Financial Instruments

MFRS 9 & MFRS 132 & MFRS 7

Financial Instruments
Definitions of Financial Instruments
Financial Instruments : A contract that gives rise to a financial assets of one
entity and a financial liability or equity instrument of another entity.

Examples:
• Shares (Ordinary shares, preference shares) – FA & Equity
• Debentures (Loan notes, Loan stock) – FA & FI
• Derivatives (Futures, Forwards, Options, Swap)

Tax payable – Not Financial Instruments due to no contract.

Definitions of Financial Instruments - SWAP
Interest Rate Swap
• Let’s say Mr. X owns a $1,000,000 investment that pays him LIBOR + 1% every month.
LIBOR stands for London interbank offered rate and is one of the most used reference
rates in case of floating securities. The payment for Mr. X keeps changing as the LIBOR
keeps changing in the market. Now assume there is another guy Mr. Y who owns a
$1,000,000 investment that pays him 1.5% every month. The payment received by him
never changes as the interest rate assumed in the transaction if fixed in nature.
• Now Mr. X decides that he doesn’t like this volatility and would rather have fixed interest
payment, while Mr. Y decides to explore floating rate so that he has a chance of higher
payments. This is when both of them enter into an interest rate swap contract. The terms
of the contract state that Mr. X agrees to pay Mr. Y LIBOR + 1% every month for the
notional principal amount $1,000,000. In lieu of this payment, Mr. Y agrees to pay Mr. X
1.5% interest rate on the same principal notional amount. Now let us see how the
transactions unfold under different scenarios.
Definitions of Financial Instruments - SWAP
Interest Rate Swap
• Scenario 1: LIBOR standing at 0.25%
• Mr. X receives $12,500 from his investment at 1.25% (LIBOR standing at 0.25% and plus 1%). Mr. Y
receives the fixed monthly payment of $15,000 at 1.5% fixed interest rate. Now, under the swap
agreement, Mr. X owes $12,500 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions
partially offset each other, the net transaction would lead Mr. Y to pay $2500 to Mr. X.

• Scenario 1: LIBOR standing at 1.00%

• Mr. X receives $20,000 from his investment at 2.00% (LIBOR standing at 1.00% and plus 1%). Mr. Y
receives the fixed monthly payment of $15,000 at 1.5% fixed interest rate. Now, under the swap
agreement, Mr. X owes $20,000 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions
partially offset each other, the net transaction would lead Mr. X to pay $5000 to Mr. Y.
• So, what did the interest rate swap did to Mr. X and Mr. Y? The swap has allowed Mr. X a
guaranteed payment of $15,000 every month. If LIBOR is low, Mr. Y will owe him under the swap,
however, if the LIBOR is high, he will owe Mr. Y. Either way, he will have the fixed monthly return
of 1.5% during the tenure of the contract. It is very important to understand that under the
interest rate swap arrangement, parties entering into the contract never exchange the principal
amount.
Definitions of Financial Instruments - SWAP
Interest Rate Swap
Mr X Mr Y
Interest income rate LIBOR + 1% 1.50%
Principal 1,000,000 1,000,000
Fixed interest income Not fixed 15,000

Scenario 1: LIBOR @0.25 1.25% 1.50%

Interest income 12,500 15,000
Interest to be received/(paid) 2,500 (2,500)
15,000 12,500

Scenario 1: LIBOR @1.0% 2% 1.50%

Interest income 20,000 15,000
Interest to be received/(paid) (5,000) 5,000
15,000 20,000
Definition of financial assets
• cash;
• an equity instrument of another entity;
• a contractual right:
• to receive cash or another financial asset from another entity; or
• to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
• a contract that will or may be settled in the entity’s own equity instruments
and is:
• a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments; or
• a derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity’s own equity
instruments.
Definition of financial liabilities
• a contractual obligation :
• to deliver cash or another financial asset to another entity; or
• to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
• a contract that will or may be settled in the entity’s own equity
instruments and is:
• a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
• a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
own equity instruments.
Definitions financial instrument - Equity
• A contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
Statement of financial position - Assets
Statement of Financial Position – Equities and
Liabilities
Financial assets
Financial Assets – Amortised Cost

