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Shirley AngPartner, Assurance17 August 2017

FRS 109 Financial Instruments


FRS 109 Financial Instruments

• FRS 109 Financial Instruments to replace IAS /FRS 39 Financial Instruments: Recognition andMeasurement

• FRS 109 includes:

Classification and measurement

'Expected loss' impairment model

A substantially-reformed approach tohedge accounting


Classification of financial assets under FRS 39 and FRS 109

FRS 39 FRS 109

Held for Trading and the fair value through

Profit or Loss (FVTPL)

Held – to – maturity investments

Loans and receivables

Available-for-sale

Financial assets

FVTPL

Amortised cost

Fair value through Other

Comprehensive Income (FVOCI)


Classification of financial assets

• No No

Yes YesNo

Yes YesYes

No No

Is the objective of the entity’s business model to hold the financial assets

to collect contractual cash flows

Is the financial asset held to achieve an objective

by both collecting contractual cash flows and selling financial

assets

Do contractual cash flows represent solely payments of principal and interests?

Do contractual cash flows represent solely payments of principal and interests?

FVPL

Amortised cost FVOCI


Classification of financial assets (Cont’d)•

Pass Fail Fail Fail

1. Hold to collect 2. BM with objective that 3. Neither 1. contractual cash flows results in collecting or 2.

contractual cash flows No

and selling financial assets Yes No

No No Yes Yes

Debt (including hybrid contracts) Derivatives Equity

Contractual cash flow characteristics’ test (at instrument level)

“Business model” (BM) assessment (at an aggregate level)

Held for trading?

FVOCI option elected?

Conditional fair value option (FVOCI) elected?

Amortised costFVOCI (with

recycling)

FVTPL FVOCI (no

recycling)


Outcome chart – Classification of financial assets


Classification and measurement of financial assets (Cont'd)

Held to maturity Loans and receivables

Amortised cost FVTPL FVOCI

At fair value through profit or loss or held for

trading

Debt Equity

Available-for-sale


Illustrative Example - Equity instruments• An entity (the holder) invests in a subordinated perpetual

note, redeemable at the issuer's option, with a fixed coupon that can be deferred indefinitely if the issuer does not pay a dividend on its ordinary shares.

• Analysis: The issuer has no contractual obligation to pay the cash flows associated with the instrument, so it classifies the instrument as equity under FRS 32. The holder has the option to classify this investment at FVOCI under FRS 109 or to classify it as at FVPL.


Classification and measurement of financial liabilities

The classification and measurement of financial liabilities remain largely unchanged from FRS 39, whereas • for the presentation of gains and losses on financial

liabilities that are designated at FVTPL on initial recognition.

• when a financial liability measured at amortised cost is modified without this resulting in derecognition, a gain or loss should be recognised in profit or loss. The gain or loss is calculated as the difference between the original contractual cash flows and the modified cash flows discounted at the original effective interest rate. (FRS 109, paragraph B5.4.6).


Classification and measurement of financial liabilities


Modification of financial liabilities –FRS 109 changes accountingIllustrative exampleA financial liability is initially recognised at an amortised cost of CU98m, reflecting proceeds at par of CU100m less transaction costs of CU2m. The financial liability has a term of seven years and bears a fixed interest rate of 6 per cent paid annually.


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)Table 1 illustrates the cash flows arising from the financial liability described above


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)The allocation of interest expense using the EIR of 6.36 per cent results in the following amortisation schedule


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)The financial liability is modified as follows: • At the end of year 2, the coupon of the financial liability is reduced to

CU4m per annum and the final redemption amount is increased to CU130m. In addition, the term of the financial liability is extended for a further two years. Third party costs amounting to CU3m are incurred as part of the modification.

• Table 3 shows the modified contractual cash flows for the period from year three to year nine, discounted at the original EIR6 of 6.36 per cent


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)

Question:Whether the entity recognises the difference between the modified contractual cash flows and the amortised cost before the modification (i.e. CU106.46 – CU98.49 = CU7.97m) immediately in profit or loss at the modification date (i.e. at the end of year 2) or Whether it should, instead, amortise the difference over the remaining expected term of the financial liability.


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)Immediate recognition of the difference in profit or loss• The amortised cost of the modified financial liability is CU106.46m at

the date of the modification (see Table 3). Consequently, the entity recognises a loss of CU7.97m (i.e. CU106.46 – CU98.49 = CU7.97m) in profit or loss at the date of the modification.

