Capital Scarcity, IFRS 9, IFRS 15, IFRS 16, IFRS 17 and Capital Optimization.

Dear,

The Financial System, and in fact the whole economy, is in a process of Systemic Transformation, from a model based in Volume to a model based in Efficient Management of Capital.

Today's economy is pulled by two forces, limited growth (due to natural resources scarcity, markets saturation, pollution, etc.) and historically high global debt ($233 Trillion, around 300% of the Gross World Product). As limited growth also limits Capital generation and global debt consumes Capital, the logical conclusion is Capital has become scarcer than ever.



Capital is the most important resource of the Financial System, which is also the most critical element of a Capitalist System (it’s the responsible of transferring and allocating capital and liquidity).



Capital scarcity makes the Financial System unstable, as we have seen since the 2008 Financial Crisis, and transfers this instability to the whole economy and society.



If Capital is scarce and it is the most important resource in a Capitalist System, the logical conclusion is  managing it efficiently; and this is the driver of the paradigm change, from a model based in Volume to a model based in Efficient Management of Capital.



Regulators are very aware of this new environment of Capital scarcity and the necessity of the paradigm change, and their logical proposal has been a new regulatory framework, focused in making visible the Capital consumption.



The Financial System has two main sources of regulation:

- Solvency from the Basel Committee on Banking Supervision of the Bank for International Settlements https://www.bis.org/bcbs/



- Accounting from the International Accounting Standards Board https://www.ifrs.org/groups/international-accounting-standards-board



The Basel Committee has increased significantly the Capital requirements in the last decade (Basel III, Basel IV, etc.), and the transparency in Capital consumption calculation (Principles for effective risk data aggregation and risk reporting) https://www.bis.org/publ/bcbs239.pdf



The International Accounting Standards Board has also brought significant changes in making Capital Consumption visible.



For instance, IFRS 9 – Financial Instruments, has modified the calculation of the Losses for deterioration of Financial Instruments, from the Incurred Losses to the Expected Losses principle In practical terms, the change produces an early recognition of the deterioration Losses and the consequent Capital consumption.



More interesting is the example of IFRS 15 - Revenue from Contracts with Customers, which modifies the process for Revenue Recognition, including a Contract Asset and a Contract Liability in the Accounting Postings.

The contract liability represents the company obligation to deliver goods or services to the customer for which the entity has received consideration (cash or non-cash) from the customer.



It’s also possible that the goods or services are delivered to the customer before the Revenue Recognition, and the correspondent value is represented by a Contract Asset.



The example of IFRS 16 – Leasing, is also very interesting. With IAS 17, the Lessees did not have to recognized the cost of Capital of a Leasing Contract, which was considered off-balance and only recognized at the time of receiving the Invoice. With IFRS 16, the Lesses have to recognized an Asset (Right of Use) and a Liability at the time of the contract activation.



Finally IFRS 17 – Insurance contracts, which increases the transparency requirements, including the recognition of profit over the period that services are provided under the contract, and the consequent Contract Asset and Liability positions.



All the above Accounting Principals have in common that the contract is represented, since the moment of its activation with an Asset and a Liability Position, influencing the Capital Position of the entity.



- The Asset Position represents a Risk Exposure which consumes Capital.

- The Liability Position reduces the ratio Capital/Debt of the entity.



As you can see, Capital requirements and Capital management are at the center of the regulators concerns. Anyway, this is logical as they know that Capital is scarce and they also know it is the main resource in a Capitalist System.



Once again, the logical conclusion is that Capital Optimization has become the main priority.



Looking forward to read your opinions.

K. Regards,

Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

Central Data Hubs and the SAP Finance and Risk Data Platform.

Dear,

One of the consequences of the new regulation, emerging from the 2008 Financial Crisis (Basel III, Basel IV, BCBS 239, Dodd-Frank, IFRS 9, etc.) is the pressure for banks Information Systems, on reconciling Analytical and Operational data.

Most Core Banking Information Systems were developed in the 70s-80s, when the computing capacity was much smaller, and regulatory requirements much softer. 

