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Financial Reporting Brief
Our featured article for May is 'Financial Instruments Accounting - A New Age' with Brendan Sheridan commenting on the move to IFRS 9 in 2018 and some implementation challenges.
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Financial Instruments Accounting – A New Age
So much has been spoken and written over the past decade or so about the need to review and change the accounting standard for recognition and measurement of financial instruments. The financial crisis of the late noughties brought much trauma to financial markets and led to a call for action by such major global organisations as G20 which included the establishment of the Financial Crisis Advisory Group (FCAG). A major focus area was the timeliness of recognition of expected credit losses and the complexity of impairment models.
The International Accounting Standard which currently deals with the recognition and measurement of financial instruments is IAS 39 which has been the ‘rulebook’ for many, many years. There is much rejoicing amongst all stakeholder groups that IAS 39 is on it's way out as it has been feared by many because of the complexity of its accounting model.
Development of Standard
IAS 39 is soon to be replaced with IFRS 9, which will be effective for accounting periods beginning on or after 1 January 2018. The International Accounting Standards Board (IASB) worked closely with the U.S Financial Accounting Standards Board to eliminate a variety of differences between their respective standards to develop a converged solution. Although every effort was made to come to a converged solution, which were successful in a number of respects, ultimately these efforts did not succeed in relation to an imparment model. The complete version of IFRS 9 was published in July 2014 and was endorsed by the European Commission in November 2016 for use by European companies. Some issues have remained under development, which include that part of IFRS 9 which was not completed in July 2014, in relation to accounting for macro hedging activities. This deals with the dynamic risk management of open portfolios by banks and similar financial institutions and continues to be under review.
IFRS 9 is for all entities, not just for financial institutions and financial services organisations. Non-financial entities will also be impacted and it should be borne in mind that IFRS 9 applies to all financial assets and liabilities, including e.g. trade receivables, lease receivables and contract assets that may arise as part of the transfer of goods and services.
Changes from IAS 39
So, what are the main changes being brought about by IFRS 9? IFRS 9 brings significant change to all of the major areas of accounting for financial instruments inluding classification and measurement, impairment and hedge accounting. IFRS 9 is built on a logical, single classification and measurement approach for financial assets that reflects the business model in which they are managed and their cash flow characteristics. Built upon this is a forward looking expected credit loss impairment model. The standard also includes an improved hedge accounting model to better link the economics of risk management with the accounting treatment of hedging instruments.
Financial asset classification and measurement is an area where many changes have been introduced by IFRS 9. The two conditions that are fundamental to the classification of assets as either amortised cost or fair value are:
- Business model test – the financial asset is held within a business model whose objective is to hold financial assets to collect their contractual cash flows, rather than to sell the assets prior to their contractual maturity to realise changes in fair value
- Cash flow characteristics test – the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Classification determines how financial assets are accounted for in financial statements and, in particular, how they are measured on an ongoing basis. Requirements for classification and measurement are the foundation of accounting for financial instruments.
Probably the most talked about part of IFRS 9 is the impairment model based on expected losses. In itself this is different from the accounting model of IAS 39 which was based on incurred losses. The financial crisis highlighted dramatically the weakness of such a basis of recognition, which relies on evidence of a trigger event which may delay the recognition of credit losses that may otherwise be apparent. The expected loss model requires an entity to recognise expected credit losses at all times and to update the amount of expected credit losses recognised at each reporting date to reflect changes in the credit risk of financial instruments. Specifically, IFRS 9 requires an entity to base its measurement of expected credit losses on reasonable and supportable information that is available without undue cost or effort, and that includes historical, current and forecast information. The new model is accompanied by improved disclosure about expected credit losses and credit risk. The impairment model involves a three stage process, revolving around what are 12-month expected credit losses and what are lifetime expected credit losses.
Banks – Financial Supervision
Banks and financial institutions will be very substantially impacted by the change from IAS 39 to IFRS 9 in relation to their financial statements and regulatory reporting. Deloitte conducted a survey of banks that are prudentially supervised according to the Basle Committee for Banking Supervision (BCBS) rules and that will prepare financial statements in accordance with IFRS 9. In it's November 2016 report arising from the survey Deloitte indicated that, inter alia, four fifths of banks expect their levels of impairment of retail banking loans and corporate banking loans to rise, with one in six preparing for an increase of 50% or more. The report describes the interaction between accounting information and regulatory capital, in which banks must be well advised to avoid an unexpected credit shortfall.
