Accounting for Derivatives. Ramirez Juan

and interest test. The contractual terms of the tranche itself have only SPPI characteristics.

      Look-through test. The underlying pool of financial instruments:

      contains one or more instruments that meet the SPPI criterion;

      also may contain instruments that:

      reduce the cash flow variability of the instruments under (i) and the combined cash flows meet the SPPI criterion (e.g., interest rate caps and floors, credit protection), or

      align the cash flows of the tranches with the cash flows of the instruments under (i) arising as a result of differences in whether interest rates are fixed or floating or the currency or timing of cash flows.

      Credit risk test. The exposure to credit risk inherent in the tranche is equal to, or lower than, the exposure to credit risk of the underlying pool of financial instruments. The standard states as an example that this condition would be met if, in all circumstances in which the underlying pool of instruments loses 50 % as a result of credit losses, the tranche would lose 50 % or less.

      The look-through approach is carried through to the underlying pool of instruments that create, rather than pass through, the cash flows. For example, if an entity invests in a tranched note issued by SPE 2 whose only asset is an investment in another tranched note issued by SPE 1, the entity looks through to the assets of SPE 1 in performing the assessment.

      Example: Tranched issuance

      Suppose that a special-purpose entity (SPE) has bought mortgage assets with a notional amount of USD 800 million and issued three tranched notes (A, B and C) that are contractually linked. All assets in the pool meet the SPPI criterion. The underlying mortgage assets pay fixed rates of interest on a monthly basis. The vehicle holds an interest rate swap that swaps the underlying mortgages monthly fixed interest for 3-month Libor. The weighted average credit spread of the assets in the mortgage pool is 400 basis points.

      • Tranche A pays a quarterly interest of 3-month Libor plus 50 basis points on a principal of USD 300 million.

      • Tranche B pays a quarterly interest of 3-month Libor plus 400 basis points on a principal of USD 200 million.

      • Tranche C pays a quarterly interest of 3-month Libor plus 500 basis points on a principal of USD 100 million.

      If the underlying pool of instruments were to lose 50 % as a result of credit losses, a loss of USD 400 million would arise (=800 million × 50 %), and the effect on the tranches would be as follows:

      • The overcollateralisation would absorb the first USD 200 million losses.

      • Tranche C would lose USD 100 million, representing 100 % of its total principal.

      • Tranche B would lose USD 100 million, representing 50 % of its total principal.

      • Tranche A would not experience any losses.

      In addition to the tranches and the asset pool, the vehicle contains another financial instrument, an interest rate swap, but it only aligns the cash flows of the underlying pool with those of the tranches, and consequently it does not affect the tranches' SPPI eligibility. Whilst all the three tranches meet two of the SPPI conditions (i.e., the underlying mortgage pool meets the SPPI criterion and the tranches pay cash flows that only represent principal and interest), only tranches A and B are eligible for amortised cost recognition, subject to meeting the business model criterion, as a 50 % loss in the underlying asset pool would not cause these tranches to experience losses exceeding 50 % of their principal amounts. As a result, the larger the level of overcollateralisation (i.e., the excess of the underlying pool size relative to the size of the issued tranches), the higher the likelihood of meeting the credit risk test.

      (*) Subject to the business model criterion being met

      When the tranche held by the investor is prepayable contingent upon a prepayment occurring in the pool of underlying assets, it may meet SPPI even if the following features exist in the structure (assuming the three primary conditions for the tranche as a whole are met):

      • The tranche is prepayable contingent on repayment occurring in the underlying pool. Because SPPI must be met for the underlying pool, it is assumed the underlying prepayment risk on the pool is consistent with SPPI.

      • Even if the collateral underlying the pool does not meet the qualifying conditions for amortised cost, the underlying collateral can be disregarded unless the instrument was acquired with the intention of controlling the collateral.

1.1.6 Reclassifications

      IFRS 9 requires an entity to reclassify financial assets if and only if the objective of the entity's business model for managing those assets changes. Such changes are expected to be infrequent, and need to be determined by the entity's senior management as a result of internal or external modifications. These modifications have to be significant to the entity's operations and demonstrable to external parties. Reclassification is applied prospectively from the start of the first reporting period following the change in business model.

      Both the amortised cost and FVOCI categories require the effective interest rate to be determined at initial recognition. Therefore, when reclassifying a financial asset between the amortised cost and the FVOCI categories, the recognition of interest income would not change and the entity would continue to use the effective interest rate determined at initial recognition. A financial asset reclassified out of the FVOCI category to the amortised cost category would be measured at amortised cost as if it had always been so classified. This will be effected by transferring the cumulative gain or loss previously recognised in OCI out of equity, with an offsetting entry against the fair value carrying amount at the reclassification date.

      However, for financial assets at FVTPL, and entity is not required to separately recognise interest income. When reclassifying a financial asset out of the FVTPL category, the effective interest rate would be determined based on the fair value carrying amount at the reclassification date.

      Figure 1.4 Reclassification of financial assets.

      1.2 THE AMORTISED COST CALCULATION: EFFECTIVE INTEREST RATE

      It was mentioned earlier that some assets and liabilities are measured at amortised cost. The amortisation is calculated using the effective interest rate (EIR). This rate is applied to the carrying amount at each reporting date to determine the interest expense for the period. The EIR is the rate that exactly discounts the stream of principal and interest cash flows to the initial net outlay (in the case of assets) or proceeds (in the case of a liability). In this way, the contractual interest expense in each period is adjusted to amortise any premium, discount or transaction costs over the life of the instrument.

      The carrying amount of an instrument accounted for at amortised cost is computed as:

      • the amount to be repaid at maturity (usually the principal amount); plus

      • any unamortised original premium, net of transaction costs; or less

      • any unamortised original discount including transaction costs; less

      • principal repayments; less

      • any reduction for impairment or uncollectability.

      Transaction costs include fees, commissions and taxes paid to other parties. Transaction costs do not include internal administrative costs.

1.2.1 Example of Effective Interest Rate Calculation – Fixed Rate Bond

      Suppose that an entity issues a bond with the following terms:

      The EIR is computed as the rate that exactly discounts estimated future cash payments through the expected life of the financial instrument:

      Solving this