Changing accounting standards

27 October 2017

Accounting standard IFRS 9 will replace IAS 39 in 2018, and corporate finance is sure to see significant effects from the move. Finance Director Europe takes a look at how businesses can avoid too much turbulence in changing times.

New standards and regulations often take so long to formulate that implementation seems like it may never happen. Schemes such as the Single Euro Payments Area (SEPA) had their deadlines pushed back time and again until they almost became running jokes. Change will come but, inevitably, some companies won’t realise it until the true scale of the transformation task is clear and they find themselves in a world of trouble.

Of course, that doesn’t apply to the readers of this magazine, who will undoubtedly have their ducks in a row well in advance of any major change. But with new accounting rules coming up next year, it’s worth considering what will change and how the corporate functions of financial institutions will have to respond.

Measuring loss

The start of 2018 will see the introduction of the IFRS 9 accounting standard across the 120 constituencies that abide by IFRS rules. It will replace IAS 39, which was first adopted by the European Union in 2004. At the heart of IFRS 9 is a revised credit loss model that will change the way banks report losses – a necessary reaction, in the eyes of many, to the financial crisis of 2008.

Due to the limitations of the current standard, bad loans were often booked too late and at too small an amount. This is because banks aren’t allowed to start booking losses until they have evidence of a triggering event, something like a market crash or big interest rate rise that would likely cause some riskier loans to go bad. This was particularly damaging during the crisis as losses weren’t booked until impairment had already happened, far too late to do anything about it.

It’s a really big change in thinking from an accounting perspective to start talking about expected credit losses and all of these concepts are going to be very new for people reading the financial statements.

The current standard also means that banks can only rely on past and current performance as an indicator of a loan’s likely repayment. They cannot factor in future predictions, no matter how well informed they may be. Your economic models might tell you that house prices are likely to go into steep decline over the next six months but your accounts cannot reflect this.

In 2009, the International Financial Reporting Standards (IFRS) set out to change this. It embarked on a long process of consultation through which it tried to ascertain which historic, current and future information had to be factored in when considering a firm’s financial health, and how they could do it in a way that was operationally manageable for the banks. The IFRS then put out three variations on a new impairment model and asked banks to choose their preferred one.

While it was clear that likely future events had to be taken into account in the make-up of these models, the IFRS was wary of going too far in the other direction. Adjusting for losses at the first hint of trouble, before any shock has actually occurred, leads to just as inaccurate a picture of a bank’s financial health. It is also likely to lead to jitters among shareholders, who might panic-sell at the sight of these high loan loss figures, even if the fundamentals don’t merit it. The right solution was somewhere between the extremes; it was just a question of finding that point.

The other big sticking point was how to combine banks’ increasingly important forward-looking systemic risk data with pure financial data in a way that gives greater insight without costing an arm and a leg. The IFRS had to do it in a way that maintained some compatibility with US standards, allowing multinationals to benchmark across their various subsidiaries.

After nine years of policy formulation and testing, the IFRS has in place a set of standards that it thinks will work.

“On the first day you lend money, you don’t have to book the entire expected loss, but a portion,” says Sue Lloyd, vice-chair of the International Accounting Standards Board, which is responsible for setting IFRS. “If I lend money to someone and it turns out the risk was worse than I thought, once I decide that a loan is under-performing relative to my initial expectations, I book the lifetime value.

“We are clear that we expect people to make the assessment relative to their initial expectations when the loan is priced, using forward-looking information, so they should be making that assessment and booking lifetime losses before defaults start to happen.”

Nothing wrong with lending

This approach tries to tread a fine line. Lloyd says that the IFRS does not want to discourage lending, or to suggest that the more you lend the worse your financial performance will be. However, even though only a portion of the expected loss has to be booked under the new system, banks will see a big change in their non-performing loan levels. According to research conducted by Deloitte, average loan-loss balances will likely be around 30% under the new standard.

This figure is difficult to stomach and will be very new for people used to reading financial statements. Also new will be the mindset with which finances are viewed in relation to the expectations that underpinned the original loan decision. For this reason, communication between the credit risk and financial reporting functions is essential. The language and the concepts that have long been specific to one must be understood by the other.

At the same time, in Lloyd’s view, constant shareholder communication is necessary in order to show that the change in standards and subsequent alteration in figures is not indicative of a dip in performance.

“Banks shouldn’t forget the importance of communication and disclosures when they move to IFRS 9,” she says. “It’s a really big change in thinking from an accounting perspective to start talking about expected credit losses and all of these concepts are going to be very new for people reading their financial statements.

“People not only need to work out the systems changes but must also ensure they spend time with the investor relations team to make sure the way they explain the market is thought about carefully. This is an opportunity for the banks to provide a fuller explanation to the market about credit risk, to give more transparency and comfort to the market.”

This is an opportunity for the banks to provide a fuller explanation to the market about credit risk, to give more transparency and comfort to the market.

To smooth the transition, other regulatory bodies are adjusting their expectations. The Basel Committee on Bank Supervision, which sets out the minimum capital requirements of financial institutions, has said that five years will be allowed before IFRS 9 impacts regulatory capital. This means, for example, that if your figures under the new standard require you to improve your capital provisions by 10%, it would be year six before the full impact of that would affect your regulatory capital situation under the Basel regulations.

“They are giving banks time so they won’t suddenly have to raise tier 1 capital in 2018,” Lloyd explains.

Pros and cons

IFRS has received encouraging feedback from many quarters. In a report issued by the European Parliament’s Economic and Monetary Affairs Committee, Jannis Bischoff and Holger Daske of the University of Mannheim argue that IFRS 9 “reflects a balanced ‘mixed measurement’ approach that incorporates the different views of the participants in the debate. The new standard will not fundamentally change the current accounting treatment for financial instruments under IAS 39.”

At the same time, IFRS 9 is not without its critics, even from within the same European committee. Chairman Roberto Gualtieri on 16 July wrote a letter arguing that “IFRS 9 has not been subject to an impact assessment on its macroeconomic consequences and its effects on long-term investment. Equally, there is no proper analysis of its consequences for crucial long-term investment.”

Get ready

A Euromoney article in February 2017 titled ‘Bank regulation: the corrosive effects of IFRS 9’ suggested that the new regulation could prove “corrosively pro-cyclical”, that in times of downturn the loss-reporting requirements might badly deplete capital levels “just when capacity is needed to keep good companies alive.”

“Today’s accounting conventions might inflate risk-weighted assets (RWAs) in order to cut banks’ CET1 by 100bp or so in a standard economic downturn,” it continued. “IFRS 9 might bring an immediate 300bp cut in similar circumstances.”

Having taken so long to formulate and test, Lloyd is confident that the benefits to banks in terms of their perception of their own financial risk will, in the longer term, outweigh any downsides. As for finance directors, all they can do is make sure they are ready.

Communication is stressed to be a significant factor in the comfort and stability of markets.
Regulatory bodies are adjusting accordingly to help ease markets into the new standard.