Integration requires processing big data-tables and managing big memory blocks, because every transaction must read and update registers of data from other areas. As computing capabilities were more limited and reconciliation requirements less stringent, Banking Systems were built as separated silos of information with very little integration with each other.

As banking systems grew, this architecture of limited integration produced banking systems with very heterogeneous data, many complex point to point interfaces, and supported by databases whose designs are very distant from the principles of the Referential Integrity.

As mentioned before, the new Financial regulation, particularly BCBS 239 (Principles for effective risk data aggregation and risk reporting), puts the focus on data quality and data reconciliation, and this is increasing the pressure for integrating Financial Data, coming from heterogeneous sources.

https://www.bis.org/publ/bcbs239.pdf

One alternative is implementing an integrated Banking System, with a holistic management of Operational and Analytical Data (like SAP Banking). But the complete replacement of a banking information system is an expensive, challenging process. Performing it in a short-term period is only feasible for small/middle-size banks.

Consequently, many banks are confronting the issue by building a Central Data Hub which receives data from all the operational systems, homogenize the data, and finally stores and delivers it to the other systems of the banking landscape.

I’ve seen several of these initiatives in the last years, and they all present common challenges.

Projects design follow and add-hoc/on-demand approach. Data architects collect data requirements from the data consumer systems, and design the data repository according to these requirements. And then, define the interfaces for collecting data from the source systems and populating the data in the destination systems. 

To some extend, this approach implies reinventing the wheel, according to the bank’s own experience, and limited integration capabilities of the bank’s information architecture.

Additionally, regulation evolves, and new requirements force the data architects to enhance the multiple repository tables and in/out interfaces, compromising the integrity of the initial design. 

SAP has tackled the issue in a completely different way, delivering the Finance and Risk Data Platform, which combines a centralized data-model with an Integrated Financial and Risk Architecture

The Finance and Risk Data Platform has been designed to fulfill present and future Accounting, Risk and Liquidity regulatory requirements, as an alternative to the add-hoc/on-demand approach of the Central Data Hubs.

The Finance and Risk Data Platform combines:

- The accumulated knowledge in the design and development of the Integrated Financial and Risk Architecture of Bank Analyzer during the last 2 decades. The Primary Data Objects of the Bank Analyzer Source Data Layer as an standard template of the Operational Data, and the Result Types of the Results Data Layer as an standard template of Analytical Data.

Data Architects can take advantage of these standard templates as a basic reference, and enhancing them for fulfilling the bank’s specific requirements, without breaking the integrity of the data-model.

- The high-performing capabilities of SAP HANA for storing and managing very-high volumes of data, without intermediate tables and assuring the referential integrity of the database.

- The Extract, Transformation and Loading capabilities of SAP Smart Data Integration in Premise and in the Cloud.

- The Analytical Layers of SAP Bank Analyzer Risk Engines, Liquidity and Risk Management on HANA, Intraday Real-time Liquidity Management, etc.

The main advantage of this approach is the possibility of an incremental implementation, covering first the requirements of a Central Data Hub, interfacing with the current operational and analytical systems of the bank, but capable of growing and fulfilling new regulatory and functional requirements, with the implementation of the multiple analytical layers of the SAP Finance and Risk Data Platform.

Looking forward to read your opinions.

K. Regards,

Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

Consequences of the Capital scarcity and the new Financial Regulation.

Dear,
Recently, I gave some workshops about IFRS 16 and SAP Flexible Real Estate, and several attendants express their concerns about the cost of the implementation and the available budget.

According to them, although their companies are feeling the pressure for being compliant with the new accounting regulation, it is very difficult to get the budget for regulatory projects which are not business driven.

In my opinion, this represents a limited understanding of the impact of the new regulation in the Financial System and the whole Economy.

As we saw in previous blogs, IFRS is not a temporary fashion. The two arms of the new regulatory framework (Basel Agreements and International Financial Reporting Standards) are the logic consequence of the new economic environment, which its main characteristic is capital scarcity.

