What are financial instruments?

What financial instruments are amortised?

There are now just two categories of financial assets, those measured at amortised cost and those at fair value. Financial assets which contain embedded derivatives no longer have to be bifurcated between host contract and the embedded derivative. However, the bifurcation concept still holds for financial liabilities and non financial assets.

Two types of financial assets have to be impaired for credit risk using a forward-looking expected credit loss model. Previously, assets were only impaired if the loss had actually been incurred during anytime up to the submission of the accounts. The assets which are affected are those which are measured at amortised costs e.g. trade receivables, vanilla loans and bonds which are pure hold to collect assets and those asset which are measured at fair value through OCI (FVOCI) such as government and corporate bonds held for less than maturity. Both types must pass the SPPI (Solely Payments of Principal and Interest) test.

Financial assets include either cash, a contractual right to receive cash, equity instruments, a contract that may be settled in non derivative or derivative equity instruments but excluding puttable instruments.The definition of financial liabilities broadly mirror that of financial assets.

An equity instrument is any contract that gives right to the residual interest in the assets of an entity.

Exclusions

IFRS 9 excludes any interest which is part of business combinations, share based payments, employee benefits, lease obligations, all of which are addressed in their respective accounting standards.

Non financial assets

Non-financial assets, such as an entity which buys commodities, can be caught by IFRS 9 if there is a practice of settling the contract by cash and where ‘own use’ exemption does not apply.

Equity instruments

For equity investments, other than those recognized in business combinations, the default position is that changes in fair value are reported in profit and loss unless the entity makes an irrevocable election on initial recognition in which case changes will be reported in OCI. There is no recycling of realised gains from OCI to profit and loss but such gains can be transferred between OCI reserves and retained earnings.

Financial assets

A financial asset is measured at fair value through profit and loss (FVTPL) if the asset is held for trading or fails the SPPI test. Examples are equity investments mentioned above, non-hedging derivatives (futures, options and swaps), convertible loan notes, gold linked bonds and contingent consideration from sale of businesses.  Under IAS 39 the convertible loan notes and commodity linked bonds would have to have been bifurcated or the entire contracted designated as FVTPL. Under IFRS 9 there is bifurcation option.

Financial liabilities

Financial liabilities are measured at amortised cost or FVTPL if there is an election or if instrument is held for trading e.g. non-hedged derivatives. Financial liabilities retain the bifurcation option. Trade creditors, vanilla or convertible loans, bank borrowings are measured at amortised cost.  Interest rate swaps, futures, options, convertible loans (on which there is an election) and contingent consideration payable are all measured at FVTPL.

Initial recognition and subsequent measurement

On initial recognition, financial instruments (FI’s) are measured at fair value plus transactions costs unless the FI is reported as FVTPL in which case the transaction costs are expensed in profit and loss. Transaction costs are those that are directly attributable to the acquisition such as professional, regulatory and tax costs.

The FV is usually just the transaction price however, if there is a difference on initial recognition, that amount is then recognised in the profit or loss where the FV is determined through ‘screen’ price or some valuation method using observable market data. In other cases, the difference is adjusted against the carrying amount of the FI.

The exception is the treatment of trade receivables which are simply measured at invoice value. After initial recognition, ‘subsequent’ measurement of financial assets is at amortised costs or FVTPL or FVOCI.  Financial liabilities are subsequently measured at amortised cost or FVTPL. However, changes in FV of financial liabilities as a result of changes in the credit risk of the entity itself (investment specific IRR) are measured at FVOCI.

The investment specific IRR is the difference between the IRR of the instrument less the benchmark interest rate which is a risk free rate usually the LIBOR and EURIBOR. Thus fluctuations in credit risk will lead to a different investment specific IRR and hence a change in FV. Amortised cost is the present value of all future cash flows discounted at the effective rate.

General (Credit) Impairment model

Only debt instruments measured at amortised cost (AC) or FVOCI are credit impaired for changes in credit risk. Measuring of credit impairment is a three stage process. In Stage 1, there has been no significant increase in credit risk since recognition and the reporting date and so we measure expected credit loss (ECL) over the next twelve months. In Stage 2, there has been a significant increase in credit risk and we must recognise ECL over the lifetime of the debt. In Stage 3, there has been either an actual breach of contract, granting of concession or a real possibility of bankruptcy, in such cases the gross carrying amount is adjusted by the loss amount and the interest is calculated on the net amount.

