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Accounting for Financial Instruments
(IAS 39)
Salzburg, April 4, 2018
Martin Gehringer
2
Investment portfolio of insurers
Scope of IAS 39
Definitions
Categories of financial instruments
Derecognition
Measurement
Initial measurement
Subsequent measurement
Hedge Accounting
Embedded Derivatives
Agenda
Investment Portfolio (Europe)
3
Source: Insurance Europe European Insurance in Figures 2016, March 2018
Total
value Asset Allocation
The total
value of the
insurers
investment
portfolio in
Europe is
10.1 bn€
4
IAS 39 and IFRS 7 need to be considered together for the accounting of financial instruments. They cover different aspects of financial instruments accounting.
IAS 39 provides rules for recognition and measurement of financial instruments depending on whether the financial instruments are held inside or outside a hedging relationship. It provides rules for:
Recognition and Derecognition
Measurement
Hedge accounting
Disclosure requirements are covered by IFRS 7.
Also important: IFRS 13 Fair Value measurement
Scope of IAS 39 (I)
5
The scope of IAS 39 includes most types of financial instruments. Exceptions are (covered by other standards):
Interests in subsidiaries (IFRS 10)
Assets and liabilities found under employee benefit plans (IAS 19)
Contracts for contingent consideration in a business combinations (IFRS 3/IFRS 10)
Share-based payments (IFRS 2)
Insurance contracts (IFRS 4)
But: In the case of an embedded derivative, IAS 39 covers the embedded derivative
Scope of IAS 39 (II) Exceptions of the Scope
6
Financial instrument: Any contract that gives rise to a financial
asset of one entity and a financial liability or equity instrument
of another entity.
Derivatives are financial instruments or contracts with the
following characteristics:
Changes in value in response to changes in the specified underlying
Requires no or little initial net investment
Are settled at a future date.
Definition
7
Categories of financial assets (I)
(1a) At Fair Value through Profit or Loss
(4) Available-for-Sale
Financial Assets
(3) Loans and Receivables
(2) Held-to- Maturity
Investments
Financial Assets
(1b) Held for Trading
All financial assets have to be categorized on initial recognition.
8
Categories of financial assets (II) (1) At fair value through profit or loss
A financial asset at fair value through profit or loss is one that is either:
held for trading
designated at initial recognition, if: measurement or recognition inconsistencies are eliminated or significantly reduced,
OR
management and performance measurement of a group of financial assets, financial liabilities or both, is done on a fair value basis, in accordance with a documented risk management or investment strategy
A financial instrument must be classified as held for trading if it is:
acquired or incurred principally for the purpose of selling or repurchasing it in the near term
part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking, OR
a derivative (except for designated and effective hedging instruments)
9
Categories of financial assets (III) (2) Held-to-maturity
Held-to-maturity investments:
Financial assets with fixed or determinable payments and
fixed maturity, AND
that an entity has the positive intent and ability to hold to
maturity.
But not:
Those that are designated as fair value through profit or
loss or available-for-sale on initial recognition, OR
Those that meet the definition of loans and receivables
10
Categories of financial assets (IV) (2) Held-to-maturity - tainting -
An entity is not allowed to classify any financial assets
as held-to-maturity if it has:
Sold or transferred on more than an insignificant amount of
held-to-maturity investments before maturity
during the current financial year, OR
during the two preceding financial years
There are limited exceptions to the tainting rules
11
Loans and receivables:
financial assets with fixed or determinable payments, AND
not quoted in an active market
But not:
those that the entity intends to sell immediately
these are classified as fair value through profit and loss
those that are designated as fair value through profit or loss or available-for-sale on initial recognition
Categories of financial assets (V) (3) Loans and receivables
12
Available-for-sale financial assets are those financial
assets that are not classified as:
loans and receivables
held to maturity investments, OR
at fair value through profit or loss
It does not mean that these financial assets will be sold
Categories of financial assets (VI) (4) Available-for-sale
13
Categories of financial assets (VII) Summary
Categories of financial assets Knowledge check
An Insurance company purchases the following
investments:
Listed shares
Listed bearer bonds
Registered bond (not quoted in an active market)
Please explain how the investments can be categorized
14
Categories of financial assets (example) UNIQA 2016
15
Source: UNIQA Group Report 2016
pages 151 and 195
Categories of financial assets (example) Zurich 2017
16
Source: Zurich Group Report 2017
pages 6 and 31
17
(1a) At Fair Value through Profit or Loss
(2) Other Liabilities
(Financial Liabilities)
(1b) Held for Trading
Categories of financial liabilities (I)
18
A financial liability at fair value through profit or loss is one that is either: classified as held for trading, OR
designated at initial recognition, IF: measurement or recognition inconsistencies are eliminated or significantly
reduced, OR
management and performance measurement of a group of financial assets, financial liabilities or both, is done on a fair value basis, in accordance with a documented risk management or investment strategy.
