- Provisions for bad debts – larger and more volatile
- Biggest impact on banks, also significant for insurers
- No convergence with US rules – lack of comparability for investors and increased costs for companies
- Big impact on systems and processes – companies need to start addressing now
On July 24 the IASB has issued the fourth and final version of its new standard on financial instruments accounting – IFRS 9 Financial Instruments. This completes a project that was launched in 2008 in response to the financial crisis.
The new standard includes revised guidance on the classification and measurement of financial assets, including impairment, and supplements the new hedge accounting principles published in 2013.
Chris Spall, KPMG’s global IFRS financial instruments leader, said: “The new standard is going to have a massive impact on how banks account for credit losses on their loan portfolios. Provisions for bad debts will be bigger and are likely to be more volatile.
“After long debate about this complex area, it is good that we finally have a complete standard and that the implementation effort can begin in earnest. We had hoped that the IASB and the US FASB could have achieved a single converged solution for banks and other entities globally, but this hasn’t been possible. Having different rules under US GAAP and IFRS will mean a lack of comparability for investors between the results of banks reporting under the different frameworks, and increased costs for those banks that have to prepare figures under both accounting frameworks.”
Colin Martin, head of KPMG UK assurance services, banking, added: “Adopting the new rules is going to mean a lot of time, effort and money for banks.” Martin added: “A major issue for banks and investors in banks will be how adoption of the new standard will affect regulatory capital ratios. Banks will need to factor this into their capital planning and we expect that users will be looking for information on the expected capital impacts.”
Insurers will also be significantly impacted by IFRS 9. Joachim Kölschbach, KPMG’s global IFRS insurance leader, said: “Insurers have to plan for adopting new standards on both financial instruments and insurance contracts over the next few years. The overall effect cannot be assessed until the insurance standard is finalised over the next 12 months, but we can expect a sea-change in financial reporting for most insurers.”
Spall added: “Other corporates should not automatically assume that the impact of the classification and measurement and impairment requirements of the new standard will be small, as it depends on the exposures they have and how they manage them. We expect that planning for IFRS 9 adoption – including implementation of the new hedge accounting requirements published in 2013 – will be an important issue for corporate treasurers and accountants generally.”
“The importance of the adopted amendments cannot be underestimated – for they imply fundamental changes to approaches used in impairment valuations. Many banks and insurers may be confronted by the need to introduce changes to existing analysis and data collection processes, requiring advance preparations, let alone the impact on the financial statements. In addition, the banks and insurance companies will have to assess the impact that application of the new standard could have on capital. Even though the new standard enters into force from 1 January 2018, financial services organizations need to start preparing for application now,” comments Marina Malyutina, Partner, Head of Financial Services, KPMG in Russia and the CIS.
New expected credit loss model
In the past, concerns have been raised about ‘too little, too late’ provisioning for loan losses. The new expected credit losses model aims to address these concerns, and accelerates the recognition of losses by requiring provisions to cover both already-incurred losses and some losses expected in the future. Spall said: “The new standard is a step change in accounting for impairment and will give rise to new challenges.”
One such challenge is the increased need for judgement. Spall explained: “Estimating impairment is an art, rather than a science. It involves difficult judgements about whether loans will be paid as due – and, if not, how much will be recovered and when. The new model widens the scope of these judgements.” A new threshold is applied to determine whether there has been significant increase in credit risk – and this in turn is used to assess whether a loan should have an allowance to cover credit losses expected in the next 12 months, or to cover all expected credit losses over the life of the loan. Spall added: “Preparers will have to make new judgements, auditors will have to review them, and users of financial statements, including prudential and securities regulators, will have to understand them.”
Spall encouraged companies, in particular banks, not to delay in assessing the impact of the expected credit loss model on their business: “Credit risk is at the heart of a bank’s business and applying the new standard will depend heavily on a bank’s credit systems and processes.”
Classification and measurement
The final standard clarifies the principles already in IFRS 9 and introduces a new ‘fair value through other comprehensive income’ measurement category for financial assets. Spall said: “The new category aims to accommodate concerns that the standard did not cater for business models where assets were held both to collect cash flows and for sale – for example, certain liquidity portfolios of banks – and that it would have created accounting mismatches for insurers. However, the amendment means that the classification and measurement requirements of the new standard are at least as complex as the current IAS 39 standard that it will replace.”
The standard introduces extensive new disclosures to address the concerns raised by users for transparency. Martin commented: “The new disclosures introduced by IFRS 9 are extensive, and entities – in particular banks – should not underestimate the effort that will be required to apply the new requirements, including having the systems and processes in place to collect data. Entities will need to think through how to incorporate the new information into their financial reporting to make sure that disclosures do not just add volume to the annual report but are part of a clear communication process with investors and other stakeholders. Preparing for the new disclosure requirements should be a key part of transition planning.”
The new standard has a mandatory effective date of 1 January 2018 but can be adopted early. As the standard has been completed in stages, the relatively few companies that have adopted previously released versions of IFRS 9 can continue using them until then. In addition, companies can adopt in isolation the part of the standard that would allow them to reflect the effects of changes in credit risk on certain marked-to-market liabilities outside of profit or loss.
Spall commented: “Companies need to think about when they plan to adopt the new standard. Many banks may need the whole three and a half years up to 2018 to prepare for adoption of the expected credit loss requirements. However, the possibility of early adoption of only the ‘own credit’ amendment would provide some welcome relief from profit or loss volatility caused by fluctuations in a company’s own credit risk.
The long lead time to mandatory adoption and the different possibilities for IFRS 9 adoption could mean a protracted but temporary period of diversity. In many jurisdictions, including the European Union, companies will not be able to adopt the new standard until it is legally endorsed or permitted by regulators. Given the significance of the standard to the financial services sector, the road to endorsement may be longer and more winding than usual.