The better the question. The better the answer.�The better the world works.
Welcome DACT Workshop
IFRS 9, IFRS 13 and regulatory developments
Amsterdam, March 9th, 2016
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Agenda today
15:40 – 16:55 IFRS 9 by Sander de Ruiter
16:55 – 17:25 IFRS 13 by Floris van de Loo
17:25 – 17:45 Other regulation by Ruud Bulkmans
15:30 – 15:40 Kick-off by André ten Damme
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The challenges for 2016 and ahead..
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EY Treasury Services locations
USA
Brazil
Argentina
Germany
Switzerland
Dubai
Turkey
The Netherlands Denmark
Belgium
UK
France
Spain
Italy
Portugal
South Africa
Austria
Nordics (Sweden)
Russia
Poland
India
Hong Kong
Singapore
South Korea
Japan
Shanghai
Australia
• Our global Centre of
Excellence Corporate Treasury offers you a focused expert knowledge
• More than 300 specialized consultants assist our customer in Treasury projects worldwide
• It is our aim to provide you with tailor-made and high-performance solutions.
Countries with EY presence
Countries without EY presence
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EY Global Treasury Services
What makes EY different? ► Cross-functional and integrated team including tax,
accounting and regulatory, IT, corporate finance, and finance transformation
► Dedicated team includes former practitioners in the treasury and finance areas of major global corporations
► Strong credentials and success stories demonstrate our ability to successfully effect change
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Increasing scope of a corporate Treasury
Common
Selective
Corporate finance ► Capital Structure ► WACC ► M&A and Post Deal Integration
Insurance ► Credit insurance ► Insurance of goods shipments ► General insurance
EWRM ► Quantitative/Qualitative ► Risk Management Framework ► Reporting
Accounting ► For own activities ► Signing the accounts
Credit risk ► Counterparty limits ► Country limits ► Commercial credit ► Credit insurance ► Trade finance/ LCs
Working capital management ► Evaluation of projects ► Monitoring KPIs
Commodity risk ► Purchase/Sale contracts ► Commodity futures and options
Pension fund management ► Risk Management ► ALM ► Selection process
Bank relationship management
Treasury technology
Debt management and financing activities
Interest rate risk management
Foreign exchange risk management
Cash & liquidity management
Tax ► Tax considerations ► Tax planning ► Base erosion and profit shifting
The better the question. The better the answer.�The better the world works.
Dutch Association of Corporate Treasurers Supporting accounting change: IFRS 9
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Agenda
This section contains information regarding: ► An overview of the new standard ► The expected issue date and prerequisites to transition ► Perceived benefits for Corporate entities ► Expected impact for Corporate entities
This section contains information regarding: ► Classification and measurement under IFRS 9, including illustration of the impact for Corporate entities ► Impairment under IFRS 9, including illustration of the impact for Corporate entities ► Hedge accounting under IFRS 9, including illustration of the impact for Corporate entities ► Transitional provisions and disclosures required by IFRS 9
This section contains information regarding: ► Impact analysis, system design and implementation considerations per phase of IFRS 9 ► Critical success factors to a successful transition ► Implications for a broader financial operating model
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IFRS 9 An overview
IFRS 9 is the new financial instruments standard, and will replace IAS 39. Endorsement by the EU is expected by H2 2016, after which adoption is permitted. While the standard is not effective until 1 January 2018, implementation is expected to require a significant investment of time and resources, resulting in many entities already commencing diagnostic and pre-implementation activities. In addition, while IFRS 9 may not be applied until endorsed by the EU, the transition provisions require all preparation be completed prior to adoption. As such, entities who foresee benefits in application of the new standard may wish to perform analysis now, ahead of an anticipated early adoption from January 2017 onwards.
While implementation of IFRS 9 brings with it a number of challenges, it is also being more frequently acknowledged as providing many benefits, including:
IFRS contains three modules: classification
and measurement, impairment and hedge
accounting
While the impact upon on each organization will differ (depending upon their risk management strategy of portfolio of financial instruments), the following demonstrates the bearing upon a ‘typical’ Dutch Corporate Treasury:
Enhanced data
analytics Alignment with other
regulations
Greater operational oversight
Benefits
Greater alignment between
finance and risk
Improved hedge
accounting framework
Expected relative impact (for corporate entity)
Classification &Measurement
Impairment Hedge Accounting
Implementation
System design
Impact assessment
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Classification and measurement The impact on Corporate Treasury
Under IFRS 9 financial assets are now classified according to their contractual cash flow characteristics and the business models under which they are held. Classification of financial liabilities under IFRS 9 remains largely unchanged from IAS 39: ► Where an entity does not hold significant
financial assets: impact is expected to be lower
► Where a financial liability is designated as FVTPL, gains / losses attributable to changes in own credit risk are recognized in OCI
Removal of tainting concept
Greater alignment with risk management
Limited requirement to reclassify
FVTPL and FVOCI options
Entity wide assessment
Benefits of the new asset model include:
Illustrative Balance sheet €’000
Property, plant and equipment XX
Intangible assets XX
Non-current financial assets* XX
Deferred tax assets XX
Total non-current assets XX
Cash and short-term deposits XX
Trade and other receivables XX
Prepayments XX
Other current financial assets* XX
Inventories XX
Total current assets XX
*Includes derivatives and AFS assets such as equity shares
Classification and measurement unlikely to change under IFRS 9: fair value approximates face value / amortized cost
Classification and measurement unlikely to change under IFRS 9 for derivatives, which are at FVPL. AFS assets will be at FVOCI (no recycling) or FVPL (optional).
