IASB unveils new accounting rules

October 2014  |  FEATURE  |  FINANCE & ACCOUNTING

Financier Worldwide Magazine

Tough new accounting rules were unveiled by the International Accounting Standards Board (IASB) in July, which will force banks to change the way they view losses. The new directives are the product of a five-year project enacted to enable company accounts to paint a significantly more accurate picture in the future.

IFRS 9 will take effect in 2018 – a decade after the financial crisis exposed failings in how banks booked accounting losses. It is hoped the new model will enhance investor confidence in banks’ balance sheets and the financial system as a whole. The long lead in time has been mandated as banks will need as much time as possible to prepare for the adoption of the expected credit loss requirements.

The new standard requires entities to account for expected credit losses from when financial instruments are first recognised, and to recognise full lifetime expected losses on a timelier basis. The new rules will see loans separated into three separate categories – performing, underperforming and non-performing. Under IFRS 9, loans will move between these stages according to changes in credit loss expectations. The new standards are expected to increase loan loss provisions on banks’ balance sheets by about 50 percent, which may force banks to set aside more capital to cover possible future losses.

This long awaited change to accounting standards will see the IASB abandon the previously discredited incurred-loss model of IAS 39. The previous model was believed to have contributed significantly to the onset of the financial crisis as it allowed banks to overstate their profits and make inadequate provisions for loans that could go bad. IFRS 9 will operate a more forward-looking impairment model, which will permit management to factor predicted changes in conditions into the impairment charge.

The new model will also make provisioning more sensible, at the cost of additional complexity. Implementation of IFRS 9 will involve considerable judgement and will add to the degree of subjectivity already inherent in loan loss provisions.

The reforms have received a mixed reception. On the one hand, accountants have largely welcomed the new standard as an improvement on the previous model. However, whether the use of the new ‘expected loss’ approach would have avoided or even mitigated the effects of the financial crisis is debatable. Regardless, “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,” said IASB chairman Hans Hoogervorst.

Supporters of IFRS 9 have noted that while the new model is not perfect the IASB has, to some degree, been forced to reach a compromise between creating a conceptual standard and one that is operationally and economically feasible.

Those banks using internal models under the advanced approach of the Basel III banking standard are able to calculate their own expected losses for regulatory capital calculation, rather than relying directly on accounting impairments. Accordingly, and depending on each bank’s new level of provisions compared with the regulatory expected losses, the effects of higher impairment charges as a result of IFRS 9 are likely to be mitigated. Banks under the Basel standardised approach do not calculate a regulatory expected loss and specific impairments flow directly into regulatory capital. Therefore, the impact of these accounting changes may be more significant for banks and portfolios under the standardised approach.

In 2012 the IASB and its American counterpart the US Financial Accounting Standards Board (FASB) tried, unsuccessfully, to reach an agreement on loan loss provisioning. As a result, the FASB has taken up a position which requires firms to recognise all expected lifetime credit losses immediately. Banks are obliged to provide for losses when they advance new loans, regardless of whether or not the borrower is at risk of default. Though attempts were made to reach a compromise, the inherent differences between the two approaches are likely to frustrate investors. The different approaches will result in a lack of correlation between those banks reporting under the two different models. There will also be cost implications for those banks that are required to report using the two different frameworks.

Iain Coke, head of the ICAEW Financial Services Faculty, believes that loan loss provisions for banks will increase by an average of 50 percent. “It will reduce profits in the year of implementation, but it may not have a major impact on the income statement in future years. That doesn’t mean banks got it wrong before – it only means banks will measure provisions differently.”

For European banks, the implementation of IFRS 9 is some considerable way off; indeed, the model still requires endorsement by policymakers before its use is allowed within the EU. However, its use elsewhere will nevertheless be permitted. Until 2018, the Basel III banking standard, with its own significant regulatory powers, should prove to be sufficient in helping banks to emerge from any periods of higher loan losses.

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Matt Atkins and Richard Summerfield