KNF Recommendation C-SKOK on Accounting for Cooperative Savings and Loan Associations

1 Financial Supervision Commission Recommendation C-SKOK concerning the accounting of cooperative savings and loan associations Warsaw, December 2015

2 Table of Contents I. Introduction............................................................................................................................ 3 II. Glossary of Terms............................................................................................................... 5 III. Scope of the Recommendation .................................................................................................... 6 IV. Principles for determining the fair value of financial instruments ................................ 8 V. Valuation and disclosure principles for debt instruments held by savings and loan associations............. 13 VI. Valuation principles for organized parts of the business separated from the assets of the savings and loan association ............................................................................................ 15 VII. Valuation principles for collateral reducing the basis for making allowances for impairment of receivables ........................................................................... 17 VIII. Principles for accounting for the merger of cooperative savings and loan associations 22 IX. Valuation principles for contributions made to the National Savings and Loan Association for the stabilization fund.... 23

3 I. Introduction Pursuant to Article 62(2) of the Act of 5 November 2009 on cooperative savings and loan associations, the Financial Supervision Commission may issue, after obtaining the opinion of the National Savings and Loan Association, recommendations regarding good practices for the prudent and stable management of savings and loan associations. In the area of accounting, cooperative savings and loan associations apply the Regulation of the Minister of Finance on special rules of accounting for cooperative savings and loan associations, and in cases not regulated by this Regulation, they apply the provisions of the Regulation of the Minister of Finance on detailed rules for recognition, valuation methods, scope of disclosure, and presentation of financial instruments. The present material constitutes a summary of the Office of the Financial Supervision Commission's previous experience in supervising cooperative savings and loan associations, particularly those related to the accounting of savings and loan associations. Due to disturbing phenomena regarding the incorrect application of asset valuation methods, which have a key impact on the financial results of individual savings and loan associations, and consequently on the incorrectly presented financial data in financial statements and reports submitted to the supervisory authority, it was necessary to develop a document constituting a collection of good practices recommended to savings and loan associations, with the aim of improving the quality of data and information presented in broadly understood reporting. The principles of good practices described in the recommendation were developed based on conclusions drawn from inspection experience and "desk-based" supervision regarding irregularities identified in the SKOK sector, primarily in the estimation of the fair value of assets. The guidelines contained in the recommendation relate to the accounting treatment of transactions that have a significant impact on the faithful and clear presentation of the asset and financial situation, as well as the correct determination of the financial result of cooperative savings and loan associations. Therefore, any deviation from the principles presented in the content of the recommendation may occur only if it does not have a significant impact on the faithful and clear presentation of the asset and financial situation of the savings and loan association and does not have a significant impact on the financial result. The principle of proportionality should also be applied in a manner that does not have a significant impact on the faithful and clear presentation of the asset and financial situation of the savings and loan association. With regard to savings and loan associations meeting both criteria: total assets below 50 million PLN and number of members below 10,000, it is possible to refrain from applying the provisions presented in Chapter V of the Recommendation - Valuation and disclosure principles for debt instruments held by savings and loan associations, regarding disclosures. The Financial Supervision Commission expects that the Recommendation concerning the accounting of cooperative savings and loan associations, which constitutes an annex to Resolution No. …./2015 of the Financial Supervision Commission of 15 December 2015 (Journal of Laws of KNF No. ….), will be implemented no later than by 30 June 2016.

4 II. Glossary of Terms Savings and Loan Association or SKOK – cooperative savings and loan association; National Savings and Loan Association – Krajowa Spółdzielcza Kasa Oszczędnościowo–Kredytowa; Office of the Financial Supervision Commission (UKNF) – Urząd Komisji Nadzoru Finansowego; Fair value - the amount for which an asset could be exchanged, or a liability settled, in an arm's length transaction between knowledgeable, willing parties. Income approach - an approach based on the present value of reliably estimated discounted future cash flows; a valuation technique that allows converting future amounts into a single present (i.e., discounted) amount. The valuation of fair value is based on the value resulting from market expectations regarding these future amounts. Observable inputs - inputs developed based on market data, such as publicly available information about current events or transactions, and reflecting assumptions that market participants would use when valuing an asset or liability. Risk premium - compensation expected by risk-averse market participants for uncertainty related to cash flows concerning an asset or liability on a percentage basis. Also referred to as "risk adjustment." Unobservable inputs - inputs for which market data is not available and which are developed using the best available information about assumptions that market participants would use to value an asset or liability. Regulation - Regulation of the Minister of Finance of 25 June 2014 on special rules of accounting for cooperative savings and loan associations.