Passed these two tests – Amortised Cost

• The business management model test (BM)

• Business model to hold the investment for collection of contractual cash flows (hold
to maturity) BM should be assessed on portfolio level
• Irregular sale does not effect BM
• Entity may have more than one BM for different portfolios

• The contractual cash flow characteristics tests (cash flows)

• Investment can generate contractual cash flows at specified time - Solely payment of
principal and interest (SPPI).
• Entity knows exactly cash flows to be received.
Financial Assets – Subsequent Measurement
Amortised Cost

Opening balance Add: Interest Less: Interest Closing balance

of FA income (b/d X received of FA
effective rate of (principle X
interest) nominal rate of
interest)
Criteria for classifying and measuring FA
Criteria for classifying and measuring FA
Accounting Mismatch
Illustration – Accounting Mismatch
• It is appropriate to use the fair value option and, thus, avoid an accounting mismatch is
where an entity holds a financial asset that is debt and that carries a fixed rate of
interest, but is then hedged with an interest rate swap that swaps the fixed rates for
floating rates.

• The interest swap is a financial instrument that would be held at FVTPL and so,
accordingly, the financial asset classified as debt also needs to be at FVTPL to ensure that
the gains and losses arising from both instruments are naturally paired in income and,
thus, reflect the substance of the hedge.

• If the financial asset classified as debt was accounted for at amortised cost, then this
would create the accounting mismatch.
Accounting Mismatch – Another Example
Illustration
• ABC Ltd, an investment property company, adopts the fair value model to measure its investment
properties.

• On 31 December 2015, ABC Ltd took out a $5.000.000 bank loan specifically to finance the
purchase of some new investment properties. Fixed interest at the market rate of 6% is charged for
the 8-year term of the loan. Transaction costs of $120.000 were incurred.

Solution
• To avoid the accounting mismatch, recognition and measurement as follows:
Dr Investment property (measured at FV)
Cr Bank loan (measured and classify as FVTPL)

The entity may choose to measure the bank loan at FVTPL instead of at amortised cost to eliminate the
accounting mismatch.
Financial Assets
Types
• Cash
• Debt Instruments – Investment in bond and receivables
• Equity Instruments – Investment in Shares (less than 20%)
• Derivatives – A derivative is a financial product whose value is derived
from another asset (also known as the underlying asset).
• Derivatives are frequently used for speculation and hedging of risk and the
most common forms of derivatives are: Forward, Futures, Options and Swaps
Financial Assets
Illustration – FA measured at FVTPL

An entity, Suarez, purchased a five-year bond on 1 January 2010 at a cost of

$5m with annual interest of 5%, which is also the effective rate, payable on
31 December annually. At the reporting date of 31 December 2010 interest
has been received as expected and the market rate of interest is now 6%.

Required:
Account for the financial asset at 31 December 2010 on the basis that it is
classified as FVTPL.
Financial Assets
• Solution – FA Classified as FVTPL
Year Expected cash flows 6% discount factor Present value $m

31 December 2011 $5m x 5% = $0.25m 0.9434 0.2358

31 December 2012 $0.25m 0.8900 0.2225

31 December 2013 $0.25m 0.8396 0.2099

31 December 2014 $0.25m + $5m 0.7921 4.1585

4.8267
Financial Assets
• Solution – FA Classified as FVTPL
Date Accounts DR (Mil) CR (Mil)
1 Jan 2010 FVTPL FA 5
Bank 5

31 Dec 2010 Fair value loss 0.1733

FVTPL FA 0.1733

Bank 0.250
Interest income 0.250

• At the reporting date of 31 December 2010, the financial asset will be stated
at a fair value of $4.8267m, with the fall in fair value amounting to
$0.1733m taken to profit or loss in the year. Interest received will be taken
to profit or loss for the year amounting to $0.25m.
Financial Assets
Illustration – FA measured at Amortised Cost

On 1 January 2019, Biko Banking Ltd purchases a debt instrument with a 5-year
term for its fair value of $1,000 million (including transaction costs). The
instrument has a principal amount of $1,250 million (the amount payable on
redemption) and carries fixed interest of 4.7% paid annually in arrears on 31
December. The annual cash interest income is thus $59 million ($1250 million X
0.047 rounded to nearest million). Using a financial calculator, the effective interest
rate is calculated as 10%. The debt instrument is classified as subsequently
measured at amortised cost.

