Reclassification of financial assets

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1 Issue 34 / March 2009 Supplement to IFRS outlook Reclassification of financial assets This publication summarises all the recent amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosure and IFRIC 9 Reassessment of Embedded Derivatives. It also includes decision trees for applying the amendments, answers to some frequently asked questions, and updated examples of their application. On 13 October 2008, the International Accounting Standards Board (the IASB or the Board) approved and published amendments to IAS 39 and IFRS 7 to allow reclassifications of certain financial assets held for trading to either held to maturity, loans and receivables or available for sale categories. The amendment also allows the transfer of certain financial assets from available for sale to loans and receivables. The IASB temporarily suspended normal due process, with agreement of the trustees of the International Accounting Standards Committee Foundation. Consequently, there was no exposure or comment period. The effective date is 1 July The amendments were made in response to requests by regulators to enable banks to record financial assets which are no longer traded in an active market at amortised, thereby reducing reported profit or loss volatility. They will also apply to non-banks that have financial assets recorded as held for trading or available for sale. The amendments introduce concepts already present in US GAAP, which allow loans to be transferred from held for trading to held for investment if there is a change in holding intent, and the transfer of securities from held for trading to available for sale or held to maturity, in rare circumstances. As a result of the accelerated amendment process, it was stated at the 13 October 2008 Board meeting that corrections would be made to the amendments, if found to be necessary. This publication includes amendments issued through to the end of March 2009.

2 Financial assets that would now meet the criteria to be classified as loans and receivables, may be transferred from held for trading to loans and receivables, if the entity has the intention and the ability to hold them for the foreseeable future. Summary of the amendments The amendments allow entities to reclassify certain financial assets out of held for trading if they are no longer held for the purpose of being sold or repurchased in the near term (paragraph 50(c)). Entities still cannot reclassify instruments that were designated at fair value through profit or loss using the fair value option (although the IASB has been requested by the European Commission 1 to permit this), nor derivatives. The amendments distinguish between those financial assets that are eligible for classification as loans and receivables and those that are not. The former are those instruments which, apart from not being held with the intent of sale in the near term, have fixed or determinable payments, are not quoted in an active market and contain no features which could cause the holder not to recover substantially all of its initial investment except through credit deterioration. Financial assets that now meet the criteria to be classified as loans and receivables may be transferred from held for trading to loans and receivables, if the entity has the intention and the ability to hold them for the foreseeable future (paragraph 50D). Neither foreseeable future nor near term are defined. Financial assets that are not eligible for classification as loans and receivables, may be transferred from held for trading to available for sale or to held to maturity, only in rare circumstances (paragraph 50B). Rare is not defined, although it is clarified in the Basis for Conclusions that rare circumstances arise from a single event that is unusual and highly unlikely to recur in the near term. Also, in 2008 the IASB stated on its website: The deterioration of the world s markets that has occurred during the third quarter of this year is a possible example of rare circumstances cited in the IFRS amendments and therefore justifies their immediate publication. Financial assets may only be transferred into the held to maturity category if the entity has the positive intent and ability to hold them to maturity. Also, entities must not forget that, from an accounting perspective, if they sell the asset before maturity, this will taint the remaining portfolio (with only a few exceptions), resulting in reclassification of the entire portfolio as available for sale. The amendments also allow reclassification of financial assets out of available for sale to loans and receivables if the entity has the intent and the ability to hold them for the foreseeable future and the assets meet the definition of loans and receivables at the date of reclassification (paragraph 50E). The flow charts on the following page provide a roadmap to illustrate the amendments. Embedded derivatives For financial instruments classified as held for trading, there is no need to consider the separation of any embedded derivatives, because the entire instrument is recorded at fair value through profit or loss. However, when an instrument is not recorded at fair value through profit or loss, it is necessary to assess when becoming a party to the contract whether to separate, and report at fair value through profit or loss, any embedded derivative (if its economic characteristics and risks are not closely related to those of the host instrument). The original version of IFRIC 9 Reassessment of Embedded Derivatives prohibited the subsequent reassessment of whether to separate embedded derivatives unless there was a change in the terms of the contract significantly modifying its cash flows. 1 The Commission wrote to the Board on 27 October 2008 requesting this as well as, amongst others, a clarification that a credit derivative in a synthetic CDO does not require separation (see later in this publication). 2

