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Robust financial system - key to survival

Financial Reporting Brief August 2020

The COVID-19 pandemic is being seen by many as the worst peacetime recession in a century. The OECD estimates that the global economy will contract 6% in the current year. This is over three times worse than the 2008/09 financial crisis at its peak.

A Business Cycle Indicator (BCI) for the Irish economy, developed by the Central Bank, offers a timely assessment. The BCI indicator fell to an unprecedented low in April, almost twice as low as the trough of the financial crisis in 2008/2009. It remains to be seen how these effects persist as the economy slowly reopens and we learn to live with COVID-19 over the medium term.

In this uncertain environment, swift, decisive and credible policy action can help provide some certainty. Central banks, including the Central Bank of Ireland, are playing a significant role in conducting monetary policy to maintain liquidity in the financial system and support the flow of credit to the economy through the crisis and in the period of recovery.

The commercial banks are the conduit and play a fundamental role in helping to stabilise systems of lending, payments, trade and liquidity. Those that engage effectively with their customers through the crisis, focus on the value of their organisations and create a pro-active vision of their way forward can ultimately emerge stronger. Business models must be adapted to the new realities.

Availability of finance

A fundamental aspect of a bank’s continuing ability to lend is its level of non-performing loans. If loans are classified as non-performing, there is a knock-on effect on how banks maintain capital at an adequate level for regulatory purposes and consequently their ability to lend. Banks in Ireland, and globally, have been under intense pressure from regulators to bring their level of non-performing loans down. The COVID-19 pandemic has brought sudden and heightened pressure to the banking system and questions have had to be addressed from a regulatory and accounting viewpoint.

A core question to be addressed is how to measure expected credit losses under the requirements of financial reporting standards, with IFRS 9 Financial Instruments being the principal standard involved. The European Banking Authority (EBA) published a statement in recent months, The Application of the Prudential Framework regarding Default, Forbearance and IFRS 9 in light of COVID-19 Measures – which was co-ordinated with the statement published at the same time by the European Securities and Markets Authority (ESMA).

The statement(s) note that circumstances of change or uncertainty, including the COVID-19 pandemic, do not in themselves change, remove nor add to the requirements of IFRS 9 Financial Instruments.

The importance of IFRS 9

In ESMA’s view, the principles-based nature of IFRS 9 includes sufficient flexibility to faithfully reflect the specific circumstances of the COVID-19 outbreak.

ESMA notes that such circumstances as payment holidays arising from economic downturn and associated public policy support measures should not be regarded as automatically having a one-to-one impact on the assessment of whether loans have suffered a significant increase in credit risk (SICR). It is critical that lenders assess whether the overall impact, including the implications of government-backed relief programmes, have a temporary impact on borrowers’ liquidity or more significantly on the credit risk over the expected life of the financial instrument. The latter will affect the assessment and measurement of expected credit losses and lead to potential erosion of the bank’s capital base and consequent ability to lend.

Assessment of credit risk

Lenders will be required to do a thorough assessment on whether a SICR has arisen in relation to individual loans or loan portfolios. More specific information will be sought about matters which include:

  • Has the customer got other borrowings or facilities, and how are they classified?;
  • What information value is there in the uptake of payment holidays – customer fear/uncertainty or an underlying change in circumstances?; and
  • Are some sectors more at risk than others, with varying levels of risk of the probability of default?

IFRS 9 requires preparers to use reasonable and supportable forward-looking information, obtained without undue cost or effort in shaping their multiple economic scenarios. The effects of COVID-19 make it difficult to obtain information and to exercise judgement.

The assessment of credit risk is a continuing process and needs to respond to changes in underlying conditions and the evolution of circumstances which may include reduction in available support measures. The future viability of many entities will be under increased pressure the longer the pandemic continues, and certain sectors of the economy are particularly exposed, including travel, tourism, retail and other sectors. The potential for reductions in activity and entity failures will have a consequent and hard-hit impact on banks and other lenders, which may be expected to tighten the availability of credit.