5 III. Scope of the Recommendation In connection with the identification by the UKNF of problems, regarding which both savings and loan associations and auditors examining their financial statements previously presented different approaches, the following areas of special doubt in the field of accounting law are indicated below, which include: • principles for determining the fair value of financial instruments; • principles for valuing an organized part of the business separated from the assets of the savings and loan association; • principles for valuing collateral reducing the basis for making allowances for impairment of receivables; • principles for accounting for the merger of cooperative savings and loan associations; • principles for valuing contributions made to the National Savings and Loan Association for the stabilization fund. An analysis of financial information of the SKOK sector during the period of supervision over savings and loan associations confirmed that some savings and loan associations failed to develop so-called "good practices" related to the aforementioned issues. On 1 January 2015, the Regulation of the Minister of Finance of 25 June 2014 on special rules of accounting for cooperative savings and loan associations entered into force. Reliable determination of fair value, in accordance with the provisions of the Regulation, is carried out based on one of several valuation methods for estimating fair value indicated in §21(2) of the Regulation. The application of the fair value determination method depends on many factors, including whether the financial asset is subject to trading on an active market or whether it is impossible to estimate the value of the financial instrument using the income approach of reliably estimated discounted future cash flows. Fair value is considered reliable if determined by: • valuation of a financial instrument at a price established on an active market; • estimation of the price of a financial instrument for which there is no active market, based on the publicly announced price of a similar financial instrument that does not differ significantly or prices of components of a complex financial instrument quoted on an active market; • application of an appropriate financial instrument valuation model, and the input data introduced into this model come from an active market; • estimation of the value of a financial instrument using the income approach of reliably estimated discounted future cash flows; the discount rate includes at least the risk-free rate and a risk premium; • estimation of the value of debt financial instruments by a specialized, independent entity providing such services, provided that a reliable estimation of future cash flows associated with these instruments is possible. There is a need to indicate correct solutions in the area of asset valuation at fair value, which should be included by savings and loan associations in their accounting policies, referred to in Article 4(1) of the Act of 29 September 1994 on Accounting, in order to achieve the goal specified in this provision, i.e., faithful and clear presentation of the asset and financial situation and financial result.

6 IV. Principles for determining the fair value of financial instruments General Principles

1. When valuing held financial instruments at fair value, the savings and loan association should apply the provisions of §21(2) of the Regulation, while in the event of an impairment indicator for a financial asset classified as "Available for sale," it should apply §24 of the Regulation. The following principles concern the detailing of methods for determining fair value indicated in §21(2) points 4 and 5 of the Regulation.
2. The purpose of estimating fair value is to determine what the price would be in a transaction conducted under normal conditions for the sale of an asset or transfer of a liability between unaffiliated market participants on the valuation date and under current market conditions.
3. In situations where the price for a similar asset or similar liability cannot be observed, the savings and loan association should determine the fair value by one of the paths indicated in the provision of §21(2) of the Regulation, within which observable inputs are used to the greatest extent possible and unobservable inputs are used to the least extent possible.
4. If observable prices for similar assets or similar liabilities are not available, nor is §21(2) point 3 of the Regulation applicable, i.e., if it is not possible to apply an appropriate financial instrument valuation model to which input data comes from an active market, the savings and loan association should determine the fair value of the financial instrument using the income approach.
5. The savings and loan association is obliged to develop unobservable inputs, using all information available in the circumstances, which may also include the savings and loan association's own data. When developing unobservable inputs, the savings and loan association may initially use its own data, but should correct them if available information indicates that other market participants would use different data. The savings and loan association should consider all available information about assumptions made by market participants. In the case of using own data, these data must be verifiable.

