following factors should be considered while determining the business model objective: The business model does not depend on the...

Effective Interest Rate [EIR]

The EIR is calculated at initial recognition of a financial asset or a financial liability. It is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the gross carrying amount of the...

SPPI Test

Solely Payments of Principal and Interest (SPPI) Test: An entity should assess whether contractual cash flows are Solely Payments of Principal and Interest (SPPI) on the principal amount outstanding for the currency in which the financial asset is denominated....