Importance of disclosure

Entities should include robust disclosure in their financial reports of material information on judgements, underlying assumptions and sensitivities, and other matters pertaining to the loans. This should provide much needed transparency to users of financial reports.

Recent European Central Bank measures include the recommendation that, given the current state of uncertainty, banks should give a greater weight to the long-term stable outlook as was evidenced by past experience and take into account the relief measures made available by public authorities.

The Financial Reporting Council (FRC) has recently published its first financial reporting thematic review since the onset of the COVID-19 pandemic.  
 
The review found that although companies provided sufficient information to enable a user to understand the impact COVID-19 had on their performance, position and future prospects, some - particularly interim reports - would have benefited from more extensive disclosure.  This includes disclosure in relation to financial instruments and ECL

IFRS 9 – Consistent application

The International Accounting Standards Board (IASB) has published a guidance statement on the consistent application of IFRS 9 in the context of COVID-19. The IASB guidance supports the foregoing and in doing so emphasises that IFRS 9 does not set bright lines or a mechanistic approach to determining when lifetime losses are required to be recognised. Nor does it dictate the exact basis on which entities should determine forward-looking scenarios to consider when estimating ECLs. The way ECLs have been implemented to date may no longer hold in the current environment and entities should not continue to apply their existing ECL methodology mechanically.

IFRS 7 Financial Instruments: Disclosures sets out a range of credit risk disclosures to enable users of financial statements to understand the effect of credit risk on the amount, timing and uncertainty of future cash flows. IFRS 7 includes many mandatory quantitative disclosures, though the need to expand through the use of qualitative disclosures will be critical in explaining how the current economic environment has impacted the amount, timing and uncertainty of future cash flows.

IFRS 9 – The corporate perspective

IFRS 9 is of relevance at a broader level than banks and other financial institutions. At the corporate level, it is particularly relevant that the scope of the standard includes all financial instruments e.g. trade receivables, contract assets, lease receivables, financial guarantees and many others. The extent of these exposures may also be greater in individual company financial statements within a group due to intra-group loans or guarantees provided by the reporting entity to other entities within the group. These could have a significant impact on the availability of distributable profits. The simplified approach available to non-financial institutions for calculation of ECL removes many of the complications in arriving at the estimate of expected losses as they are calculated on a lifetime basis.

Interim reporting

Interim reporting season is at its peak and issuers need to consider what additional reporting matters may arise during the COVID-19 period. IAS 34 Interim Financial Reporting requires an explanation of events and transactions that are significant to an understanding of the changes in financial positon and performance since the end of the last annual reporting period. For banks, particularly, the decline in economic activity and resulting credit deterioration since the end of the last annual reporting period is likely to warrant extensive disclosure. Such disclosure would extend to any new areas of judgement or estimation uncertainty. While IAS 34 does require certain disclosures in this regard, entities may consider that where there is a particular need, the more extensive disclosures of IFRS 7 may provide information which is valuable to investors.

Conclusion

The enormous challenge of COVID-19 remains and is not likely to dissipate until an effective vaccine is identified to eradicate it, which appears to be some time away. Economies will continue to suffer recession and financial systems will have to endure the effects and survive to achieve semi-solid ground with a platform for future recovery and development. Banks have a key role to play in the overall efforts required with the key objective of ensuring they have the capital available to continue their ability to make finance available to the economy and society in general. The constraints of regulatory measures and accounting requirements will need careful attention.

Our Deloitte publication IFRS in Focus — Expected credit loss accounting considerations related to Coronavirus Disease 2019 discusses certain key IFRS accounting considerations related to accounting for expected credit losses (ECL) that may result from the COVID-19 pandemic. The focus of the publication is for lenders and banks, though much of it will be applicable to measurement of ECL in industries other than financial services.

 

Monthly Reporting Pack - July 2020

 

Irish/UK GAAP and related developments

IFRS and related developments

Legal and regulatory developments

Publications

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