The economic environment emerging from the 2008 Financial crisis has two characteristics; limited growth (mainly due to natural resources scarcity) and excess of debt (225% of the GDP)

https://eu.usatoday.com/story/money/economy/2018/04/19/global-debt-tops-164-trillion-imf-warns/530893002/

As a consequence of these two forces; weak growth limiting capital generation, and global debt consuming capital, Capital is becoming very scarce.

And never forget that Capital is the main and most critical resource of the Financial System.

Regulators are very aware of the new economic environment, and push the Financial System towards the new paradigm, “Capital Optimization”.

Basel Agreements (Banking Solvency), IFRS 9 (Financial Instruments Accounting), IFRS 16 (Leasing Accounting), Solvency 2 (Insurance Solvency) and IFRS 17 (Insurance Accounting) have the common objective of making visible the cost of Capital of Financial Assets and Liabilities.

The above list does not represent just a compliance requirement, with limited or no impact to the business. What actually represents is a legal constrain that will drive the way in which companies operate; first Financial Companies, and later the whole economy.

If Capital is scarce and bank’s capital requirements rise, there is less capital available for lending and investing, consequently capital scarcity spreads from the Financial System to the whole economy, and all corporates feel the consequence.

We must understand that this is a Systemic change for the Financial System, from a model based in volume, to a model based in Capital Optimization.

Coming back to the initial point, IFRS 16 requires that Leasing companies make visible the cost of capital of every contract.

And as it happens with any cost, cost of capital reduces the margin and profitability, or forces the company to raise the selling price (making the company less competitive).

It sounds logic then to reduce the cost of capital of the Leasing contract. Let’s see how to do it.

Every Leasing contract represents a collection of three groups of cash-flows.

- Invoices that the lessee will pay in exchange for using the leased asset.
- Value of the leased asset at the beginning and the end of the contract.
- Maintenance costs of the leased asset.

And the value of the contract (leased asset) at the time of the contract activation is determined by discounting the above cash-flows by an interest rate, which combines the funding cost and the contract spread (representing the risk that the contract expected cash flows do not become actual).

Reducing the contract spread, reduces the capital costs and increases the company margin and profitability.

This should be the objective of an IFRS 16 implementation, reducing the capital costs by reducing the risk (spread) associated to the three groups of cash-flows of their Leasing contracts.

We will see detailed examples of the related capital optimization activities in a future blog.

Looking forward to read your opinions.

K. Regards,
Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

IFRS 16 compliance in Leasing Contracts with SAP Flexible Real Estate.

Dear,
As you know, world’s economy is constrained by two forces, limited growth and huge debt, which make capital scarce.

As a consequence, regulators have adapted the Accounting Standards to the requirements of this new economic environment, which is triggering a systemic transformation of the economy, from a model based in Volume, to a model based in Efficient Management of Capital.

We have discussed in the past, how Basel IV and IFRS 9 increase the recognition of the critical value of Capital in the new environment.

Today we will look at the new IFRS 16 Accounting Standard, which increases the visibility of the Cost of Capital in Leasing Contracts.

Traditional Nominal Accounting considers a Leasing Contract as an off-balance commitment, which is only represented in the accounting books at the time of invoicing. But commitments represent taking a risk which consumes Capital, and this Cost of Capital is not visible under Traditional Nominal Accounting. For this reason a new Accounting Standard has become necessary.

Regulators are very aware of the new economic system, constrained by Capital scarcity, and come with a new regulation for Leasing contracts

IFRS 16 postulates that the value of a Leasing Contract is determined by determining the current value of all the future expected Inflows and Outflows of the Leasing Contract (Fair Value).

The procedure for determining the Fair Value is analogous to other IFRS Accounting Standards (IFRS 9, IFRS 17) which discounting these expected Inflows and Outflows according to an Interest Rate, that represents the Price of the money without risk and a Spread representing the risk that the expected Inflows and Outflows do not become actual.

The calculation represents a huge technical challenge, as it represents the necessity of integrating flows of data from very heterogeneous sources, The key word is Integration, and this has been the main value proposition of SAP for the last 40 years.

