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Financial Reporting Brief - March 2015

Impairment losses – Improved recognition?

Welcome to our Financial Reporting Brief for March, our opportunity to update you on recent developments with our featured article "Impairment losses – Improved recognition" commenting on the expected loss impairment model under IFRS 9 and the challenge of implementation.

Impairment losses – Improved recognition

In April 2009 shortly after G20 commenced their summit meetings to discuss a response to the financial and economic crisis, G20 published a Declaration on “Strengthening the Financial System”.

The principles of the Declaration were:

  • strengthen transparency and accountability
  • enhance sound regulation
  • promote integrity in financial markets
  • reinforce international cooperation

On foot of these principles, major reforms were agreed to include:

  • Expand the Financial Stability Forum (FSF) with a broadened mandate and a stronger institutional basis and enhanced capacity, it later became the Financial Stability Board with greater influence over developments.
  • Strengthen international cooperation.
  • Strengthen frameworks for prudential regulation.
  • Impose that all systematically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight.
  • Endorse the principles of the FSB on pay and compensation in significant financial institutions to ensure consistency with long tern goals.
  • Call on protection of public finances and international standards against the risks faced by non-cooperative jurisdictions including tax havens.
  • Agree on more effective oversight of the activities of credit rating agencies, as they are essential market participants.
  • Agree that the accounting standard setters improve standards for the valuation of financial instruments. The FSB made a number of recommendations on pro-cyclicality that address accounting issues, which included:
     - Reduce the complexity of accounting standards for financial instruments
     - Improve accounting standards for provisioning, off-balance sheet exposures and valuation uncertainty
     - Make significant progress towards a single set of high quality global accounting standards.

Where are we now?
The most recent G20 Summit in November 2014 included a paper from the Global Partnership for Financial Inclusion (GPFI). The GPFI paper states ‘The global economy has changed since 2007, with the most acute phase of the financial crisis having now passed, and significant reforms having already been achieved. 2014 is an appropriate time to begin transitioning the financial agenda from that of “crisis response” towards a more ‘steady state’ of operation. We cannot afford to become complacent or reform fatigued as the policy changes remaining are both significant and complex.’

The above indicates that much has been achieved in recent years, including in the area of accounting, but there is much still left to do and a need for continuing vigilance and responsiveness.

In our February article we commented on the developments in the past number of years in accounting standards including financial instruments, fair value, consolidations, revenue recognition and other developments. In this article the focus is on IFRS 9 and, in particular, accounting for impairment losses on financial assets.

Impairment Losses – Recognition
IFRS 9 ‘Financial Instruments’ was finally completed in July 2014, some five years after work began. G20 and the FSB called in 2009 for a converged financial instrument standard to replace IAS 39, with the IASB and the US FASB developing it jointly. Convergence efforts ended early in 2014, with both of the standard-setters publishing their own financial reporting standards subsequently. While both have adopted an ‘expected losses’ basis of recognition for impairment, the failure to fully converge standards is not an ideal outcome for such a significant sector in such a critical area of accounting. Investors will have to understand accounts prepared under both regimes and it means more work for certain banks who will have the burden of calculating impairment on two different bases which is frustrating those banks with the additional workload and potential for duplication of effort. The key area of divergence between the US standards and the International Standards is how far companies should look forward when they make provisions for losses – the FASB is likely to require companies to make provisions over the lifetime of a loan at the initial recognition of the loan, rather than just 12 months as required by the IASB. 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 Expected Loss Impairment model in IFRS 9 will apply to debt instruments measured at amortised cost or FVTOCI, lease receivables, contract assets and certain written loan commitments and financial guarantee contracts. The loan loss allowance will be for either 12-month expected losses or lifetime expected losses. The latter applies if credit risk has increased significantly since initial recognition of the financial instrument.

The assessment of whether there has been a significant increase in credit risk is based on an increase in the probability of a default occurring since initial recognition. This 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. Banks, auditors and regulators will be challenged that there could be different valuations of collateral and different treatments of trigger events that result in unexpected losses.

Basel Guidance
The application of the new accounting requirements should be assisted and supported by the guidance recently issued in draft by the Basel Committee on Banking Supervision. Comprising eleven fundamental principles, the guidance sets out supervisory expectations for banks relating to sound credit risk practices associated with implementing and applying an expected credit loss (ECL) accounting framework. The guidance also includes an appendix specifically dealing with IFRS 9. The appendix provides guidance on (i) certain aspects of the ECL requirements in the impairment sections of IFRS 9 that are not common to the ECL, (ii) the assessment of significant increases in credit risk, and (iii) the use of practical expedients. There may be much work to do before these guidelines are finalised particularly on the interaction between regulatory requirements and the implementation of IFRS 9.

Deloitte Global Banking Survey
The Deloitte Fourth Global IFRS Banking Survey launched just as IFRS 9 was finalised in Summer 2014 and included key findings:

  • Banks require 3 years implementation time, so may come under pressure even with a 2018 effective date.
  • Increasing expectations that banks’ pricing will be affected by accounting change.
  • Over half of the banks surveyed believe that the expected loss approach will result in banks’ provisions increasing by up to 50% across all loan asset classes.
  • 70% of banks surveyed anticipate their IFRS 9 expected loss provision to be higher than the current regulatory expected loss provision.
  • Coordinating multi-disciplinary effort including finance, credit, risk and IT and resource constraints cited as the key IFRS 9 implementation challenges.
  • 50% of banks surveyed are concerned about credit data reconciliation and credit data quality.

Conclusion
Endorsement of IFRS 9 at European level is on the EU agenda with a possible timing of late 2015 which if it happens will overcome one of the major hurdles to global acceptance of the standard.

In practical terms it will of course be widely welcome across the range as it represents a more straight-forward and cohesive solution than IAS 39.

Three years to go to implementation of IFRS 9 in 2018. A busy time for banks and financial institutions with information technology, systems, training and related requirements. It will require a determined team effort with effective leadership and direction.

It is not just about banks and financial services entities, non-financial services entities should not lose sight of the changes that will be brought about by IFRS 9 including those in relation to classification and disclosure. In a later article we may return to the challenges that will face the non-financial services sector.

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