IFRS9 sets out a new model for the classification and measurement for banks’ ‘banking and trading books’ that represent significant revisions from past methods. An ‘expected loss’ impairment model and a transformed approach to hedge accounting sets out a new methodology.
“The new model is designed to increase clarity,” said Anthony Harbinson, Global President, ACCA (Association of Chartered Certified Accountants). “IFRS9 is more principles based rather than being driven by numerical and objective standards.”
IFRS9 will utilise the ‘expected loss’ model to replace the ‘incurred loss’ model of IAS39. The difference in principle between the two is that in IAS39 ‘incurred’ meant there needed to be objective evidence of loss before making a provision. IFRS9 will require all of those losses to be provided for, plus a provision at least for losses that are expected to arise in the next 12 months.
“Some of the failures in 2008 were caused by compliance standards that were too rules based rather than being driven by principles.”
Banks would have to make loan loss provisions in the ‘banking book’ (i.e. on loans and advances to customers). Assets in the ‘trading book’ should be assessed at fair value, which means their value should already reflect any impairment. The other concept, expected loss, is an attempt to value the position. It is really not the same as ‘value at risk’, for example.
The standard introduces a principle-based system for the classification and measurement of financial assets, which depends upon the entity’s business model for managing the financial asset and the financial asset’s contractual cash flow characteristics.
Harbinson emphasises, “Accounting standards are moving forward based on principles based criteria. For example, ‘fair value’ assessments should mean that impairment of the asset should be built into that value. The concept of ‘expected shortfall’ is a more conservative measure than the current ‘value at risk.’”
The main impact of the changes to hedge accounting in IFRS9 will affect corporates outside the financial sector. The changes are designed to better align hedge accounting with the hedging strategies of companies.
Firstly, the sort of risks and the type of hedging instruments that can be used have been widened. This makes it easier to hedge more commodity risks – such as jet fuel for airlines.
Secondly the bureaucracy around hedge accounting has been relaxed. Hedged and hedging items must still be designated and documented. However, testing for effectiveness has been distilled in a single, more general test rather than several specific numerical ones, that is, within the range of 80% – 125%.
According to Harbinson, “Hedging tests also need to be more general rather than quantitative. This forces risk managers to think more holistically about their activities. Many corporates have not used hedge accounting in the past because of its complexity. More may do so in the future if it is simpler.”
The aim is to make things clearer and simpler. However, this appears to be challenging. The IASB, has been frank with its assessment that the “biggest difference under the new standard will be in the accounting for impairment.” It states that entities are required “to estimate and account for expected credit losses for all relevant financial assets, starting from when they first lend money or invest in a financial instrument.” They must also use “all relevant information that is available to them.”
“The impairment of a hedge is where there is not perfect negative correlation or loans to counterparties who cannot possibly pay back,” says Harbinson.
The regulation also requests banks to assess credit risks at the very beginning of the lending process. All companies should assess the recoverability of their receivables and banks would not be an exception. Most banks are doing this, but now they are required to disclose the information in a more structured way. What analysts want is clarity and that is the aim with this standard.
Harbinson believes participants need to assume a holistic attitude towards risk and compliance activities. “In practice, a bank’s risk management activities such as a dealing room should not represent an adversarial compliance and business environment. Rather it should be constructively challenging with some healthy skepticism.”