As classification and measurement of financial liabilities under IFRS 9 remains largely unchanged from IAS 39, the below provides an analysis of the impact of Classification and Measurement under IFRS 9 on an illustrative Corporate entity’s assets:
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Classification and measurement Accounting model under IFRS 9 (assets)
The following provides a summary a summary of the classification and measurement model of IFRS 9:
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
Derivatives Equity
No
Yes
Amortised cost FVPL
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 Fail
Held for trading?
Yes No
FVOCI option elected ?
‘Business model’ assessment (at an aggregate level)
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Impairment The impact on Corporate Treasury
Under IFRS 9, financial assets are subject to a revised impairment model; focusing on expected rather than incurred losses. The impact on Corporate entities is expected to be reduced where: ► The fair value of the portfolio of financial
assets held approximates their book value
► Financial assets are already carried at fair value (either through P&L or OCI)
Benefits of the new impairment model include:
Illustrative Balance sheet €’000
Property, plant and equipment XX
Intangible assets XX
Non-current financial assets* XX
Deferred tax assets XX
Total non-current assets XX
Cash and short-term deposits XX
Trade and other receivables XX
Prepayments XX
Other current financial assets* XX
Inventories XX
Total current assets XX
*Includes derivatives and AFS assets such as equity shares
Impairment unlikely to change under IFRS 9: fair value approximates book value / amortized cost (presuming receivables are short term)
Impairment unlikely to change under IFRS 9: derivatives are currently carried at FVPL, and AFS assets will be at FVOCI (no recycling) or FVPL (optional).
As impairment under IFRS 9 does not impact financial liabilities, the below provides an analysis of the impact of impairment under IFRS 9 on an illustrative Corporate entity’s assets:
More insights in credit risk of portfolios
Greater Operational Oversight
More alignment Finance and Risk
Alignment regulations
Enhanced data analytics
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Impairment Accounting model under IFRS 9 (assets)
The following provides a summary a summary of the impairment model of IFRS 9:
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Hedge accounting The impact on Corporate Treasury
The objective of the IFRS 9 hedge accounting framework is to simplify application, align accounting outcomes to economic realities, and provide useful information regarding risk management activities. Development of the revised framework involved ongoing industry consultation to address as many concerns of information preparers and users as possible. This yielded a more practical standard, which streamlines implementation for those already applying hedge accounting, and incentivizes those not to reconsider.
Benefits of the new hedge accounting model include:
Illustrative Balance sheet €’000
Property, plant and equipment XX
Derivative assets XX
Cash and short-term deposits XX
Total assets XX
Trade payables XX
Deferred revenue XX
External borrowings XX
Derivative liabilities XX
Total liabilities XX
Hedge reserve XX
Total equity XX
As hedge accounting under IFRS 9 impacts both financial assets and liabilities, the below provides an analysis of the impact of impairment under IFRS 9 on an illustrative corporate entity’s (selected) assets and liabilities:
Due to differences in effectiveness testing and accounting models, as well as the items qualifying for hedge accounting, IFRS 9 has the potential to cause significant changes to an entity’s balance sheet
IFRS 9 also has the potential to effect the timing of revenue recognition and presentation within an entity´s Profit or Loss
Less P&L volatility
Additional qualifying exposures
Simplified testing model
Less breakage of hedges
Less clerical burden
Unrecognized future cash flows arising from FX and commodity exposures will also be impacted
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Hedge accounting Changes from IAS 39
Summary of changes to the hedge accounting model under IFRS 9:
Requirement IAS 39 IFRS 9
Risk component as eligible hedged item Financial items All items
80%-125% test 3 5
Prospective effectiveness testing 3 3
Retrospective effectiveness testing 3 5
Quantitative effectiveness test 3 Depends
Qualitative effectiveness test 5 Depends
All ineffectiveness must be recognised 3 3
Accounting for ‘costs of hedging’ 5 3
Dedesignation (risk management objective unchanged) 3 5
Discontinuation (risk management objective changed or other qualifying criteria not met) 3 3
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Hedge accounting Changes in qualifying hedged items and instruments from IAS 39
Summary of changes to the eligibility of hedged items and hedging instruments under IFRS 9:
Requirement IAS 39 IFRS 9
Hed
ged
item
s
All items eligible under IAS 39 3 3
Derivatives, as part of an aggregated exposure 5 3
Risk components of non-financial items 5 3
Components of nominal amounts (i.e., layers) for fair value hedges. 5 3
Hed
ging
inst
rum
ents
All instruments eligible under IAS 39 3 3
Financial instruments measured at FVPL 5 3
Own use contracts 5 3
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Hedge accounting Risk management objectives
Item Risk strategy Risk objective
Description ► Established at a high level ► Identifies risks and how
entity responds to them ► Typically in place for
longer period ► May include flexibility ► Often a formal policy
document ► Part of hedge
documentation
► Applies at level of particular hedging relationship
► Describes how a particular hedging instrument is used to hedge a particular exposure designated as the hedged item
► Part of hedge documentation
Examples ► Maintain 40% of liabilities at floating interest rate
► Assure long-term price stability of commodity purchases
► Hedge foreign currency risk of all forecast purchases in USD up to 12 months
► Designate an interest rate swap as a fair value hedge of a GBP 100m fixed rate liability
► Designate a coal forward contract to hedge the first 100 tones of coal purchases in March 2016
► Designate a foreign exchange forward contract to hedge the foreign exchange risk of the first USD100 purchases in March 2016
Risk management activity
Accounting for risk management
activity
Risk management strategy
Risk management objective
What is the significant of risk management strategies and objectives? ► Link between risk management activity and
accounting ► Affects discontinuation of hedge accounting
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Hedge accounting Hedged items: overview
The general requirements of what qualifies as an eligible hedged item are unchanged compared to IAS 39. A hedged item can be: ► A recognized asset or liability ► An unrecognized firm commitment ► A highly probable forecast transaction
Or ► A net investment in a foreign operation
All of above can either be a single item or a group of items, provided the specific requirements for a group of items are met.