3 Reclassification out of fair value through profit or loss Is the financial instrument a derivative? Is it a financial asset designated at FVTPL on initial recognition? No reclassification permitted Is the financial asset no longer held for the purpose of selling in the near term? (paragraph 50(c)) Does the financial asset meet the definition of loans and receivables at the date of reclassification? (paragraph 50D and definition of Loans and Receivables paragraph 9) Are the circumstances rare? (paragraph 50B) Does the entity intend and have the ability to hold the financial asset for the foreseeable future or until maturity? (paragraph 50D) Unclear (2) Does the entity intend and have the ability to hold the financial asset until maturity? (Definition of held to maturity in paragraph 9) Reclassification as loans and receivables permitted Reclassification as available for sale permitted Reclassification as held to maturity and available for sale permitted With Look back option to 1 July 2008 if consistent with the date of change of intent Reclassification out of available for sale Does the financial asset meet the definition of loans and receivables at the date of reclassification? (paragraph 50D and definition of Loans and Receivables paragraph 9) Does the entity intend and have the ability to hold the financial asset until maturity? (Definition of held to maturity in paragraph 9) Does the entity intend and have the ability to hold the financial asset in the foreseeable future or until maturity? (paragraph 50E) Reclassification as loans and receivables permitted With Look back option to July 1, 2008 if consistent with the date of change of intent No reclassification permitted Reclassification as held to maturity permitted No Look back option to July 1, 2008 (reclassification was already permitted by IAS 39 paragraph 54) 2 The amendments, as worded, allow financial assets to be reclassified to loans and receivables if they meet the relevant criteria as of the reclassification date, even if on original recognition, they were quoted in an active market and so would not have been eligible to be recorded in this category. However, to reclassify such assets, it would also be necessary for there to be an intention to hold them for the foreseeable future or to maturity. The question has been asked as to whether, if an asset would now qualify to be regarded as a loan and receivable but the entity cannot assert that it will hold it for the foreseeable future, the asset can, alternatively be reclassified to available for sale, if the circumstances are rare. This question is likely to be relevant only if the entity regards the intent to hold the asset for the foreseeable future as more onerous than no longer having the intent to hold the asset for sale in the near term, which will turn on the interpretation of both these terms, and the circumstances are, indeed, rare. In our view, the amendments can be read both to prohibit such an alternative assessment for such assets or to allow it. Therefore, until the IASB clarifies this issue, we believe that entities can interpret the amendments to permit this alternative assessment if they so wish. We would expect them to disclose this interpretation in their accounting policies, if the effect is material. 3

4 In response to requests for clarification, the Board made it clear that any reclassification made on or after 1 November 2008 takes effect from the date of reclassification. The amended IFRIC 9 requires: (a) An entity to assess whether an embedded derivative is required to be separated from a host contract when the entity reclassifies a hybrid financial asset out of the fair value through profit or loss category; and (b) The assessment to be made on the basis of the circumstances that existed on the later of: the date when the entity first became a party to the contract, and the date at which a change occurs in the terms of the contract that significantly modifies the cash flows that otherwise would have been required under the contract. IAS 39 is also amended to state that if the fair value of an embedded derivative that would have to be separated on reclassification cannot be reliably measured, the entire hybrid financial instrument must remain classified as at fair value through profit or loss and cannot be reclassified. Effective date The effective date of the amendments is 1 July Reclassifications before 1 July 2008 are not permitted but, prior to 1 November 2008, entities were able to go back to 1 July 2008 and make transfers as of that date, as long as the assets met the criteria for reclassification at that time. Any reclassification of a financial asset made on or after 1 November 2008 will take effect only from the date when the reclassification is made. An amendment issued by the Board on 27 November 2008 made clear that the look back option to 1 July 2008 was no longer available after 1 November Reclassifications out of available for sale into held to maturity were already permitted for debt instruments before the amendment, whenever there was a change in intent or ability. The 1 July 2008 effective date applies only to the newly permitted reclassifications. Therefore, an entity may not reclassify from available for sale into held to maturity as of 1 July 2008, unless it had changed its intention and decided to reclassify as at that date. The amendments to IFRIC 9 and IAS 39, as they relate to separation of embedded derivatives upon reclassification, are applicable for annual periods ending on or after 30 June IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is to be applied upon transition, accordingly, retrospective application will be required. Any entities that have not reassessed their embedded derivatives will need to restate their financial statements when implementing the amendments. Accounting for reclassified assets Any reclassification should take place at the fair value at the date of reclassification. For example, an instrument that was acquired at its par value of 100, had declined in fair value to 60 and is now reclassified to held to maturity, will have a new amortised of 60. The new would be amortised back to the instrument s expected recoverable amount over its expected remaining life through the effective interest method. Therefore, the loss of 40 recognised in prior periods will not be reversed through profit or loss on reclassification, but will be amortised through interest income over the remaining life of the contract. 4

