Can IFRS 9 prevent Greek tragedy?

IFRS 9, the global accounting standard on financial instruments, is among the most heavily scrutinised projects of the International Accounting Standards Board.

Recent events in Greece have dragged it further into the spotlight as some claim early adoption will help ease the burden of EU members’ sovereign debt, while others insist changing accounting rules is not the answer.

Speaking at a recent conference, new chairman of the IASB Hans Hoogervorst said the standard – which is not yet finished – would “give us a little bit more leeway in terms of Greek government bonds”, claiming for this reason, many at the European Commission “think we should adopt it quickly”.

IFRS triptych

IFRS 9 Financial Instruments is made up of three parts, of which impairment accounting is most relevant for sovereign debt. During the financial crisis, the current incurred loss model attracted much criticism, as it was felt only recognising losses after the event crippled banks’ ability to make provision for bad assets, effectively meaning there was no early warning system in place.

As a result, some called for a move to an expected loss model, a more forward-looking plan that takes into account current financial positions, as well as what can reasonably be expected to happen in the future.

An IASB spokesman said since the crisis, there has been great pressure on the standard setters to resolve the issue, and Hoogervorst’s call for adoption of IFRS 9 is one part of their response.

However, some stakeholders have balked at a straight switch to IFRS 9, despite a recent survey by Deloitte indicating the majority of big banks think the global standard is an improvement on its predecessor, IAS 39.

Policymakers in Europe are loathe to officially adopt the standard before it is completed; the hedge accounting and asset/liability offsetting arms have yet to be finalised, and these two issues are in themselves among the knottiest problems in accounting standards.

In late 2009 Charlie McCreevy, then European Commissioner for internal market and services, wrote to the IASB saying “changed financial outlook and market improvements” meant IFRS 9 would not be adopted at that time. With sovereign debt tightening its stranglehold on member states, will politicians reconsider?

Barnier says no. Successor to McCreevy, he told a recent meeting: “I do not believe this will be the first solution to the problems we face in Europe at the moment,” insisting that the Commission must see the other components of IFRS 9 before making a decision.

Transparency fears

Investors will be relieved, according to the CFA Institute, which warned Hoogervorst’s plan will allow account preparers to avoid recognising losses and is “antithetical to the objective of transparent information”.

The proposed IFRS 9 would allow some assets to be held at cost price and some at fair value – known as a mixed model – and proponents say this could support stricken banks that would otherwise see the value of their assets go through the floor.

The CFA Institute wants accounts to be prepared solely under fair value, otherwise known as mark-to-market, which would see assets valued at current market prices. For Greece and similar struggling economies this could be disastrous, as today’s asset prices can be significantly lower than cost, leading to a “cliff effect” where balance sheet bottom lines plummet alarmingly.

CFA senior policy analyst Vincent Papa said investors want to see losses when they occur, and the proposed mixed model of impairment accounting “gives preparers too much freedom to present accounts as they see fit – a pure fair value model will take away this freedom”.

Papa warned current proposals would present a “false plateau” and undermine investor confidence in the numbers, concluding: “The only way to solve this crisis is to tell it as it is.”

Unsurprisingly, the IASB does not agree. Where IAS 39 used fair value measurement, IFRS 9 is based on expected cash flows, meaning if the holder of an asset is confident it will continue to bring in cash over its lifetime, it might not have to be written down to the extreme lows dictated by market prices.

To trade, or not to trade

Here, the purpose of the asset also comes into consideration. If, for example, a bank plans to hold a loan for its full term, it makes more sense to value it at cost, thereby avoiding recording huge losses derived from a current market price that is irrelevant to an asset that will never be sold.

Assets that will be held to full term and never sold are entered into the banking book, while those intended for sale go into the trading book. Under the IASB’s mixed model, banking book assets (such as mortgages) would be valued at cost price, while trading book assets would be marked to market, and therefore run the risk of devaluing.

Here, the accounting standards become still more complicated. While banking book assets are recorded at cost price, which does not change, they may nevertheless be marked down (impaired) if the holder suspects they will not achieve the returns they hoped for when buying the asset.

In the case of Greece, this means lenders can value loans to the country at cost price – thereby avoiding the cliff effect of marking them to market – but may still be forced to write their value down if they think the debtor will not be able to repay the full amount.

Recent emergency meetings on sovereign debt indicated that the appropriate credit impairment might only be 21%, meaning lenders could reasonably expect to recover 79% of the value of loans to Greece. Under mark to market, this figure might be closer to 50%, illustrating Hoogervorst’s point on IFRS ‘easing the pain’ of the current crisis.

Impair Vs. market

However, there are some who say the difference between IFRS 9 and IAS 39 is academic, given that the jury is out on the level of Greek debt that will be recoverable. If, for example, markets decide little debt will be recoverable, lenders would be forced to record significant impairment on it, and the cliff edge would still be precipitous.

Kathryn Cearns, technical accountant at Herbert Smith, said banks must remain convinced the debt is recoverable to justify valuing it at or near cost price. If they decide the asset return will be poor, they must write down its value (impair it) accordingly, and set aside provisions to cover expected losses. Additionally, bank regulators can choose to force a full write-down to market value simply for regulatory purposes, again meaning capital could be lost.

Iain Coke, head of financial services at the ICAEW, had similar words of warning. “There is much market uncertainty surrounding sovereign debt and impairment,” he said. Many people believe Greek debt is heavily impaired and should be written down. This would hit balance sheets hard and could potentially have a similar effect as marking to market, if the impairment is so great as to wipe 50% off asset value.

Coke said holding assets at cost could in fact create a bigger one-off hit for banks as they would be forced to impair assets in one lump sum, rather than tracking a more gradual decline as market prices fall.

Mixed model

Despite this, the institute supports the IASB’s mixed model, as do many other prominent voices in the market. Cearns said accounting under IFRS 9 is “simpler”, while Coke described it as “more intuitive” and most respondents to Deloitte’s survey think it will improve financial statements.

A dogmatic response to the complexities of sovereign debt has few fans, it would seem. While rushing headlong into adoption of the unfinished IFRS 9 could potentially alleviate sharp shocks, it might do little to stem Greece’s freefall if the market has made up its mind that impairment is inevitable. At the same time, sticking with the old fair value-friendly IAS 39 has made it harder for banks to recognise the impact of recent developments in the Eurozone, even though some investors consider it a more truthful representation of market reality.

One thing is for sure – the IASB has a few months left to complete the standard, as no debt crisis seems to be enough to nudge the EU into adopting IFRS 9 in its half-baked state.

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Fiona Westwood of Smith and Williamson.