Advanced financial accounting - Riassunti

FINANCIAL INSTRUMENTS

Introduction – Financial Instruments Area

Financial Instruments (FIs): wide, complex and delicate area of Financial Statements, with frequent relevant changes in IFRSs and regulation.

IFRSs on Financial Instruments have general application that all entities must comply, no matter in which industry they operate.

For Banks, Financial institutions and Insurance companies the rules on FIs are particularly relevant, because of the importance and weight of FIs in their core business.

Hence, there is an especially strong need to develop Financial Statements solutions both IFRSs compliant and, at the same time, efficient due to their structure and characteristics.

THIS IS A STRATEGIC ISSUE: with direct and often relevant impact on their key financials both of performance and financial structure/regulatory capital

Current IFRSs standards on Ifs

With IFRS 9 (that regards Financial Instruments) now in force, an important change is taking place.

From the IAS 39 to IFRS

9:IAS 39 era in vigore fino al 2017 ed è ora stato sostituito da IFRS 9. IAS 39 era molto razionale nella sua struttura, ma la sua applicazione era troppo complessa: l'IASB ha avviato un processo a lungo termine per migliorare e semplificare le regole. La crisi finanziaria globale del 2008 ha generato problemi più ampi e molto più critici delle aspettative, producendo sia misure urgenti che un aumento della necessità di riformare l'ambito generale delle regole. Il processo ha impiegato 9 anni per diventare efficace, ottenendo l'approvazione da parte dell'EY e preparando le entità all'adozione. I cambiamenti sono stati apportati tenendo presente che i mercati sono diventati illiquidi e inattivi (a causa della crisi). I principali cambiamenti sono stati: - È stato consentito effettuare alcune modifiche nella classificazione: le entità potevano classificare in una classe di valutazione meno volatile dello Stato Patrimoniale vari Attività Finanziarie precedentemente classificate nelle classi sotto le regole di valutazione al Fair Value, con l'effetto di ridurre l'impatto della crisi sul Reddito (o su Altri Componenti del

Income) and Equity for entities owning relevant portfolios of financial assets particularly exposed in terms of prices and/or liquidity

Financial Instruments

IFRS 9 applies to:

• Financial Assets (left side of the Statement of Financial Position)
• Financial Liabilities
• Hedge Accounting

It sets articulate rules for:

• Recognition/Derecognition (recognition is the moment in which we write the financial asset into our account, derecognition is the moment in which we remove the financial asset from our account)
• Classification/Reclassification (classification gives information about what are the aims of the entity which has invested in the financial assets)
• Measurement/Impairment (measurement are the rules in ordinary situations and impairment are the valuations when there are losses in value)

The former classification of Financial Assets was in 4 classes:

• FVTPL: Financial Assets at Fair Value Through Profit and Loss
• HTM: Held to Maturity Investments
• L&R: Loans and Receivables
• AFS:

Available for Sale The current classification is less complex and has 3 classes: - At Amortised Cost (amortised doesn't mean the depreciation concept, but a financial technique through we measure the changes in value) - At Fair Value Through Other Comprehensive Income (FVTOCI): we use the Fair Value, but the changes in Fair Value are written in the Other Comprehensive Income section - At Fair Value Through Profit or Loss (FVTPL): changes in Fair Value impact directly into the Net Income or Net Loss For classification it is important to consider if we are dealing with: - Debt instruments - Equity instruments Debt Instruments can be handled with 3 possible treatments: - At Amortised Cost, if two criteria are both met: - Business Model: the aim of the entity investing in the instruments has to be "Held to Collect", we hold the instrument to collect the cash flows (it is a subjective requirement) - Contractual Terms: the terms have to comply with the SPPI – SolelyPayments of Principal and Interest (objective requirement) - at FVTOCI if two criteria both met: - Business Model: the aim of the entity has to be "Held to Collect and Sale", we hold the instrument to collect the cash flows and to sell them if it is profitable (subjective requirement) - Contractual Terms: the terms have to comply with the SPPI (objective requirement) - at FVTPL - If above criteria are NOT met - Or if the debt instrument has been designated (irrevocably) at recognition in order to avoid a measurement or recognition inconsistency ("accounting mismatch"): asymmetry or inconsistency in accounting treatment in the financial statements of related groups of assets and liabilities We have an example considering insurance companies investing in bonds: on the left side of the Statement of Income we have a stable valuation of the bonds and on the other side we would have a very updated information on risk (because insurance liabilities are related with the riskiness of).

insurance contracts, so the tendence of IFRS is incorporating current information of the risk outstanding).

In this case we would have an accounting mismatch and we could decide to shift to the valuation of assets though FVTPLEquity Instruments can be handled with 2 possible treatments:

• At FVTPL
• In some cases, at FVTOCI, by irrevocable choice at initial recognition

AMORTIZED COST

Let's focus on the amortized cost class: this class is valued with a technique that tries to measure the progressive accrual of interest during time.