Required:
Prepare the entries of Biko Banking Ltd for all years from initial recognition
to derecognition of the financial asset.
Financial Asset – Amortised Cost (Solution)
Opening Carrying Interest income @ Coupon interest Closing carrying
Year Amount EIR 10% received amount

$m $m $m $m
2019 1,000 100 (59) 1,041
2020 1,041 104 (59) 1,087
2021 1,087 109 (59) 1,137

2022 1,137 113 (59) 1,190

2023 1,190 118 (1,309) (0)
Financial Asset – Amortised Cost (Solution)
Date Accounts Dr Cr
1/1/2019 Investment in debt security 1,000
Cash 1,000

31/12/19 Investment in debt security 100

Interest income 100
Cash 59
Investment in debt security 59

31/12/20 Investment in debt security 104

Interest income 104
Cash 59
Investment in debt security 59

31/12/23 Investment in debt security 118

Interest income 118
Cash 1,309
Investment in debt security 1,309
Financial Liabilities and Equities
Financial Liabilities – Sub. Measurement
FL measured at Amortised Cost or FVTPL
• Financial liabilities - other than liabilities held for trading and derivatives
that are liabilities are classified as amortised cost using the effective
interest rate method.
Opening balance Add: Finance cost Less: Interest Closing balance
of FL charged (b/d X paid (principle X of FL
effective rate of nominal rate of
interest) interest)

• Financial liabilities held for trading and derivatives are classified as FVTPL.
Financial Liabilities – Amortised Cost
Illustration
Broad raises finance by issuing $20,000 6% four-year loan notes on the
first day of the current accounting period. The loan notes are issued at
a discount of 10%, and will be redeemed after three years at a
premium of $1,015. The effective rate of interest is 12%. The issue
costs were $1,000.
Required
Explain and illustrate how the loan is accounted for in the financial
statements of Broad. (Assume the FL classified as Amortised cost).
Financial Liabilities – Amortised Cost (Solution)
• With both a discount on issue and transaction costs, the first step is
to calculate the initial measurement of the liability.

Cash received – the nominal value

($20,000 x 90%) $18,000
less the discount on issue

Less the transaction costs ($1,000)

Initial recognition of the financial liability $17,000

Financial Liabilities – Amortised Cost (Solution)
Opening Plus statement of profit or loss Less the cash Closing balance, being the
balance finance charge paid (6% x liability on the statement
@12% on the opening balance 20,000) of financial position

Year 1 $17,000 $2,040 ($1,200) $17,840

Year 2 $17,840 $2,141 ($1,200) $18,781

Year 3 $18,781 $2,254 ($1,200) $19,835

Year 4 $19,835 $2,380 ($1,200) Nil

($21,015)

Total finance costs $8,815

Financial Liabilities – Amortised Cost (Solution)
Date Accounts DR (Mil) CR (Mil)
Year 1 - Initial Bank 17,000
Bank 17,000

Year 1 – Sub Interest expense 2,040

FL at Amortised cost 2,040

FL at Amortised cost 1,200

Bank 1,200

• The finance cost will increase the liability. In year 1, total interest is $2,040.
The annual cash payment of $1,200 (6% x $20,000 = $1,200) will reduce the
liability
Financial Liabilities – FVTPL
Illustration
On 1 January 2011 Swann issued three year 5% $30,000 loans notes at
nominal value when the effective rate o f interest is also 5%. The loan
notes will be redeemed at par. The liability is classified at FVTPL. At the
end of the first accounting period market interest rates have risen to
6%.
Required
Explain and illustrate how the loan is accounted for in the financial
statements of Swann in the year ended 31 December 2011.
Financial Liabilities – FVTPL (Solution)
• Initial measurement is at the fair value of $30,000 received and, although
there are no transaction costs in this example, these would be expensed
rather than taken into account in arriving at the initial measurement.
• For YE 31 Dec 2001, With an effective rate of interest and the coupon rate
both being 5%, at the end of the accounting period the carrying value of
the liability will still be $30,000.
• This is because the finance cost that will increase the liability is $1,500 (5%
x $30,000 – the effective rate applied to the opening balance), and the cash
paid reducing the liability is also $1,500 (5% x $30,000 – the coupon rate
applied to the nominal value).
Financial Liabilities – FVTPL (Solution)
Date Accounts DR (Mil) CR (Mil)
1 Jan 2011 Bank 30,000
FL at FVTPL 30,000

