Deloitte Financial Reporting Brief November 2018

Insights

Deloitte Financial Reporting Brief

November 2018

This month’s article "Financial Instruments: A More Workable Solution?" comments on some of the many challenges to be faced by entities on implementation of IFRS 9.

Financial Instruments – A More Workable Solution?

Is this the biggest development in financial reporting requirements since the initial mandatory implementation of IFRS in 2005 for entities listed on recognised stock exchanges preparing group financial statements? Over the years we have had major developments such as the ‘consolidation pack’, the ‘fair value’ standard and others, but quite possibly none compare with the pervasive impact of IFRS 15 ‘Revenue from Contracts with Customers’ together with the scale of change that will be brought about for many by IFRS 9 ‘Financial Instruments’.

Both these Standards have been a long time in creation, with both being issued by the International Accounting Standards Board (IASB) in 2014 allowing a relatively long lead-in period up to their mandatory implementation for accounting periods beginning on or after 1 January 2018.

Over the years we have written many articles on both standards, exploring in summary their more technical aspects. Earlier this year, in April 2018, we commented on some of the more practical aspects of IFRS 15 and some of the aspects that matter to the investors and other stakeholders. In this article, we comment on IFRS 9.

IFRS 9 – A Way Forward
The IASB’s project to replace IAS 39 commenced in 2008 with different phases for classification and measurement of financial assets and liabilities, the expected loss impairment model and new general hedge accounting requirements. In many ways, IFRS 9 simplifies and standardises what had previously been seen as major complexities in IAS 39 and it brings in a more robust model for impairment loss recognition which was being cried out for after the major financial crisis of some ten years ago. It adopts an approach across all areas which appears more closely linked with the practical aspects of how businesses operate, including a principles-based approach to classification of financial assets and liabilities based on business models and cash flows.

Many assume that the accounting for financial instruments is an area of concern only for large financial entities like banks. This is not the case. Almost every entity has financial instruments that they need to account for. In particular, almost every entity has trade receivables and the new financial instruments standard changes the way entities must think about impairment.

Impairment – A practical expedient
The basis of impairment recognition has changed from IAS 39, where there was a need for objective evidence of impairment i.e. a loss event needed to occur before an impairment was booked, to IFRS 9 based on expected credit losses, with recognition of a loss allowance before the credit loss is incurred.

The impairment guidance in IFRS 9 is complex and requires a significant amount of judgement. However, certain simplifications have been made specifically for trade receivables, contract assets and lease receivables. Under the ‘general’ approach of IFRS 9, impairment is measured in two stages – ‘lifetime expected credit loss’ and ‘12-month expected credit loss’, with certain assessment and measurement complexities. In recognising that many financial assets such as trade receivables can be short-term by nature, IFRS 9 allows for, the provision matrix approach to ECL measurement as a practical expedient, to enable entities to recognise lifetime expected losses on all these assets without the need to identify significant increases in credit risk. In some business categories, customers may be allowed extended credit and to recognise this IFRS 9 provides the accounting policy choice of using the ‘general’ or the ‘simplified’ approach.

The Deloitte publication 'A Closer Look — Applying the expected credit loss model to trade receivables using a provision matrix' considers the new accounting requirements for Impairment under IFRS 9 with a focus on the practical expedient suggested in the standard, and suggests a potential way of applying the provision matrix approach in practice.

An Impact on Reported Profits?
IFRS 9 will make some products and business lines in the banking world structurally less profitable, depending on the economic sector, the duration of a transaction, the guarantees supporting it, and the ratings of the counterparty. Banks will need to review their portfolio strategy at a much more granular level than they do today, with such considerations as:

  • The sensitivity of different sectors with regard to decisions on allocation of lending
  • The more distant the redemption, the higher the probability that the counterparty will default
  • Collateral guarantees will help mitigate the increase in provisions
  • Counterparty risk ratings will have a direct impact on profitability

The shift in structural profitability suggests that banks should, where possible, steer their commercial focus to sectors that are more resilient through the economic cycle. Banks could also consider mechanisms to capture opportunities for asset distribution in the market and thereby reduce their need for balance sheet capacity for risk-weighted assets.

