5.4. Valuation of financial assets and liabilities, derivative financial instruments

At the moment of the initial recognition the financial assets are classified into the following categories:

• financial assets measured at amortised cost,
• financial assets measured at fair value through other comprehensive income,
• financial assets measured at fair value through profit or loss.

The above mentioned classification is based on the entity’s business model for managing the financial assets and the characteristics regarding the contractual cash flows (i.e.‘criterion SPPI’).

The financial assets could be classified depending on the Group’s business model to the following categories:

• a business model whose objective is to hold financial assets in order to collect contractual cash flows,
• a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets,
• other business model than business model whose objective is to hold financial assets in order to collect contractual cash flows and business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.

Classification, measurement and presentation of financial assets

Classification, presentation and measurement of financial liabilities

The assessment of the business model is made at the initial recognition of the asset. The business model criteria refers to the way the Group managing financial assets in order to generate cash flows.

The Group evaluates the purpose of the business model, to which the particular financial assets are classified on the level of particular portfolios of the assets – performing the analysis on those portfolio level is a reliable reflection business activities regarding these models and also reflects to information analysis of those activities provided to the Group’s management.

The assessment of the business model is based on the analysis of the following information regarding the portfolio of the financial assets:

• applied policies and business aims for the particular portfolio and its practical implementation. In particular, the management’s strategy regarding the acquisition of revenues from contractual interest payments, maintaining a specific interest rate profile of the portfolio, managing the liquidity gap and obtaining cash flows as a result of the sale of financial assets is assessed,
• the manner in which the profitability of the portfolio is assessed and reported to the Bank’s Management Board,
• types of risk that affect the profitability and effectiveness of a given business model (and financial assets held under this business model) and the manner of managing the identified types of risk,
• the way in which the managers of business operations are remunerated under a given business model – eg. whether the remuneration depends on changes in the fair value of financial assets or the value of contractual cash flows obtained,
• frequency, value and moment of sale of financial assets made in prior reporting periods, the reasons for these sales and expectations regarding future sales activity. However, information on sales activity is analyzed taking into account the overall assessment of the Group’s implementation of the adopted method of managing financial assets and generating cash flows.

Before making a decision regarding allocating a portfolio of financial assets to a business model which purpose is to obtain contractual cash flows, the Group reviews and evaluates significant and objective quantitative data influencing the allocation of asset portfolios to the relevant business model, in particular:

• the value of sales of financial assets made within the particular portfolios,
• the frequency of sales of financial assets as part of particular portfolios,
• expectation analysis regarding the value of planned sales of financial assets and their frequency of the particular portfolios, this analysis is carried out on the basis of probable scenarios of the Group’s business activities in the future.

The portfolios of financial assets from which sales are made that do not result from an increase in credit risk meet the assumptions of the business model, which purpose is to obtain contractual cash flows, provided that these sales:

• are at low volume (even with a relatively high frequency of sales) or
• are made rarely – as a result of one-off events, which the probability to occur again in the future, according to the Group’s professional judgment is rare (even with a relatively high volume) or
• they occur close to the maturity date of the financial assets being sold, and the revenue obtained from such sales is similar to those which could be obtained from remaining contractual cash flows as if the financial asset was held in the Group’s portfolio to the original maturity date.

The following sales are excluded from the analysis of sales value:

• the sales resulting from an increase in the credit risk of financial assets, regardless of their frequency and volume,
• the sales resulting from one-off events, which the probability to occur again in the future, according to the Group’s professional judgment is rare,
• the sales made close to maturity.

A held to obtain contractual cash flows or sale business model includes a portfolio of financial assets whose purpose is, in particular, managing current liquidity levels, maintaining the assumed profitability profile and/or adjust the duration of the asset and financial liabilities, and a level of sales are higher than for those financial assets classified in a model which purpose is to obtain contractual cash flows.

The business model comprising financial assets held for sale and other includes assets that do not meet the criteria to be classified into the business model, which purpose is to obtain contractual cash flows the business model which purpose is to obtain contractual cash flows or sales and also acquiring cash flows from interest and capital is not the main business target.

For the purposes of assessing cash flow characteristics, ‘principal’ is defined as the fair value of a financial asset at the time of initial recognition. ‘Interest’ is defined as the time value of money and the credit risk related to the unpaid part of principal and also other risks and costs associated with a standard loan agreement / a security (e.g. liquidity risk or administrative costs) and margin.

When assessing whether the contractual cash flows constitute solely payments of principal and interest, the Group analyzes contractual cash flows. This analysis includes an assessment whether the contractual terms include any provisions that the contractual payments could be changed or the amount of the contractual payments could be changed in a way that from an economic point of view they will not only represent repayments of principal and interest on the outstanding principal. When making this assessment, the Group takes into account the occurrence of, among others:

• conditional events that may change the amount or timing of the payment,
• financial leverage (for example, interest terms include a multiplier greater than 1),
• terms regarding the extension of the contract or prepayment option,
• terms that the Group’s cash flow claim is limited to a specified assets (e.g. non-recourse assets),
• terms that modify the time value of money – e.g. mismatch of the frequency of the revaluation of the reference interest rate to its tenor.

