Wolters Kluwer: Expected Losses Accounting Under IFRS 9
Posted: 10 April 2015 | Author: Jeroen Van Doorsselaere | Source: Wolters Kluwer
In February 2015, the main topics of discussion were a bit scattered. On one hand, there were investor updates about pension accounting and the use of International Financial Reporting Standards (IFRS) around the world (see previous commentaries). Meanwhile, the IASB board meetings began discussions about macro hedging for open portfolios, revenue from contracts with customers, another disclosure initiative update and round accounting for expected losses in the context of IFRS 9.
Accounting for Dynamic Risk Management (IAS 39 Replacement)
In April 2014, a discussion paper was issued on the Portfolio Revaluation Approach. After a comment period, the International Accounting Standards Board is now assessing their proposals. The objective of the IASB in proposing the Portfolio Revaluation Approach was to abandon the static view within the context of IAS 39 and focus on more alignment with dynamic risk management.
The IAS 39 replacement, IFRS 9, released in July 2014 did not come with a solution for open portfolios because it would have delayed the release of IFRS. The Portfolio Revaluation Approach discussion paper received 126 comment letters and a review of those comments is underway. Having the Portfolio Revaluation Approach closely aligned with dynamic risk management was accepted by most respondents, and even the respondents that were against the method failed to come with an alternative. However, it is clear that there is still a lot of work to do before reaching a final agreement.
In the discussion paper, three possibilities were outlined as a means to solve the open portfolio issue. Working with a complete inclusion of dynamic risk management measurement accounting was not welcomed, and most that responded preferred the other options that focus on risk mitigation (despite the operational challenges) portfolios being reflected in accounting.
Additionally, respondents highlighted key issues with the current approach. The issues are related to where the approach of the IASB deviates from the risk management practices, such as revaluing exposures, which is inconsistent with the objective of solving the accounting mismatch. Although most respondents are aligning the approach with the managing of NII and future NII, the concern is that this is merely point-in-time information. The fact that banks that do not hedge interest rate risk in hedge accounting could potentially have less volatility than one who do not, which is against the primary objective of removing the accounting mismatch.
On the other hand, the Portfolio Revaluation Approach was highly supported by users of financial statements as it focuses on NII and makes a clear difference between trading and hedging derivatives relating closely to ALM. However, it is clear that this is just the beginning and issues around behaviorism, pipeline transactions, insurance contract application and the removal of impracticalities for which currently proxy hedging is still used, needs to be addressed. Respondents were clear that this is a step in the right direction and also seems to indicate that GFRC is the best way to bring IFRS 9 risk and finance closer together.
BCBS Comments on IFRS 9
While the IASB is busy evaluating other topics, the Basel Committee on Banking Supervision has issued guidance on accounting for expected credit losses. This specific paper also addresses practices around the implementation of the IFRS 9, Phase 2 impairment. Within this paper, the BCBS acknowledges that there are fundamental differences between the Basel requirements and the IFRS 9 requirements.
- The Basel framework expected loss models will look through-the-cycle. While in IFRS 9, the expected loss models use more point-in-time logic (see below graph from FT.com)
- The Basel framework will also work with models limited to a 12 month horizon, while life time expected losses are required in IFRS 9.
- In addition, the loss given default will focus more on downturn economic scenarios. In IFRS 9, it could be based on all different economic scenarios.
Despite these differences, the BCBS provides a necessary guidance to promote governance via adequate and policies and processes for detection of problem assets that should be aligned between risk and finance. To address that, the BCBS is proposing 11 principles, eight of which are related to the way expected loss models should be implemented and three are related to how supervision should act and react to these different models.
The most important things to highlight are that a bank’s credit risk methodologies should clearly define the key terms related to the assessment and measurement of expected credit losses, such as loss and migration rates, loss events or default. The necessary back testing should be foreseen. It should include macro-economic factors that are forward looking. In addition, this process should be supported by the necessary systems and tools for measuring and assessing credit risk. The bank should also use experienced credit judgment based on the necessary policies and procedures.
In addition to what is discussed above, what is maybe even more important is the additional guidance the BCBS has been giving on its expectations.
- The BCBS expects that banks will only issue high credit risk exposures.
- From the moment delinquency has been established, an entity should not hesitate to move the contract from a 12 month to a lifetime expected loss status.
- The low credit risk assumption foreseen in IFRS 9 should only rarely be used as banks should move instruments within an expected loss state whenever there is a sign of delinquency.
- The committee also expects banks to assess significant assets individually as opposed to assessing it with a group of assets.
- The committee strongly pushes forward the 16 objective evidence indicators to be used within banking. When doing a credit assessment, a financial institution should not only look to a downgrade in absolute numbers, but should consider all of the elements.
- The committee also expects that multinational banks provide a decent credit model as opposed to proxy models, such as loss rates based on historical data or provision matrices or rebuttable presumptions.
- The BCBS is giving guidance on how to define words, such as “significance” and “default,” which is stricter than in an IFRS 9 context.
Although comments are still expected, it is clear that this paper will provide some additional guidance on how to make sure the concept of aligning Governance, Finance, Risk and Compliance (GFRC) are controlled.
Revenue from Contracts with Customers
In May 2014, both the IASB and FASB issued IFRS 15, pertaining to revenue from contracts with customers, effective in 2017 with early adoption. During that time, it was agreed that a Transition Resource Group would handle any issues regarding the implementation of the standard. Within the joint board meeting it was indicated to change the IFRS 15 with amendments even before the effective date.
The boards were presented with several implications from this amendment. The problem areas include licenses, separate performance obligations and whether an entity is acting on its behalf or as an agent. The boards decided to improve the application guidance and further clarify the different issues set out by the TRG, including:
- For licenses, the board agreed that intellectual property has sufficient standalone functionality and is unaffected by the entities activities as such. An entity’s promise that a customer can access its intellectual property as deemed necessary for the contractual obligation is significant if the activities itself does change the intellectual property. Furthermore, decisions were made that sales-based or usage-based royalties in exchange for license should not be split in a single royalty (constraint versus non constraint).
- Regarding identified performance obligation, the IASB has decided to add illustrative examples to improve the guidance around this subject.