5 Any subsequent increase in expected recoveries will also be recognised through interest income, by increasing the effective interest rate. This is achieved by an amendment of paragraph AG 8 of IAS 39. An issue that was discussed at some length at the board meeting to approve the amendments was how, in practice, to determine the new effective interest rate once the asset has been reclassified. The effective interest rate will depend on the level of cash flows expected, so higher expected cash flows will result in a higher effective rate. This calculation will necessarily be judgmental, but the amendment to paragraph AG 8 will reduce the effect on reported profit of changes in estimates, while the requirement to disclose the expected cash flows will provide information to users of the financial information as to how the judgment has been applied. If the instrument is reclassified as available for sale, any subsequent change in fair value (other than amortisation of interest at the new effective interest rate) from the fair value at the date of reclassification will be recorded in the available for sale revaluation reserve in equity (other comprehensive income) until the asset is derecognised or impaired. For any asset reclassified out of available for sale to held to maturity or loans and receivables, any gain or loss recorded in the revaluation reserve in equity will be amortised to profit through interest income over the asset s remaining life, until the asset is derecognised or impaired. Impairment There is no need to assess for impairment for a financial asset if classified as held for trading. However, once an asset is reclassified to loans and receivables, held to maturity or available for sale, it will subsequently need to be reviewed for impairment using the IAS 39 impairment rules for the category into which it is reclassified. If an asset that is reclassified as available for sale is deemed impaired, then any decline in fair value subsequent to reclassification will need to be recorded as an impairment loss. If an asset is reclassified from available for sale to held to maturity or loans and receivables, and it is subsequently considered impaired, then the cumulative gain or loss that was previously recorded in equity will need to be recognised immediately in profit or loss. Going, any asset reclassified to loans and receivables or held to maturity will need to be assessed for impairment not only individually, but also collectively. Embedded credit derivatives In February 2009, the IASB staff issued a Q&A on the IASB website providing guidance on another matter relating to credit derivatives: whether embedded credit derivatives in collateralised debt obligations (CDOs) not classified as at fair value through profit or loss need to be separated and accounted for separately under IFRS. The Q&A notes that subordination ( waterfall ) features generally do not result in the separation of an embedded credit derivative from the CDO. However, AG 30(h) of IAS 39, requires separation of embedded credit derivatives within CDO structures which do not hold the reference assets but, instead, create credit exposure to these assets using credit derivatives (such as credit default swaps). Accordingly, entities that reclassify CDO investments out of the fair value through profit or loss category must determine whether any related credit derivatives need to be separated. The IASB acknowledges that IFRS and US GAAP may treat these instruments differently due to different approaches to the assessment of embedded derivatives. However, it did not find cause to amend IFRS to harmonise with US GAAP as these inconsistencies will be addressed in the planned joint project on recognition and measurement of financial instruments. Hedge accounting It is probable that financial assets which are now being reclassified were, while recorded as held for trading, economically hedged for some of their risks, such as movements in LIBOR, by derivatives that were also recorded at fair value through profit or loss. Hedge accounting was not previously necessary to obtain consistency of measurement. While the assets could be reclassified as loans and receivables as of 1 July 2008, the hedging derivatives could not. Gains or losses on the derivatives will continue to be recorded in profit or loss subsequent to 1 July 2008 and these will not be offset by similar recorded gains or losses on the transferred assets. Hedge accounting cannot be applied retrospectively, so the derivatives can only be treated as hedges of the transferred assets for accounting purposes once the hedges have been documented and the hedge effectiveness demonstrated. Also, as the derivatives will no longer have a fair value of zero, it is probable that there will at least be some hedge ineffectiveness, especially for cash flow hedges, or they may fail the effectiveness test altogether. If an instrument is reclassified into held to maturity it is not eligible for hedge accounting for interest rate risk. 5

