Following concerns about a lack of adequate controls and accounting rules in the run-up to the financial crisis, a new accounting standard on financial instruments has been released by the global standard setter, the International Accounting Standards Board (IASB), to address impairment losses and hedge accounting.
IFRS 9, Financial Instruments is the final part of IASB's response to the financial crisis, which includes a forward-looking ‘expected loss’ impairment model and a substantially-reformed approach to hedge accounting as key elements in a single, integrated standard.
The new standard will come into effect on 1 January 2018 with early application permitted. It is designed to address concerns which emerged following the global financial crisis when banks were unable to account for losses until they were incurred, even when it was apparent to them that they were going to experience those losses.
The final version of IFRS 9 brings together the classification and measurement, impairment and hedge accounting phases of the IASB’s project to replace IAS 39, Financial Instruments: Recognition and Measurement.
IASB says IFRS 9 provides 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.
It includes a forward-looking expected credit loss model which IASB says will result in more timely recognition of loan losses and is a single model that is applicable to all financial instruments subject to impairment accounting, thus reducing complexity. The IASB has already announced its intention to create a transition resource group to support stakeholders in the transition to the new impairment requirements.
In addition, IFRS 9 addresses the so-called ‘own credit’ issue, whereby banks and others book gains through profit or loss as a result of the value of their own debt falling due to a decrease in credit worthiness when they have elected to measure that debt at fair value.
Andrew Spooner, lead financial instruments partner at Deloitte, said: ‘The new standard on financial instruments will affect all sectors though the introduction of an expected loss model for loan loss provisioning, but will impact banks most.
‘Banks have told us they expect provisions will increase, on average, by 50% on adoption. IFRS 9 should give investors better insight into the credit quality of all financial assets, not just those that are considered "bad".'
The changes will reduce profits in the first year of implementation, but this is likely to have only a short-term impact on income statements. However, IFRS 9 will increase running costs for banks and financial institutions.
Iain Coke, head of ICAEW’s financial services faculty, said: ‘It is important to remember that this accounting change will not change the cashflows of underlying loans.
‘However, when combined with tougher regulatory capital requirements, it may force banks to hold more capital for the same risks. This may make banks safer but may also make them more costly to run.’
The new accounting rules accounting mean that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognised in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted by IFRS 9.
The standard also includes a substantial overhaul of the hedge accounting model to align the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements.
Tony Clifford, partner at EY, said: 'The impairment requirements in the new standard are going to be based on an expected credit loss model and replace the IAS 39 incurred loss model. This has the potential to impact the capital requirements of banks and may also make it harder to compare the reported results of different entities.
'Adopting the IFRS 9 ECL requirements is going to require significant effort and investment for many entities, in particular, banks and insurers. Financial and non-financial institutions alike need to start planning an initial assessment of the likely impact of the new IFRS 9 ECL requirements to manage a successful transition and implementation.'
The standard will be effective for annual periods beginning on or after 1 January 2018.
The relatively tight timeframe for implementation will be a challenge for some financial institutions. Spooner warned: ‘Putting the new requirements into practice by the effective date, however, will be a challenge. 2018 is not far away, given the need to better integrate credit risk management with financial reporting.’
Hans Hoogervorst, IASB chairman, said: ‘The reforms introduced by IFRS 9 are much needed improvements to the reporting of financial instruments and are consistent with requests from the G20, the Financial Stability Board and others for a forward-looking approach to loan-loss provisioning.’
Deloitte’s Fourth Global IFRS Banking Survey, published last month, found that over half of the banks surveyed expected IFRS 9 to increase loan loss provisions by up to 50%, with 70% saying the new provisions could potentially increase the amount of capital they will need to hold.
Half (56%) said the pricing of lending would be affected, up from just 9% in 2011. Despite this, nearly a quarter of boards are considered to have little or no awareness of the forthcoming change.
A project summary providing an overview of the new standard is available to download from www.ifrs.org.