Impairment Model – Business Impact
The impact of IFRS 9 goes well beyond a simple technical change in accounting policy. There are a wide range of factors that need to be considered, including:

  • The impairment model is likely to have a negative impact on equity and net income and there is also likely to be much greater volatility in provisions. It is therefore significant in terms of capital and business model management, and its consequences could potentially lead to restructuring, divestments and repositioning in other market segments.
  • Implementing the Expected Credit Loss Model is challenging with the need to develop estimates of expected credit losses over the life of the financial instrument and monitor exposures continually and the ability to apply judgement to determine what is a ‘significant increase’ and what is a ‘default’ in estimating ‘expected losses’.
  • Information systems must be adapted for calculating expected losses based on payment forecasts, available risk data and probabilities of default, in a manner which enables reporting in accordance with IFRS 9. Potential issues regarding data quality, availability and collection are likely to be at the forefront of implementation efforts.

Disclosure
The importance of transition-period disclosures is heavily emphasised with a call for both qualitative and quantitative disclosures. Internal controls over these disclosures are important to management’s ability to address the risks that the disclosures are inaccurate or incomplete. Management should first identify whether appropriate internal controls exist for the disclosures and then specify the information and analyses used to support them, with appropriate testing of the design and operating effectiveness of the relevant controls.

In its recent letter to Audit Committee Chairs and Finance Directors, the FRC comments that IFRS 9 may not have a material effect on the results of non-banking companies, in which case, many of the transition disclosures may not be required.

However, the FRC does draw particular attention to its expectation that companies will:

  • have updated their hedging documentation and assessed the effectiveness of existing hedges on application of the new requirements
  • explain and, where possible, quantify material differences between IAS 39 and IFRS 9, including key assumptions adopted on implementation
  • take particular care when considering the application of the standard to embedded derivatives reconsider the accounting for previous debt modifications, such as refinancing, that did not result in derecognition
  • if relevant, explain why the impact is not material, particularly where significant financial instruments are recognised in the financial statements

Conclusion
In conclusion, IFRS 9 is a very substantial change to how a company reports its corporate message and goes well beyond a routine technical change in accounting policy.

There are many practical considerations including, for example:

  • Does the new standard change how a company manages risks, with perhaps a need to rethink the business model
  • Classification and measurement challenges - transition should not be underestimated with emphasis on understanding the business model and associated cash flows 
  • Expected credit loss model - a real challenge including the development of a model capable of applying the ECL methodology to different asset classes
  • Impact on IT systems, processes and controls with increased reporting requirements for the business model underlying the classification process, hedge accounting and forward looking data needed to implement the impairment model 
  • Communication – managing the challenges that will be posed by the greater level of judgements to be made in aligning with the business model

One of the many publications brought out by our Member Firms is ‘Implementation Guide for Corporates’. It aims to help with understanding the financial and operational impacts that IFRS 9 may have on organisations and should provide substantial assistance with implementation.

Our Irish Firm has strong capabilities to advise, support and assist you in moving to and implementing IFRS 9.

What's New? Monthly Reporting Pack – November 2018

Irish/UK GAAP & Related Developments

FRC publishes findings on the quality of corporate reporting in 2017/2018

FRC Lab report on business model reporting and risk and viability reporting

FRC publishes a report on developments in audit

FRC sets out new strategic focus to ensure audit serves the public interest

FRC to examine the Future of Corporate Reporting, calls for participation

FRC pushes companies for improved quality reporting

Why diversity makes a positive difference to organisational culture

Changing climate: Changing reporting

Financial Reporting Council publishes Annual Report

UK government publishes a "no deal technical notice" on accounting and audit

FRC updates taxonomies to reflect changes to UK GAAP and IFRS standards

Charity Commission publishes report on the reliability of charity financial information

IFRS & Related Developments

ESMA announces enforcement priorities for 2018 financial statements

Recent sustainability and integrated reporting developments

IASB finalises amendments to IFRS 3 regarding the definition of a business

IASB finalises amendments to IAS 1 and IAS 8 regarding the definition of materiality

IASB issues summary of share-based payment research project

Legal and Regulatory Developments

Desk-top review by IAASA on companies’ bank covenants disclosures

IAASA survey of companies’ annual reports identifies corporate taxes as a principal risk and source of uncertainty

Publications

Maintaining control in the cloud

IFRS in Focus — IASB amends the definition of a business in IFRS 3

IFRS in Focus — Third Transition Resource Group meeting discussing the implementation of IFRS 17 'Insurance Contracts'

IFRS on Point

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