• According to paragraph B3.3.6 of FRS 109, any costs or fees incurred in the modification adjust the amortised cost of the modified financial liability and are amortised over the remaining life of the modified financial liability. In this illustrative example, the entity adjusts the amortised cost of the financial liability to account for the third party costs arising from the modification amounting to CU3m. This results in an adjusted amortised cost of the financial liability of CU103.46m (i.e. CU106.4m – CU3m).


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)• For the purposes of allocating interest expense throughout the modified

expected life of the financial liability, the entity computes a revised EIR that discounts the modified contractual cash flows back to the adjusted amortised cost of the financial liability (i.e. CU103.46m) at the date of the modification. In this case, the revised EIR is 6.84 per cent.

Table 4 illustrates these calculations:


Modification of financial liabilities –FRS 109 changes accounting (Cont’d)The difference between the modified contractual cash flows of the financial liability discounted using the original EIR and the amortised cost of the original financial liability (i.e. CU106.46 – CU98.49 = CU7.97m) adjusts the latter at the date of the modification


Classification of hybrid financial instruments


Example


Impairment model


Expected life for ECL measurement


Step 1 – Determine the scope


Step 2: Applying paragraph B5.5.40


For Example


'Expected loss' model• The new expected loss model will apply to all financial assets that

are: debt instruments such as loans, trade receivables, bonds and

debt securities measured at either amortised cost or FVOCI. issued financial guarantee contracts within the scope of FRS 109.

These financial guarantee contracts are not measured at FVTPL and loan commitments are not measured at FVTPL.

lease receivables that are within the scope of IAS 17 and contract assets that are within the scope of FRS 115.

• Under FRS 109, equity investments are not required to be assessed for impairment as they are measured at either FVOCI, where gains and losses are no longer reclassified to profit or loss or at FVTPL .


'Expected loss' impairment model (Cont'd)The following table sets out how the three stages of the impairment model are applied after initial recognition:

- Credit risk has not increased significantly since initial recognition

- Recognise 12 – month expected credit losses- Credit risk has increased significantly since

initial recognition - Recognise life-time expected losses- Interest revenue recognised on a gross basis

- Credit impaired financial assets (FRS 39 triggers)

- Recognise life-time expected losses

- Interest revenue recognised on a net basis

-

Stage 1

Stage 2

Stage 3


'Expected loss' impairment model (Cont'd)


'Expected loss' impairment model (Cont'd)The recognition of impairment (and interestrevenue) is summarised in the table below:

Stage 1 2 3

Recognition of impairment

12 month expected loss

Lifetime expected credit loss

Recognition of interest

Effective interest on the gross amount

Effective interest on the (net) carrying amount


'Expected loss' impairment model (Cont'd)• Use of qualitative information

Examples include: - External market indicators for a particular

financial instrument (such as the credit spread or credit default swap prices),

- A change in the borrower’s operating results or its expected performance and behaviour, and

- An adverse change in the regulatory, economic or technological environment of the borrower.


'Expected loss' impairment model (Cont'd)• Use of past due information

- Days past due information can also indicate that credit risk has increased significantly.

- There is a rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due. However, this ‘30 days past due’ rebuttable presumption serves only as a backstop, that is, as the latest point at which lifetime losses are recognised.


At what level shall an entity make the assessment?

• An entity does not have to assess each single financial asset separately but can make the assessment based on a portfolio of assets instead. For example, for retail loans, an entity normally does not update and monitor credit risk information for every customer until the customer breaches the contractual terms. A loss allowance based only on credit information at an individual loan level in this case would not provide relevant information.

• Loans can only be aggregated if they share similar credit risk characteristics. Shared credit risk characteristics might include the instrument type, credit risk ratings, collateral type or value, date of initial recognition, remaining term to maturity, industry or geographical location of the borrower.


Three approaches


Impact of a significant increase in credit risk


12 month versus lifetime expected credit losses

• Entity B has a reporting date of 31 December. On 1 July 20X1 Entity B advanced a 3-year interest-bearing loan of CU2,000,000 to Entity A. Management estimates the following risks of defaults and losses that would result from default at 1 July 20X1 and at 31 December 20X1 and 20X2:


12 month versus lifetime expected credit losses (Cont’d)• Note that the probability that there will be no

default is implicit in the percentages above. • Note also that the loss that will transpire should a

loss occur in the event of default in the next 12 months does not correspond to the expected cash shortfalls in the next 12 months.

• What credit loss provision should Entity B book at: (i) 1 July 20X1;(ii) 31 December 20X1 &

(iii) 31 December 20X2?


12 month versus lifetime expected credit losses (Cont’d)• At 1 July 20X1:

On initial recognition Entity B should recognise a credit loss provision equivalent to 12-month expected losses.

