IFRS 9 NEW ACCOUNTING MODEL FOR FINANCIAL INSTRUMENTS

IFRS 9 - NEW ACCOUNTING MODEL FOR FINANCIAL INSTRUMENTS (Replacing IAS-39) Hasan Marfani December 2018 1

Agenda � Background � Reasons of IFRS 9 for Replacement of IAS-39/Key Elements � Overview of Classification and Measurement Requirements � IFRS 9 Credit Impairment Overview � Key Judgments and Challenges related to IFRS 9 implementation � Impact on Modaraba/Leasing Sector By Hassan Marfani, ACA 2

Background On 24 July 2014, the International Accounting Standards Board (IASB) issued the final version of IFRS 9. As per IASB, IFRS 9 is effective for accounting periods beginning on or after 1 January 2018. SECP has already adopted IFRS with effective date of 01 July 2018. . By Hassan Marfani, ACA 3

Reasons for replacement of IAS-39 - Cont… � The criticism on IAS-39, in brief : ► ► ► Fair value accounting was said to have created cycles of accounting write downs and distressed selling of assets during the Crisis The application of IAS-39 impairment model for loan loss provisions results in delayed recognition of credit losses The over complexity of IAS-39 such as mined valuation models, multiple impairment approaches, complicated category transfer rules and hedge accounting requirement. By Hassan Marfani, ACA 4

Reasons for replacement of IAS-39 - Cont… ► ► In view of above criticism, IASB received calls to reduce the complexity of accounting standards for financial instruments from G-20, the Financial Stability Board, the European Union and regulators and other stakeholders from around the world. The work on IFRS 9 started in 2009 and after 5 years of extensive technical work and stakeholders consultations, the final standard was issued in July 2014. By Hassan Marfani, ACA 5

IFRS-9 – Classification and Measurement of financial instruments By Hassan Marfani, ACA 6

By Hassan Marfani, ACA 7

By Hassan Marfani, ACA 8

Classification of Financial Assets 1. Fair Value through P/L 2. Fair Value through OCI 3. Amortized Cost (AC) Types of Instruments Debt Instrument Equity Instrument Note FV through P/L Note FV Through OCI Note Amortized Cost Note 3 yes Note 2 Yes Note 1 Yes Note 4 Yes Never Note 1 1. Business model: Hold to collect (sole purposes is to earn interest and then in end principal) & 2. cashflows are SPPI(sole principal payment and interest)- Important note: return must not be linked to performance of the entity Note 2 1. Business model: Hold to collect (sole purposes is to earn interest and then in end principal) & Sale & 2. cashflows are SPPI(sole principal payment and interest)- Important note: return must not be linked to performance of the entity Note 3 1. Business model: Hold to Sale & 2. cashflows are SPPI(sole principal payment and interest)- Important note: return must not be linked to performance of the entity Note 4 Only if company has initially designated the instrument at FV through OCI, however it is irrevocable option and all the gains/losses shall By Hassan Marfani, ACA 9 be routed through OCI except for Dividend income

Summary Of Financial Assets Amortized Cost F. V through OCI F. V through P/L Hold to Collect Hold to collect and Sell Hod to sell Cashflows SPPI No condition Categories Only debt securities Debt and equity Securities FV + TC FV Amortized Cost Fair Value Change in FV N/A OCI P/L Recycling of gains N/A Only debt securities N/A Can be impaired N/A Business Model Initial Measurement Subsequent measurment Impairment By Hassan Marfani, ACA 10

Classification of Financial Liabilities 1. Fair Value through P/L 2. Amortized Cost By Hassan Marfani, ACA 11

IFRS-9 Classification and Measurement – Un-quoted Equity Instruments ►No cost exemption for unquoted equity instruments all equities at fair value ►Cost may be used as a proxy for fair value in certain circumstances ►Indicators of when cost might not represent fair value § § § § A significant change in the performance of the investee Changes in expectation that technical milestones will be achieved A significant change in the market for the investee company or its products A significant change in the global economy or the economic environment A significant change in the observable performance of comparable companies, or in the valuations implied by the overall market. Internal matters such as fraud, commercial disputes, or litigation, or changes in management or strategy. Evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties. By Hassan Marfani, ACA 12

IFRS-9 Classification and Measurement – Debt Instruments (Cont…) Business Model Test ► In some cases, an entity may have more than one business model, in which case, the assessment would be made at a portfolio level rather than an entity level. ► Is a matter of fact and not management intention. ► Reclassifications of portfolio is not allowed unless there is a change in business model By Hassan Marfani, ACA 13

Reclassification of Financial Assets-b/w Categories-AC, FVOCI, FVP/L AC AC N/A FVTOCI FV at reclassification date becomes its new ACCA, cumulative gain/loss in OCI is adjusted against FV of FA at reclassification date. IRR does not change. (In short bring asset to amortized cost again as per original table) From FVTPL To FVTOCI FV is measured at reclassification date. Difference from amortized cost should be recognized in OCI. IRR not adjusted as a result of reclassification N/A FV at reclassification date becomes its nw FV at reclassification gross CA. New IRR is date becomes its calculated CA. New IRR is calculated By Hassan Marfani, ACA FVTPL FV is measured at reclassification date. Difference from CA should be recognized in P/L. IRR is adjusted as a result of reclasssification FV at reclassification date becomes its new CA. Effective intrest rate is changed, Cumulative gain/loss on OCI is reclassified to profit or loss at reclassfication date N/A 14