Entire item
Hedged item
Groups of items
Aggregated exposures
Components of an item
Selected contractual cash flows
Risk components
Nominal components
Proportion
Layer
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Hedge accounting Hedged items: risk components
IAS 39 did not allow the designation of risk components for non-financial items. IFRS 9 creates parity between financial and non-financial hedged items and consequently also allowed risk components of non-financial items to be designated as hedged items, provided that the risk component can be separately identified and reliably measured.
Criteria for designation
Separately identifiable
Reliably measurable
Contractually specified
Other components
Rebuttable presumption: inflation risk
Mar
ket s
truc
ture
Illustrative Example ► Purchasing coffee from a specific area in Columbia ► Hedge expected coffee purchases for the next 12months, by entering into a
futures contract with Arabica coffee as underlying instrument. ► Coffee is purchased in Columbia via physical supply contracts that are
entered into up to 6 months in advance. ► Supply contracts are variable rate, however the benchmark is Arabic Coffee
and the price differential from to the local market is fixed
The entity enters into coffee futures to lock in the coffee benchmark price for the next year. Six months later, when entering into the supply contracts, the price differential between the coffee benchmark and local price is also fixed. The Arabica benchmark price is a non-contractually specified risk component, designated as the hedged risk in the item.
Non-contractually specified risk component
1-year Coffee futures contract on Arabica coffee
Physical contract: benchmark + differential
6 months 12 months t0
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Hedge accounting Hedged items: aggregated exposures
IAS 39 did not allow the designation of a derivative as a hedged item. Therefore, when applying such risk management strategies, entities had to discontinue the first hedge and set up a new hedge with the two derivatives jointly designated as the hedging instrument. IFRS 9 now allows the designation of an aggregated exposure as a hedged item. In other words, the entity could designate the second-level relationship as a separate hedge without affecting the first-level relationship.
First level
Non-derivative exposure
Derivative
Hedging instrument
Hedged item
Seco
nd le
vel
Illustrative Example ► 10-year USD fixed rate debt ► The entity transfers debt into a functional currency variable rate liability by
entering into a CCIRS ► The aggregated variable rate debt exposure gives rise to cash flow IR risk ► 1 year later, the entity hedges this by entering into a 9-year IRS. The entity could designate the IRS as a hedging instrument to hedge the aggregated exposure, which is the combination of the original exposure on the debt and the CCIRS.
Aggregate exposure
Debt issuer
Debt holder
CCIRS
IRS
USD
USD
EUR
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Hedge accounting Hedged items: nominal amounts (layers)
IAS 39 does not allow designation of layers for fair value hedges, in particular, bottom layer hedges are not allowed. Consequently, an entity that currently wants to hedge part of a group of items within a fair value hedge must identify specific items within the group or designate a percentage of the total as the hedged item. Under IFRS 9 , entities can now designate components of nominal amounts (i.e., layers) for fair value hedges.
Illustrative Examples
The first 50 tones of sugar stored in a silo
The bottom layer of CHF 60m of a CHF 100m loan
CH
F 10
0m lo
an
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Hedge accounting Hedged instruments
Under IFRS 9, the hedging item can be fully or partially designated. There is also revised accounting for costs of hedging
Entire item
Hedging instrument
Partial designation
Exclude costs of hedging
Proportion of the nominal
amount FX risk
component
Costs of hedging
► Time value of options
► Forward element of forward contracts
► Foreign currency basis spread
Transaction-related hedged items
► Costs of hedging recognized in P&L when the transaction occurs or they become part of a basis adjustment.
► In the interim, the fair value changes are accumulated in OCI.
Time period-related hedged items
► Costs of hedging are recognized in profit or loss over time (amortization).
► In the interim, the fair value changes are accumulated in OCI.