7 Income Approach 6. When determining the fair value of a financial instrument in accordance with §21(2) point 4 of the Regulation, the savings and loan association should apply the income approach. 7. The income approach is based on converting future cash flow amounts (inflows reduced by outflows) into a single present (i.e., discounted) amount. The purpose of applying the income approach is to obtain a fair value valuation that reflects current market expectations1 regarding these future amounts. 8. The income approach is a tool used to link future cash flows with the present amount using a discount rate. Valuation of the fair value of an asset or liability using this approach includes all of the following elements on the valuation date: a. estimated future cash flows with respect to the financial instrument being valued; b. expectations regarding possible fluctuations in the amount and timing of cash flows representing uncertainty inherent in cash flows; c. time value of money (i.e., the risk-free interest rate); d. price of uncertainty related to cash flows (i.e., risk premium); e. other factors that market participants would consider in the given circumstances; f. in the case of a liability, the risk of non-performance associated with the liability, i.e., the savings and loan association's own credit risk (debtor). 9. General principles for applying the income approach: a. cash flows and discount rates should reflect assumptions that market participants would make when valuing an asset or liability; b. cash flows and discount rates should include only factors attributable to the asset or liability being valued;

1 The savings and loan association determining the fair value of an asset should use a discount rate appropriate for the given asset, not a discount rate appropriate for the savings and loan association or another similar entity. Similarly, expectations regarding cash flows accepted in the valuation of a given financial instrument also concern the instrument being valued and not other centers generating cash.

8 c. double counting or omission of the effects of risk factors associated with applied discount rates and cash flows should be avoided; d. assumptions regarding cash flows and discount rates should be internally consistent; e. discount rates should reflect the basic economic factors of the currency in which cash flows are denominated. Risk and Uncertainty 10. Cash flows used in the income approach are of an estimated nature. 11. Market participants demand benefits (i.e., risk premium) in connection with uncertainty related to financial flows concerning an asset or liability. Therefore, the valuation of fair value includes a risk premium reflecting the amount that market participants would demand as compensation for uncertainty related to cash flows. Otherwise, the valuation would not faithfully reflect fair value. 12. To estimate the expected return for valuing risky assets, capital asset pricing models (Capital Asset Pricing Model - CAPM) should be used. The expected rate of return should be determined taking into account the specific risk of the given financial instrument. Disclosures regarding valuation at fair value 13. Guided by the principles contained in point 2, the savings and loan association should disclose at least the following information2: a. description of the valuation technique(s) and inputs used in the fair value valuation. If there was a change in accepted assumptions (e.g., regarding planned cash flows or discounting), the savings and loan association should disclose the change and its reasons;

2 These information should be disclosed in the notes to the financial statement in every situation if they could significantly influence the assessment of the asset and financial situation and financial result of the savings and loan association.

9 b. quantitative information on significant unobservable inputs used in the fair value valuation; c. presentation of the sensitivity of the fair value valuation to changes in unobservable inputs, if a change in these inputs resulting in a different amount could lead to a significantly higher or lower fair value valuation. If there are connections between inputs and other unobservable inputs used in the fair value valuation, the savings and loan association should also present a description of these connections and the manner in which they may affect the change in unobservable inputs in determining fair value; d. information about the reasons for changes in fair value, if changes are significant, and the method and effects of calculating such change resulting, in the case of financial assets and financial liabilities, from the change of each element of unobservable inputs (usually determined to reflect possible alternative assumptions significantly affecting the change in fair value). For this purpose, the effect of the change is assessed with respect to the financial result and total assets. Valuation 14. In the case of the existence of historical data (e.g., regarding the actual repayability of a given financial instrument or cash flows actually generated for the savings and loan association by a given instrument), it is not permissible to apply a financial instrument valuation model at fair value without taking into account the historical repayment results of this instrument or cash flows actually generated for the savings and loan association by a given instrument. 15. In addition to actual (historical) cash flows, the savings and loan association should use (historical) projected trends of planned future cash flows with respect to a given financial instrument in fair value valuation, along with a detailed justification of accepted assumptions and indication of the method of implementing accepted assumptions. 16. When valuing fair value solely based on unobservable inputs, the savings and loan association should justify the method of forecasting future cash flows with respect to actual (historical) cash flows generated by the financial instrument and actual effectiveness of actions taken to realize cash flows from a given financial instrument. 17. When discounting planned future cash flows to present value, the savings and loan association should apply a discount rate corresponding to market participants' expectations regarding the discount that should correspond to issued financial instruments. The savings and loan association should not apply only the risk-free rate or the rate resulting from the weighted average cost of capital for the given savings and loan association as a discount rate, because the savings and loan association would not obtain financing at the level of its members' deposits in the situation of having on the asset side, for example, only financial instruments with increased risk, including those issued based on overdue credits and loans.