6 If the reclassification amendments are applied the disclosure requirements are substantial. Disclosures If the reclassification amendments are applied, the disclosure requirements are substantial. They are intended to permit a user of the financial statements to determine what would have been the accounting result had the reclassification not been made. The collection of this data will require the maintenance of parallel information, giving rise to additional effort for the entity. The disclosure requirements include: 1. The amount reclassified into and out of each category. 2. For each reporting period until derecognition, the carrying amounts and fair values of all financial assets that have been reclassified in the current reporting period and in previous reporting periods. 3. For financial assets reclassified in rare circumstances, the rare situation and the facts and circumstances indicating that it was rare. 4. In the reporting period when financial assets are reclassified, the fair value gains or losses on those assets recognised either in profit or loss or in other comprehensive income in that reporting period and in the previous reporting period. 5. Over the remainder of the instruments lives, the gains or losses that would have been recognised in profit or loss or other comprehensive income had they not been reclassified, together with the gains, losses, income and expenses now recognised. 6. As at the date of reclassification, the new effective interest rates and estimated amounts of cash flows the entity expects to recover. Implementation questions The following are some questions and answers on implementation which have arisen with respect to the amendments: Scope of the amendment Q1: Is it possible to apply the amendments to reclassify a financial asset which was originally classified as held for trading because it was part of a portfolio of identified instruments that are managed together and for which there is evidence of a recent actual pattern of short term profit-taking (paragraph (a) (ii) of the definition of held for trading)? A: A reclassification out of held for trading can only be made if the entity no longer has any trading intent with respect to that instrument. Therefore, despite the transition rules, reclassification is only possible from the date of cessation of trading intent. While this situation is not specifically referred to, we believe, in practice, that the amendments will be applied to such financial assets if they are no longer held with trading intent. Q2: Do the amendments apply to recognised loan commitments? A: Loan commitments that can be settled net in cash or by delivering or issuing another financial instrument are derivatives. The amendments only apply to nonderivative financial assets and so cannot be applied to a loan commitment. This means that any commitments to lend can only be reclassified as of the date the loans were drawn down, at the fair values of the loans on those dates. Effective date Q3: Was 31 October 2008 the last possible date on which it was possible to choose to reclassify a financial asset as of 1 July 2008? 6

7 A: Yes, all decisions to use the look back option to 1 July 2008 must have been made prior to 1 November 2008, as clarified in the October IASB Update. Q4: If financial assets were reclassified before 1 November 2008 on the basis of paragraph 50C of the amendments, because the entity no longer intended to sell the asset in the short term and there were rare circumstances, what were these circumstances and at what date should the reclassification be made? A: The answer to this question has several components: a) In many cases, it will be reasonably clear that the market was sufficiently disrupted for the trading circumstances to be considered rare before 1 July 2008, in which case the effective date of reclassification would be the later of 1 July 2008 and the date of change in intent to sell. b) It is possible that some markets only became seriously disrupted after 1 July, in which case it would not be possible to say that there were rare circumstances at that time. If this is the case, it may not be possible to determine exactly when the requirements of paragraph 50C were met, as the circumstances will have emerged over a period of time. Selecting the effective date for reclassification will require judgment and it is possible that different entities could form a different assessment. It would be expected that participants in particular markets will have similar views and that there will be local consensus on this issue. Entities will need to gather and document evidence to support their selected date. c) While it is possible that rare circumstances arose by different dates for different markets, it is unlikely that entities will be able to demonstrate evidence for different reclassification dates for different assets within the same market (unless there is a clear difference in intent). d) The amendments allow reclassification if there has been a change in intent and the circumstances are rare, but do not require the decision to be made immediately when these two criteria are met. Therefore, entities would be permitted to select a later reclassification date in order to reclassify all assets as at the same date, in order to reduce the practical of applying the amendment, provided that at the selected date of reclassification both criteria were still being met. In addition: i) It should be noted that there are two parts of the test: not only must there be rare circumstances (paragraph 50C) but also there must be no intent to sell the asset in the short term (paragraph 50(c)). It is possible that the entity was still seeking to sell assets even after the start of the rare circumstances and so reclassification would only be possible once this intent had changed. The date of change of intent might vary from one group of assets to another, but entities will need to have evidence of the change in intent, which may not be easy to obtain. ii) As clarified by the IASB, this will be an issue primarily where the decision to reclassify was made before 1 November On or after 1 November 2008, the assessment of rare circumstances must be made at the decision date. Q5: On 1 July 2008, an entity still intended to sell, in the near term, a financial instrument which was no longer quoted in an active market and so would otherwise have met the criteria to be reclassified as a loan and receivable in accordance with the new paragraph 50D. If the entity, subsequent to that date, changed its intention and decided to hold the asset for the foreseeable future, what is the appropriate date of reclassification? A: The date of change of intent. If that date was before 1 July 2008, the earliest reclassification date would be 1 July If the change of intent was later, then the date of reclassification would be that later date. Q6: Can an entity apply the look back option to reclassify a financial asset from held for trading as at 1 July 2008 if there have been active efforts to sell that asset since 1 July 2008 or sales since that date of similar assets? A: In order to reclassify as of 1 July 2008, the entity must demonstrate that the asset was no longer held with the intent to sell in the short term. In addition, if the asset is to be reclassified into loans and receivables, the entity must have no intention to sell the asset in the foreseeable future. Efforts to sell the asset or actual sales of similar assets are difficult to reconcile with the intent not to sell in the short term or in the foreseeable future. In any event, management should, in accordance with IAS 1, disclose any significant judgments made in this regard. Q7: If the entity had disclosed that a financial asset recorded as held for trading as at 30 June 2008 was fair valued by reference to quoted market prices (i.e., level 1 of the fair value hierarchy), can it subsequently be reclassified as of 1 July 2008? A: Yes, provided the conditions to reclassify are met. The reclassification amendmends do not require, as a prerequisite, the absence of an active market. Rather, they only require, for reclassifications to loans and receivables, a change in intent to sell and both the intent and ability to hold the instruments for the foreseeable future. Alternatively, instruments can be reclassified from held for trading to available for sale or held to maturity provided it can be demonstrated that: there has been a change in intent to sell the instrument; and that there are rare circumstances as described in paragraph 50B. 7