31 Dec 2011 Interest expense 1,500

FL at FVTPL 1,500

FL at FVTPL 1,500
Bank 1,500
Financial Liabilities – FVTPL (Solution)
• As the liability has been classified as FVTPL this carrying value at 31 December
2011 now has to be revalued.
• The fair value of the liability at this date will be the present value (using the new
rate of interest of 6%) of the next remaining two years' payments

Cash 6% Present value of the

flow discount factor future cash flow

Payment due 31 December 2012 (interest only) $1,500 x 0.943 $1,415

Payment due 31 December 2013 $31,500 x 0.890 $28,035

(the final interest payment and the repayment of
the $30,000)

Fair value of the liability at 31 December 2011 $29,450

Financial Liabilities – FVTPL (Solution)
Opening Plus statement Less cash paid Carrying value Fair value Gain
balance of profit or loss (5% of the liability of the liability to
finance charge x at at income
@5% 30,000) year year end statement of
on the opening end profit or loss
balance

1/1/2011 $30,000 $1,500 ($1,500) $30,000 $29,450 $550

Date Accounts DR (Mil) CR (Mil)

31 Dec 2011 FL at FVTPL 550

FV gain 550
Financial Liabilities – FVTPL (Solution)
Year 2 (YE 31 December 2012)
• The finance charge in the statement of profit or loss for the year end 31
December 2012 will be the 6% x $29,450 = $1,767, and with the cash
payment of $ 1,500 being made, the carrying value of the liability will be
$29,717 ($29,450 plus $ 1,767 less $1,500) at the year end.

• If at 31 December 2012 the market rate of interest has fallen to, say, 4%,
then the fair value of the liability at the reporting date will be the present
value of the last repayment due of $31,500 in one year's time discounted
at 4% (ie $31,500 x 0.962 = $30,288), which in turn means that as the fair
value of the liability exceeds the carrying value, a loss of $571 (ie $30,288
less $29,717) arises which is recognised in the statement of profit or loss.
Financial Liabilities – FVTPL (Solution)
Opening Plus statement Less cash paid Carrying value Fair value Loss
balance of profit or loss (5% of the liability of the liability to
finance charge x at at income
@6% 30,000) year year end statement of
on the opening end profit or loss
balance

1/1/2012 $29,450 $1,767 ($1,500) $29,717 $30,288 $571

Date Accounts DR (Mil) CR (Mil)

31 Dec 2012 Interest expense 1767

FV gain 267
Bank 1500
31 Dec 2012 FV Loss 571
FL at FVTPL 571
Financial Liabilities – FVTPL (Solution)
Year 3 (YE 31 December 2013)
• In the final year ending 31 December 2013 the finance cost to the
statement of profit or loss will be 4% x $30,288 = $1,212, increasing
the liability to $31,500 before the final cash payment of $31,500 is
made, thus extinguishing the liability.
Opening Plus statement Less cash paid Carrying value FULL PAYMENT
balance of profit or loss (5% of the liability at
finance charge x at year end
@4% 30,000) year
on the opening end
balance

1/1/2013 $30,288 $1,212 ($1,500) $31,500 $31,500

Financial Liabilities – FVTPL (Solution)
Opening Plus statement Less cash paid Carrying value Fair value Gain /(loss)
Summary balance of profit or loss (5% of the liability of the liability to
finance charge x at at income
• @5% (2011) @ 30,000) year year end statement of
6% (2012) @ end profit or loss
4% (2013)
on the opening
balance