Accounting
Option that hedges a transaction related hedged item:
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Hedge accounting The new hedge effectiveness assessment The requirement to measure ineffectiveness and to recognize ineffectiveness in profit or loss remains the same. However, a retrospective quantitative effectiveness assessment using the 80%–125% bright lines is no longer required. A prospective effectiveness assessment is still required.
Hedge effectiveness test
Economic relationship • Between
hedged item and hedging instrument
• Systematic change in response to same or related underlyings
Credit risk does not dominate • Credit risk
does not frustrate economic relationship
Hedge ratio • Consistent
with actual ratio used by entity
• Different ratio only if accounting outcome would be inconsistent with purpose of hedge accounting
Extent of hedging
Hedge ratio t0
Hedge ratio tn
Hedge ratio and rebalancing:
When does rebalancing apply?
How much to hedge?
What volume of hedges will be required?
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On transition to IFRS 9, entities can apply the fair value option on an all-or-nothing basis for
(already existing) own use contracts.
Fail
Hedge accounting Fair value option for ‘own use’ contracts IFRS 9 Financial Instruments extends the fair value option to ‘own use’ contracts. When applying the fair value option an entity may make an irrevocable designation to measure an own use contract at FVTPL, where it eliminates or significantly reduces an accounting mismatch.
Illustrative Example ► An entity is in the business of procuring, transporting, storing, processing
and merchandising soybeans and sunflower seeds. ► The inputs and the outputs are agricultural commodities which are traded in
liquid markets. ► The entity has both a broker business and a processing business, which are
operationally distinct. ► The entity analyses and monitors its net commodity risk position,
comprising inventories, physically settled forward purchase and sales contracts and exchange traded futures and options. The target is to keep the net fair value risk position close to nil.
Under IAS 39, the physically settled forward contracts from the processing business have to be accounted for as own use contracts, whereas all other contracts are accounted for at fair value through profit or loss. The resulting accounting mismatch does not reflect how the entity is managing the overall fair value risk of those contracts.
Non-financial item
Financial instrument
Right of cash settlement
Practice of cash settlement
Pass
Pass
Business purpose of contract Pass
Own use contract
Fail
Fail
Own use contracts
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Hedge accounting Discontinuation Under IFRS 9 an entity would have to discontinue hedge accounting if the qualification criteria are no longer met. This includes if the risk management objective for the hedging relationship has changed. IFRS 9 now introduces partial discontinuation of hedge accounting, which means that hedge accounting continues for the remaining part of the hedging relationship.
Scenario Discontinuation • The risk management objective has
changed • Full or partial
• No longer an economic relationship between the hedged item and the hedging instrument
• Full
• The effect of credit risk dominates the value changes of the hedging relationship
• Full
• When rebalancing, the volume of the hedged item or the hedging instrument is reduced
• Partial
• The hedging instrument expires • Full
• The hedging instrument is (in full or in part) sold, terminated or exercised
• Full or partial
• The hedged item (or part of it) no longer exists or is no longer expected to occur
• Full or partial
The option to voluntary revoke a hedge relationship under IAS 39 has been removed
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Hedge accounting Disclosures The disclosure requirements for entities applying hedge accounting are set out in IFRS 7. In order to maximize the effectiveness of its disclosures, an entity must consider the necessary level of detail, the balance between different disclosure requirements, the appropriate level of disaggregation and whether additional explanations are necessary. The IASB has made it clear that disclosures with respect to risk management activities should be specific to the entity rather than generic or ‘boiler plate’.
Disc
losu
re o
bjec
tives
Risk management strategy
Effects of hedging on future cash flows
Effects of hedging on financials
Activity specific matters
The following provides an extract of IFRS 9 transition disclosures with respect to hedge accounting in the context of a Corporate entity:
Consideration Disclosure • Hedge
relationships • Transactions previously de-designated from fair value hedge
relationships relating to a portion of our borrowing portfolio have been re-instated in fair value hedges from the application date. These transactions were and continue to be in effective economic relationships based on contractual amounts and cash flows over the life of the transaction, however previously they did not satisfy the requirements for hedge accounting.
• We have redefined our hedge relationships relating to the portion of our offshore borrowing portfolio in fair value hedges to exclude borrowing margins from the hedged risk. This has resulted in de-designating our existing fair value hedge relationships and re-designating from the application date without any change to the underlying economic objective of the hedging.
• Foreign currency basis spreads and forward
• We have elected to separate and exclude foreign currency basis spreads from instruments designated as hedging instruments.
• The cumulative change in fair value of the foreign currency basis spreads is recognized in a separate component of equity. Cross currency basis spreads are included in interest on borrowings in the income statement over the life of the borrowing.
• Upon transition to IFRS 9, the balance of foreign currency basis spread was a loss of xx. We have elected not to retrospectively apply the provisions in relation to the accounting treatment of foreign currency basis spread. Accordingly, this amount will be unwound partly to the P&L and partly to the cash flow hedging reserve over the remaining life of the associated borrowing.