In a typical scenario, the valuation of a Leasing Contract under IFRS 16 with SAP RE-FX requires managing 4 sources of Data.

- Invoicing Data.- The Leasing Contract manages the generation of Payment Flows from the Contract tenant to the Landlord. The Payment Flows are generated by the Contract Financial Conditions and used in the determination of the Fair Value of the Contract.

- Underlying Asset (Leased Asset) Depreciation.- The Capital associated to the Underlying Asset is committed to the Contract, at the moment of the Contract activation. On the other hand, the Depreciation costs of the Underlying Asset determine the Profitability of the Contract and the residual value of the underlying asset.

- Maintenance Costs of the Underlying Asset (Leased Asset).- The costs associated to the maintenance activities, necessary for keeping the Underlying Asset in working order during the contract duration, determine the Profitability of the Contract. Consequently the Planned Maintenance Costs of the Underlying Asset determine the Capital Committed to the Contract at the moment of the Contract Activation.

- Market Data.- Discount Interest Rate for determining the current value of the future Inflows and Outflows combine the Market Interest Rate without Risk for the maturity of the Leasing Contract, plus an Spread, representing the risk that the Actual Cash Flows do not match the Expected Cash Flows.

From SAP ECC release EhP6 upwards and S/4HANA, SAP provides a new functionality for Valuation of Flexible Real Estate Contracts.

Simplifying, the configuration has two elements:

1) Generation of the Expected Cash-Flows of the Leasing Contract with the functionality of the SAP RE-FX Financial Conditions.

2) Configuration of what Financial Conditions are taken into account in the valuation of the Leasing Contract and in which way.

As the Financial Conditions generate Cash-Flows payable by the Contract tenant, a new group of Statistical Financial Conditions have been included in the system. These Statistical Financial Conditions generate Cash-Flows that are not included in the invoice to the tenant, but can be included in the IFRS 16 Valuation.
For Instance.- The Maintenance Costs can be represented with Statistical Financial Conditions that will be taken into account by the valuation, without being included in the amounts payable by the Contract tenant.

The integration capabilities of the Plants Maintenance, Assets Accounting, Service Management, Profitability Analysis and Flexible Real Estate modules of SAP ECC and S/4HANA, support the reconciliation between the expected and actual Cash-Flows, the accurate valuation of the Leasing Contracts under IFRS 16 and full compliance with the new Accounting Standard.

Additionally, and this is critical in an environment of Capital scarcity, the holistic vision provided by the integration of the above modules, support the Optimization of the resources committed and allocated to the Leasing contracts, reducing the Capital consumption and maximizing the company sustained profitability.

Looking forward to read your opinions.
K. Regards,
Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

Implementing a Capital Optimization model with SAP Bank Analyzer.

Dear,
The Financial System is in the middle of a Systemic Transformation, from a Business Model based in Volume to a Business Model based in Efficient Management of Capital.

The increasing Capital Requirements levels (specially after the implementation of Basel IV), low growth rates of the Global Economy and huge Global Debt (around $233 trillion) are putting a big pressure in Banks’ Solvency positions.

The pressure in the Banks’ Capital positions is not a temporary fashion, Capital scarcity is here to stay and makes Capital Optimization the main priority for Banks’ executives.

As you could see in previous blogs, in my opinion SAP Bank Analyzer is the best Capital Optimizer in the market.


https://www.linkedin.com/pulse/capital-optimization-clearing-houses-blockchain-sap-bank-frances/

https://www.linkedin.com/pulse/capital-optimization-trading-activities-sap-bank-analyzer-frances/

https://www.linkedin.com/pulse/capital-optimization-investment-activities-sap-bank-frances-gil/

http://sapbank.blogspot.com/2017/06/capital-optimization-and-business-case.html

http://sapbank.blogspot.com/2014/05/liquidity-and-capital-optimization-with.html

http://sapbank.blogspot.com/2016/03/impairment-calculations-and-capital.html

But for some reason that I can’t understand, it’s difficult to find voices explaining the Bank Analyzer capabilities as a Capital Optimizer.

