Part 2
IFRS 9: Phases and stages
The new standard includes revised guidance on classification and measurement of financial assets, including a new expected credit-loss model for calculating impairment, and supplements the new general hedge accounting requirements published in 2013. Although the permissible measurement bases for financial assets are similar to IAS 39, the criteria for classification into the appropriate measurement category are significantly different. The new standard also replaces IAS 39’s “incurred loss” model for impairment with an “expected loss” model.
For banks, in particular, it is the new requirements around impairment which will have the most profound impact. IAS 39, in effect, prevented recognition of credit losses until an objective trigger event, such as a default, occurred. The underlying philosophy was well-intended. It was designed to prevent the use of advance provisioning to create “hidden” reserves which could be applied to smooth earnings and flatter performance in a downturn. However, the crisis led to growing concerns that, in many cases, provisions were too little, too late, as losses turned out to be greater than financial statements had recognized or implied.
The “expected credit loss” model in IFRS 9 means entities will have to recognize some amount of expected credit losses immediately, and revise the total level of expected losses each period to reflect changes in the credit risk of financial instruments held and expectations of future credit losses on those assets. Initial application of the new model may result in a large negative impact on equity for banks, and potentially insurers, as equity will reflect not only incurred credit losses but also expected credit losses. The impact will be substantially influenced by the size and nature of its financial instrument holdings, their classifications, and the judgments made in applying IAS 39 requirements.
The “expected credit loss” model recognizes two categories or stages of impairment, depending on changes in credit quality and assets generally can move into and out of the two buckets.
Not so simple
There are a number of challenges and uncertainties inherent in implementing the new standard. Among the key ones are:
- The need to develop more forward-looking estimates of future credit losses;
- The transfer of assets between impairment categories is likely to be highly dependent on judgment and internal management processes;
- Interpretation of the terms “significant increase” in credit risk and of “default” will also require judgment; and
- Ensuring comparability of approaches, and hence of reported performance, within and between banks will be challenging.
A further complication is that the IASB and FASB have been unable to agree on a common standard. The FASB issued an exposure draft of a proposed current expected credit loss (CECL) impairment model in December 2012 that was different from the model in IFRS 9. Although the FASB’s proposed model was also an expected loss model, it included a single measurement approach based on lifetime expected credit losses. The FASB is still considering its proposals and its final impairment model is expected to be issued in the first half of 2015.
Hans Hoogervorst, chairman of the IASB, has said the two boards would meet to review the situation later this year.
He held out the possibility that regulators might impose additional disclosure requirements to bridge the gap, although that would impose additional costs on preparers.
Insurance: Particular challenges
Although the main concern during the crisis focused on potential asset impairment in the banks, the impact of IFRS 9 may be felt, perhaps paradoxically, more heavily by insurers. Banks have already had to respond to massive new regulatory requirements, but insurers are now facing probably the biggest change to their financial statements they have ever seen.
Insurers are facing major new regulatory changes of their own in the form of Solvency II, which comes into force on January 1, 2016, and a planned new insurance contracts accounting standard scheduled to be finalized in 2015 with a three-year implementation period (i.e., a likely mandatory effective date of January 1, 2019). Planning for the new requirements needs to be integrated to ensure consistency, compatibility and the avoidance of unintended consequences.
As with banks, the impact of moving to the expected loss model may be significant for some insurers.
However, the classification and measurement element of IFRS 9 is likely to be more significant in the insurance context, since it goes to the heart of the insurance business model of matching asset and liability cash flows. For insurers, ensuring that financial assets are classified appropriately will require, in particular:
- Determination of the objective of the business model in which the assets are managed;
- Analysis of their contractual cash flow characteristics (that is, whether they give rise to cash flows that are solely payments of principal and interest); and
- Comparison of the treatment of gains and losses on insurance contracts with the treatment of gains and losses on matching assets—in order to identify any accounting mismatches.
Timescales are short. There is pressure in a number of jurisdictions to move to earlier adoption of IFRS 9. If so, there is very little time to wait. However, insurers and banks in the European Union will not be able to apply IFRS 9 until it has been endorsed into European Union law.
Far-reaching implications
While IFRS 9 and the FASB’s proposed CECL model are nominally accounting changes, the actual impact on financial institutions is far more extensive.
These new standards require extensive cooperation between credit-risk management and accounting functions. Accounting will now involve the determination of expected credit losses, including forgone interest, principal loss and the timing of expected cash collections based on available portfolio information and possibly complex cash flow and loss algorithms. The new accounting model requires tracking of exposures across time and extensive new disclosure requirements.
To be continued