Financial liabilities held for trading consist of: derivative liabilities that are not hedging instruments, AND
obligations to deliver securities borrowed by a short seller (an enterprise that sells securities that it does not yet own)
The fact that a liability is used to fund trading activities does not make that liability one held for trading
Categories of financial liabilities (II)
19
Transfer of risks and rewards
Transfer the contractual rights to receive cash
flows or pass through settlement
Derecognition (I)
Derecognition of financial assets
Contractual rights to the cash flows from the financial asset expire
“Qualified” transfer
See next
slide
Derecognition
OR
AND
20
Derecognition (II) Retention and transfer of risks/rewards
Examples of retention of substantially all risks and rewards:
Repos, stock loans, total return swaps
Sales of short-term receivables where all credit risk is guaranteed
Examples of transfer of substantially all risks and rewards:
Sale with option to repurchase at fair value at time of repurchase
Sale of portfolio of assets but retain right to service the assets for a fee
21
Financial asset or financial liability
is initially recognised
at cost fair value of
consideration given
in case of asset
fair value of
consideration
received in case of
liability
Include: transaction costs on purchase (fees and commissions paid
to brokers, advisers and dealers, transfer taxes and duties)
Exclude: transaction costs that may be incurred on disposal
Transaction costs are not included in the case of a financial asset or financial liability at fair value through profit and loss
Initial measurement
22
Financial assets
are subsequently recognised
at amortised cost
Loans and
receivables
Held to maturity
investments
at fair value Financial assets held
for trading or designated as at fair
value through profit and loss
Available-for-sale
securities
Subsequent measurement (I) Financial assets
23
After initial recognition
Available-for-sale financial assets are measured at fair value
Fair value differences are taken to OCI recognised as a separate component in equity
recycled on disposal
Other points impairment loss shall go to profit or loss
impairment loss on equity investments cannot be reversed
interest recognition using effective interest rate
FX differences to profit or loss (debt instruments)
Subsequent measurement (II) Available-for-sale
24
An insurance company acquires 100 shares of entity X on
January 1, 2015 for € 20 each. During 2015, 2016 and 2017
the following happens:
For 2015, X pays a dividend of € 1 per share
On December 31, 2016 the quoted price of a share is € 24
On December 31, 2017 the quoted price of a share is € 16
In March 2017, the insurance company sells all of its shares for
€ 39
Assume that the shares are accounted for as
Held-for-trading
Available-for-sale
Booking entries?
Subsequent measurement (III) Example HfT / AfS
25
Gains and losses on financial assets and liabilities
at fair value through profit or loss (including all
derivatives) should be taken to the profit or loss
statement.
Gains and losses on available-for-sale financial
assets should be recognised in OCI (except for
impairment).
Different rules for hedging
Subsequent measurement (IV) Gains and losses
26
After initial recognition
Loans and receivables are carried at amortised
cost using the effective interest rate method
Held-to-maturity investments are carried at
amortised cost using the effective interest rate
method
Subsequent measurement (V) Held-to-maturity investments/Loans and receivables
27
Effective interest Rate that exactly discounts estimated future cash flows
through the expected life of the financial instrument (or when appropriate, a shorter period) to the net carrying amount of the instrument method of allocating the interest income or expense over the
relevant period, AND
of calculating the amortised cost
Example effective interest method: An insurance company buys a loan for € 9,500k as of December 31, 2012 and a face value of € 1,000k. The loan pays a coupon of 4.0 % p.a. The loan is repaid as of December 31, 2014 (face value). Booking entries?
Subsequent measurement (VI) Effective Interest Method
28
Example (cont.)
Cash Flows:
Book values:
Yield 5.87%
Subsequent measurement (VII) Effective Interest Method
29
Financial liabilities at fair value through profit or loss and derivatives that are financial liabilities are carried at fair value
Gains and losses are taken to the income statement
All other financial liabilities are carried at amortised cost
Again, different rules for hedging!!
Subsequent measurement (VIII) Financial liabilities
30
Fair value Amortised cost Transaction
costs
FV through profit or loss - adj. to
P&L Expensed
Held-to-maturity - Capitalized
Loans and receivables - Capitalized
Available-for-sale - adj. to
OCI Capitalized
Subsequent measurement (IX) Summary
31
Source: UNIQA Group Report 2016
pages 109/110
Measurement (example) UNIQA 2016
32
Source: UNIQA Group Report 2016
pages 127/128
Measurement (example) UNIQA 2016
33
Source: UNIQA Group Report 2016
pages 225/226
Measurement (example) UNIQA 2016
34
A company has to assign its investments to different levels depending on the liquidity and market activity of the respective financial instruments.