I'll try to put my two cents for changing this with this blog.

1) The first step in a Capital Optimization process is measuring accurately the Capital consumed in every market segment that the bank is exposed to.

This is the main value proposition of the Integrated Financial and Risk Architecture of SAP Bank Analyzer.

Bank Analyzer – Credit Risk module will calculate the Risk Weighted Assets of every contract, every risk exposure of the bank’s portfolio, and consequently the Regulatory Capital consumed.

Once we know the Capital consumed by every Contract/Exposure, we can aggregate the Capital consumed according to the analytical dimensions that we have defined in the Bank Analyzer-Results Data Layer, and consequently we will know the Capital consumed in every market segment in which the bank operates.

Alternatively, the SAP Bank Analyzer Credit Portfolio also give us the Economic Capital consumed by market segment, and all the complementary parameters to the Capital consumed.

2) The second step in a Capital Optimization process is the efficient assignment of Collaterals to exposures for reducing the Risk Weighted Assets and the Capital consumed.

The assignment of Collaterals to Exposures is not always an static assignment. The 1 to 1 assignment of a Collateral to an exposure is just the trivial case, but it’s usual that several (n) exposures are assigned to several (m) collaterals.
In case (n) exposures are assigned to (m) collaterals there’s an Optimal Distribution of the Collateral portions to the Exposures, which reduces the Risk Weighted Assets, and consequently the Capital consumption. This is the basis of the Dynamic Management of Collaterals that we discussed in a previous blog, and we will analyze again in a future one.


https://sapbank.blogspot.com/2012/09/capital-management-chapter-v-dynamic.html

The Bank Analyzer – Credit Risk Module has strong capabilities for the Optimal Distribution of Collaterals to Exposures in the Level 2 of the Calculation of the Risk Weighted Assets. These capabilities look at the Probabilities of Default and Exposures at Default of the Exposures and the Collaterals Values, adjusting efficiently the assignment of Collateral portions to Exposures.

3) The third step of a Capital Optimization process is maximizing the Banks profit reducing the Capital Consumed. Every market segment has a potential expected profit, and every market segment has a potential Expected Loss, and consequently a potential Capital Consumption.

Optimizing Capital means identifying the market segments with higher Expected Profit weighted by the Expected Capital consumed of the market segment.

This is the most difficult element of a Capital Optimization process, because it requires a double-synchronized simulation, looking for a solution which minimizes the Risk Weighted Assets maximizing the Expected Profit.

This optimization engine is still not available, but the Integrated Financial and Risk Architecture of Bank Analyzer has been designed for having an Integrated and Reconcilable vision of Risk and Accounting (Profit).

The IFRA is the technical foundation for running cycles of simulation that Capital Managers should run for achieving the Optimal Planning of the bank’s portfolio, reducing the RWA and maximizing at the same time the expected Profit.

Finally, the future will require the automatic calculation and simulation of banks investments, for proposing the Optimal Sales and Execution planning of the Bank. I’ve personally worked in some of this models, by adapting the Theory of Constrains to portfolio management.

These simulations require very strong computing capabilities, but this is the value that SAP HANA provides for solving the problem.

Looking forward to read your opinions.

K. Regards,
Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

Optimizing the Chart of Accounts in SAP Bank Analyzer Smart-AFI and the Universal Journal.

Dear,

Previous versions of SAP ECC and Bank Analyzer gave a preeminent importance to the Posting Key Figures over the GL-Accounts.

From the first SAP R3 release, the Costing Based Operating Concern of the Profitability Analysis module gave us a very flexible framework for building a complete multidimensional Profit and Loss analysis engine. The only difficulty is that the Costing Based Operating Concern is built on Key Figures which makes difficult its reconciliation with the Profit and Loss postings of the General Ledger which are built in GL-Accounts.

On the other hand, we could also use the Account Based Operating concern of the Profitability Analysis module, which provides a complete multidimensional Profit and Loss analysis engine built in GL-Accounts, fully reconcilable with the General Ledger Postings, but the reconciliation problem with the Costing Based Operating Concern remains.

