The new IFRS 9 Financial Instruments will replace the older standard IAS 39 in January 2018 and it practically means that if you are affected, you need to start getting ready NOW.
Because your comparative period starts in January 2017 and you will need to restate the numbers for 2017 in line with the new standard.
New IFRS 9 will be effective in many jurisdictions, including the European Union and UK, Australia, Canada, Singapore and Hong Kong, etc. China also launched a working draft in August 2016 that is consistent with the IFRS 9. Even the US capital market also accepts the IFRS reporting of those foreign companies.
The IFRS 9 will enormously affect the financial institutions, but not only them. And, it takes a LOT of hard work!
According to the Deloitte’s survey, the implementation project will probably take 3 years in some institutions. That’s a LOT!
In this article, you will learn about:
- The biggest weaknesses in the older standard IAS 39 Financial Instruments: Recognition and Measurement,
- The main changes introduced by IFRS 9 Financial Instruments,
- Key points for the successful implementation of IFRS 9 into your business.
This article was written by Mr. Wang Jun Spark and I just need to add that even if you don’t work in the financial institution (like a bank), you should still keep your eyes open.
The reason is that many IFRS 9 rules affect also trading companies, leasing companies and many other businesses.
Weaknesses of the IAS 39
During and after the 2008 global financial crisis, IAS 39 was fiercely criticised for its drawbacks in its inherent logic. The main critical arguments are:
- Inconsistent classification
It seems the classification logic of the IAS 39 is less consistent, which is difficult to understand and implement.
For instance, the Loans & Receivables’ category is defined by the legal form, while available for sale (AFS) is classified by the holder’s intention and ability, and finally the held to maturity (HTM) is defined by all above factors.
Furthermore, there are two subtypes of the AFS: debt instruments and equity instruments.
- Insufficient and delayed provision
Under the incurred loss model as prescribed by IAS 39, the accrual of the credit losses was “too little and too late”.
It means that insufficient provisions cannot timely reflect the accelerated deterioration during the 2008 global financial crisis.
In addition, there are different credit loss benchmarks for AFS and Loans & Receivables, where the fair value is for the former and the expected future cash recovery for the latter.
- Hedge accounting
Sometimes, it is difficult to comply with current hedge accounting principles (under IAS 39) due to their rigid requirements.
For example, the hedge effectiveness ratio must be within the range 80%-125% that is very hard to control and verify.
In addition, if the reporting entity cannot meet those restrictions, they shall prepare another set of disclosures to reflect the hedging results, rather than incorporating the risk management activities in the financial statements.
- Classification and measurement
As the first part of the three phases of the IFRS 9, Classification and Measurement is designed with more consistent logic.
The financial assets will be categorized into three groups, namely the FVPL (Fair Value through Profit and Loss), FVOCI (Fair Value through Other Comprehensive Income) and AMC (Amortized Cost), which are determined by the types of the contractual cash flow, business model, and the status of the fair value designation.
In most cases, the embedded financial asset will be recognized together with the host contract without separation under the IFRS 9.
Thirdly, the fair value fluctuations of the financial liabilities under the FVPL caused by the changes in the issuer’s own credit risk will be booked against the OCI (Other Comprehensive Income), instead of profits of the beginning period.
- Expected credit loss model
Though the classification and measurement is the very important foundation, the most significant change is in the second part, impairment, where the ECL (Expected Credit Loss) model with a forward looking approach to replace the incurred loss approach that heavily rely on historical information.
The ECL model is more consistent with the economic value of a financial asset and more proactive in the economic downturn.
However, the three-stage credit loss recognition that requires advanced modelling skills and high data quality poses a new big challenge to most banks in accrual and disclosure.
Subsequently, the expected loss will probably cause significant reductions and fluctuations in the profits afterwards.
- Hedge Accounting
As the third part, hedge accounting is more closely linked to the risk management activities in more flexible ways.
The changes are in the definition and requirement to establish the hedging relationship, scope of the hedging instruments and the hedged exposures.
The hedge accounting cannot create any real economic value by itself, so its purpose is to offset the fluctuations in the net profits or other comprehensive income by booking the opposite changes in the hedging instrument and the hedged exposures to the same period.
The new hedge accounting has a closer relationship with the economic hedging activities by setting a wider scope for the applicable tool and exposure, and removing the 80%-125% requirement in the hedge effectiveness ratio.
Under the IFRS 9, the economic relationship between the tool (hedging instrument) and the exposure (hedged item) becomes the most significant criteria to apply the hedge accounting.
In addition, some costs of the hedging instrument directly related to the hedging periods can be amortized evenly, instead of charging the net profit at the very beginning.
Hedge accounting of IFRS 9 is applicable in many cases except for the macro hedge regarding the net interest rate exposures, which is now under IAS 39 and would be another separate standard under IASB discussion.
