IFRS 9: ready for impact
ME PoV Fall 2017 issue
Saumya Krishna explores how impairment under IFRS 9 will impact organizations and its relevance to the Middle East region.
The International Financial Reporting Standard IFRS 9 (Financial Instruments) comes into effect on 1 January 2018. Pervasive in nature, it introduces a paradigm shift in financial reporting from historical application of impairment reviews for determining allowances to a forward-looking approach (Expected Credit Loss, or ECL, model) reflecting the decision-making process of companies. Born from the financial crisis to change the way banks and other financial institutions account for loans and other financial assets, organizations should not underestimate its implications on their internal control system, financial statements and the bottom line. The standard will affect both, financial and non-financial institutions.
Does it have any additional relevance to the Middle East region?
The Middle Eastern culture is deep-rooted in tradition and values. The corporate sector is characterized by closely held family-owned companies, multiple-entity organization structures, related party transactions and often, an overlap between ownership and management.
Credit default is also viewed differently in the region—for instance, it is a known business practice not to charge interest on late payment, and equally common for debtors to delay payments for months. Related party loans are sometimes given at low or no interest charge, irrespective of the borrower’s financial credibility. IFRS 9 will require an impairment provisioning on such assets after taking into consideration the associated risks and the probability of default, including the time value of money related to delays. This requirement directly impacts the profit and loss statement and is likely to influence business decision-making in the future.
The region is also unique in the way it reacts to changes in macroeconomic variables. Consider the example of the sharp drop in oil prices during 2015 and 2016. While oil-importing European economies reacted positively to this drop, it implied adverse business conditions for most businesses in the region due to heavy economic reliance on hydrocarbon revenues. Similarly, while the unemployment rate is a critical indicator of economic health in western countries and may be an important variable in estimating expected losses, it is of low relevance in the Gulf Cooperation Council (GCC) region on account of a predominant, contract-based expatriate workforce.
The impact of IFRS 9 reaches beyond accounting. It requires changes in systems and processes. Established market dynamics of western markets may not be relevant in the region. As part of impairment provisioning under IFRS 9, companies will have to identify relevant macroeconomic variables for their businesses, study them for historical trends and impact, establish their relationship with historical default rates and track them for available forecasts in order to estimate expected losses.
As put by Ranjith Chandran: “It is challenging for Small and Medium Enterprises (SMEs) to fundamentally change the way of calculating bad debt provision for receivables from an incurred loss to an expected loss model, and make a provision charge from day one. Clients who were earlier reluctant to make impairment provision on customers who, though paid in full but much later than the due date, will now have to take an impairment loss under IFRS 9. This is because the timing of payments directly affects present value and thus the amount of impairment loss.
Management and auditors will have to watch out for fundamental errors in the expected loss model because of the lack of availability of historic default rates and the relative inexperience in incorporating forward-looking information into the ECL provision matrix. Both, the data and the methodology have never been subject to scrutiny in the past.”1
FAQs on IFRS 9 for non-financial entities
IFRS 9 fundamentally redrafts the accounting rules for financial assets without established precedents or tools, especially for non-financial entities. As the mandatory implementation date of 1 January 2018 is fast approaching, chief executive, financial and risk officers (CEO, CFO and CRO) have begun discussing implementation. Below, we address some of the key issues and questions.
Q. What is the key difference between the old and the new approach to impairment?
A. In some ways IFRS 9 is much simpler than its predecessor IAS 39. It is principle-based and logical rather than rule-based. It enables accounting to reflect the nature of the financial asset (determined by its cash flow characteristics), the company’s business model (how the assets are managed) and its risk management practice on financial statements. It is forward-looking and ensures a more accurate, and timely assessment of expected losses.
Q. I’m not a financial institution. Does it really impact me?
A. Yes, if you have any of the following assets (Financial Assets): debt instruments, lease receivables, trade receivables, retention receivables, contracts assets (defined in IFRS 15), related party loans (e.g. loan given to a parent/subsidiary/any related party), construction work in progress and derivatives.
Note: There is no difference between IFRS 9 and IAS 39 when it comes to Financial Assets that are opted at Fair Value Through Profit and Loss (FVTPL) at original recognition.
Q. What is the overall framework of IFRS 9?
A. IFRS 9 stands on three pillars:
- Classification and measurement: This relates to how a financial asset is accounted for in financial statements and how it is measured on an ongoing basis. It requires an understanding of the characteristic of the financial asset and the purpose of holding it.
The standard introduces a cash flow and business model test that are typically qualified by trade receivables, vanilla bonds, debt instruments and loan to related parties. As such, these assets will require an impairment assessment and subsequent adjustment to carrying values.
Equity and Derivatives will continue to be accounted for at fair value. Embedded derivatives are no longer required to be separated from the Financial Assets.