In both cases, we are talking about non-financial related postings. Concepts like Fair Value or Risk-related Costs are very difficult to model in the Profitability Analysis Module of SAP ECC. For covering this gap, SAP developed something new.

The new concept was the SEM-Banking (Strategic Entreprise Management for Banks) module of SAP ECC (IS-Banking), which was the precursor of SAP Bank Analyzer, and the first tool capable of providing a Contract (or more exactly Position) based multi-dimensional Cost-Analysis framework for Banks. Again, SEM Banking was built on Key Figures (Costing Based Operating Concen), with the commented advantages in terms of flexibility and disadvantages in terms or reconciliation.

With Bank Analyzer, SAP solved the problem. In Bank Analyzer we don’t have a Cost Based “Operating Concern” and an Account Based “Operating Concern”, instead the Posting Key Figures and the GL-Accounts are integrated in the same structure (the RDL Result Type) and we can find both in the Financial Position Object.

Nevertheless, this improvement also brought some difficulties; in Bank Analyzer (before Smart-AFI) the Posting Key Figures and GL Accounts of the Accounting entries are not determined at the same time. The Posting Key Figures are determined first (from the Item Type of the BT or the Calculation Step), and later the GL-Accounts.

In fact, the accounting logic is technically configured in the Posting Key Figure (Key Figure Class) and there’s no configuration in the GL-Account, which in Bank Analyzer (before Smart-AFI) was merely the value of a Characteristic with no configuration.

As a consequence of this, it was technically possible to assign a GL-Account to a Posting Key Figure with a different accounting nature, generating serious inconsistencies on the Financial Statements of the Bank.

I’ve seen several clients with bad implementation of Bank Analyzer, with inconsistent Financial Statements, as a consequence of an incorrect configuration of the Posting Key Figures and GL-Accounts determination.

Bank Analyzer Smart-AFI has tackled the above problem simplifying the Accounting Logic Configuration. With Bank Analyzer Smart-AFI, the GL-Accounts are at the center of the Accounting Logic, and they are technically defined with the Accounting Role that they must play, reducing the risk of the inconsistent configurations mentioned above.

By the way, this is coherent with the new Accounting Logic of the Universal Journal of S4 HANA, where we don’t build the multidimensional Profit and Loss analysis engine with Cost Based or Account Based Operating Concerns. All the accounting entries are centrally posted in the Universal Journal, in the form of Coding Blocks and GL-Accounts.

As you can see, in Bank Analyzer Smart-AFI, the GL-Account has become a central pillar of the configuration, and consequently, the Chart of Accounts Optimization has become one of the most critical activities in a Bank Analyzer implementation.

Optimizing the Chart of Accounts has always been a key success factor in a Bank Analyzer implementation. Suboptimal definitions of the Chart of Accounts bring accounting systems difficult to maintain, and in some cases, inconsistent Financial Statements. Smart-AFI brings a new a more simplified accounting architecture. It’s the responsibility of the implementation team to take advantage of it.

Looking forward to read your opinions.

K. Regards,

Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/groups/92860

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

IFRS 9 and IFRS 15 Business Case with SAP Revenue Accounting and Bank Analyzer.

Dear,

Since January the 1^st 2018, Banks and Corporates should be compliant to the new Accounting Standards IFRS 9 and IFRS 15.

In my opinion, most of Banks and Corporates are far from being ready to be compliant to these legal requirements and we will see some examples in the oncoming months.

On the other hand, there is some confusion about the implications of IFRS 9 and IFRS 15, so I’ll try to make a short description with a practical example.

IFRS 15 is relevant for Contracts with customers with particularly visible implications in contracts combining the delivery of Services and Goods.

For instance, a Telecommunications company confirms a contract with a customer committing to deliver Internet access for 12 months for 35 EUR/month and a subsidized Wifi Router for 50 EUR.

Before the IFRS 15 Accounting Principle was implemented, the above contract would produce a revenue in the Telecommunications company of 35 EUR every month, and a one-time revenue of 50 EUR (for selling the Router).