The SPPI test is conducted for each financial asset classified into the business model, which purpose is to obtain contractual cash flows or a business model which purpose is to obtain contractual cash flows or sale, as at the initial recognition date or as at the latest significant annex date changing the terms of contractual cash flows.

The Group performs an SPPI test at the level of homogeneous groups of standard products or at the level of a single contract for non-standard products.

In situation when the time value of money is modified for a particular financial asset, the Group is required to make an additional assessment (i.e. Benchmark Test) to determine whether the contractual cash flows are still solely payments of
principal and interest on the principal amount outstanding by determining how different the contractual (undiscounted) cash flows could be from the (undiscounted) cash flows that would arise if the time value of money element was not be modified (the benchmark cash flows).

Benchmark Testing is not permitted for situation that some terms modify contractual cash flows, such as the built-in leverage element.

Financial assets are not reclassified in the reporting periods following the initial recognition, except for the reporting period following the change of the business model for managing financial assets by the Group.

The reclassification of financial assets is applied prospectively from the reclassification date – without restatement of previously recognized gains or losses (including impairment gains or losses) or interest.

The following are not changes in business model:

• a change in intention related to particular financial assets (even in circumstances of significant changes in market conditions),
• the temporary disappearance of a particular market for financial assets,
• a transfer of financial assets between parts of the entity with different business models.

If the terms of the financial asset agreement change, the Group assesses whether the cash flows generated by the modified asset differ significantly from those generated by the asset before modifying the terms of its agreement. If a significant difference is identified, (defined by the quantitative criteria presented below), the original financial asset is derecognised, and the modified financial asset is recognized in the books at its fair value.

Income or expense arising as at the date of determining the effects of the significant modification is recognized in the profit and loss in the item ‘Profit (loss) on derecognition of financial assets and liabilities not measured at fair value through profit or loss’.

If the cash flows generated by the modified asset measured at amortized cost are not materially different from the original cash flows, the modification does not result in derecognition of the financial asset. In this case, the Group recalculates the gross carrying amount of the financial asset, and the result on the immaterial modification is recognized in interest income. Quantitative information about financial assets that were subject to modification that didn’t result in derecognition was presented in Note 47.2.

The assessment whether a given modification of financial assets is significant or insignificant modification depends on the fulfillment of qualitative and quantitative criteria.

The Group has adopted the following quality criteria to determine significant modifications:

• currency conversion, unless it results from existing contractual provisions or requirements of applicable legal regulations,
• change (replacement) of the debtor, excluding the addition/departure of the joint debtor or taking over the loan in inheritance,
• consolidation of several exposures into one under an annex or settlement/restructuring agreement.

The occurrence of at least one of these criteria results in a significant modification.

The Group has adopted the following quantitative criteria to determine significant modifications:

• extension of the loan term by at least one year and at least a doubling of the residual maturity to the original maturity (meeting both conditions jointly) for Stage 1 and Stage 2, or
• increasing the current loan amount/limit by at least 10% for Stage 1 and Stage 2 or increasing the current loan amount/limit for a contract in Stage 3.

If the terms of a financial asset agreement are modified, and the modification does not result in derecognition of the asset from the balance sheet, the determination, whether the credit risk of a given asset significantly increases, is made by comparing:

• lifetime PD on the reporting date, based on modified conditions, with
• lifetime PD estimated on the basis of data valid at the date of initial recognition and initial contractual terms.

In the case of modification of financial assets, the Group analyzes whether the modification has improved or restored the Group’s ability to collect interest and principal. As part of this process, the Group assesses the borrower’s ability to pay in relation to modified terms of agreement.

Financial assets are derecognized when the contractual rights to the cash flows from the financial assets expire or when the Group transfers the contractual rights to receive the cash flows in a transaction in which substantially all risk and rewards of ownership of the financial asset are transferred.

The Group derecognizes a credit or a loan receivable, or its part, when it is sold. Additionally, the Group writes-off a receivable against the corresponding impairment provision (completely or partially) when the debt redemption process is completed and when no further cash flows from the given receivable are expected.

The value of contractual cash flows required under contracts of financial assets, which were written-off in 2021 and are still subject to enforcement proceedings as at 31 December 2021, is PLN 425,329 thousand (as at 31 December 2020 – PLN 597,760 thousand).

Accumulated profits and losses that have been recognized in other comprehensive income from equity instruments designated to be measured at fair value through other comprehensive income are not recognized in the profit and loss account when these financial instruments are removed from the balance sheet.
The Group derecognizes a financial liability, or its part, when the liability expires. The liability expires when the obligation stated in the agreement is settled, redeemed or the period for its collection expires.

Repo and reverse-repo transactions, as well as sell-buy back and buy-sell back transactions are classified as sales or purchase transactions of securities with the obligation of resale and repurchase at an agreed date and price.

Sales transactions of securities with the repurchase obligation granted (repo and sell-buy back) are recognized as at transaction date in amounts due to other banks or amounts due to customers from deposits depending upon the counterparty to the transaction. Securities purchased in reverse-repo and buy-sell back transactions are recognized as loans and receivables from banks or as loans and receivables from customers, depending upon the counterparty to the transaction.

The difference between the sale and repurchase price is recognized as interest income or expense, and amortized over the contractual life of the contract using the effective interest rate method.

Other significant accounting policies are presented in the Notes below.