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July 24, 2014 1:02 pm
Tough new rules are set to push banks to take a hit on their balance sheets for losses they expect to make in the future in the culmination of a five-year project to make company accounts paint a more accurate picture.
The international accounting standard setter on Thursday published a standard on financial instruments, a key part of which is a change in the impairment model for how companies recognise losses.
The new standard, issued by the London-based International Accounting Standards Board as IFRS 9 Financial Instruments, moves from an incurred loss model to an expected loss model, marking a big change for banks, insurance companies and the users of financial statements.
For the first time, banks will have to recognise not only credit losses that have already occurred but also losses that are expected in the future. This is designed to help ensure that they are appropriately capitalised for the loans that they have written.
IFRS rules are required to be used by listed companies in more than 100 countries, although the US is a notable exception, and in Japan the use of them is voluntary.
Concerns about impairment came under the spotlight during the financial crisis because banks were unable to book accounting losses until they were incurred, even though they could see the losses coming.
At times the incurred loss rule meant banks overstated profits upfront and did not make prudent provisions against expected losses, particularly in areas such as the loans they secured against real estate.
For an example on how impairment charges will be applied under the new standards
At the G20 summits in 2009, world leaders declared that improvements needed to be made to financial reporting, and the IASB took up the baton to address the weakness in existing standards, alongside its US counterpart, the Financial Accounting Standards Board.
The new standard, which comes into effect on January 1 2018, means that companies must make a provision for potential credit losses over the next 12 months. Where credit risks are deemed to have increased significantly, banks have to record the lifetime expected credit loss.
For an explanation on four key points behind the rule changes
The new standard’s publication comes as the largest banks across the eurozone are facing the European Central Bank’s stress tests and asset quality review in November, which could result in their having to put aside more capital.
According to a Deloitte survey published last month, more than half of the banks surveyed by the professional services firm believed that the new IFRS 9 expected loss accounting rules would increase loan loss provision by up to 50 per cent, adding to the pressure they already face from regulators.
Efforts between the IASB and the US FASB to create a converged financial instruments standard ended earlier this year, which will reduce investor comparability of European banks against their US counterparts.
Dr Nigel Sleigh-Johnson, head of the financial reporting faculty at ICAEW, the UK accountancy body, said: “While, importantly, both boards have moved from an incurred loss model to an expected loss one, it’s not an ideal outcome for such a significant sector in such a significant area of accounting. Investors will have to understand sets of accounts prepared under both regimes, and it will be harder for investors to benchmark.”
It will also mean more work for banks that have both an international and a US presence, according to Andrew Spooner, lead financial instruments partner at Deloitte.
“These banks will have the burden of calculating impairment on two different bases,” he said.
The key area of divergence between the US and international standards is how far companies should look forward when they make provisions for losses. The FASB standard, which is still in the works, is likely to require companies to make provisions over the lifetime of a loan, rather than just 12 months.
Banks [with both an international and a US presence] will have the burden of calculating impairment on two different basis
- Andrew Spooner, Deloitte partner
While the US approach will not change the size of the losses, it will accelerate the timing of when they appear on banks’ balance sheets.
The new standard is likely to provide better transparency on a company’s credit risk and provisioning process but it introduces a greater degree of subjectivity because it is more forward looking. One challenge for auditors, banks and regulators is that banks could have different valuations of collateral and different treatments of trigger events that resulted in an expected loss.
Mr Spooner said: “When you have more judgment, there is potential for greater variability and there is a potential lack of comparability as the prospects for the future are assessed differently by different institutions.”
Companies will face the cost of upgrading their systems and processes to move from calculating incurred loss to expected loss.
Q & A: four key points on the new standards
1. What is IFRS 9 Financial Instruments?
IFRS 9 is a new international standard that represents a package of reform to financial instruments accounting. The standard, which was published on Thursday by the International Accounting Standards Board, will come into effect on January 1 2018, and is the culmination of five years of work to improve the previous standard, IAS 39.