With the implementation of IFRS 15 the company is required to adjust the revenue recognition to a Fair Price of the two sold elements (Router and Internet Access) and the completion of the commitment with the client (deliver the Router and provide the Internet Access). For instance, the Router has been sold to a lower price (subsidized) because the client has committed with a 12 months contract of Internet Access, so it seems logical that a portion of the revenue for selling the router is distributed during the 12 months of the Internet Access.

The International Accounting Standard Board proposes a 5 steps process for fulfilling the IFRS 15 requirements.

Step 1.- Identify the contract with the customer.- This first step has been run just above, identify the contract with the client, in which the company commits to deliver a bundle of services and goods.

Step 2.- Identify Separate Performance Obligations.- Performance Obligations are the promises to the client to transfer Goods or Services. In the above example, the two Performance Obligations are, delivering the Internet service and the Router. At the same time, the company must identify the Stand Alone Selling Price of each Performance Obligation, which is a “Fair Price” that the company would charge for the goods or services if they were sold separately.

The current version (1.3), SAP Revenue Accounting and Reporting does not have the capacity of determining the Stand Alone Selling Prices, but the company can use average historical prices for determining the Stand Alone Selling Price of each Performance Obligation.

In this example we would assume that the Stand Alone Selling Price of the Internet Access is 40 EUR/month and the Stand Alone Selling Price of the Router is 55 EUR.

Step 3.- Determining the Transaction Price which is the actual price that the company is charging to the client for each Performance Obligation. In this case the Transaction Prices are 35 EUR/month for the Internet Access and 45 EUR for the Router.

Step 4.- Allocating the Transaction Price to each Performance Obligation in an amount that depicts the revenue that the company can recognize for delivering the Goods/Services to the client. In our example, they are the following.

Performance Obligation	Transaction Price	Standalone Selling Price	Allocated Amount	Calculation of the Allocated Amount
Router	50 EUR	55 EUR	48 EUR	470*55/535
12 month Internet Service	35*12=420 EUR	40*12=480 EUR	422 EUR	470*480/535
	470 EUR	535 EUR	470 EUR

Step 5 .- Recognize revenue when each performance obligation is satisfied.

Month 1.- Performance Obligation 1 is fully satisfied and Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 48 EUR + 35.17 EUR

Month 2.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.17 EUR

Month 3.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.17 EUR

Month 4.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.17 EUR

….

Month 10.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.17 EUR

Month 11.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.16 EUR

Month 12.- Performance Obligation 2 is satisfied in 8.33%. Revenue Recognition is 35.16 EUR

On the other hand, when the company issues the invoices to the client, the company assumes a Credit Risk that the client is not paying the due amount.

IFRS 9 describes the process for measuring the Expected Loss, which starts by determining the Probability of Default of the Client, based in a Credit Risk model which classifies the Client according to the payment behavior of the clients belonging to the same Risk segment. This process is called Historization and is supported by the SAP Bank Analyzer System.

The second step is determining a Fair Value provision that will reduce the recognized revenue until the client makes the payment. The provision amount is determined by the Key Date Valuation of the AFI-Bank Analyzer module, by discounting the Cash-Flow (due amount) with a Yield Curve with the same maturity of the Cash-Flow and the correspondent Spread of the client’s Probability of Default.

Obviously the provision will increase if the client does not make the payment on time, and the Account Receivable becomes impaired.

SAP offers a complete business suite for fulfilling the requirements of the new Accounting Standards. Unfortunately, technical and functional skills for implementing them are scarce, making the implementation projects very challenging.

Looking forward to read your opinions.

K. Regards,

Ferran.

www.capitency.com

Join the SAP Banking Group at: https://www.linkedin.com/group

Visit my SAP Banking Blog at: http://sapbank.blogspot.com/

Let's connect on Twitter: @FerranFrancesGi

Ferran.frances@capitency.com

Financial Instruments Product Costing Planning with SAP Bank Analyzer.