Three levels are defined by IFRS 13: Level 1: Quoted prices (unadjusted) in active markets for identical
assets or liabilities that the entity can access at the measurement date
Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly
Level 3: Unobservable inputs for the asset or liability
Fair Value hierarchy Levels
Levels IFRS 13 (example) UNIQA 2016
35
Source: UNIQA Group Report 2016
pages 131/133 (extract)
Levels IFRS 13 (example) UNIQA 2016
36
Source: UNIQA Group Report 2016
page 196/198 (extract)
37
A financial asset is impaired when
Carrying amount is greater than estimated recoverable amount
At each balance sheet date, an entity must assess if there is objective evidence of impairment; evidence includes (incurred loss approach): financial difficulty of issuer
default or delinquency, or concessions by lender
high probability of bankruptcy or financial reorganisation, OR
disappearance of active market in investment due to financial problems
In addition, for equity investments: significant changes in technological, market, economic or legal
environment
significant or prolonged decline in fair value
Impairment (I)
38
Assessment
The existence of objective evidence of impairment
is assessed:
Individually for individually significant financial assets
Individually or collectively for financial assets that are
not individually significant
If there is no objective evidence of impairment at an individual level, the asset is grouped with assets of similar credit risk characteristics for collective assessment
Impairment (II)
39
Measurement
Impairment loss is the difference between the carrying amount and the Present Value of expected future cash flows discounted at original effective rate
Recognition
The carrying amount of the asset must be reduced to its estimated recoverable amount, and the loss is included in profit or loss for the period
Reverse impairment through income statement only if change causing the reversal can be related objectively to an event occurring after the write-down
Impairment (III) Assets carried at amortised cost
40
Financial assets carried at fair value
This section applies only to available-for-sale financial assets.
Financial assets held for trading
fair value adjustments are to net income
impairment loss is recognised automatically
A decline in value may have been recognised in equity as part
of the usual measurement process
When there is objective evidence of impairment, the
cumulative net loss that had been recognised in OCI is
reversed in OCI and recognised in profit or loss for the period
Impairment (IV) Assets carried at fair value
41
The amount is measured as the difference
between acquisition cost and:
current fair value (for equity instruments), OR
recoverable amount (for debt instruments)
Recoverable amount is the present value of expected future
cash flows discounted at the current market rate of interest
for a similar financial asset
Impairment (V) Assets carried at fair value
42
An insurance company acquires 100 shares of entity X on
January 1, 2015 for € 20 each. During 2015, 2016 and 2017
the following happens:
For 2015, X pays a dividend of € 1 per share
On December 31, 2016 the quoted price of a share is € 24
On December 31, 2017 the quoted price of a share is € 16
In March 2017, the insurance company sells all of its shares for
€ 39
Assume that the shares are accounted for as
Available-for-sale and the decline in the fair value as at
December 31, 2017 is an impairment
Booking entries?
Impairment/Subsequent measurement Example HfT / AfS (continued)
43
Source: UNIQA Group Report 2016
pages 129/130
Impairment (example) UNIQA 2016
44
Source: Zurich Group Report 2017
page 25
Impairment (example) Zurich 2017
45
Fair value - Something is
already locked in and you
need to protect it
Cash flow - You are
locking in something
Definition
Hedging the exposure to changes in the fair
value of an asset or liability due to a particular
risk or a firm commitment to buy or sell an asset
at a fixed price.
Definition
Hedging the exposure in the cash flows of an
asset, liability, forecasted transaction or the
FX risk of an unrecognised firm commitment.
Hedge Accounting (I) Major types of hedges
46
Examples of fair value hedges Fixed rate debt issued by the entity and hedged using a receive fixed/pay
floating interest rate swap
Available-for-sale equity security hedged with a purchased put option
Hedge of the variability in the price of a firm commitment to acquire a product in 2 months
A firm commitment to buy a machine in 6 months time for a fixed USD foreign currency amount hedged by a USD/GBP forward contract
Examples of cash flow hedges Floating rate debt issued by the entity and hedged using a receive
floating/pay fixed interest rate swap
Forecast USD foreign currency sales of fuel in September hedged by a USD/Euro forward contract
Hedge Accounting (II)
On April 8, 2015 an insurance company buys a bond with a 5 year maturity and a
fixed interest rate coupon of 2% p.a. The face value is € 1,000k and the purchase
price is 100 %. To avoid volatility due to fair value changes the insurance
company buys a payer swap with a nominal value of € 1,000k where it pays the
2% coupon to the counterparty of the swap and receives interest payments based
on the LIBOR. The fair value of the swap is zero.