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Preparation timelines should maintain flexibility in order to
permit early adoption
Sophisticated Approach Simplified Approach Month
Impact assessment (C&M) April
Impact assessment (Impairment) May
System design (C&M and Impairment) Jun
Parallel run, including IFRS 9 disclosures Jan
Impact assessment (hedge accounting) Sept
System design (hedge accounting) Oct
Build test & deploy (hedge accounting) Nov
Go Live Jan
Implementation approach Scoping and timeline
2018 2017
2016
Scoping Determining the implementation timeline of IFRS 9 for a corporate is highly dependent upon the nature of financial instruments held by the entity: ► Significant portfolio of non core financial
assets such as bonds etc. (referred to as the ‘Sophisticated Approach´): comparative disclosures (1 Jan 2017) required in order to show changes in classification / measurement and impairment. This will increase lead time.
► Insignificant portfolio of non core financial assets (referred to as the ‘Simplified Approach´): only transitional disclosures required in order to demonstrate changes in hedge accounting (impact disclosures for FY17 expected to be insignificant).
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Implementation approach Classification and measurement
IFRS 9 introduces a new classification model for financial assets that is more principles-based. Financial assets are now classified according to their contractual cash flow characteristics and the business models under which they are held. IFRS 9 will require an increased amount of judgment in performing the contractual cash flows and business model tests, including significant documentation considerations. Given the potential for increased P&L volatility and impact on capital, entities are advised to analyze the impact of the new model as early as possible. Benefits of the new model include:
Deliverables: ► Accounting analysis: assessment of existing and forecast assets
against your business model, identifying classification under IFRS 9. In addition, the magnitude of instruments in which the cash flows characteristics test will be applicable.
► Performance assessment: analyze efficiency of your business model in achieving your desired accounting outcomes.
Value proposition: Stabilize your P&L and equity volatility, while maintaining alignment with market practice.
Deliverables: ► System diagnostic: analysis of your system capabilities to track
changes in asset management, and data accessibility / viability.
► System design: implementing (where necessary) system changes, including the design of roles and responsibilities.
Value proposition: Develop and implement a fit for purpose solution.
Deliverables: ► Contract analysis: detailed analysis of your asset base, including
documentation of accounting positions and policies.
► Technical support: training for your staff, including assistance with contractual cash flows and business model tests.
► Board support: interaction with those charged with governance, including preparation of briefing papers.
Value proposition: Assess your business model to achieve alignment with industry practice and achieve your desired accounting outcomes.
Removal of tainting concept
Greater alignment with risk management
Limited requirement to reclassify
FVTPL and FVOCI options
Entity wide assessment
Impa
ct a
sses
smen
t Sy
stem
des
ign
Impl
emen
tatio
n
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Implementation approach Impairment
IFRS 9 introduced a forwarded looking, expected loss model as replacement for the IAS 39 incurred loss model. The change has occurred as a result of views that the IAS 39 model did not reflect impairment losses incurred in a timely manner during the financial crisis. IFRS 9 will require an increased amount of judgment in identifying and quantifying inputs into expected loss models, resulting in potential variances in application. As a result, IFRS 9 requires numerous disclosures designed to create transparency across industry participants. Benefits of adopting IFRS 9 Impairment are:
Deliverables: ► Financial impact: financial impact assessment including sensitivity
analysis of methodological assumptions and risk parameters.
► Organizational impact: impact assessment for each dimension of your business, from data management to stakeholder engagement.
Value proposition: Facilitates revisiting of credit modelling activities and pricing structures while enabling greater operational oversight of credit risk.
Deliverables: ► System diagnostic: identification of new data requirements and
assessment of current calculation engines.
► System design: design / implement initial system changes, including design of roles and responsibilities.
Value proposition: Leveraging your existing systems to develop and implement a fit for purpose solution. This enables identification of possible alignment with other regulatory data requirements.
Deliverables: ► Impairment methodology: develop and implement the impairment
methodology: quantitative and financial perspective.
► Technical support: training for your staff, including assistance with testing, validating and implementation of models.
► Board support: interaction with those charged with governance, including preparation of briefing papers.
Value proposition: Smooth transition with minimal business disruption, and implementation of a solution designed to enable an efficient operating model going forward.
More insights in credit risk of portfolios
Greater Operational Oversight
More alignment Finance and Risk
Alignment with regulations
Enhanced data analytics
Impa
ct a
sses
smen
t Sy
stem
des
ign
Impl
emen
tatio
n
Page 33
Implementation approach Hedge accounting
The objective of the IFRS 9 hedge accounting framework is to simplify application, align accounting outcomes to economic realities, and provide useful information regarding risk management activities. Development of the revised framework involved ongoing industry consultation to address as many concerns of information preparers and users as possible. This yielded a more practical standard, which streamlines implementation for those already applying hedge accounting, and incentivizes those not to reconsider. Benefits of hedging under IFRS 9 include:
Deliverables: ► Accounting analysis: assessment of the eligibility of your risk
management strategies for hedge accounting under IFRS 9.
► Performance assessment: analysis of the effectiveness of your risk management strategies in achieving your objectives.
Value proposition: Designing of effective hedge structures and aligning accounting outcomes with the economic reality of your risk management strategies.
Deliverables: ► System diagnostic: identification of system requirements, and
assessment against existing capabilities.
