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New standards
- Section 3855, Financial Instruments - Recognition and Measurement:
- when to recognize a financial instrument (asset) on BS
- at what amount
- how to present related G/L
- Section 1530, Comprehensive Income:
- new req'ts for temporary presentation of certain G/L outside of NI
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Implications of new standards on Held-to-maturity
- Amortized cost on BS. Unaffected by changes in FV while asset is held. But selling sig amount will result in all HTM reclassified as AFS for >= 2 years leading to discontinuity in II.
- major impediment to using HTM as potentially reduces flexibility in managing portfolio for rebalancing or strategic benefit, and creates reporting challenges if asset sale becomes attractive.
- prior to selecting HTM, consider potential for unusual CFs (LLs, dividends) resulting in need to liquidate HTM
- G/L: booked to NI: regular II (coupons and dividends), change in amortized cost
- Volatility in NI, asset and equity: no change
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Implications of new standards on Available-for-sale
- Carried on BS at FV
- G/L:
- NI: regular II (coupons and dividends), change in amortized cost
- OCI: change in dif btw FV (incl forex translation) and amortized cost
- Volatility of NI:
- OCI segregates volality of FV of invested assets outside NI.
- but FV volatility may be re-intro into NI: increase in FV of invested assets decreases portfolio yield / discount rate for policy liabilities -> increases policy liabilties and decreases NI -> liabilities and NI more volatile
- income mismatch since change in asset flows thru OCI and change in policy liabilities flows thru NI, which offset (partially or fully) in CI
- Volatility of asset and equity: increase
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Implications of new standards on Held-for-trading with FV option
- Marked to FV on BS
- All G/L recognized immediately in NI
- Volatility:
- greater volatility of assets and related G/L
- if all assets classified as HTM / FV option, discount rate used will reflect market yield -> policy liabilties more volatile
- income can still match as long as CFs match between policy liabitlies and supporting assets -> G/L in assets and in policy liabilities will offset
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Book value / book yield
- book value of an asset:
- traditionally amortized value. 3855 -> MV or amortized value
- determination of BV of an asset which supports policy liabilities will in turn affect book yield for that asset
- book yield of an asset:
- rate which equates the statement value of an asset to its future CFs.
- more variable from period to period now vs. pre-3855 (based on purchase price)
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Impact on f.s.if all debt securities are classified as HTM or AFS or HFT and market interest rates increase
- HTM: no effect on f.s.
- AFS:
- NI is only impacted by liabilities decrease
- OCI is only impacted by assets decrease
- equity change uncertain
- HFT:
- NI change uncertain; is impacted by decrease in both assets and liabilities
- OCI is not used
- equity change uncertain
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NI/OCI
- NI
- = realized G/L from HTM/AFS/HFT
- + unrealized G/L from HFT
- OR
- = all regular II (dividends and bond coupons)
- + change in amortized cost for HTM and AFS
- + change in FV for HFT
- OCI
- = unrealized G/L from AFS
- = change in dif between FV and amotized cost for AFS
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Impact of new standards on valuation
- Discount rate selection: process didn't change. but BV of an asset (MV, the amortized value etc.) supporting policy liab may change, which will, in turn, affect book yield for that asset
- Volatility: change in PfAD from changes in discount rate
- Tax implications: tax timing differences
- Challenges to confirming completeness and accuracy of asset data post-3855:
- Pre-3855, one-to-one mapping btw asset and accounting measurement. no longer the case now
- Book yields are much more variable from period to period
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3855 'at what amount' - 6 measurement base alternatives
- Historical cost
- Current cost (reproduction cost and replacement cost)
- Net realizable value
- Value in use
- Fair value
- Deprival value
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Fair Value - Pros and cons
- Pros: reflects:
- market risk preferences and expectations wrt. amounts, timing and uncertainty of future CFs
- current market expectations wrt. financial instrument’s future CFs discounted at risk-adj'd return avail in market place
- Cons:
- If active / liquid market doesn't exist for a financial instrument, measurement is complex and uncertain
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IFRS - 4-level measurement hierarchy of FV
- Estimates of FV:: observable market prices, incl market-based adj's
- Level 2: accepted valuation models or techniques; all sig inputs are consistent with what market participants can be expected to use
- Substitutes for FV:: current cost, with possibile substitution of historical cost
- Level 4: models and techniques that use entity inputs
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OCI
- Change in the value of net assets that is not due to owner activities (investments or distributions)
- CI = NI + OCI
- Changes in OCI will flow directly through equity on BS; surplus is amended and renamed equity.
- Equity is expanded to show not only retained earnings, but also AOCI and ACI (retained earnings + AOCI).
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OSFI - Criteria for FRFIs to use FV option
May apply FV option if - Institution has a documented risk mgt strategy to manage the group of financial instruments together on FV basis and can demonstrate that significant financial risks are eliminated or significantly reduced
- FVs are reliable
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