5 practical considerations while implementing IFRS 9
The IASB project to review accounting for financial instruments had two main objectives: to simplify accounting for financial instruments and to address deficiencies in their recognition and measurement which were exposed by the financial crisis.
IFRS 9 is effective for periods beginning on or after 1 January 2018 and it is therefore essential consider transitional arrangements, accounting options and practical expedients, and to finalise a detailed plan for its implementation.
The impact of this standard goes well beyond a simple technical change in accounting policy. It may require some restructuring of the Risk and Finance functions and major changes in the recognition of credit losses, data management, information systems, governance and internal controls.
1. Risk management strategy: Does the new standard change how a company manages risks?
The impact of the new standard could be significant in terms of capital and business model management. The impairment model is likely to have a negative impact on equity and net income, but it is also likely to generate more volatility in provisions. These consequences could persuade some companies to rethink their business model, which could lead to restructuring, divestments and repositioning in other market segments.
It may also be appropriate for companies to review their current risk management strategy and the financial instruments they used manage financial risks. IFRS 9 allows more risks to be managed whilst achieving hedge accounting, meaning that there are opportunities to implement more dynamic hedging programmes.
Companies should therefore review their hedging strategy, assessing all sources of risk, defining their risk appetite and analysing available hedging options to identify impacts and opportunities of using alternative accounting treatments better aligned with risk management activities.
2. Classification and measurement: challenges that should not be underestimated
IFRS 9 requires financial instruments to be classified into one of three categories: Fair Value through Profit or Loss (FVTPL), Amortised Cost and Fair Value through Other Comprehensive Income (FVTOCI).
The classification determines how they are recorded in the financial statements and how they are valued. There is one principles-based classification approach for all types of financial assets, which depends on two criteria, the business model and the characteristics of the cash flows of the financial assets considered.
The challenges associated with classifying financial instruments should not be under-estimated. It will be necessary to :
- assess how the entity manages its loans and receivables in terms of its business model and collecting the contractual cash flows from these assets;
- undertake a review of all financial assets to ensure a consistent approach to classification and valuation;
- understand the rules relating to the reclassification of financial instruments between categories.
3. Expected credit loss (ECL) model: a real challenge!
Under the forward-looking approach in IFRS 9, companies will have to recognise immediately a certain amount of expected credit loss as an expense through profit or loss. At each subsequent balance sheet date, the expected credit risk should then be re-evaluated, to take into account any significant increase in the credit risk and expected loss.
Implementing the ECL model can be a real challenge for companies:
- They will need to develop estimates of expected credit losses over the life of the financial instrument and monitor their exposures continually, and comply with new financial reporting requirements.
- The interpretation of ‘significant increase’ and ‘default’ is subject to judgment: estimating ‘expected loss’ will not be a simple task.
- They must develop an ECL model capable of applying the expected loss methodology to different asset classes.
- An increase in cooperation between the Risk and Finance departments is required.
4. Impact on IT systems, processes and controls
Not all the data required for IFRS 9 will be readily available within Risk and Finance departments. More reporting and documentation may be required for the business model and hedge accounting, and forward-looking data will be needed to implement the impairment model.
Information systems must be adapted for:
- calculating expected losses based on payment forecasts, available risk data and probabilities of default;
- reporting in accordance with IFRS 9 requirements.
Issues around data quality, availability and collection are likely to be at the forefront of the implementation efforts for IFRS 9. It is therefore important to plan the implementation ahead of new systems, processes and modelling tools, in order to prepare for the inevitable organisational and governance changes to come.
It will be necessary for companies to communicate the impact if IFRS 9 to markets, their shareholders and other stakeholders, emphasising that some changes will be merely accounting adjustments while others will have direct consequences for business lines.
Companies should therefore ensure that all stakeholders are adequately informed and all communications (internal and external) are accurate and in line with the new standard.
Taking into considering the numerous judgement areas in the application of IFRS 9 together with the alignment with risk management strategy, we expect the level of comparability of financial statements between different companies to decrease with the implementation of IFRS 9.