- 12-month expected loss = (2.5% * CU800,000]

= CU20,000• At 31 December 20X1:

Entity B first evaluates whether credit risk has increased significantly since the loan was initially recognised (on 1 July 20X1). If Entity B has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low. The evaluations are as follows:

• credit risk relative to initial recognition? The total risk of default has increased from 7.5% to 13.0% which is clearly significant

• is absolute level of credit risk ‘low’? Although ‘low’ is not quantified, a 13.0% risk of default certainly appears to not be low. IFRS 9 B.5.5.23 refers to an example of low credit risk being an external rating of ‘investment grade’. The lowest rating generally considered investment grade is ‘BBB’ meaning adequate capacity to meet financial commitments.

• the credit loss provision should therefore be based on lifetime expected losses. Lifetime expected loss = (3.0%+10%) * CU700,000 = CU91,000.


12 month versus lifetime expected credit losses (Cont’d)• At 31 December 20X2:

- Entity B again evaluates whether credit risk has increased significantly since 1 July 20X1. If Entity A has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low.

- The evaluations are as follows • credit risk relative to initial recognition? The total risk of default has

now decreased to 3.0% and is therefore lower than the risk at initial recognition of 7.5%

• is absolute level of credit risk ‘low’? This evaluation is not relevant given there has not been a significant increase in the instrument’s credit risk compared to the level at initial recognition.

• The credit loss provision should therefore return to being based on 12-month expected losses. 12-month expected loss = (1.0% * CU500,000) = CU5,000


Information that may be relevant in assessing changes in credit risk


Identifying a significant increase in credit risk – “Default” examples• Instalment loan

Lender A makes a 5 year amortising loan with payments of principal and interest payable in regular monthly instalments. The borrower is also subject to six-month financial covenants. For this loan a definition of default based on missed payments and covenant breaches could be suitable.

• Term LoanLender B makes a 5 year loan with interest payable monthly and principal all due on maturity. In this case it is unlikely that a definition of default that is based solely on missed payments will be sufficient. This is because the main repayment is not due until maturity and hence a definition based on late payment would not capture the possibility that events take place before maturity that result in the borrower becoming unlikely to repay


Dual measurement approach In summary, the expected loss model under FRS 109 uses a dual measurement approach as shown in the diagram below.


Purchased and Originated Credit –Impaired Financial AssetsIndicators that an asset is credit-impaired would include observable data about the following events:• Significant financial difficulty of the issuer or the borrower • Breach of contract • The lender has granted concessions as a result of the borrower’s

financial difficulty which the lender would not otherwise consider • It is becoming probable that the borrower will enter bankruptcy or other

financial reorganisation • The disappearance of an active market for that financial asset because

of financial difficulties • The financial asset is purchased or originated at a deep discount that

reflects the incurred credit losses


Purchased and Originated Credit –Impaired Financial Assets (Cont'd)• Under this specific approach, an entity is required to apply the credit-

adjusted effective interest rate to the amortised cost of the financial

asset from initial recognition.

• Thereafter it only recognises the cumulative changes in lifetime

expected credit losses since initial recognition as a loss allowance.

• The amount of the change in lifetime expected credit losses is

recognised in profit or loss as an impairment gain or loss.

• An improvement in credit quality beyond that which was estimated at

the time of initial recognition, results in impairment gains being

recognised in profit or loss.


Purchased and Originated Credit –Impaired Financial Assets (Cont'd)For financial assets, a cash shortfall is thedifference between:

• The present value of the principal and interest cash flows due to an entity under the contract; and

• The present value of the cash flows that the entity expects to receive.


Measuring expected credit losses• FRS 109 defines expected credit losses as “the

weighted average of credit losses with the respective risks of a default occurring as the weights”.

• Three key building blocks:- an unbiased and probability-weighted amount

that is determined by evaluating a range of possible outcomes

- the time value of money - reasonable and supportable information about

past events, current conditions and forecasts of future economic conditions


Measuring expected credit losses (Cont’d)• Probability-weighted amount

- An estimate of expected credit losses shall however always reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs even if the most likely outcome is no credit loss.

- FRS 109 requires expected credit losses to be discounted to the reporting date using the effective interest rate determined at initial recognition or an approximation of it.


• Time valueFRS 109 requires expected credit losses to be discounted to the reporting date using the effective interest rate determined at initial recognition or an approximation of it.

