BANKS AND FINANCIAL INSTITUTIONS must provision for bad loans much earlier, under changes to IFRS accounting rules that will force organisations to better accurately represent their financial health.
Global standard setter the IASB published IFRS 9 on Thursday, the accounting standard for financial instruments, abandoning its discredited incurred-loss model in favour of a forward-looking impairment model, moving to how companies recognise losses they expect to occur in the future.
The new model, which will take effect in 2018 - ten years after the financial crisis that exposed the failings in how banks booked accounting losses - introduces a three-stage process to loan loss provisioning, based on a continuous assessment of the level credit risk. Specifically, 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 more timely basis.
The previous standard, known as IAS 39, was heavily criticised for contributing to the onset of the financial crisis by allowing banks to overstate their profits and make inadequate provisions for loans that could go bad.
It is expected that the new model will increase loan loss provisions on banks' balance sheets by around 50%, potentially forcing banks to set aside more capital to cover possible future losses.
"Increasing the accounting provisions will reduce regulatory capital," said Iain Coke, head of ICAEW's Financial Services Faculty. "Banks will need to consider the impact of the new standard on their regulatory capital, taking into account the results of regulators' stress-testing and asset quality review exercises."
Alongside the ‘expected loss' impairment model, the new rules include a new approach for classification of and measurement of financial instruments, a reformed model for hedge accounting and remove the volatility in profit or loss caused by changes in the credit risk of liabilities measured at fair value.
Hans Hoogervorst, chairman of the IASB, said IFRS 9 has introduced "much needed improvements" to the reporting of financial instruments and are consistent with requests from the G20 for a forward-looking approach to loan loss provisioning.
"The new standard will enhance investor confidence in banks' balance sheets and the financial system as a whole," Hoogervorst said.
Efforts between the IASB and US counterpart FASB to create a converged standard failed. The project hit the buffers in 2012 after the boards expressed different views about how to account for the impairment of financial instruments. FASB's standard, which is still being deliberated, is likely to recognised losses up-front and distanced instead of IASB's so-called three-bucket approach.
"Having different rules under US GAAP and IFRS will mean a lack of comparability for investors between the results of banks reporting under the different frameworks, and increased costs for those banks that have to prepare figures under both accounting frameworks," said Chris Spall, KPMG's global IFRS financial instruments leader.
In terms of transitioning to the new standard, it has a mandatory effective date of 1 January 2018 but can be adopted early, Spall expects banks will need the whole period to prepare for adoption of the expected credit loss requirements.
"The possibility of early adoption of only the ‘own credit' amendment would provide some welcome relief from profit or loss volatility caused by fluctuations in a company's own credit risk," he said.
"The long lead time to mandatory adoption and the different possibilities for IFRS 9 adoption could mean a protracted but temporary period of diversity. In many jurisdictions, including the European Union, companies will not be able to adopt the new standard until it is legally endorsed or permitted by regulators. Given the significance of the standard to the financial services sector, the road to endorsement may be longer and more winding than usual."
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