► System design: implementing (where necessary) system changes, including the design of roles and responsibilities.
Value proposition: Leveraging your existing systems to develop and implement a fit for purpose solution – identifying common challenges and practical solutions.
Deliverables: ► Hedging framework: identify your risk management objectives,
design testing scripts, and complete documentation.
► Technical support: training for your staff, including assistance with deal setup within your treasury software.
► Board support: interaction with those charged with governance, including preparation of briefing papers.
Value proposition: Smooth transition with minimal business disruption, and implementation of a solution designed to enable an efficient operating model going forward.
Less P&L volatility
Additional qualifying exposures
Simplified testing model
Less breakage of hedges
Less clerical burden
Impa
ct a
sses
smen
t Sy
stem
des
ign
Impl
emen
tatio
n
Page 34
IFRS 9 A practical world view
Benefits of the IFRS 9 hedge accounting framework The extent of benefits achieved by hedging under IFRS 9 will be impacted by a number of factors. These will vary by entity and industry, however may include: ► The risk management objectives of the entity;
► The magnitude of hedging activities undertaken;
► The nature of the hedging instruments entered into;
► The maturity of the corporate treasury center; and
► Accounting policies with respect to the use of hedge accounting.
Classification & Measurement as well as
impairment may be applicable to some
Corporates
Benefits
Less Profit or Loss volatility
Additional qualifying exposures
Simplified testing model
Less breaking of
hedges
Less clerical burden
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IFRS 9 Brochure
► EY periodically publishes updates about IFRS 9 and the impact it has
► We have published a brochure on the 7th of March, which will be shared with you together with the material of today’s session
The better the question. The better the answer.�The better the world works.
Dutch Association of Corporate Treasurers Valuations adjustments: IFRS 13
Page 37
Agenda
This section contains information regarding: ► Pre-Lehman and Post-Lehman situation ► Credit risk in valuation of derivative ► What is Credit Valuation Adjustment (CVA) / Debit Valuation Adjustment (DVA)? ► CVA Components
This section contains information regarding:
► Counterparty Credit Risk exposure ► What is the exposure to counterparty risk? ► Exposure at Default (EAD): Maturity model ► Reducing exposure ► Collateral and Margining
This section contains information regarding:
► Probability of Default (PoD) calculation: Market vs. Historical PoD’s ► Main data and proxies used for PoD calculation ► Proxy curves
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What is CVA/DVA?
► Credit Value Adjustment (CVA) is the market value of the risk component correcting for the Counterparty Credit Risk (CCR) in the value of the derivative
► Debt Value Adjustment (DVA) is the market value of the risk component correcting for the own
credit risk in the value of the derivative
► IFRS requires adjustment of Fair Value for CVA/DVA
CVA was a major driver of balance sheet volatility during the crisis
Page 40
Key terms
Abbreviation Description
MtM • Mark-to-market, current (default) risk free value of an OTC derivative, can be positive or negative for the firm
• Related to replacement cost in case of counterparty default (exposure measurement)
CVA • Adjustment made to the risk free value of derivative assets to reflect the default risk of the counterparty
• Takes into account that in the event of counterparty default the firm will not realize the future value of the transaction
DVA • Debit Valuation Adjustment – Adjustment made to derivative liabilities to reflect the default risk of the corporate
PD • Probability of default, the likelihood that a counterparty will default
• 2 forms: market implied and real world (often called historical PDs)
LGD • The loss that the firm would incur in the event of the counterparty default
• This is the loss given default
EAD
• The exposure that the firm would have at default – this is the current exposure plus any likely drawdown/increase in
lines that could occur before default, or changes in the exposure of derivatives or repo transactions, taking collateral
into account
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Pre-Lehman Banks are considered to have very low risk
Lehman defaults September 15, 2008 Lehman Brothers defaults and goes bankrupt.