10 V. Valuation and disclosure principles for debt instruments held by savings and loan associations 18. Debt instruments are classified as "loans and receivables and other receivables." Initial valuation of debt instruments takes place in accordance with §18(2) of the Regulation. 19. Valuation of debt instruments on the balance sheet date is carried out based on the provisions of §21(1) and taking into account the provisions of §23 of the Regulation. For the correct measurement of credit risk, no later than on the last day of the month ending the quarter, the savings and loan association makes an assessment of credit risk based on applicable provisions and taking into account information developed by the savings and loan association, which should be subject to disclosure in the notes to the financial statement, regarding: a. the original schedule, all changes made, and the current schedule of planned cash flows from held debt instruments (on a monthly basis); b. a description of any changes in the schedule of planned cash flows along with justification of the reasons for these changes; c. the age structure of receivables forming the basis for the issuance of a debt instrument, divided into the following periods of overdue status (not overdue, overdue up to 1 year, overdue up to 2, 3 …. 10 years); d. the value of receivables on the date of issuance of the debt instrument, divided among individual debtors of savings and loan associations, the amounts of repayments made by these debtors from the date of issuance of the debt instrument to the valuation date, and the amounts received by the savings and loan association resulting from the aforementioned payments; e. the average period of overdue status of credits and loans forming the basis for the issuance of a debt instrument on the date of issuance; f. the annual average effectiveness of collecting the portfolio of credits and loans similar3 to the portfolio forming the basis for the issuance of debt instruments for the period for which the debt instrument was issued;

3 In terms of quantity (i.e., number of customers) and value (i.e., value of individual exposures)

11 g. determination of the actual effectiveness of collecting individual credits and loans forming the basis for the issuance of a debt instrument in quarters following the issuance of the debt instrument. It should be emphasized that the effectiveness of collection in individual savings and loan associations is different and cannot be equated with the effectiveness of collection in the entire sector; h. a realistic plan for collecting individual amounts. The plan should take into account the period for which the debt instrument was issued, along with the indication of monthly or quarterly collection goals. It should be based on curves presenting the actual effectiveness of the savings and loan association's collection in a period at least corresponding to the period for which the debt instrument was issued for a portfolio similar4 to the portfolio of credits and loans forming the basis for the issuance of the given debt instrument. The plan should be updated periodically (quarterly) depending on whether the difference between the planned and actual amount of cash received significantly affects the valuation of the debt instrument and thus the financial situation and financial result of the savings and loan association (also in the context of savings and loan associations fulfilling all norms resulting from legal provisions); i. the discounted present value of cash flows on a given reporting date. The discount rate should include at least: the risk-free rate and a risk premium, the amount of which is related to the characteristics of the issued securities (i.e., debt instruments whose repayability depends on the repayability of credits and loans overdue for many years). The absence of the above information indicates the inability to reliably estimate cash flows associated with these instruments.

4 In terms of quantity (i.e., number of customers) and value (i.e., value of individual exposures)

12 VI. Valuation principles for organized parts of the business separated from the assets of the savings and loan association 20. Financial assets arising from subscribing to shares or stock of another entity in exchange for a non-monetary contribution are classified as financial assets available for sale. 21. Initial valuation of financial assets arising from subscribing to shares or stock of another entity in exchange for a non-monetary contribution is determined based on §18(3) of the Regulation, taking into account appropriately the provision of §21(2) and the principles presented in Chapter IV in points 1 to 17. 22. When valuing held shares and stock on the balance sheet date, the savings and loan association should apply the fair value valuation principles presented in Chapter IV in points 1 to 17. 23. When separating an organized part of the business, the savings and loan association should develop an economic justification for this operation, along with an indication of the impact of this event on the financial results of the savings and loan association in a horizon at least accepted for the fair value valuation of the organized part of the savings and loan association's business. The savings and loan association should disclose5 planned costs, which the savings and loan association up to the moment of separation of the organized part...

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