The International Accounting Standards Board has issued the final element of iits own long-awaited financial instruments accounting standard after failing to reach a consensus with the U.S. Financial Accounting Standards Board on key elements related to credit losses and loan impairments.
The package of improvements included in IFRS 9 “Financial Instruments” includes a logical model under International Financial Reporting Standards for classification and measurement, a single, forward-looking “expected loss” impairment model and a substantially-reformed approach to hedge accounting. The new standard will take effect on Jan. 1, 2018 with early application permitted.
“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 in a statement. “The new standard will enhance investor confidence in banks’ balance sheets and the financial system as a whole.”
The IASB noted 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. As part of IFRS 9, the IASB has introduced a new, expected-loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new standard requires entities to account for expected credit losses from when financial instruments are first recognized and to recognize full lifetime expected losses on a more timely basis.
The IASB announced last month its intention to create a transition resource group to support stakeholders in the transition to the new impairment requirements (see IASB Goes Its Own Way on Financial Instrument Impairment).
The IASB acknowledged that it was unable to reach an agreement with FASB so there is not a converged standard in IFRS and U.S. GAAP on financial instruments as the two boards had planned under the Norwalk Agreement of 2002. That work took on new urgency in the aftermath of the 2008 financial crisis.
“Work on IFRS 9 was accelerated in response to the financial crisis. In particular, interested parties including the G20, the Financial Crisis Advisory Group and others highlighted the timeliness of recognition of expected credit losses, the complexity of multiple impairment models and own credit as areas in need of consideration,” said the IASB in a project summary it released Thursday of IFRS 9. “The IASB has worked closely with the FASB throughout the development of IFRS 9. Although every effort has been made to come to a converged solution, ultimately these efforts have been unsuccessful. Throughout the lifecycle of the project the IASB has consulted widely with constituents and stakeholders on the development of the new standard.”
The two boards did recently succeed in producing a converged standard on revenue recognition, however, and are still trying to resolve their differences over the leasing standards. In the meantime, FASB is still working on finalizing the financial instruments standard under U.S. GAAP and hopes to complete the work by the end of the year.
“The FASB is completing its proposed current expected credit loss’ model, which would require companies to reflect on day one when they put a loan on the balance sheet any losses they expect to incur over the lifetime of the loan, even if the loan is fully performing,” said FASB spokesperson Christine Klimek. “The FASB plans to issue a final standard by the end of 2014. The FASB also is completing its approach to classification and measurement of financial instruments which will include improvements to existing U.S. GAAP. That standard also is expected to be issued at the end of the year.”
The new IFRS 9 requirements should not be seen as a panacea, according to the Institute of Chartered Accountants in England and Wales.
“The new loan loss requirements will provide earlier indications of potential losses on loans made by banks and other financial institutions, and that is a major and long over-due step forward,” said Dr. Nigel Sleigh-Johnson, head of ICAEW’s Financial Reporting Faculty. “However, those who think that provisions made in the run-up to the global financial crisis were too little, too late’ should not see the change as a panacea. Even an expected loss model won’t result in provisions being made for unexpected losses.”
The new model focuses more on the level of credit losses expected in the future and allows for earlier recognition of losses than was previously possible under the IASB’s standards. It introduces a three-stage approach to loan loss provisioning, based on ongoing assessment of the level of credit risk.
While FASB’s “current expected credit loss” model would require companies to reflect on day one when they put a loan on the balance sheet any losses they expect to incur over the lifetime of the loan, even if the loan is fully performing, the IASB model only would require impairments when there are signs of deteriorating credit quality. According to FASB, comments that were received on the FASB proposal show that both U.S. and global investors strongly prefer the FASB’s lifetime losses approach. The FASB plans to issue a final standard by the end of 2014.
During redeliberations, FASB noted that it performed extensive analysis to consider the current expected credit loss model, the IASB’s model, and other models that were recommended by the banking community and others. The analysis helped the board understand in each of these models the impact on the balance sheet as well as the income statement.
After several years of trying to agree a joint solution with the FASB, the publication of the new requirements apparently marks the end of the effort to converge standards in this area, according to the ICAEW. “While almost everybody has agreed that moving to a more forward-looking model would provide more useful information, it’s been very difficult to agree on the precise details of the new accounting model,” said Sleigh-Johnson. “It is regrettable that the IASB and the FASB have been unable to agree on all aspects of their models, but ultimately it is more important that we finally have a standard in place that will provide global investors with more timely information about increases in credit risk and expected credit losses.”
In the area of classification and measurement, IFRS 9 introduces a logical approach for the classification of financial assets, which is driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are generally considered to be overly complex and difficult to apply. The new model also results in a single impairment model being applied to all financial instruments, thereby removing a source of complexity associated with previous accounting requirements.
“Accounting for financial instruments was highly criticized during the financial crisis,” said Anne-Lise Vivier, accounting publications managing editor with Thomson Reuters. “The delayed recognition of impairment losses and, in particular, credit losses on loans, was highlighted as one of the aggravating factors of the financial meltdown and a major weakness of the existing accounting standard for financial instruments. The IASB and the FASB have both been working for nearly a decade on a new model for the accounting and reporting of financial instruments. Despite years of joint efforts, the FASB and the IASB could not reach convergence on their financial instruments project.”
IFRS 9 also introduces a substantially-reformed model for hedge accounting, with enhanced disclosures about risk management activity. The new model represents a significant overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements. In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
IFRS 9 also removes the volatility in profit or loss that was caused by changes in the credit risk of liabilities elected to be measured at fair value. This change in accounting means that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognised in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted by IFRS 9.