Post-Lehman “Banks can go bankrupt”
Credit risk banks Credit risks of banks are in Lending or in fair value fluctuations on derivatives
Risk mitigation Market participants can use collateral to mitigate credit risk on derivative transactions
Uncollateralized? For uncollateralized transactions: still a credit risk for banks
Credit risk on FV Credit risk FV should be reflected in valuation of derivative (requirement under IFRS / Dutch GAAP
CVA Credit Valuation Adjustment needs to be made and incorporated in the valuation
Example Valuation ex. CVA: 10
CVA -1
Valuation incl. CVA 9
CVA / DVA An overview
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Credit Valuation Adjustment (CVA) Example
Fair value Difference (CVA)
Difference %
Value excluding CVA € 50,800,523 - -
Value with counterparty:
Rabobank (AA-) € 47,347,373
€ 3,453,149 6,79%
ING (A) € 46,378,769
€ 4,421,753 8,70%
SNS (BBB-) € 39,760,582
€ 11,039,940 21,73%
CVA takes counterparty risk into account and can vary substantially depending on the creditworthiness of the counterparty
Attention
► Valuation of (uncollateralized) derivative depends on counterparty
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CVA Components
¾ CVA is the incorporation of the cost of the counterparty credit exposure in the value of an OTC derivative, i.e. cost of a potential credit loss arising from future counterparty default
¾ The risk of credit loss arising from future counterparty default is driven by: ¾ Market Risk Factors ¾ The PD and LGD of the counterparty ¾ Credit risk mitigation (netting, cash margining and collateral)
¾ Potential future credit loss = Future MtM – future collateral – recovery
¾ Future positive MtMs are only considered in the context of CVA
¾ In the absence of independence between the credit worthiness of the counterparty and the exposure, the CVA can be written as shown below
EE is average over a given time bucket of the (netted) MtM, if positive
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Example of Counterparty Credit Risk
Interest Rate Swap between Corporate and Bank
Floating liability payments Lays off exposure to the market
Pay Floating
Pay Fixed rate
Bank Corporate
► Market value at inception is 0 to both counterparties (no arbitrage)
► As soon as interest rates deviate from initial expectations, the trade will become more valuable to one counterparty
► The replacement cost at that point will be positive to one counterparty and negative to the other
► The counterparty to whom the trade is more valuable hence has an exposure
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Counterparty Credit Risk exposure For OTC derivatives
Life of contract
Out of the money
In the money Counterparty Credit Risk for the firm
Counterparty Credit Risk for the counterparty
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Exposure at Default (EAD): Maturity model
► The Exposure at Default calculation can be performed through increasingly sophisticated models
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MTM: Where the MTM is the replacement cost
MTM + Regulatory Add-on: Mark-to-Market + (Notional * Add-on Factor)
MTM + Calibrated Add-on: Internal Add-on calculation
Analytical calculation: Analytical solutions for EE and PFE
Montecarlo Simulation: Full projection of market risk factors and revaluation of exposure at default
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Reducing Exposure
Close-out/Break clauses • A clause that involves the termination of all
contracts with the counterparty undergoing a credit event with predefined conditions that define the costs
• Reduce life time of exposures
Collateral • When an exposure arises, a counterparty has
to post collateral with the other counterparty • Market risk • Liquidity risk • Operational risk
Netting • When a netting agreement is in place, it is
possible to net the value of trades with the default counterparty before settling the claims
• Correlation between MtM value of trades is important
Reduction of Exposure
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Collateral and Margining ¾ Financial collateral is used to reduce the positive exposure ¾ Parties typically have to post:
• Initial Margin • Variation Margin
¾ Credit support annex (CSA) – defined terms • One way or two way • Acceptable collateral (e.g. cash, government securities etc.) • Haircuts • Frequency • Threshold amount (unsecured amount) • Minimum Transfer Amount (no smaller collateral transfer) • Independent Amount (given upfront)
¾ Some issues: • Collateral disputes • Operational / settlement failures
¾ Margin period of risk: period over which additional collateral may not be forthcoming • Measures the time between last received margin call and closeout/re-hedge in a worst-case scenario • Collateral haircuts are meant to reflect the potential variation in the value of the collateral over that
period
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PD calculation: Market vs. Historical PD’s Impairment
► Single name CDS Curves ► Bond Market Based Approaches ► Credit Curves for related entities ► Moody’s KMV Credit Curves ► Proxies
► Standard PD’s per rating class ► Internal IRB PD’s
Market PD’s
Historical PD’s:
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PROXY CURVES DESCRIPTION
► CDS Spread curves for over 2000 entities published daily – historical data available ► Full term structure information across 11 tenors (6M, 1Y, 2Y, 3Y, 4Y, 5Y, 7Y, 10Y, 15Y,
20Y, 30Y) ► Recovery Rate, Currency, Tier, Sector, Aggregate Ratings, Quote depth available for
each entity ► Additional CDS liquidity details (e.g., Bid/Offer, No of daily quotes, No of EOD
contributions, Quote staleness measures) available as additional service
Single name CDS Curves
► If entity has large bond issuance and a liquid bond market, credit risk information from bond market may be used to proxy CDS curves, e.g., supranationals
► Asset Swap Spreads or spread to bunds of bonds with comparable maturity can be used as proxy for CDS spreads
► Alternatively, OAS can be used as proxies ► Lack of clarity how to define the spread. What is it remunerating (credit, liquidity, risk
free?)
Bond Market Based Approaches
► Parent or subsidiary entities may be actively traded in the CDS market – may use these curves but may need to adjust the spreads according to relationship between entities, guarantees
► Entities with Op Co/Hold Co structures, only LGD adjustment may be necessary without any adjustments to the default probabilities
Credit Curves for related entities
Main data & proxies used for PD calculation
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Main data & proxies used for PD calculation (continued)
► Equity implied CDS curves based on the Merton type ► Moody’s model links CDS spreads to risk neutral default probabilities and risk-neutral
default probabilities to physical default probabilities – conversion of CDS spreads into EDF levels and vice-versa. Sharpe ratio approach.
► Implied LGD, Sector LGD and spreads/EDFs across the term structure available ► Historical data available
► Use entities with CDS spreads with same rating, sector and region ► Benchmark curve constructed using geometric mean of all CDS spreads with similar
attributes ► Calculate geometric mean across all tenor points
► Use past default experience to predict future default likelihood ► For example, Moody’s publishes transition matrices per rating class ► Can be used to calculate PD per rating class
PROXY CURVES DESCRIPTION
Moody’s KMV Credit Curves
Benchmark Curve Construction
Historical data
The better the question. The better the answer.�The better the world works.