It is interesting that the BCBS has recently released a statement on the interim regulatory treatment of accounting provisions and standards which states that the BCBS supports the use of expected credit loss accounting approaches but has seen fit to retain the current regulatory treatment of provisions under the Basel Framework for an interim period. The BCBS will thoroughly review the longer term regulatory treatment of provisions. Jurisdictions may adopt transitional arrangements to smooth the process.
Practical Implementation Issues
Albeit that over three years will have elapsed between the publication of a much heralded standard in July 2014 and its implementation in January 2018 there is a real concern in the banking and financial services industry that at least in some cases they may be pushing water uphill in terms of their preparedness. Systems, skills and resources are in huge demand as we enter the final preparation phase.
Some key considerations and challenges for those charged with governance include the following:
- What plans are in place to conclude on key decisions, build and test necessary models and infrastructure, execute dry/parallel runs and deliver high quality implementation by 2018?
- Has the entity identified all changes to existing systems and processes, including data requirements and internal controls to ensure they are appropriate for use under IFRS 9?
- How will reporting processes and controls be documented and tested, particularly where systems and data sources have not previously been subject to audit?
- What are the key accounting interpretations and judgements and why are they appropriate?
- What KPIs and management information will be used to monitor drivers of expected credit loss and support effective governance over key judgements?
- How will the IFRS disclosure requirements be met and how will these disclosures facilitate comparability?
Less than a year to go to the effective implementation date, it’s time to batten down the hatches and make sure everything is good and ready. Fail to prepare, prepare to fail….. stakeholders do not want surprises!
Some of the many publications on our global firm's website, www.iasplus.com, in relation to IRFS 9 are as follows:
What's New - Monthly Reporting Pack - April 2017
Irish/UK GAAP & Related Developments
- FRC Letter to Investors
- FRC comments on Business, Energy and Industrial Strategy Committee report on Corporate Governance
- UK BEIS Select Committee publishes its report on corporate governance
- ICAEW and ICAS publish updated guidance on realised and distributable profits under the UK Companies Act 2006
- UK Charity Commission publishes reviews into the quality of charity annual reports and accounts
- FRC publishes revised operating procedures for reviewing corporate reporting
- FRC issues a Discussion Paper on the role of Auditors and Preliminary Announcements
IFRS & Related Developments
- Recent integrated reporting developments
- IASB proposes amendments to IFRS 9 regarding the classification of certain prepayable financial assets
- BCBS guidance on the treatment of problem assets
- FSB consults on evaluation framework for G20 financial regulatory reforms
- ESMA publishes report on the activities of accounting enforcers and their findings within the EU in 2016
- BCBS has 'not yet reached a conclusion' on IFRS 9
- BCBS frequently asked questions on changes to lease accounting
- IASB video on loan loss accounting and financial stability
Financial Reporting Brief
- April 2017: The New Standards - Busy Times Ahead
- Quarterly Financial Reporting Brief: April 2017
- March 2017: Long–Term Value Focus - ESG Reporting
- February 2017: Financial reporting - Incremental Improvement
- January 2017: The Future of Financial Reporting
- Quarterly Financial Reporting Brief: January 2017
- December 2016: 2016 Reporting - The Challenges
- November 2016: Financial Reporting – The Supervisors’ Views
- October 2016: A New Challenge – The Companies Accounting Bill
- Quarterly Financial Reporting Brief: October 2016
- September 2016: Corporate Reporting - Where to now?
- August 2016: Uncertainty – The Accounting and Reporting Challenge
- July 2016: Non-GAAP Measures – Focus of Attention
- Quarterly Financial Reporting Brief: July 2016
- June 2016: The Challenges of a New Leasing Standard
- May 2016: Revenue Standard - Moving Towards Implementation
- April 2016: A Focus on Non-Financial Reporting