Year 2011 (5%) $30,000 $1,500 ($1,500) $30,000 $29,450 $550

Year 2012 (6%) $29,450 $1,767 ($1,500) $29,717 $30,288 ($571)

Year 2013 (4%) $30,288 $1,212 ($1,500) $30,000 ($30,500) Nil

Compound Instruments
Compound instruments – Financial instruments that have
characteristics of both equity and liabilities. It should be split into:
• Financial liabilities (the debt)
• Equity instrument (the option to convert into shares)
• Has to do split accounting.
• Step 1 – calculate FV of FL component – Based on PV of future cash flows
assuming non-conversion and to apply discount rate equivalent to interest in
similar non-convertible debt instrument
• Step 2 – calculate equity instrument portion – that is balancing.
Compound instruments

Value of convertible loan 100

Less: Liability (80)
(PV of cash flows – discounted at interest rate without conversion option)
Equity instruments (balancing) 20

• Liability classified and measured as amortised cost.

• Equity instrument is maintained at 20 and not re-measured every year.
Compound instruments - Illustration
Graham Gooch issues a 3% $200,000 two-year convertible bond at par. The
effective rate of interest of the instrument is 8%. The terms of the convertible bond
is that the holder of the bond, on the redemption date, has the option to convert
the bond to equity shares at the rate of 10 shares with a nominal value of $1 per
$100 debt rather than being repaid in cash. Transaction costs can be ignored.
Graham Gooch will account for the financial liability arising using amortised cost.

Required
Explain the accounting for the issue of the convertible bond.

43
Compound instruments - Solution
• A convertible bond creates both an equity and a debt instrument. On initial recognition the debt
element will be measured at fair value – ie the present value of the future cash flow, with the
equity element representing the balancing figure.
Cash flow Discount Present value of the future cash flow
(3% x factor
$200,000) @ 8%

Year 1 $6,000 x 0.926 $5,556

Year 2 $206,000 x 0.857 $176,542

Fair value of the debt element $182,098

Fair value of the equity element (balancing figure) $17,902

Proceeds of the issue $200,000

44
Compound instruments - Solution
• A convertible bond creates both an equity and a debt instrument. On initial recognition the debt
element will be measured at fair value – ie the present value of the future cash flow, with the
equity element representing the balancing figure.
• The Cr to equity can be reported in a reserve entitled ‘Other components of equity’. Equity is not
subsequently remeasured.
• The liability on the other hand will be accounted for using amortised cost charging income with a
finance cost at the rate of 8%.

Date Accounts DR (Mil) CR (Mil)

Year 1 - Initial Cash $200,000

FL at Amortised cost $182,098
Equity (Other Component of Equity) $17,902

45
Compound instruments - Solution
Income statement Closing balance
Opening balance Less cash
finance cost @ 8% of the liability

Year 1 $182,098 $14,568 ($6,000) $190,666

Year 2 $190,666 $15,334* ($6,000) $200,000

• * includes rounding
• At the end of Year 2 the liability can be extinguished by the payment of $200,000
in cash, or if the option is exercised by the bond holder, then it is extinguished by
the issue of 20,000 $1 ordinary shares at nominal value with a share premium of
$180,000 also being recorded.

46
Compound instruments - Solution
Date Accounts DR (Mil) CR (Mil)
Year 2 - End Interest expense $15,334
FL at Amortised cost $15,334
FL at Amortised cost $6,000
Cash $6,000
Redeem Cash FL at Amortised cost 200,000
Bank 200,000
Note: Equity component will remain in
equity as non-distributable reserve
OR - Conversion Equity (Other Component of Equity) $17,902
FL at Amortised cost $200,000
Ordinary shares capital 217,902 47
Inter-company loan and loan to employee
Illustration: Inter-company loan

Parent provided an interest-free loan of CU 100 000 to its subsidiary, the loan is
repayable in 3 years and market interest rate is 5%.

Required:
a. How shall we classify the intercompany loan and measure it subsequently?
b. Calculate initial measurement of the loan and prepare relevant journal entries.
c. Calculate subsequent measurement and prepare relevant journal entries.
Inter-company loan – Solution
a. How shall we classify the intercompany loan and measure it subsequently?

