21 Aug 2014
The International Accounting Standards Board issued its long-awaited new financial instruments standard (“IFRS 9”) at the end of July. The new standard, is designed to respond to some of the criticisms levelled at current accounting in the light of the financial crisis – in particular, that loan losses were recognised too slowly and in too small amounts – ‘too little, too late’. But could the same be said of IFRS 9?
It’s certainly not a short or easy read. Weighing in at some 238 pages (excluding the illustrative examples) and in the kind of technical language that only us accountants know and love, it’s certainly not for the faint-hearted! So I suppose in that sense it isn’t ‘too little’. But the size of the standard isn’t what we’re getting at here – the main question is will it change the numbers very much? Well, to some extent we will have to wait and see.
But is it too late? The standard becomes mandatory in 2018 which, as a colleague pointed out, is a nice round decade after the crisis – so it’s too late for this crisis, but given that it’s meant to help avert another, it’s not too late in every sense.
What does the IASB say about the new requirements – and what does this mean for businesses? We consider the larger elements of the standard below.
The IASB describes classification and measurement as how financial assets and financial liabilities are accounted for in financial statements, and how they are measured on an ongoing basis. IFRS 9 classifies financial assets based on cash flow characteristics and the business model in which an asset is held. The IASB hopes that this will be easier to apply than the old rules-based requirements. The model also results in a single impairment model being applied to all financial instruments.
IFRS 9 certainly reads very differently from its predecessor. Rather than today’s reliance on the terms of an instrument and whether it is traded or not, IFRS 9 looks to the company’s business model and how it is managing its financial assets to create value. But it has basically the same four accounting methods as the existing standard. And those companies who have spent time working through the impact have generally reported it to be marginal.
The IASB says that during the financial crisis, the delayed recognition of credit losses on loans and other financial instruments was identified as a weakness in existing accounting standards. The new standard requires, among other things, that companies would recognise 12 month expected credit losses on day one and lifetime expected credit losses where there has been a significant increase in credit risk.
In loan loss provisions, the standard moves away from today’s incurred loss model (something definite needs to have happened that demonstrates less cash will now be collected) to an expected loss model (that includes forward looking information and what is expected to happen but hasn’t yet). So overall, you would expect losses to be booked sooner. But this might not change things that much in 2018 – other factors have been at work in the last few years. In particular, regulators have put pressure on banks to recognise loan losses sooner within the constraints of the current model. And economic conditions have generally improved – so if this continues through to 2018 then the impact of the implementation of the standard is expected to be lower.
Though the impact might be lessened, it’s pretty certain that there will be one and most, if not all, banks’ loan loss provisions will increase. Also, it seems pretty certain that were we to have another crisis, bigger loan losses would be booked quicker.
The new hedge accounting requirements came out in November last year, and though they aren’t part of the changes introduced this July, then are part of the complete version of IFRS9. The November standard introduced a substantially reformed model for hedge accounting, with enhanced disclosures about risk management activities. The new model is, the IASB says, a significant overhaul of hedge accounting. Users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
It seems likely that this will have a greater impact on non-financial services entities than on banks and insurers. But for those affected, IFRS 9 will bring welcome relief. It moves away from a very rules-based approach and will allow hedge accounting for some common hedging strategies that fail to qualify today. We’re looking forward to no longer having to explain to companies why they are getting volatile profits from hedges that, from a risk management perspective, are economically sound! So, for that reason at least, we think the efforts will be worth it in the end.