Impairment of Financial Assets Under IFRS 9 By Hassan Marfani, ACA 15

Background In response to the reporting issues highlighted by the Global Financial Crisis, a Financial Crisis Advisory Group (FCAG) was setup in October 2008 The objective of FCAG was to advice IASB and US FASB to bring improvements in the financial reporting standards that could enhance investor confidence in the financial markets The FCAG, in its report published in July 2009, identified delayed recognition of loan losses as one of the primary weaknesses in the accounting standards and recommended to explore alternatives model which is more forward looking By Hassan Marfani, ACA 16

Incurred Loss Model under IAS-39 Interest income is recognized over the period of the loan on the basis of contractual cash flows (Effective interest method) Impairment is recognized only when there is a objective evidence of impairment i. e. when a loss event has occurred It may argued that interest income is overstated in periods before a loss event occurs because it is inherent in the nature of assets that certain credit losses will occur By Hassan Marfani, ACA 17

Expected Loss Model of IFRS 9 The impairment requirements applies to debt instruments such as loans, debt securities, bank deposits, lease receivables, loan commitments and financial guarantee contracts. Under the expected loss model impairment is recognized over the life of assets on the basis of future expected loss events In other words, impairment allowance is made even before there any objective evidence of impairment or occurrence of default event The scope of impairment requirements, therefore is much broader and are designed to result in earlier recognition of credit losses This model will potentially address the concerns about IAS 39 incurred loss model i. e. too little and too late By Hassan Marfani, ACA 18

Overview of Expected Loss Model of IFRS 9 3 stage model which recognizes impairment over time based on changes in credit quality since origination of loans Stage 1 Stage 2 Stage 3 Performing Underperforming Non-performing Loans with low credit risk and with no significant increase in credit risk since origination Loans for which credit risk has increased significantly since initial recognition Loans with objective evidence of impairment 19

IFRS 9 Credit Impairment Overview The key change brought by IFRS 9 is in relation to the accounting provisions for loan losses which are required to be made using expected loss model under the IFRS 9. Currently, loan loss provisions are made when there is an objective evidence of impairment (i. e. incurred loss model). This is a fundamental shift in provisioning.

IFRS 9 Credit Impairment Overview The credit risk has increased significantly since initial recognition improvement deterioration Stage 1 Allowance: Criterion: Interest revenue based on: 12 -month expected credit losses Gross carrying amount Stage 2 Stage 3 Lifetime expected credit losses + Objective evidence of impairment Gross carrying Gross amount Net carrying amount If no reasonable expectation of recovery – Write off

IFRS 9 Credit Impairment Overview Staging Approach Information to take into account for assessment of increased credit risk Changes in external market indicators – price of borrower debt or equity Adverse changes in business or economic conditions Changes in internal price indicators and credit ratings downgrade Changes in external credit ratings Internal watch-list accounts Changes in the value of collaterals and repayment behaviour Changes in operating results 30 days past due rebuttable presumption However…. By Hassan Marfani, ACA

IFRS 9 Credit Impairment Overview Expected Credit Loss 2 1 3 ECL = PD x LGD x EAD Risk Parameters 1 PD • The probability of defaulting if you haven’t already 2 LGD • The forecasted economic loss if the default happens • Discount factor (EIR) By Hassan Marfani, ACA 3 EAD • The forecasted exposure at each point in time

IFRS 9 Credit Impairment Overview Steps Involved Step 1 Portfolio Segmentation and Staging Step 2 Determinatio n of Exposure at default (EAD) Step 3 Step 4 Determination of segment wise PDs Estimation of LGD By Hassan Marfani, ACA Step 5 Computation of ECL and Scenarios

Key Challenges Exposure at Default (EAD): ► ► Probability of Defaults (PDs) ► ► Loss Given Default (LGD): ► ► ► Revocable and Irrevocable commitments Credit Conversion Factors Estimation Behavioral analysis of revolving facilities Lack of availability of historical data of 5 to 7 years Determination of statistically significant relationship between Macro-economic factors and defaults ratio Economic LDG rather than collateral based LGD Lack of availability of historical recovery data for credit portfolio to compute workout LGD Allocation of collateral amongst facilities Discounting of future cash flows By Hassan Marfani, ACA

Implementation Challenges Components Implementation challenges ► Determine segmentation criteria ► Consider existing models and data availability for various portfolios ► Criteria for low credit risk Transfer criteria ► Definition of trigger events ► Significant deterioration in credit Expected loss modeling ► Determination of models for 12 month and lifetime expected loss ► Discount rate ► Internal data (internal credit ratings, historical loss experiences) ► External data – Macro economic statistics and credit ratings ► Update of internal data used for credit risk management regularly Portfolio segmentation Sources of information By Hassan Marfani, ACA

Challenges for Modaraba and/or Leasing Sector while adopting IFRS-9 1. 2. Since recycling of Gain for equity instruments is not allowed under FV through OCI category, realized gain will not be distributed to certificate holders. Impairment model as suggested in IFRS-9 uses proactive approach which has more inclination towards risk assessment side, historical data and economic indicators which create following challenges for Modaraba/leasing sector: I. II. Lack of Human Resource with relevant expertise Dealing of Modaraba/leasing sector in SME sector posing risk of non availability of relevant data for assessment of credit risk III. Categorizing any financing as stage 1 or 2 is always a subjective matter raising difference of opinions b/w Mgt. and auditors IV. Cost Constraints V. Initial impact on profitability By Hassan Marfani, ACA 27