At amortized cost. The reason is that the interest-free intercompany loan still meets
both conditions for amortized cost classification:
• It is held within the business model whose aim is to collect contractual cash
flows (I guess that no intercompany loan is there for other purpose), and
• The contractual cash flows arise solely from payments of principal and interest
(here, interest payments can be zero and this condition is still met).
Inter-company loan – Solution
b. Calculate initial measurement of the loan.
The loan should be measured at fair value initially. The fair value of this loan is CU 86 384 (it is CU 100
000 in 3 years discounted to present value with the market rate of 5%). There is a difference between the
cash received of CU 100 000 and the fair value of the loan of CU 86 384 amounting to CU 13 616.

So, the parent recognizes the loan initially as:

Debit Loans receivable CU 86 384
Debit Investment in subsidiary CU 13 616
Credit Cash CU 100 000

The subsidiary’s entry is very similar:

Debit Cash CU 100 000
Credit Loans payable CU 86 384
Credit Equity – capital contributions CU 13 616

If the loan is provided in the opposite direction (by subsidiary to parent), then analogically, the “below-
market” component is recognized as a distribution (dividend) from subsidiary.
Inter-company loan – Solution
c. Calculate subsequent measurement and prepare relevant journal entries.

Subsequently, you need to re-measure the loan at its amortized cost by charging an interest
(assuming there’s no repayment in the first year).

The journal entry in parent’s books is:

Debit Loans receivable CU 4 319 (86 384*5%)
Credit Profit or loss – interest income CU 4 319
Impairment of Financial Assets
• Replaces the incurred loss model
• Delayed recognition was a weakness
• Only recognised when default occurred
• More useful information
• Reflects changes more timely
• Forward looking
• Measurement is reasonable and supportable
• Historical, current and forecast information
• 2 Approaches – General Approach and Simplified Approach

PMI 02/2018 52
Impairment of Financial Assets
• MFRS 9 requires recognition of impairment losses on a forward-looking basis which means that
impairment loss is recognised before the occurrence of any credit event. These are referred to as
expected credit losses (‘ECL’).
• Credit loss is the difference between all contractual cash flows that are due to an entity in
accordance with the contract and all the cash flows that the entity expects to receive, discounted
at the original EIR or credit-adjusted EIR
• Approaches and Impairment requirements of MFRS 9 as follows:
Financial Assets General Simplified
Assets measured at amortised cost / (Loan) / (Debtors)
Assets measured at FVTOCI with recycling /
Loan commitments (not at FVTPL) /
Financial guarantee contracts (not at FVTPL) /
Lease receivables (IFRS 16) /
Contract assets (IFRS 15) /
Impairment of FA- General Approach
• Expected credit losses (ECL) are required to be measured through a
loss allowance at an amount equal to:
• The 12-month expected credit losses (expected credit losses that result from
those default events on the financial instrument that are possible within 12
months after the reporting date); or
• Full lifetime expected credit losses (expected credit losses that result from all
possible default events over the life of the financial instrument).

• A loss allowance for full lifetime expected credit losses is required for
a financial instrument if the credit risk of that financial instrument has
increased significantly since initial recognition, as well as to contract
assets or trade receivables that do not constitute a financing
transaction in accordance with MFRS 15.
Impairment of FA- General Approach
• ECL can be 12-month ECL or lifetime ECL depending on whether there was a
significant increase in credit risk.
• Changes in the loss allowance are recognised in P/L as impairment gains/losses