8 Foreseeable future is a more complex concept and will vary in duration, depending on circumstances. Normally it will be longer than the near term. Near term and foreseeable future Q8: Are near term and foreseeable future the same? A: Neither term is defined. Near term is a period of time, whose length might be interpreted differently by different entities but is likely to remain fixed. We have seen cases where it has been interpreted for individual entities to be a period as short as three months or as long as a whole year. Foreseeable future is even more difficult to interpret and will vary in duration depending on circumstances. Normally it will be longer than the near term but the two periods are not necessarily contiguous. This will be a matter of judgment. Each entity needs to determine how it will interpret these terms and it will usually be necessary to disclose how they are interpreted as part of the judgments made, in accordance with IAS 1. Q9: Can an entity assert that it intends to hold a financial asset for the foreseeable future if it is prepared to sell the asset on receipt of a reasonable offer? A: In general, no. To have the intent not to sell the asset in the foreseeable future, the entity should normally have an expectation that it will not consider any offers. While circumstances may change in future, the intent not to sell in the foreseeable future implies that there is no expectation that there will be a change in circumstances over this period of time. Transfers from available for sale Q10: If a financial instrument is reclassified from available for sale to loans and receivables should the amount recorded in equity also be reclassified out of equity? A: No, the negative revaluation reserve will remain in equity, to be amortised to profit or loss over the asset s life in accordance with paragraph 54 unless the asset is subsequently sold or deemed to be impaired, in which case, the balance is transferred to profit or loss. Effective interest rate Q11: How should the new effective interest rate (EIR) be determined on a financial instrument reclassified from available for sale to loans and receivables? A: Upon reclassification, a new EIR must be calculated so as to accrete the asset s fair value as at the date of reclassification to the expected level of cash flows to be received. If the asset is not considered to be impaired, the cash flows should not include future credit losses and the EIR will be equivalent to the market yield as of the date of reclassification. This is also the EIR that is required to be disclosed by paragraph 12A(f) of the amendments. If the asset is regarded as impaired when reclassified, then the expected cash flows will reflect the expected recoveries and so the EIR will be lower than the yield determined by the market. If, subsequent to reclassification, the asset is deemed to be impaired, then the new EIR calculated as of the date of reclassification will be used to discount the expected cash flows in order to calculate impairment losses. As mentioned in the response to question 11, the amount previously recorded in equity for the revaluation of the asset will also be amortised to profit or loss over the remaining life of the asset. While this amortisation will normally be recorded in interest income, it will not form part of the EIR. If in the future the asset is deemed to be impaired and any deficit in equity 8