1° condition - Business Model

It is necessary to evaluate if the asset is owned within a business model whose objective is Held To Collect: so the aim is to hold the assets in order To collect contractual cash flows over the life of the instrument

The business model:

• is a critical factor for classification
• is decided by the key managers of the entity
• CANNOT be applied to a single financial asset
• CAN be applied to a group

(portfolio) of financial assets

This HTC assets can be sold and, if the sale occurs, classification doesn’t change only if it doesn’t impact on the business model.

Examples of sales of the HTC assets:

• The financial asset no longer meets the entity’s investment policy (ex. rating of the financial asset drops under the entity’s policy-permitted minimum level)
• The entity wants to reduce risk concentration
• An insurance company wants to make adjustments in the investment portfolio to reflect a change in expected duration (timing of payouts)

When more than an infrequent number of sales takes place:

• It is necessary to assess whether sales are consistent with the objective of collecting contractual cash flows
• For instance: the objective is not met if sales indicate that a group of financial assets is held in an actively managed portfolio, in order to maximize return exploiting market changes
• Specific disclosures are required

2° condition -

Contractual Terms

Contractual cash flows of the financial asset must be composed only:

• by payments of principal and interest on the outstanding amount of debt
• in the currency in which the asset is issued (no embedded exchange risk exposure)

In order to check if the instrument has these features, we have to run the SPPI test (Solely Payments of Principal and Interest)

Any "leveraged" financial asset CANNOT be classified in the "at Amortized Cost" class, because its features can increase variability of contractual cash flows. Examples:

• Interest rate options, Futures, Forwards, Swaps on fixed-income securities
• Fixed interest rate bonds with principal repayment linked to a stock exchange index

We have an exception: debt instruments indexed to inflation (both for payment of interest and repayment of principal) CAN be classified in "at Amortized cost" class: inflation adjustments relate to time-value of money. Of course, link to inflation

must not be leveraged

Any particular or complex financial instrument must be analysed specifically, applying and interpreting general rules

MEASUREMENT OF FINANCIAL ASSETS

Measurement implies to two strongly related issues:

• Valuation: determination of the carrying amount of a Financial Asset in the Statement of Financial Position
• Accounting treatment: the way in which changes in values of Financial Assets are recorded in the Financial Statements, that is whether gains and losses on Financial Assets should be included in:

Profit or Loss

Other Comprehensive Income (and through it in Equity)

or recognized directly in Equity (N.B: currently not admitted)

The valuation of Financial Assets at initial (first) recognition ("at inception"):

• Must be always at Fair Value
• In case of Financial Assets not at FVTPL, value can be increased of Transaction Costs directly attributable to the acquisition of the Financial Asset

Important: overhead costs (general and

administrative costs) shall NOT be considered The valuation of Financial Assets subsequent to first recognition depends on their classification:

• At Amortized Cost: we value only Debt Instruments meeting both conditions:
  • business model
  • contractual terms
• At Fair Value: we value
  • Equity
  • Stand-alone Derivatives
  • Debt Instruments: HTCS or not meeting both conditions for Amortised or HTCS; or if designated at recognition

If a Financial Asset has a negative fair value (ex. a stand-alone derivative), it is recognized as a liability Amortized Cost Valuation Method Valuation steps:

1. Calculate effective interest rate of the Financial Asset. The value of the initial cash flow outflow will be equal to the present value of the future cash inflows produced by the financial asset this is the effective interest rate
2. Apply effective interest rate to amortized cost and calculate interest income accrued during the period
3. The amortised cost of the Financial Asset is increased/decreased of the

rom an investment equals the Present Value of Cash outflows required for the investment. In this case, the cash inflows are the interest payments received annually, and the cash outflows are the initial purchase price of the instrument. To calculate the effective interest rate, we need to find the rate that makes the present value of the cash inflows equal to the present value of the cash outflows. The formula to calculate the present value of a cash flow is: PV = CF / (1 + r)^n Where PV is the present value, CF is the cash flow, r is the interest rate, and n is the number of periods. Using this formula, we can calculate the present value of the cash inflows and the present value of the cash outflows. The present value of the cash inflows is calculated as follows: PV inflows = 59.05 / (1 + r)^1 + 59.05 / (1 + r)^2 + 59.05 / (1 + r)^3 + 59.05 / (1 + r)^4 + 59.05 / (1 + r)^5 The present value of the cash outflows is simply the initial purchase price of the instrument, which is 1,000. To find the effective interest rate, we need to solve the equation: PV inflows = PV outflows 59.05 / (1 + r)^1 + 59.05 / (1 + r)^2 + 59.05 / (1 + r)^3 + 59.05 / (1 + r)^4 + 59.05 / (1 + r)^5 = 1,000 By solving this equation, we can find the effective interest rate.