- Impairment: Single impairment model based on a forward-looking expected credit loss (ECL) model.
- Hedge accounting: IFRS 9 allows more exposure to be hedged and provides for principle-based requirements that are simpler than IAS 39 and aligned with an entity’s risk management strategy.
Q. What is ECL and how will this be estimated?
A. Every receivable carries with it some probability of default and, therefore, has an expected loss attached to it.
IFRS 9 introduces new impairment requirements that are based on a forward-looking expected credit loss (ECL) model. In simple terms, it is the present value of probability adjusted estimate of loss that would occur if the asset defaults.
ECL should be based on the nature of the financial asset, financial strength and credibility of the debtor, experience in dealing with similar assets, current macroeconomic conditions, expectations of future trends and behavior, forecasts of relevant variables and judgment.
We know that some companies in the region do not have an advanced understanding of their customers’/borrowers’ financial strength, and credit ratings from agencies are not as readily accessible as in other parts of the world. As such, estimating the ECL
will require a fundamental shift in the internal processes and credit risk management framework of companies
to be able to capture, document and analyze relevant qualitative and quantitative factors. In the initial years of implementation, companies would also need to perform data mining to consider and quantify historical loss rates of customers/lessees/borrowers/other debtors.
As such, a positive outcome of IFRS 9 impairment assessment requirements is a necessary shift towards better Know Your Customer (KYC) practices in the region.
Q. Would investments in equity interest be assessed for impairment under IFRS 9?
A. No. Investment in equity is accounted either at Fair Value Through Profit and Loss (FVTPL–in which case all changes in fair value are automatically included in the profit and loss statement) or at Fair Value Through Other Comprehensive Income (FVOCI), in which case changes in fair value are adjusted on the balance sheet.
Q. What’s the expected financial impact of the new impairment framework?
A. It is widely expected that impairment provisioning will increase under IFRS 9, and the biggest impact would be felt during the transition period from IAS 39 to IFRS 9.
The IASB invited preparers of financial statements from major geographical regions to participate in fieldwork to test and discuss its proposals, including
the operational challenges for implementation of IFRS 9, the responsiveness of the proposed model compared to IAS 39 and the directional impact on allowance balances. It was estimated that on transition, the impairment provisions under IFRS 9 could be 20-250 percent higher compared to IAS 39. It is expected that the impairment provisions will be highest where the economic forecast is the worst.
Deloitte conducted an ECL survey in the United States during 2017 to understand how the banks are approaching ECL implementation and the challenges they face. On average, most surveyed banks expect that their impairment provisioning would increase by more than 10 percent (different for different categories of loans) as a result of transition to IFRS 9.
The issue most often cited by surveyed banks as their most challenging implementation task is development of statistical ECL models.
While IFRS 9 can be seen as an accounting policy change, in line with the intention of the IASB and regulators, it creates business-wide challenges for organizations. ECL provisioning will have a direct, quantifiable impact on the profit and loss statements and an indirect but material impact on a wide range of factors contributing to shareholder value.
The impairment under IFRS 9 will align accounting to actual business practice reflecting a better and more prudent view of the credit default and related exposure. Additional disclosures will ensure higher transparency for shareholders, investors and other users of the financial statements.
Implementation of a suitable ECL framework is going to be one of the most significant accounting projects over the coming years. Each entity will have to build its own ECL model appropriate for its size and complexity; and supported by historical, current and forecast data of relevance. Management’s judgment and understanding of business risks will play an equally important role in validating the inputs and output of the ECL model. Availability of forward-looking data in the region may prove to be challenging for regional economies where availability of historical and forecast data, and resource availability is limited. Entities will need to find a balance between complexity, practicality and accuracy.
Businesses need to begin the process as soon as possible, or risk falling behind in meeting critical deadlines or worse, risk non-compliance.
by Saumya Krishna, Assistant Director, Valuations Modeling Services, Financial Advisory, Deloitte, Middle East
1. Ranjith Chandran, Partner, Deloitte
(IFRS 9 and Financial Instruments Subject Matter Expert)
A brief history
The global financial crisis in 2008 invited a chorus of criticism of accounting policies, in particular relating to the use of fair value accounting for financial instruments. Enter IAS 39: rule-based and backwards looking, grounded on historical data that proved to be disconnected from new market realities. Fair value accounting led to a domino effect when all organizations, whether financial institutions or not, reacted similarly and at the same time to changes in market conditions thereby exacerbating its impact and further contributing to its collapse.
Regulators recognized that the current models were not designed to recognize credit losses on a forward-looking basis. As a result, the International Accounting Standards Board (IASB) retraced and the revised expected loss framework within IFRS 9 was issued in 2014. It is mandatory for periods beginning on, or after, 1 January 2018.