9 relating to the asset is transferred directly to profit or loss, this will be in addition to any impairment loss as calculated in the previous paragraph. Transfers to loans and receivables Q12: What happens if the market for a financial asset reclassified to loans and receivables in accordance with paragraph 50D or 50E becomes active again subsequent to reclassification? In particular, if the asset is again quoted in an active market, or the entity resumes its intent to sell the asset in the foreseeable future (and so it no longer meets the criteria contained in the definition of loans and receivables), is it necessary or permitted to reclassify the asset to another category, such as held for trading, available for sale or held to maturity? A: It is clear that it is not permitted to transfer any asset into the held for trading or designated at fair value categories subsequent to initial recognition. It is not clear whether the amended IAS 39 either requires or permits reclassification out of loans and receivables to available for sale or held to maturity, if the asset once again becomes quoted or is held with an intent to sell in the foreseeable future. It is our view that until this issue is addressed by the IASB, entities have a choice whether or not to reclassify assets previously transferred to loans and receivables when they no longer meet the criteria set out for that category. This choice of policy should be applied consistently for all assets and should be disclosed. This issue is equally applicable to financial assets that were originally classified as loans and receivables and is not restricted solely to those that have been reclassified. Q13: Upon reclassification of a financial asset to loans and receivables, should it be tested for impairment? A: The fair value of the asset as at the date of reclassification will become its new and no further impairment losses will normally need to be provided as of that date. However, subsequent to the date of reclassification, the entity will need to assess whether there is objective evidence of impairment as required by IAS 39. It should be noted that any asset recorded at amortised must be assessed for impairment individually (unless it is individually insignificant) and, if not individually impaired, also on a collective basis. It is possible that, for a portfolio of assets transferred from available for sale to loans and receivables, an allowance may be needed for impairment based on a collective assessment, even if none of the assets is individually deemed to be impaired. It is unclear whether it is necessary to make such an assessment on reclassification if so, there could be a need to transfer some of the loss previously recorded in equity to profit or loss. This is not a new problem: it would have also been applicable for transfers from available for sale to held to maturity in the past. Until this issue is clarified by the IASB, it is our current view that the assets once reclassified are treated as if newly originated, in which case no immediate impairment should be recorded. Impairment Q14: Upon reclassification of an available for sale debt instrument into loans and receivables does an entity need to individually assess the instrument for impairment if the entity has previously done so before reclassification, or can just a collective assessment be made? A: The fact that an entity assesses impairment on a collective basis, on the grounds that the reclassified financial assets are now deemed not to be individually significant, does not allow it to avoid recycling its revaluation reserve to profit or loss. Paragraph 64 of IAS 39 states that an entity first assesses whether objective evidence of impairment exists individually for financial assets that are individually significant, and individually or collectively for financial assets that are not individually significant. The amount transferred to profit or loss must be similar whatever the method that is used to calculate impairment. As a result, impairment is normally assessed on an individual basis, as before. Hedge accounting Q15: Is an entity able to start to hedge account for risks of an asset at the date of reclassification even though the reclassification was made with retroactive effect? A: Hedge accounting is only allowed from the date that the hedge relationship meets the criteria set out in IAS 39. Applying hedge accounting with retroactive effect is not allowed because the hedge relationship would not have been adequately documented and the effectiveness of the hedge would not have been tested before hedge accounting was applied. Q16: Should an entity re-document a hedge relationship if the hedged asset is reclassified from available for sale to loans and receivables? A: Not necessarily, but this will depend on how specific the hedge documentation was at the date of reclassification. 9

10 Examples of applying the reclassification amendments Example 1: Reclassification from trading into loans and receivables (with no impairment) On 30 September 2007, Bank A originates a 6%, 5 year loan for 100 million with the intention to syndicate 80% after origination. At the date of origination it therefore classifies 80% of the loan as held for trading and the other part (20%) as loans and receivables (the loan is not quoted in an active market). Due to the current market situation, the syndication fails and the loan is retained by the bank, with the intention to hold it for the long term. By 30 June 2008, the part of the loan that was classified as held for trading (80%) decreased in fair value to 65 million. On 25 October 2008, using the amendment, the bank reclassifies the part of the loan recorded as held for trading to loans and receivables in its third quarter financial statements, as of 1 July Its amortised is recorded at 65 million. At that date, the bank estimates that it will recover all the contractual cash flows on the loan (i.e., with no impairment). The contractual cash flows are as follows: Coupon 30 September September September September September Principal The EIR that exactly discounts these future cash flows to the fair value of the loan at the date of reclassification is 13.5%. This new EIR is then used to amortise the difference between the amortised of the loan at the date of reclassification and the redemption value until the maturity date. Accordingly, the amortised will accrete as follows: Period end* brought Interest income at 13.5% Coupon Difference recorded in amortised 30 September September September September September carried = 80 x 6% = 65 x 13.5% x 3/12 (from 1 July to 30 September) = 62.3 x 13.5% = 65.9 x 13.5% = 70 x 13.5% = 74.7 x 13.5% * The period ending 30 September 2008 represents three months. All other periods in this table are 12 months. 10

