The delayed recognition of credit losses associated with loans and other items was widely identified as a weakness in the accounting standards and, the prescribed method then, the “incurred loss model”, which required the recognition of credit losses only upon the loss event was also criticised as one of the main reason which led to the financial crisis. It is not surprising therefore, that the accounting bodies sought a way to remedy this and the outcome from this initiative was IFRS 9: Financial Instruments.
Although the standard is effective for annual periods beginning on or after 1 January 2018, one year on from its implementation, many are now discovering that the journey is not straightforward and uncomplicated – and there are worries about unforeseen and unintended consequences on company’s results, liquidity, leverage and impact to the company’s financial ratios.
One of the key changes is the new impairment requirements in IFRS 9. These are now based on an expected credit loss (ECL) model which replace the previous approach of recognising credit loss only upon the loss event. The guiding principle of the ECL is to reflect the general pattern of deterioration or improvement in the credit quality of financial instruments. The amount of ECL recognised depends on the extent of credit deterioration since initial recognition. Under the general approach, there are two measurement bases:
• 12-month ECL (Stage 1), which applies to all items (from initial recognition) as long as there is no significant deterioration in credit quality
• Lifetime ECL (Stages 2 and 3), which applies when a significant increase in credit risk has occurred on an individual or collective basis
To measure ECLs, one needs to take into consideration a probability-weighted outcome, the time value of money (to discount the ECLs to reporting date) and reasonable/ supportable information that is available without undue cost or effort represented by past events, current conditions and forecasts of future economic conditions.
The challenge here is that IFRS 9 is principles-based and does not provide any standard model for computing expected credit losses. Companies must therefore create their own ECL model, one that would be compliant with IFRS 9 yet at the same time would not unduly affect the company’s financial performance in a manner which could not be explained to its stakeholders.
Companies have to consider and then determine what would be the most appropriate ECL approach for their unique circumstances. This could be cash flow-based, or looking at forward exposures, provision matrix, and other factors. There is almost no way to qualitatively determine how to assess ECLs.
Consider a multi-national company (“MNC”) with global operations, they could have too much data pertaining to different geography regions and that the same norm in one continent would be totally unacceptable in another. And then consider this: the standard itself mandates that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. Surely this would be very different in some countries when a routinely acceptable payment cycle would be upwards of 60 days.
Another requirement in the standard is that there is an assumption that that default does not occur later than when a financial asset is 90 days past due unless an entity has reasonable and supportable information to demonstrate that a more lagging default criterion is more appropriate. It is well-known that in many parts of Asia, 90 days repayment is considered an acceptable business practice. These differences would make it a very challenging task for the MNC to explain which set of circumstances would be most appropriate. Of course, one could argue that different circumstances could lead to different ECL assessment within the company, but the efforts for these could be prohibitively high and the end result may or may not be anywhere nearer to the holy grail of getting the impairment assessment accurate!
This task does not get any easier for the small and medium enterprises (“SME”) either. Consider a typical SME, they could be struggling to obtain appropriate information for them to assess the impact of future economic conditions to their ECL, and even if they could get their hands on certain publications or research materials, they would have to assimilate this to their ECL assessment, and very often, these would be extensions of numerous assumptions and the outcome would not put them any closer to the holy grail compared to their counterparts (MNCs).
The fact that the standard does not provide a clearer guidance on how to even produce a provision matrix does not make things any clearer. In a way, the accounting bodies recognise that companies in different parts of the world and different industries could have a very different set of factors to consider and assess. However, without more detailed guidance, companies are very often uncertain whether their treatments are in line with the requirements of IFRS 9.
Another key change is that the accounting categories ‘Available for Sale,’ ‘Held to Maturity’ and ‘Loans and Receivables’ will be eliminated, and instead ‘Fair Value through Other Comprehensive Income’ (“FVOCI”), and “amortised cost” will be created. Companies will need to hone their fair-value expertise as it relates to the instruments within the scope of IFRS 9, and study the process for determining whether a financial asset should be classified under and measured as FVTOCI, Fair Value Through Profit or Loss (“FVTPL”), or amortised cost.
The concept of Solely Payments of Principal and Interest is being introduced in IFRS 9. The solely payments of principal and interest (SPPI) test requires that the contractual terms of the financial asset (as a whole) give rise to cash flows that are solely payments of principal and interest on the principal amounts outstanding ie cash flows that are consistent with a basic lending arrangement.
In this case, interest is defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.
In order to meet this condition, there can be no leverage of the contractual cash flows. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Leverage is generally viewed as any multiple above one.
However, unlike leverage, certain contractual provisions will not cause the ‘solely payments of principal and interest’ test to be failed. For example, contractual provisions that permit the issuer to pre-pay a debt instrument or permit the holder to put a debt instrument, back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest as long as the following certain conditions are met:
The pre-payment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding (which may include reasonable additional compensation for the early termination of the contract).
Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument are also regarded as being solely payments of principal and interest, provided during the term of the extension the contractual cash flows are solely payments of principal and interest as well (for example, the interest rate does not step up to some leveraged multiple of LIBOR) and the provision is not contingent on future events.
Understanding this is of paramount importance as only instruments which meet the SPPI standard can be held at amortised cost, and if the instruments do not meet this, they will have to be fair-valued. For most companies, my belief is that this is just a matter of getting used to a new concept which is being introduced. The consideration of whether a financial instrument meets the SPPI standard should be fairly intuitive and if there are any doubts over whether this is met, then usually the said instrument would not have met the SPPI test.
That said, a likely outcome would be more instruments would be subjected to fair value whether be it under FVTPL or FVOCL. Hence the need for companies to be able to perform and/or properly assess valuation process would become more vital in the financial reporting process.
An interesting change under IFRS 9 is the option to opt for an irreversible election to adopt FVOCI, even for equity instruments. However, unlike its predecessor standard, any financial instrument that is accounted for as FVOCI would have its gains/losses transferred directly to retained earnings instead of being recycled through profit and loss. What this means is that any item which is classified this way would NEVER have an impact to the company’s profit and loss, and accordingly, careful considerations should be made before making this election.
As with any change, the year of change is always challenging. As the old adage rings, the devil is always in the details and this is always true for accounting standard changes, but with the passage of time, generally acceptable working practices would be established for the different aspects in IFRS 9 and once that finally happens, the ultimately lofty goal of a less complex standard to replace IAS 39 would be realised!