e.g. Credit rating fall, one e.g. Credit rating significant,

month loan default Loan – NPL category
Impairment of FA- General Approach
• Calculation of ECL will be based on PD/EAD/LGD model:
• PD(probability of default) - That is, the likelihood that the borrower would not
be able to repay in the short payment period.
• EAD(exposure at default) - That is, the loss that occurs if the borrower is
unable to repay in the short payment period.
• LGD(loss given default) - i.e. what % of EAD will not be recovered at default,
this should take into account any collaterals held - That is, the outstanding
balance at the reporting date.
• A bank may calculate its expected loss by multiplying the variable:
• Expected Loss (EL) = PD x EAD x LGD
Probability of Default (PD)
• Default probability (PD) is the likelihood over a specified period, 12 month or
lifetime expected loss. That is the probability a borrower will not be able to make
scheduled repayments.
• PD depends not only on the borrower's characteristics but also on the economic
environment.
• PD may also be estimated using historical data and statistical techniques
• Generally, the higher the PD, the higher the interest rate the lender will charge
the borrower. Creditors typically want a higher interest rate to compensate for
bearing higher default risk.
• Measure in percentage (%).
Exposure at default (EAD)
• Exposure at default (EAD) is the total value a bank loan is exposed to when a loan
defaults.
• Using the internal ratings-based (IRB) approach, financial institutions calculate their risk.
• Banks often use internal risk management default models to estimate respective EAD
systems.
• Outside of the banking industry, EAD is known as credit exposure.
• EAD is the predicted amount of loss a bank may be exposed to when a debtor defaults on
a loan.
• Banks often calculate an EAD value for each loan and then use these figures to determine
their overall default risk.
• EAD is a dynamic number that changes as a borrower repays a lender.
Loss Given Default (LGD)
• Loss given default (LGD) is the amount of money a bank or other financial institution loses
when a borrower defaults on a loan, depicted as a percentage of total exposure at the
time of default. A financial institution’s total LGD is calculated after a review of all
outstanding loans using cumulative losses and exposure.
• Banks and other financial institutions determine credit losses by analyzing actual loan
defaults. Quantifying losses can be complex and require an analysis of several variables.
An analyst takes these variables into account when reviewing all loans issued by the bank
to determine the LGD.
• For example, consider that Bank A lends $2 million to Company XYZ, and the company
defaults. Bank A’s loss is not necessarily $2 million. Other factors must be considered,
such as the amount of assets the bank may hold as collateral, whether installment
payments have already been made to reduce the outstanding balance, and whether the
bank makes use of the court system for reparations from Company XYZ. With these and
other factors considered, Bank A may, in reality, have sustained a far smaller loss than the
initial $2 million loan.
Example, ECL = PD X EAD x LGD
A borrower takes out a $400,000 loan for a condo. After making installment payments on
the loan for a few years, the borrower faces financial difficulties and defaults when the loan
has an outstanding balance, or exposure at default, of $300,000.
The bank forecloses on the condo and is able to sell it for $240,000.
Required: Calculate ECL.
• The net loss to the bank is $60,000 ($300,000 – $240,000), So EAD = $60,000
• The Loss Given Default (LGD) is 20% (($300,000 – $240,000)/$300,000).
• The expected loss would be calculated by the following equation:
• ECL = Probability of Default (PD) X Exposure at Default (EAD) X Loss Given Default (LGD)
• ECL = PD (100%) X EAD ($300,000) X LGD (20%) = $60,000.
• If the financial institution were projecting out a potential but not certain loss, the
expected loss would be different.
• Using the same figures from the scenario above, but assuming only a 50% probability of
default, the expected loss calculation equation is:
• ECL = PD X EAD X LGD = 50% X $300,000 X 20% = $30,000
Impairment of FA- General Approach
Example: illustrative calculation of lifetime ECL and 12-month ECL for a loan
On 31 December 20X1, Entity A lends Entity B $100,000. Entity B will repay the loan in 5 annual
equal instalments amounting to $25,000 (i.e. $125,000 in total). The effective interest rate (EIR) is
7.9%. Calculation of ECL will be based on PD/EAD/LGD model:
• PD – probability of default (assessed by Entity A). Say 3%.
• EAD – exposure at default (= amortised cost of the loan),
• LGD – loss given default (i.e. what % of EAD will not be recovered at default, this should take into
account any collaterals held). Say 80%.

