On July 24, 2014 the International Accounting Standards Board (IASB) issued the fourth and final version of its new standard on accounting for financial instruments – International Financial Reporting Standard (IFRS) 9 Financial Instruments (completely replacing the former IAS 39 rule). The project was launched in 2008 in response to the financial crisis and is the first accounting standard in the financial services industry that requires alignment and convergence with risk management frameworks. The primary aim of IFRS 9 is to establish a significantly improved accounting standard for presenting users of financial statements with information that is relevant, useful, and more comprehensive in assessing the amounts, timing and uncertainty of a firm’s cash flows from financial instruments. The new standard includes revised guidance on the classification and measurement of financial assets, including impairment, and supplements the new hedge accounting principles published in 2013.
The IFRS 9 mandatory adoption date is presently no later than January 1, 2018 for banks and January 1, 2021 for insurance companies, and all these firms need to gain a solid understanding of the standard and assess how it will impact their accounting and risk management processes and systems for financial instruments.
The impact on banks and insurance companies
The new standard will have a massive impact on how banks account for credit losses in their loan portfolios. Provisions for bad debts will be bigger and are likely to be more volatile, and adopting the new rules will require a lot of time, effort and money. Insurers will also be significantly impacted by IFRS 9. The insurance industry has to plan for the adoption of new standards on both financial instruments and insurance contracts over the next few years. The overall effect cannot be assessed until the insurance standard is finalized, but a sea-change in financial reporting for most insurers can be expected.
How exactly does IFRS 9 impact existing accounting standards?
The areas within IFRS 9 that are changing from the previous ruling are very complex and comprehensive. The ruling mandates major changes in three main categories of accounting for financial instruments:
• Classification and Measurement of Financial Assets:
- Examples of financial assets that are impacted by this standard include commercial and retail loans, mortgages, equities, bonds (fixed income), derivatives (e.g. stock options; swaps), structured products such as CMOs (collateralized mortgage obligations), and foreign exchange positions
- Financial assets will be measured either at amortized cost or fair value depending on the type of cash flows generated and the business model used.
• Impairment (Credit)
- IFRS 9 replaces the “actual incurred loss” accounting model for credit deterioration in IAS 39 with an “expected credit loss” model that requires forecasting/projection of loss allowances for loan portfolios based on various risk and economic factors.
- The type of expected loss calculations (projections) required depends on the degree of credit deterioration of each individual financial asset (e.g. loans), with 3 stages of deterioration (impairment) defined.
• Hedge Accounting
- Improvement areas under IFRS 9 include a greater number of accepted types of hedge transactions, less P&L volatility resulting from hedge accounting, and significantly simplified methods for testing and accounting for the effectiveness of hedges which is more aligned with risk management needs.
IFRS 9 implementations require significant multi-disciplinary expertise & time
In addition to having a major impact on accounting organizations, the IFRS 9 standard affects numerous other areas within financial institutions, and is a significant multi-disciplinary initiative. In fact, in a 2014 Global IFRS 9 Banking Survey¹, Deloitte indicated that survey respondents identified coordinating multi-disciplinary efforts including accounting, credit, risk, IT and related resource constraints as the key IFRS 9 implementation challenge.
Additionally, Boards of Directors and C-level executives need to be aware that Implementing IFRS 9 will have a wide range of impacts on their business, and will require the involvement of many stakeholders beyond those listed above. Some of these impacts and requirements include:
• P&L – impact on transition and the inevitable volatility going forward
• Capital – also impact on transition and inevitable volatility going forward
• Impact on credit risk management frameworks, models and pricing
• Consideration of forward economic guidance and options available for scenario forecasting
• Direction from Commercial/Trading business front office managers on design frameworks for risk & accounting
• Collection of market and master data for both commercial lending and capital markets trading businesses
IFRS 9 mandates major changes in accounting requirements & processes
When companies first converted to IFRS reporting standards, most were also still required to continue preparing financial statements in accordance with local accounting standards (i.e. Local GAAP). As a simplifying measure, many firms chose to continue only generating one set of accounting postings to general ledgers and sub ledgers using Local GAAP rules, and then use reconciliation analysis to restate Local GAAP consolidated statements into IFRS.
Going forward with IFRS 9, however, companies will no longer be able to perform this restatement method in accounting for their financial instruments. This is because IFRS 9, unlike other IFRS standards, requires its accounting rules to be applied at a very detailed level, where accounting logic is processed for individual business transactions and postings. Therefore, while the credit risk models that will be used to calculate expected loss will still typically be run at a portfolio level, the actual accounting for all financial instruments, expected credit losses, and changes in fair value will need to be applied at the individual legal contract level.
This will require financial institutions to convert over to a full implementation of IFRS 9 rules at the General Ledger level by migrating to a parallel (dual) accounting and reporting process. Parallel accounting (i.e. booking two sets of accounting postings to two different General Ledgers for each business transaction) drives a need for accounting automation because such procedures are too complex and cumbersome to be performed manually. However, the reality is that even with the official deadline of January 1, 2018, some firms may not have enough time to fully implement an accounting automation engine beforehand. They may put temporary measures in place to be compliant by the deadline, and then continue on with the project thereafter to reduce manual operations by automating multi-GAAP accounting. Furthermore, the eventual full automation of the IFRS 9 accounting process will also prepare firms to more easily comply with future inevitable accounting standard and regulatory pressure changes.
By Peter Benesh, Director Solutions Marketing, Axway.