After considerable analysis and debate, the accounting for financial instruments will be changing to address some of the concerns and problems highlighted during the financial crisis -- in particular, credit losses were not recognized early enough. Although these modifications will likely not take effect until the beginning of 2018, companies should start assessing their impact and developing implementation plans now.
The standard-setters' original plan was to converge U.S. GAAP and IFRS, but after several years we now have models that are more divergent than when they started. While U.S. GAAP retains much of its current classification and measurement guidance, the changes under IFRS are more significant and complex. Because the two standards are actually further apart -- and substantially different from current accounting practices -- organizations with reporting requirements under both U.S. GAAP and IFRS will face added complexities.
These changes impact organizations, especially financial institutions, across various assets including receivables, loans and debt securities. Companies will need to invest time in understanding the new requirements, revamping their processes and analyzing their effects. For example, they can expect reserves to increase as the impairment model moves from an incurred loss model to an expected loss model; accordingly, capital needs will also rise. Some banks have estimated that reserves may increase by as much as 50 percent.
Changes in classification and measurement of financial instruments will likely lead to greater P&L volatility. There would be minimal changes under U.S. GAAP, as much of the current guidance would be retained. Key U.S. GAAP changes include:
- Equity securities will be measured at fair value, with changes recorded to P&L. The available-for-sale category, which recorded changes in fair value through other comprehensive income, is no longer permitted;
- Changes in instrument-specific credit risk for financial liabilities that are measured under the fair value option would be recognized in OCI; and,
- Fair value disclosures for loans will need to be based on exit prices; the current practical expedient is eliminated.
For those reporting under IFRS, there are more significant changes to classification and measurement. (See chart.) For IFRS filers, including U.S. multinationals filing IFRS statutory reports, the process for classifying financial assets will need to significantly change. New methods will need to be established that evaluate the contractual cash flow characteristics of financial assets and the business model, using the specified criteria. In addition, the process to bifurcate embedded derivatives will need to be eliminated.
NEW IMPAIRMENT COMPLEXITIES
Even though U.S. GAAP and IFRS both move from an incurred loss model to an expected loss model, the new impairment models differ. Under U.S. GAAP, management's current estimate of lifetime expected credit losses would be recognized as an allowance each reporting period. CECL would be an estimate of the contractual cash flows that an entity does not expect to collect, considering past events, current conditions, and reasonable and supportable forecasts.
Under IFRS, lifetime expected credit losses will be recognized only on assets for which the credit risk has significantly increased since initial recognition. Entities will recognize 12-month expected credit losses (credit losses that result from default events that are possible within the next 12-month period) for all other assets.
Accordingly, impairment would generally be less under IFRS than U.S. GAAP on individual financial assets until there is a significant increase in credit risk. In addition, the new process to determine when there has been significant credit risk deterioration and the bifurcation of the calculation adds to the complexities under IFRS, and further compounds the challenges for multi-GAAP filers. Fortunately, banks may be able to streamline this new process by leveraging existing processes and models utilized for Basel, CCAR, and other internal and external reporting.
As for timing, IFRS 9 has an effective date of Jan. 1, 2018, and early adoption is permitted. The U.S. GAAP standard is likely to be issued by the end of the first quarter of 2015, with final decisions made by the end of the year; the effective date will likely align with IFRS 9. Given this time line, it would be prudent for companies to begin their implementation plans now.
They should establish a strong governance program, identifying core participants such as accounting policy, credit risk, controllership and IT, and setting project protocols. Then companies can perform an assessment of how the proposed changes impact the organization, from the financial, tax and regulatory expected quantitative impacts to the potential data, process, control, modeling and technology gaps. Based on the results of this assessment, implementation plans can be developed outlining resource and budget needs with an appropriate time frame, as well as the required action steps.
The changes will impact most organizations, and in particular financial institutions. Multinational organizations that have reporting requirements under both U.S. GAAP and IFRS will face two new processes that will need to be established given the divergence in standards. Although there are a few years until the effective date, senior management and external parties must take steps now to be prepared. Early analysis allows for an efficient and cost-effective process, less business disruption and minimal risk of surprises.
Lisa Filomia-Aktas is a partner at Big Four firm EY.
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