11 Example 2: Reclassification from trading into loans and receivables (with impairment) On 30 September 2007, Bank A acquired a 6%, 5-year bond that was originally quoted in an active market. The bond was acquired at its par value of 80 million and its maturity date is 30 September The bond was held for trading purposes and was classified accordingly as held for trading. Period end* brought Interest income at 19.6% Coupon Difference recorded in amortised 30 September September September September September carried By 30 June 2008, the market is no longer active and the fair value of the security has declined to 35 million. This is because principal and interest are no longer expected to be fully recovered, and the market rate for an instrument with similar risk characteristics is significantly higher than the security s coupon. The bank now intends to hold the bond in the foreseeable future. On 30 September 2010, the bank still expects not to receive the interest payments, but now expects to recover 100% of principal (i.e., 80 million). According to revised IAS 39 paragraph AG8, the bank should not write up the recorded value of the bond but, instead, should revise the EIR. The revised EIR that exactly discounts the revised expected future cash flows to the current amortised of the bond ( 52.4 million) is 23.6%. This new EIR is then used to amortise the residual difference between the amortised of the bond and its expected redemption value until the maturity date. Accordingly, the amortised will accrete as follows: On 25 October 2008, using the amendment, the bank reclassifies the bond to loans and receivables in its third quarter financial statements, as of 1 July Its amortised is recorded at 35 million. At that date, the bank estimates that it will receive no interest and just 75 million of principal repayment at maturity date. Period end brought Interest income at 23.6% Coupon Difference recorded in amortised 30 September September carried The EIR that exactly discounts these expected future cash flows to the fair value of the bond at the date of reclassification is 19.6%. This new EIR is then used to amortise the difference between the amortised of the bond at the date of reclassification and its expected redemption value until the maturity date. Accordingly, the amortised will accrete as follows: = 35 x 19.6% x 3/12 (from 1 July to 30 September) = 36.6 x 19.6% = 43.8 x 19.6% = 52.4 x 19.6% = 62.7 x 19.6% = 52.4 x 23.6% = 64.7 x 23.6% * The period ending 30 September 2008 represents three months. All other periods in this table are 12 months. 11

12 It is currently unclear whether the prepayment option would need to be separated and recorded at fair value through profit or loss. Example 3: Reclassification from trading into available for sale In June 2006, Bank A purchased a cash CDO (i.e., a collateralised debt obligation in which the SPE which issues the security is required to hold the underlying reference assets, rather than derivatives referenced to those assets) with a 2020 maturity date at its par value of Euro 100 million. The CDO was held for trading purposes and was classified accordingly as held for trading. By June 2008, the CDO had declined in fair value to 75 million and was no longer traded in an active market. Consequently, the bank determines that it no longer has the intent to trade the CDO. On 25 October 2008, using the amendment, the bank reclassified the CDO to available for sale as of 1 July The CDO is reclassified at its fair value at that date ( 75 million) and will be subsequently remeasured at fair value with any change in fair value recorded in the available for sale revaluation reserve (except for amortisation through the effective interest rate) until the CDO is impaired or derecognised. The EIR is determined using the method described in examples 1 and 2. The EIR is the rate that exactly discounts the expected future cash flows (with the expected maturity date) to the fair value of the CDO at the date of reclassification. This EIR is used to amortise the difference between the fair value of the CDO at the date of reclassification and the expected redemption value at the expected maturity date. Although the legal maturity of the CDO is 2020, the CDO could mature earlier if the underlying assets prepay earlier. It is currently unclear whether the prepayment option would need to be separated and recorded at fair value through profit or loss. Example 4: Reclassification from available for sale into loans and receivables In June 2006, Bank A purchased a cash CDO with a 2020 maturity date at its par value of 100 million. The CDO is classified as available for sale. By June 2008, the CDO has declined in fair value to 75 million and is no longer traded in an active market. The bank has determined that it intends to hold the CDO for the foreseeable future. On 25 October 2008, using the amendments, the bank reclassified the CDO into loans and receivables as of 1 July Its amortised was recorded at 75 million (the fair value of the CDO at the date of reclassification). At that date, the bank estimated that it would recover all the contractual cash flows on the CDO (i.e., with no impairment) with an expected maturity in June The contractual cash flows are as follows: 30 June June June (...) 6 Coupon 30 June Principal The EIR that exactly discounted these future cash flows to the fair value of the CDO at the date of reclassification was 12.10%. This new EIR was then used to amortise the difference between the amortised of the CDO at the date of reclassification and the redemption value until the expected maturity date. Accordingly, the amortised will accrete as follows: 16 6 = 100 x 6% 12