Dear,
Capital Optimization requires efficient planning, providing management with the necessary information for having resources when they are requested, and taking corrective actions in case of deviations.

Planning relies in accurate Product Costing, assuring that profit and margin objectives are fulfilled in every financial period.

Product Costing for Financial Products has three dimensions; Risk driven Capital Costs, Funding Costs and Process Costs.

1) Risk driven Capital Cost.- IFRS 9 and Basel III require that every bank develops a Risk Model which supports the estimation of the Expected Loss of every Financial Asset. The Expected Loss represent the values of the potential losses in a Financial Asset, multiplied by the probability of that loss occurring, and it is the basis for determining the Fair Value Provisions and Capital Requirements of the Bank. The Fair Value Provisions and Capital Requirements represent a cost for the bank, which must be included in the Product Costing estimations of the bank.

Bank Analyzer -AFI supports the determination of the Fair Value Provisions (IFRS 9) and Bank Analyzer – Credit Risk supports the determination of the Credit Risk Capital Requirements (Basel III), according to the Expected Loss of the Financial Asset. Credit Risk Capital Requirements can be included in the Financial Asset Statement (AFI sub-ledger) as Off-Balance Postings, representing the Capital Cost of the Financial Asset, assuring that the sales price will cover the Risk Driven Capital Costs.

Assuming that the bank has a consistent common risk model per Financial Asset, it means that we can assume a direct relationship between the Expected Loss for Capital Requirements (Basel III) and Fair Value (IFRS 9), to the extent that gives the bank an opportunity to reduce Fair Value provisions in case of excess of Capital Requirements determination.

This double approach of the Expected Loss (Solvency and Accounting) per Financial Asset is a very interesting Value Proposition of the Integrated Financial and Risk Architecture.
Bank Analyzer stores the Expected Loss in the Credit Risk Result Type, and the Fair Value Provisions on the Accounting Result Type of the Results Data Layer. In both cases the results are stored individually per every Financial Asset which opens the gate for representing the Capital Requirements as Accounting Provisions per Financial Asset.

Capital Requirements must be determined under base and stressed scenarios, for this reason, in practical terms, Product Cost Planning requires the bank use Standard Costs, that must be reconcilable with the Expected Loss of the banks risk model, and Capital requirements estimations. This reconciliation is also supported by the Integrated Financial and Risk Architecture of Bank Analyzer.

2) Funding Costs.- The bank has to get liquidity from the market, compensating the liquidity consumed in Lending and Investing. Bank Clients and Capital Markets provide this liquidity at an interest rate, which represents a cost, that the bank must include in the cost estimations of its products.

Liquidity requirements fulfillment are a shared responsibility by all the bank branches and Treasury department. Some branches get liquidity that others consume, with the Treasury department compensating liquidity requirements or excess in the Capital Markets. In exchange for covering the liquidity requirements of other branches, liquidity providers receive internal transfer of the funding cost value (transfer price for liquidity). We’ll talk about this in more detail in a future blog.

3) Process Costs.- In order of getting clients and managing investing and contracts with them, the bank needs resources; staff, information systems, branches, etc. Every contract has to support a fair distribution of its related banks costs, assuring that the selling price is higher enough for assuring a positive margin. The fair distribution of the banks process costs is achieved with the cost analysis model of the bank, using Management Accounting techniques for services like Activity Base Costing, Internal Cost Orders, Cost Center Accounting, etc.

As you can see above, the first two families of costs are financial services driven, while the third is general services driven. Integrating all in the same Financial Statement requires a seamless integration between the Analytical Banking and the ERP System. This is the main advantage of combining SAP Bank Analyzer and S4 HANA Universal Journal, combining in the a unified Financial Statement, all the revenues and cost of a Financial Instrument, so the bank will have the profits and losses of every business segment, and the allocated capital.

We looked at the concept briefly in a previous blog.

https://www.linkedin.com/pulse/why-bank-analyzer-afi-sub-ledger-anymore-chapter-ii-ferran-frances/

And we will come back to this topic, in more detail, in a future one.

Looking forward to read your opinions.
K. Regards,
Ferran.