Main changes introduced by IFRS 9 Financial Instruments
The main changes introduced by IFRS 9 Financial Instruments are illustrated in the following chart:
As shown in the above picture, starting from the leftmost IAS 39, the upper box of second column is for IFRS 9 (2014) and the lower one for macro hedge that is currently still in discussion. The third column and the forth columns are more detailed layers of the changes.
The summary of the changes is as follows:
Related standards and applicable scope
Besides the IFRS 9, there are also some other IAS or IFRS arranging the definition, measurement and reporting of the financial instruments and the hedge accounting, such as:
- IAS 32 Financial Instruments: Presentation for definitions of the financial assets and liabilities,
- IFRS 13 Fair Value Measurement about the fair value, and
- IFRS 7 Financial Instruments: Disclosures governing the disclosures.
Surprisingly, the above-mentioned fair value macro hedge of the IAS 39 is still effective until a new release of this topic finalized by the IASB.
It would be more accurate to speak about the applicable scope of the IFRS 9 part by part.
However, the impairment of the finance lease receivables falls under the IFRS 9 expected credit loss model.
In addition, the hedge accounting is probably with the widest scope because it is applicable to non-financial assets or liabilities as a hedged exposure.
Overall, most significant changes in the accounting of the financial instrument are in the asset measurement and credit assets impairment.
How to implement IFRS 9 – key points
IFRS 9 is about the financial accounting, risk control, regulatory reporting and capital management, which means further impact on the corporate governance and management of credit and market risks.
Therefore, a flexible combination of the accounting scheme and risk management system must be the solid foundation of implementation.
According to Deloitte survey, the IFRS 9 takes about three years to implement and more than 50% additional loss provision.
Furthermore, the ECL model will probably lead to big fluctuations in the net profits and KPI between each period. The British Bankers Association also said that the IFRS 9 implementation is a difficult process comparable to the first time adoption of the IFRS and only second to the Basel II.
The following picture indicates that the main implementation challenges are:
- Upgrading the business and accounting system,
- Establishing the expected credit loss model,
- Managing the fluctuations of the profits and KPIs (key performance indicators),
- Reconciling the financial reporting and the Basel III regime, and
- Aligning hedge accounting with risk management activities.
To get through these challenges successfully, the correct understanding in the new standard is a MUST.
The starting point of the successful implementation is to clarify relationships between the conceptual framework and quantify requirements by figuring out the logical or timing sequences, cause and effect for the three phases.
It would be much better if there were a parallel run period for both IAS 39 and IFRS 9 to find out and investigate the variances caused by the new rule. Meanwhile, preparing for the impact on the KPI and regulatory ratios also needs some time.
Reorganizing the accounting workflow
Certain new professional judgements required by the IFRS 9, such as the contractual cash flow, business model, and significant increase in the credit risk, are beyond the traditional accountants’ scope and capability. Thus, existing system and work flow needs modification with the help from other departments.
A concise approach with elaborated parameters and precise control points to determine the classification of financial instruments is the most important foundation of the first part.
Furthermore, the second part has much more significant impact on the net profit and KPI because of the ECL model that is based on future events for the loan, debt securities, and interbank lending.
The possible huge fluctuations in the net profits, KPI and stock prices of the reporting entity will lead to subsequent negative comments and enormous pressures on the management team.
Therefore, the establishment of the ECL model with tuning parameters to achieve widely acceptable and well-managed impairment provision results is the key of the second phase.
In addition, the unexpected variances caused by the new standard should be investigated to find out better explanations to the key stakeholders and get prepared for the future.
Since the third part of IFRS 9, hedge accounting is not compulsory and the fair value macro hedge is still under discussion, postponing this part is not a bad option.
Aligning with Basel III and risk management
Despite of the continuous communications between the IASB and the BCBS (Basel Committee on Banking Supervision), there are still gaps between these two systems, especially in the impairment loss.
Therefore, there would probably be differences between the accounting and capital management needs reconciliation.
Reporting entity also needs enhance the procedures to track, identify, and measure the credit risk and market risk as a sound foundation of the ECL and hedge accounting.
About the author
Mr. Spark, WANG Jun is a Senior Regulatory Intelligence Expert for Wolters Kluwer Financial Services with more ten years of professional experiences. Spark has deep insight in financial accounting, IFRS 9 Financial Instruments, regulatory reporting, risk management, and the China banking industry.
His expertise also includes Basel III reporting, Capital Adequacy Ratio, Liquidity and Funding Risk.
Spark is a CICPA (China Institute of Certified Public Accountants), FCCA (fellow of the Chartered Association of Certified Accountants), CMA (Certified Management Accountant), and a panel of the Expert committee of ESNAI (Electronic Shanghai National Accounting Institute).
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