Measuring expected credit losses (Cont’d)


Measuring expected credit losses (Cont’d)• Reasonable and supportable information


Measurement of expected credit losses for different types of asset/exposure


Measurement period

• Entity E makes a 12-month loan to Entity F. The contract states that the loan can be extended for a further 6 months at the sole option of Entity E (the lender). Entity E’s management considers that it is probable that the loan will be extended. It is assumed that the loan meets FRS 109’s ‘solely payments of principal and interest’ condition to be measured at amortised cost.

• The expected losses would be measured based on the 12-month contractual term. The measurement would not take into account possible future losses arising from management’s decision to extend the loan for the additional 6 month period, unless or until the extension option is actually exercised. This is because the extension is at the sole option of the lender, so 12 months is the maximum contractual period over which the lender is exposed to credit risk.

• If Entity F (the borrower) has the right to extend the loan however, the maximum contractual credit risk period would be 18 months.


Practical Exemptions

• ‘Low credit risk’ exceptionFRS 109 does not define ‘low’ credit risk. It does state that the credit risk on a financial instrument is considered low for the purpose of FRS 109, if:• the financial instrument has a low risk of default• the borrower has a strong capacity to meet its

contractual cash flow obligations in the near termand

• adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations


FRS 109 includes the following simplifications:


Segregating trade receivables

• The following are some examples of criteria that might be used to group assets:- geographical region - product type- customer rating- collateral or trade credit insurance - type of customer.


Illustrative example Trade receivables and contract assets that do not contain a significant financing component

Fact - Company E, a manufacturer, has trade receivables of CU100 million in

20X1 representing balances from a large number of small clients. The trade receivables do not have a significant financing component and are accordingly measured for impairment purposes at an amount equal to lifetime expected credit losses. Company E operates in only one geographical region.

- Company E uses a provision matrix to determine expected credit losses on the receivables. The provision matrix is based on historical observed default rates over the expected life of the trade receivables, adjusted for forward-looking estimates such as the deterioration in economic conditions expected by Company E in the coming year. This process results in the following provision rates which are based on the number of days that a trade receivable is past due:


Illustrative example (Cont'd)


Building a provision matrix• Single loss-rate approach

An entity might determine an average historical loss rate by comparing the total balance of trade receivables at various past due dates and determining the amounts collected/not collected. This would then be adjusted as necessary to reflect changes in circumstances.

• Provision matrix

Estimate expected credit losses (ECLs) based on the ‘age’ of receivables. Accordingly, the operational challenge is to determine the relationship between the age of your receivables and the risk of non-payment. In order to ‘build’ a provision matrix the typical steps will be:

1 segregate receivables into appropriate groups

2 within each group, determine: a age-bands b historical back-testing dates (data points)

3 for each age-band, at each back-testing date determine: a the gross receivables b the amounts ultimately collected/written-off. If material, adjustments should be made to exclude the effect of non-collections for reasons other than credit loss (eg credit notes issued for returns, short-deliveries or as a commercial price concession)

4 compute average historical loss rate by age-band

5 adjust historical loss rates if necessary, eg to take account of changes in: a economic conditions b types of customer c credit management practices

6 consider whether ECLs should be estimated individually for any period-end receivables, egbecause specific information is available about those debtors

7 apply loss rate estimates to each age-band for the other receivables in this group.


Contract asset

• ‘Contract asset’ is a term introduced by the new revenue recognition standard (FRS 115 Revenue from Contracts with Customers).

• FRS 115 provides a detailed definition but contract assets are broadly equivalent to unbilled revenue. Even though contract assets are not financial assets, and are accounted for mainly under FRS 115, FRS 109’s impairment requirements apply to them. This means that when entities recognise revenue in advance of being paid or recording a receivable, they also need to recognise an expected credit loss.


Other long term trade receivables, long term contract assets and lease receivables

For other long term trade receivables and lease receivables, entities have an accounting policy choice to either:- apply the general three stage approach or - the ‘simplified approach’ of recognising

lifetime expected credit losses.


The specific approach for purchased or originated credit-impaired financial assets, and the simplified model for trade receivables, contract assets and lease receivables, differ from FRS 109’s general model


Under FRS 109 (2014), the scope of the three-stage impairment approach is extended to such off-balance sheet items.

An entity would consider the expected portion of the loan commitment that will be drawn down within the next 12 months when estimating 12-month expected credit losses (Stage 1), and the expected portion of the loan commitment that will be drawn down over the remaining life of the loan commitment when estimating lifetime expected credit losses (Stage 2).