13 Period end brought Interest income at 12.10% Coupon Difference recorded in amortised 30 June June June June June June carried The negative available for sale revaluation reserve of 25 million was frozen at the date of reclassification and will be amortised to profit or loss over the remaining life of the CDO. As a result, it will be debited to profit or loss as follows: Period end AFS revaluation reserve brought Amortisation of AFS revaluation reserve in profit or loss 23 AFS revaluation reserve carried Interest income at 12.10% 30 June 2009 (25) (3.1) (21.9) June 2010 (21.9) (3.4) (18.5) June 2011 (18.5) (3.9) (14.6) June 2012 (14.6) (4.3) (10.3) June 2013 (10.3) (4.9) (5.4) June 2014 (5.4) (5.4) Net interest income On 30 June 2011, the bank estimates that the CDO is now impaired. It expects that it will no longer receive any coupon and that only 80% of principal amount will be recovered (i.e., 80 million). According to paragraphs 54(a) and 67 of IAS 39, Bank A recycles all of the residual AFS revaluation reserve to profit or loss. Additionally, it records an impairment loss measured as the difference between the CDO s carrying amount and the present value of estimated future cash flows discounted at the CDO s revised EIR (i.e., the EIR determined at the date of reclassification) = 75 X 12.10% = 78.1 x 12.10% = 81.5 x 12.10% = 85.4 x 12.10% = 89.7 x 12.10% = 94.6 x 12.10% 23 The amortisation of the AFS reserve equals the difference between the interest income calculated using the effective interest method and the coupon received on the CDO. 13

14 The present value of the expected future cash flows discounted using the EIR determined at the date of reclassification (12.10%) is 56.8 million. The total impact on profit or loss is as follows: Amortisation of AFS revaluation reserve in profit or loss Impairment loss on the CDO 30 June 2011 (14.6) (28.6) 24 (43.2) The amortised of the CDO will then accrete as follows: Period end brought Interest income at 12.10% Coupon Total impact on profit or loss Difference recorded in amortised 30 June June June carried Following the impairment, the net amount recorded in profit or loss is only the interest income recorded using the EIR of 12.10% since the entire AFS revaluation reserve has already been recycled to profit or loss. Example 5: Reclassification from available for sale into held to maturity The assumptions used are the same as in example 4 except that, on 25 October 2008, the bank decides to reclassify the CDO as held to maturity based on its intent and ability to hold the CDO until maturity and there is still an active market for CDOs. On 25 October 2008, the fair value of the CDO was 60 million. According to paragraph 54 of IAS 39, the reclassification is only effective prospectively, starting on 25 October Accordingly, the decrease in fair value between 1 July 2008 and 25 October 2008 ( 15 million) must be recognised as an unrealised loss in the AFS revaluation reserve (assuming, as before, that the asset is not considered to be impaired) and the amortised of the CDO at the date of reclassification is 60 million. Following the reclassification on 25 October 2008, the CDO should be accounted for in a similar manner to that shown in example 4. The bank appreciates that it may not sell the CDO without tainting the entire held to maturity portfolio. 24 (28.6) = (Present value of expected future cash flows discounted at 12.10% less amortised carried on 30 June 2011 (before impairment)) = 56.8 x 12,10% = 63.7 x 12.10% = 71.4 x 12.10% 14

15

16 Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is is a a global leader in in assurance, tax, transaction and advisory services. Worldwide, our 130, ,000 people are united by by our shared values and an an unwavering commitment to to quality. We make We make a difference a difference by helping by helping our people, our our people, clients our and clients our wider and our communities wider achieve communities potential. achieve their potential. For more information, please visit Ernst & Young refers to to the global organization of of member firms of of Ernst & Young Global Limited, each of of which is is a a separate legal entity. Ernst & Young Global Limited, a a UK company limited by by guarantee, does not provide services to to clients. About Ernst & Young s International Financial Reporting Standards Group The move to to International Financial Reporting Standards (IFRS) is is the single most important initiative in in the financial reporting world, the impact of of which stretches far beyond accounting to to affect every key decision you make, not just how you report it. it. We have developed the global resources people and knowledge to to support our client teams. And we work to to give you the benefit of of our broad sector experience, our deep subject matter knowledge and the latest insights from our work worldwide. It s how Ernst & Young makes a a difference EYGM Limited. All Rights Reserved. EYG no. AU0247 In line with Ernst & Young s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.

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