Required:
Calculate the 12-month ECL and lifetime ECL.
Impairment of FA- General Approach
Schedule for amortised cost

Year Balance 1 Jan Interest in P/L Cash Flow Balance 31 Dec

2002 100,000 7,926 (25,000) 82,926
2003 82,926 6,573 (25,000) 64,500
2004 64,500 5,127 (25,000) 44,627
2005 44,627 3,537 (25,000) 23,164
2006 23,164 1,836 (25,000) (0)
Calculation 12 Month and Lifetime ECL
Reporting PD
Date EAD PD (cumulative) LGD ECL ECL
31-12-01 100,000 3% 3% 80% 2,224 12 Month
31-12-02 82,926 3% 6% 80% 1,709
31-12-03 64,500 3% 9% 80% 1,231
31-12-04 44,627 4% 13% 80% 1,053
31-12-05 23,164 4% 17% 80% 506
6,723 Lifetime
Impairment of FA- Simplified Approach
• The simplified approach is required for trade receivables or contract assets that
result from transactions that are within the scope of IFRS 15 and do not contain a
significant financing component.
• Also known as simplified loss rate approach and loss allowance calculated using
lifetime ECL.
• The lifetime ECL are calculated using a provision matrix which can be constructed
using the following steps:
• receivables are segmented based on different credit loss patterns (e.g. based on customer
type, product type, geographical region, collateral etc.)
• ageing of receivables is prepared (e.g. not past due, past due 1-30 days, 31-60 days, 90+ days)
• historical loss patterns are calculated and treated as a starting point is estimating loss rate
• historical data is adjusted to take into account reasonable and supportable information that
is available without undue cost or effort at the reporting date about current conditions and
forecasts of future economic conditions
Impairment of FA- Simplified Approach
Example: lifetime ECL for trade receivables using a provision matrix

Entity A is a service provider and has 2 types of customers: individual customers (B2C) and business
customers (B2B). Entity A believes that B2C / B2B segmentation best reflects credit loss patterns.
Sales are usually made on credit, therefore Entity A has a significant balance of trade receivables
outstanding at each reporting date. As there is no significant financing component, Entity A
recognises lifetime ECL for all its trade receivables.

For the purpose of this example, loss rate is calculated based on sales made in January of a given
year. In real life, the loss rate should be based on data from several months, but it cannot be too old
as it may yield outdated results.

The illustrative calculation of loss rate for B2C customers is presented below.
Impairment of FA- Simplified Approach
Receivables Receivables
Payments Payments Loss Rate
outstanding ageing
sales in January 100,000 not overdue 2% (2/100)
paid on time 50,000 50,000 overdue 1-30 days 4% (2/50)
paid 1-30 days 27,000 23,000 overdue 31-60 days 9% (2/23)
after due date
paid 31-60 days 15,000 8,000 overdue 61-90 days 25% (2/8)
after due date
paid 61-90 days 6,000 2,000 overdue 91+ days 100% (2/2)
after due date (not paid at all)
Impairment of FA- Simplified Approach
• Additionally, Entity A analysed forward-looking information (GDP forecasts,
changes in unemployment rate, changes in law) and concluded that there is no
indication that the above historical loss rate should be adjusted.
• The amount of loss allowance to be adjusted on measurement date depending on
the outstanding amount on that date.
• Also, the loss rate also need to be adjusted based on analysed forward-looking
information (GDP forecasts, etc).
• As at 31 December 20X1, Entity A prepared ageing of its trade receivables from
B2C customers and calculated lifetime ECL as presented in the following table.
Impairment of FA- Simplified Approach
Amount Ageing Loss Rate ECL Allowance
300,000 not overdue 2% 6,000
140,000 overdue 1-30 days 4% 5,600
60,000 overdue 31-60 days 9% 5,217
23,000 overdue 61-90 days 25% 5,750
5,000 overdue 91+ days 100% 5,000
Total ECL allowance 27,567

Dr Impairment loss (PnL) 27,567

Cr Loss allowance (BS) 27,567
De-recognition
• Financial assets should be derecognized (e.g. disposal) when:
• The contractual rights over the cash flows expire.
• Substantial risk and reward of ownership transferred

• Financial liabilities should be derecognized when it is extinguished

(e.g. restructuring) that is:
• The obligation in the contract is discharged
• The obligation in the contract is cancelled
• The obligation in the contract is expires

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Financial assets
Financial Liabilities and Equities