2. What is the key element to IFRS 9?
At its heart, IFRS 9 changes the impairment model for how companies recognise losses. This came into the spotlight during the financial crisis when banks were unable to book accounting losses until they were incurred, even though they could see the losses coming. IFRS 9 moves from an incurred loss model to an expected loss model. This means that companies such as banks will have to recognise not only credit losses that have already occurred but also losses that are expected in the future.
3. Who will be most affected?
Undoubtedly the banks and insurance companies that hold large portfolios of loans on their books. Banks will face the cost of updating their systems and processes to move from calculating incurred loss to expected loss. The US standard for financial instruments, which its standard setter the Financial Accounting Standards Board is set to publish later this year, is stricter than IFRS 9 on the timing of loan loss provisions and will accelerate the timing for loan losses to appear on the balance sheet. So banks that have international and US operations will also face the burden of adjusting their systems to calculate impairment under two different accounting regimes.
4. What else is part of IFRS 9?
Impairment aside, there are three other main elements to IFRS 9: classification and measurement, hedge accounting and own credit. IFRS 9’s approach to classification of financial assets moves from complex, rule-based requirements to a principle-based approach, driven by cash flow characteristics and the business model in which an asset is held.
Hedge accounting is also being overhauled, with enhanced disclosures about risk management activity under the new standard so that users of financial statements have better information on the effect of hedge accounting on the financial statements.
Lastly, IFRS 9 changes accounting so that gains caused by deterioration of an entity’s own credit risk on such liabilities are no longer recognised in profit or loss. Under the old regime, changes in the credit risk of liabilities were measured at fair value, which meant that if a bank’s debt fell in value, it booked gains in its profit and loss account.
Case study: the impairment of financial assets
A bank makes a five-year loan of $1,000,000 to Company A in the last quarter of 2018. The bank makes an initial credit assessment consistent with the economics of the lending decision.
As long as a loan is performing as expected when money was first lent, no credit loss is suffered economically, so IFRS 9 requires a portion of lifetime expected credit losses to be recognised (12-month expected credit losses).
In this instance, the bank assesses that there has been no change in the credit risk – ie the risk of a default occurring – since initial recognition. The bank estimates the loan loss allowance based on 12-month expected credit losses to be $1,250.
A year later, at December 31 2019, the bank assesses the credit risk over the life of the loan based on currency conditions and relevant forecast conditions over the remaining life of the loan. While the loan is currently performing, the bank determines that the credit risk on the loan – the likelihood of it defaulting – has increased significantly.
When a loan’s credit risk increases significantly from the initial expectations the lender is no longer being compensated for the losses to which it is exposed and so IFRS 9 requires lifetime expected credit losses to be recognised.
The bank estimates that at December 31 2019 the lifetime expected credit losses for the loan are $9,000.
Previous IFRS (IAS 39)
● Impairment of financial assets is recognised on an incurred loss basis, which requires objective evidence of likely impairment before a provision can be made.
● At December 31 2018, there is no objective evidence of impairment, hence no provision is made.
● At December 31 2019, the bank continues to recognise the loan at $1,000,000 because there is still no objective evidence of impairment that has an impact on the estimated future cash flows of the financial asset, even though the risk of impairment has increased significantly.
New requirements (IFRS 9 – 2014)
● Impairment of financial assets is recognised on an expected credit loss basis, which requires historic, current and forecast information to be considered in determining the loss allowance.
● At December 31 2018, the bank recognises a loss allowance at an amount equal to 12-month expected credit losses of $1,250. The bank recognises an impairment loss of $1,250 in profit or loss.
● At December 31 2019, the bank has assessed that the credit risk of the loan has increased significantly since initial recognition and therefore recognises a loss allowance of an amount equal to lifetime expected credit losses. The bank recognises an additional impairment loss of $7,750 (or $9,000-$1,250) in profit or loss accordingly.
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