IFRS crucial developments for banks
The International Accounting Standards Board (IASB) is continuing in its efforts to overhaul financial reporting — a number of new standards have been issued and others are expected to be finalized over the next few months.
Major changes for Financial Instruments
The new standard, IFRS 9 Financial instruments is being finalized in phases, the first phase on classification and measurement was completed in October 2010. The second phase, relating to the impairment of amortized cost financial assets, is the current hot topic and would potentially have a greater impact on banks than on any other industry. The third phase on hedge accounting, but without “macro” or portfolio hedging, is only expected to be finalized later in 2011.
IFRS 9 phase I deals with the classification and measurement of all financial assets within the scope of IAS 39. The new standard is principles-based, with less extensive rules and application guidance than IAS 39. Therefore, its application will require the careful use of judgment. To be measured at amortized cost, debt instruments are subject to two tests: the business model test and the characteristics of the financial asset test. Qualitative and quantitative indicators are considered for this assessment.
The new impairment model would be based on expected credit losses and would determine expectations of future credit losses based on reasonable and supportable historical, current and forward looking information. Assets subject to impairment would be divided into three categories based on the level of credit deterioration. This new approach potentially raises certain challenges and the operational success of the new approach could potentially depend on: (i) refining the criteria/factors that trigger a transfer from category 1 to category 2; and (ii) banks being able to maintain vintage information.
The IASB proposes to substantially simplify hedge accounting, by better aligning the accounting for hedging activities with risk management practices. The exposure draft (ED) issued in December 2010 sets out the basic hedge accounting model, while a separate ED for macro hedging is expected to be issued later in 2011. The EU created a ‘carve-out’ in 2005 from certain aspects of the IAS 39 hedge accounting rules to ease hedge accounting. The following aspects were carved out: hedges of prepayment risk in macro fair value hedges; hedges where the hedged risk is lower than that represented in the hedging instrument (also known as the sub-libor issue); and the ability to apply fair value hedge accounting to demand deposits. It is expected that the IASB will attempt to address these issues when discussing macro hedge accounting. However, it is not yet clear whether the new proposals will have the same broad effect as the EU carve-out.
IFRS 9 Mandatory effective date tentatively deferred…
Recently on August 4, the International Accounting Standards Board (IASB) published, for public comment, an exposure draft (ED) of proposals to defer the mandatory effective date of IFRS 9 Financial Instruments to annual periods beginning on or after 1 January 2015. Earlier application would continue to be permitted.
IFRS 9, as currently drafted, must be applied for annual periods beginning on or after 1 January 2013, including the presentation of comparative figures. The proposed deferral comes in light of the extension of the IASB’s timeline for completion of the remaining phases of the project to replace IAS 39 beyond June 2011, the feedback received from constituents and the IASB’s prior intention to allow entities to adopt all parts of IFRS 9 at the same time.
The recent joint IASB/US FASB exposure draft (ED) Offsetting Financial Assets and Financial Liabilities proposed removing the existing differences in the offsetting requirements under US GAAP and IFRS. These differences result in significantly larger balance sheet sizes for banks reporting under IFRS when compared to those reporting under US GAAP. The key difference is that balances relating to derivatives that are executed with the same counterparty under a master netting agreement may be offset under US GAAP, whereas under IFRS, there also has to be the ability and the expectation that they will be settled net.
IFRS 9, a major change, but not the only one
As described above, IFRS 9 will have a huge effect of the banks’ financial statements but the IASB announced significant decisions on different international accounting standards, not all endorsed by the European Union yet, that could impact them as well such as IFRS 10 on Consolidated financial statements, IFRS 13 on Fair value measurement or amendments to IAS 19 on Employee benefits.
Issued by the IASB on 12 May 2011, effective for annual periods beginning on or after 1 January 2013, IFRS 10, replacing IAS 27 on Consolidated and separate financial statements and SIC 12 on Consolidation of special entities, establishes principles for the presentation and preparation of financial statements when an entity controls one or more other entities. The main change introduced by the new regulation is that consolidation financial statements shall include controlled entities, as assessed using a single control model (instead of the two-model approach, which is currently applied). Based on this model, the control is the basis for consolidation of all types of entities. According to the new standard, control is composed of three items:
- the power over the investee,
- the exposure or rights to variable returns from involvement with the investee,
- the ability to use power over the investee to affect the amount of the investor’s return.
This means that banks will have to reassess which entities, including structured entities, they control based on this new approach. Moreover, a significant volume of disclosures about consolidated and non consolidated entities as set out in IFRS 12 on Disclosures of interests in other entities will require the financial institutions to update their database and systems in order to provide the requested information.
Also issued on 12 May 2011, effective also for annual periods beginning on or after 1 January 2013, IFRS 13 on Fair value measurement, establishing new guidance on fair value measurement and disclosure requirements, aims to achieve a convergence between IFRS and US GAAP in that respect. The conditions to be met to use the fair value have not changed, the main change introduced by this new standard relates to how fair value is measured (both at the initial measurement and subsequent measurement). When determining the fair value of an asset or a liability, the entity shall take into consideration the characteristics of this asset or liability when market participants would consider them to determine the price of these instruments. For example, the place where the asset is available or the restrictions on its use could be considered when determining the fair value of the related item. And, as usual, this standard will also result in additional disclosures in the financial statements.
Regarding IAS 19 on Employee benefits, the main change, applicable from 1 January 2013, relates to the removal of the option for deferred recognition of changes on pension plan assets and liabilities (“corridor approach”). This will increase the volatility in the balance sheet of entities that applied the corridor approach and will limit the changes in the net pension asset or liability recognized in the income statement to net interest or income and service costs.
All these changes will most certainly impact the financial data but the business, systems and organization will be concerned too. The timing of the adoption of the standards will constitute an additional constraint to deal with for the entities. When assessing the impact of these changes in accounting, the banks will also have to consider all the interactions between accounting and other regulatory or economic matters such as Basle III requirements, taxes…
By Sylvie Testa, Partner, Financial Services, Ernst & Young, Luxembourg
and Aida Jerbi, Executive Director, Financial Accounting Advisory Services (FAAS) leader, Financial Services, Ernst & Young, Luxembourg