Loan Commitments and Financial Guarantees


Loan Commitments and Financial Guarantees (Cont’d)The following table summarises the requirement for loan commitments and financial guarantees:

Stage Apply To ECL to be computed

Stage 1 – No significant increase in credit risk

Expected portion to be drawn down within the next 12 months

12-month expected credit losses

Stage 2 – Significant increase in credit risk

Expected portion to be drawn down over the remaining life of the facility

Lifetime expected credit losses


Key Implementation challenges –impairment


Hedge accountingWhat do FRS 39 and FRS 109 have in common?1. Optional

A hedge accounting is an option, not an obligation – both in line with FRS 39 and FRS 109.

2. TerminologyBoth standards use the same most important terms: hedged item, hedging instrument, fair value hedge, cash flow hedge, hedge effectiveness, etc.

3. Hedge documentationBoth FRS 39 and FRS 109 require hedge documentation in order to qualify for a hedge accounting.

4. Categories of hedgesBoth FRS 39 and FRS 109 arrange the hedge accounting for the same categories: fair value hedge, cash flow hedge and net investment hedge. The mechanics of the hedge accounting are basically the same.


Hedge accountingWhat do FRS 39 and FRS 109 have in common?5. Hedge ineffectiveness

Both FRS 39 and FRS 109 require accounting for any hedge ineffectiveness in profit or loss. There is an exception related to hedge of equity investment designated at fair value through other comprehensive income in line with FRS 109 : all hedge ineffectiveness is recognized to other comprehensive income.

6. No written optionsYou cannot use written options as a hedging instrument in line with both FRS 39 and FRS 109 .

•


Hedge accounting (Cont’d)Differences in hedge accounting between FRS 39 and FRS 109• FRS 109 aligns hedge accounting requirements

with how an entity manages risk changing existing requirements.

Top 3 welcome changes:


Hedge accounting (Cont’d)

Top 3 welcome changes:


Top four look-outsThe top four look-outs are: Factoring of receivables - Could result in

some receivables being measured at fair value.Not all intra-group funding is scoped in FRS

109 – Intra-group loans in the scope of FRS 109 are required to be measured at fair value on initial recognition.

Holding shares in other companies –measured at fair value, even if the shares are unquoted and difficult to value.

Renegotiated borrowings – gains or loss must be recognised in P/L at the time of renegotiation.


Disclosures• Classification and measurement The disclosure requirements on adoption of FRS 109

(2014) depend on whether an entity transitions:o from FRS 39 (and so applies the classification and

measurement requirements of FRS 109 for the first time); or

o from an earlier version of FRS 109. More extensive disclosures are required in the former

case. This section highlights the key disclosures, but does not reproduce all of the disclosures required by the standard.

Adobe Acrobat Document


Disclosures

• Relevant to all transitions On adoption of FRS 109, an entity discloses in the reporting period that includes the DIA (date of initial application)): the original measurement category and carrying amount determined

under FRS 39 or an earlier version of FRS 109; and the new measurement category and carrying amount determined under

FRS 109 for each class of financial assets and financial liabilities.

• In addition, an entity explains how it has applied the classification requirements of FRS 109 and the reasons for any designations or de-designations of financial assets and financial liabilities as at FVTPL. The entity also discloses the amount of any financial assets and financial liabilities that were previously designated as at FVTPL but are no longer so designated, distinguishing between mandatory and elective de-designations.


Disclosures

Additional disclosures on transition from FRS 39An entity discloses the changes in the classifications of financial assets and financial liabilities as at the DIA, showing separately:▫ the changes in the carrying amounts on the basis of their

measurement categories under FRS 39; and▫ the changes in the carrying amounts arising from a change in

measurement attribute on transition to FRS 109.


Disclosures


Effective Date


TransitionAs a practical expedient, entities may on transition, use the 30 day past due rebuttable presumption and provide:

• Lifetime expected credit losses for those financialinstruments that are 30 days past due, and

• 12-month expected credit losses for the remainingfinancial instruments that are not 30 days past due.


Transition (Cont'd)If initial credit quality information cannot be gatheredwithout undue cost or effort for the retrospectiveapplication of the 3-stage approach, then the entity wouldassess whether the credit risk of the financial asset is low(i.e. investment grade) at the date of initial application:- If credit risk is low at the date of initial application, then

12-month expected credit losses would be recognisedat that point

- If credit risk is not low then lifetime expected credit losseswould be recognised at each reporting date untilderecognition.


Transition (Cont'd)On the date of initial application, an entity is required to discloseinformation that permits the reconciliation of the ending impairmentallowance under FRS 39 Financial Instruments: Recognition andMeasurement or the provisions under FRS 37 Provisions, ContingentLiabilities and Contingent Assets to the opening loss allowance orprovision determined in accordance with the new model in FRS 109(2014).


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How I can help further:Shirley Ang63042386E [email protected]

Thank you

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