The calculated impairment loss is recognised in the profit or loss and a corresponding ‘value adjustment’ provision in the balance sheet or capital reserves for AC and FVOCI type instruments respectively. FVOCI do not have an impairment account on the asset side of the balance sheet as FV cannot be directly impaired.

Trade receivables and contract assets under IFRS 15

For such  assets which do not have a significant financing element, IFRS 9 permits a simplified approach where ECL may be calculated using a provision matrix which groups the receivable according to different attributes e.g. product type, geography, customer rating, type of customer, collateral or trade credit insurance.

Off balance sheet items

IFRS 9 applies to certain off-balance sheet transactions; bank loan commitment, overdraft facilities which have an undrawn commitment and financial guarantee contracts e.g. a intercompany guarantees to a bank.

Implementation

As mentioned, impairment only applies to ‘hold to collect’ or ‘hold to collect and sell’ assets. Credit risk is also known as default risk because it implies a probability of default (PD).

It is a forward looking model which tries to anticipate losses due to credit impairment. Usually investment grade assets will not experience significant increases in credit risk and so the expected loss (EL) calculations will be 12 month forward looking.  A significant increase would imply a downgrading of asset say from AA to BB rating because there has been deterioration in the company’s results and so we would look forward over the lifetime of the exposure to estimate EL’s.  Only, when an asset becomes non-performing do we actually adjust the net carrying amount and the associated interest.

Impact on reserves

On transition date and initial recognition, it is likely that ECL will have a negative impact on reserves and income statements of those companies which carry material financial assets.

In subsequent years the impact will be much less as long as credit risk is managed and when assets mature or are sold, any unused provisions will be realised as income in the profit and loss. Credit risk can be assessed on a family of assets having similar characteristics. IFRS 9 does not prescribe any method for calculating ECL’s and so companies will have to develop internal models or outsource this work.

Expected Credit Loss (ECL) calculation

The mathematical formula for ECL is the product of three variables, Exposure at Default (EAD), Loss Given Default (LGD) and Probability of Default (PD). Basel defines EAD as the gross exposure under default by an obligor and this is an important variable in calculating a bank’s base capital.

LGD is the loss suffered, expressed as a percentage of the EAD. For instance, Basel under Article 161 of the Capital Requirements Regulation (CRR) recommends 45% (0.45) for senior exposures without eligible collateral. PD is the key factor and is the likelihood of default over an observable period, usually twelve months and is based upon analysing a debtor’s financials or cash flow adequacy such as operating margins, liquidity or leverage or it may be estimated by observing prices of CDS’, bonds, options or from trio of external credit rating agencies, Fitch, S&P and Moody’s.

PD is calculated over the next twelve months or lifetime depending on which stage the asset falls from a credit risk perspective. IFRS 9 uses point-in-time estimation (PIT) though Basel favours through-the-cycle (TTC) for measuring PD. The EAD amount is the principal or amortised amount plus any accrued interest up to the reporting date. Please note, when calculating EAD whether the asset is measured at FV or Ac, the EAD is always based on the amortised cost.

Collateralised debt

In instances where a debt has a security attached to it, Article 223 recommends a comprehensive volatility adjusted approach where both EAD and the collateral are volatility adjusted for corrective factors; term exposure, market volatility and currency mismatch.

The Adjusted Value of Exposure (E*) then, is given by the following formula, E* = max {0, EVA – CVA} where EVA = EAD x (1 + corrective factor for exposure) and CVA = Collateral Value (C) * (1 – market volatility factor – currency mismatch factor).  The collateral value is adjusted for market and currency volatilities using volatility data contained in Article 224. The effective LGD is then LGD x E*/E.

Probability of Default (PD) and unlisted entities

PD can be calculated in one of two ways, from transition matrices published by external rating agencies where the debt is quoted on a large exchange or using an internal model.

One such internal model makes use of the Analytic Hierarchical Process (AHP), a decision making tool where we can use mathematics and psychology to rank multi- financial criteria of unlisted entities and at least one listed entity. The AHP gives us normalised weighted financial criteria and then the sum product of these weightings and each entity’s normalised financial criteria will give a score which can be ranked against other entities. The PD for the chosen entity is calculated by adjusting the PD of the listed entity in proportion to the relative scores