Swap
counterparty Insurance
company Bond issuer
LIBOR
2%
2%
Hedge Accounting (III) Example of a Fair Value Hedge
47
On April 8, 2015 an insurance company buys a bond with a 5 year maturity and a
fixed interest rate coupon of 2% p.a. The face value is € 1,000k and the purchase
price is 100 %.
On December 31, 2015 the yields on a comparable bond have risen to 3% and
the price of the bond decreased to 95% while the fair value of the swap increased
to €40k.
What are the booking entries as of December 31, 2015?
48
Fair value hedges
1. Gain or loss on hedging instrument is recognised immediately in P&L
2. Hedged item is adjusted for change in fair value due to the hedged risk and the gain or loss recognised immediately in the P&L
3. By default, hedge ineffectiveness is captured immediately in P&L
Cash flow hedges
1. Gain or loss on hedging instrument that is fully effective is recognised in a separate component of equity (through OCI)
2. No adjustment is made to the hedged item
3. Gain or loss on the hedging instrument that is not effective is recognised immediately in the P&L
Hedge Accounting (IV) Accounting treatment for qualifying hedges
49
Key Steps to achieving a qualifying hedge Identify the type of hedge
fair value OR
cash flow
Identify the hedged item or transaction
Identify the nature of the risk being hedged
Identify the hedging instrument
Demonstrate that the hedge has and will continue to be effective
Document the hedging relationship above, including the risk management objectives and strategy for undertaking the hedge
Hedge Accounting (V)
50
Hedge effectiveness
Demonstrate that the hedge has and will continue to
be highly effective
At inception, effective means flows fully offset
(stronger than 80-125%)
Ongoing, effectiveness only needs to show 80-125%
Please calculate the hedge effectiveness in the
example.
Hedge Accounting (VI) Hedge effectiveness
51
Please explain the three key features of a derivative according
to IAS 39?
How are derivatives categorized?
How must derivatives be measured?
Embedded Derivatives (I) Knowledge check
52
A component of a hybrid financial instrument that includes both
a derivative and a host contract – with the effect that some of
the cash flows of the combined instrument vary in a similar way
to a stand-alone derivative.
An embedded derivative should be separated from the host
contract and accounted for (separately) as a derivative if
the economic characteristics and risks of the embedded derivatives are
not closely related to those of the host
a separate instrument with the same terms as the embedded item
satisfies the definition of a derivative, AND
the hybrid instrument is not already measured at fair value with changes
taken to the income statement
Embedded Derivatives (II) Definitions
53
Embedded Derivatives (III) Identification and measurement
Hybrid contract host contract + embedded derivative
Host contract is an element which is left had the embedded
derivative been eliminated from the hybrid contract
Host contract does not have to be a financial instrument
What is a host contract?
Any financial asset or liability
Measurement
Separation of derivative (at fair value through profit or loss) and host
contract (depending on the category)
Otherwise, hybrid is accounted for at fair value through profit or loss
in its entirety
Embedded Derivatives (IV) Examples
Reverse Convertible Bond Is a bond linked to an underlying stock. The security offers a
steady stream of income due to the payment of a high coupon
rate. In addition, at maturity the owner will receive either 100%
of the par value or, if the stock value falls, a predetermined
number of shares of the underlying stock.
Credit Linked Note Is a structured security which allows the issuer e.g. a bank to
transfer a specific credit risk e.g. of a government or
company to investors. The issuer is not obliged to repay the
debt if a specified event occurs.
54
The two main categories of disclosures required by IFRS 7 are:
1. Information about the significance of financial instruments
Accounting policies
Financial position: Categorization of the financial instruments, including
fair values for those financial instruments valued at amortized cost
Income statement: income, expense, gains, and losses by category
including impairments
Others: Hedging, embedded derivatives, reclassifications, collaterals,
credit losses
2. Information about the nature and extent of risks arising from financial
instruments
Description of the risk management system (qualitative information)
Quantitative information on market risk including a sensitivity analysis
as well as credit and liquidity risk
55
Disclosure requirements
Summary IAS 39
Categorization: Financial Instruments have to be categorized
according to IAS 39.
Measurement: The category determines whether a financial
instrument is measured at fair value or amortized cost; changes in
the fair value are recognized through P&L or OCI.
Impairment: An impairment test has to be performed for all
categories except for Fair Value through profit or loss.
Hedging: An effectiveness of 80%-125% is a precondition for hedge
accounting.
Embedded derivatives: Where a financial instrument contains not
closely related risks the host contract and the embedded derivative
have to be separated or fully accounted at fair value through P&L.
56
Thank you for your attention!
57
Martin Gehringer
Ernst & Young GmbH
Wirtschaftsprüfungsgesellschaft
Mergenthalerallee 3-5
65760 Eschborn
Telefon +49 6196 996 12427
Mobile +49 160 939 12427
martin.gehringer@de.ey.com
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