Dutch Association of Corporate Treasurers Other Regulation
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Agenda
This section contains information regarding: Regulation, challenges and impact of: ► OTC Derivatives reform: EMIR & MiFID II ► Notional Pooling ► Tax: FTT and BEPS
Wrap-up and Questions
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2013 2014 2015 2016 2017 2018 2019
Basel III: 2013
Gradual phasing in of capital requirements
The following provides a summary of regulatory change over the recent and coming period:
Paym
ent r
egul
atio
n FX
/ H
edgi
ng re
gula
tion
SEPA: August 2014
SEPA SCT and SDD effective. Non-EUR countries follow in 2016
Basel III: 2015
Higher capital requirements. Leverage ratio tracked/disclosed
PSD II: 2015
Complete legislative process by end 2015
Basel III: 2017
Update to Leverage ratio requirements
PSD II: 2017
PSD II effective in law EEA
EMIR: 2012
EMIR comes into force. Regulation on OTC derivatives, CCP and trade repositories
MiFID II: July 2014
MiFID II and MiFIR announced replacing MiFID I
Dodd Frank: July 2015
Volcker Rule live
MiFID II: July 2016
Deadline for implementation of MiFID II under national laws
EMIR: September 2016
NFC+: Variation margining requirements for non-centrally cleared trades
MiFID II: January 2018
Start of application MiFID II and MiFIR Level 1 and 2 in EU States
Dodd Frank: 2019
Supplementary leverage ratio
Other matters Regulatory developments
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EMIR & MiFID II
Main aims: ► EMIR focuses mainly on post-trade aspects of trade
lifecycle
► Increase transparency
► Reduce counterparty credit risk
► Reduce operational risk
Impact ► Reporting and reconciliation and confirmation
requirements in place
► Compression requirements, if > 500 trades with a single counterparty
► Need to continuously monitor NFC- versus NFC+ status � FX threshold: EUR 3bn rolling 1 month gross notional
value
� Breach one, clear all
► Both group external and internal derivative trades must be reported
EMIR
MIFID II
Main aims: ► Reduce systemic risk, strengthen financial stability,
transparency and investor protection by focusing on OTC markets and pre- and post-trade transparency requirements
Impact f Possibly fewer and more expensive products being
offered, due to higher bank costs f Act upon new distribution models
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Basel III
Main aims: ► Basel III will force the banks to
� maintain a much bigger capital base
� withstand sudden market disruption
� lower levels of leverage – the ratio of capital to assets – will become obligatory
� have greater stores of spare cash on hand to tide them over temporary difficulties
Possible impact: f Operational liquidity: short term deposits and
‘cash at hand’ placed with banks expected to yield less
f Banks face higher cost of capital: fee structure expected to change over time
f Impact on (intended) notional pooling f Basel III currently includes a CVA exemption for
non-financial corporates
Trickle-down impact on corporate treasury: f Required capital is linked to the quality of the liabilities, which will certainly affect credit availability, appetite for
deposits, and pricing for certain services f Banks may revalue their relation with corporates f Operational liquidity
f Short term deposits and ‘cash at hand’ placed with banks expected to yield less or may be discontinued f Longer term offer possibly more attractive returns
f Reduced access to notional pooling
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Financial Transaction Tax (FTT)
Main aims: ► Developing a common tax within the EU reserved for financial transactions
► 8 December 2015: 10 Eurozone countries agreed on some aspects of FTT, giving themselves till mid 2016 to reach agreement on remaining issues
Possible impact ► 10 countries: Germany, France, Italy, Austria, Belgium, Greece, Portugal, Slovakia, Slovenia and Spain
► The statement said all share transactions, including intraday trading, would be taxed. The tax would be paid by traders in one of the countries participating in the scheme on shares issued in those countries
► Subject to completion of the (political) process and negotiations
Many question marks and potentially large impact
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Base Erosion and Profit Shifting (BEPS)
Main aim: ► Address the negative effect of tax avoidance strategy
► Address the widespread perception that corporations don’t pay their fair share of taxes
Timeline: ► BEPS action plan endorsed by G20 in 2013
► OECD produced detailed reports and actions in September 2014 (guidelines, not yet law)
► EU has proposed the EU Anti BEPS directive
► Expected to be approved by EU in 2016/2017
Focus for Treasuries ► Foreign Treasury vehicles: low effective tax rates reason for scrutiny
► Limits on interest expense deductions
► Increased focus on tax-asymmetry (e.g. hybrid debt)
► Transfer pricing (including cashpools, intercompany funding)
► Increasingly important that tax, treasury and business are aligned with regard to decision making on intra-group financial transactions
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BEPS site on ey.com
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Alerts
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Further information
Should you have any queries or require any further information, please do not hesitate to contact our team of industry leading advisors:
Ruud Bulkmans Director +31 88 407 1193 [email protected]
Sander de Ruiter Senior Manager +31 88 407 1590 [email protected]
Floris van de Loo Director +31 88 407 1654 [email protected]
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