Blog: An About-Face in Accounting for LossesOctober 25th, 2016
International Accounting Standard 39, Financial Instruments: Recognition and Measurement (IAS 39), was originally issued in March 1999; however, an archeologic dig through that standard turns up remnants that date back as far as 1986. Back then, the drafting of accounting standards was performed by technically-minded accountants who were kept in a darkened room, rarely to see the light of day.
As early as 2005, the International Accounting Standards Board (IASB) and the US standard-setter, the Financial Accounting Standards Board (FASB), included on their joint agenda a project to simplify the accounting for financial instruments. However, following the 2008 financial crisis, the door to their dark room was pried open by the G20 leaders and the recommendations of international bodies, including the newly created Financial Stability Board.
The loss recognition rules of IAS 39 were under fire for contributing to the financial crisis because only realized impairment losses could be recognized. This meant delaying the recognition of losses, making financial reporting less useful. To address this criticism the new standard, IFRS 9 Financial Instruments, has fundamentally changed the accounting rules for losses on financial instruments
The technical bit
IAS 39 clearly states that an event has to have occurred and that event has to have an effect on future cash flows from the financial instrument. To avoid any doubt, the standard goes on to state: “Losses expected as a result of future events, no matter how likely, are not recognized.”
The change to an expected loss model in IFRS 9 means that an entity is now required to recognize the 12-month expected loss. The recognition of that future expected loss commences on initial recognition of the asset. On future reporting dates the loss recognized is increased to the lifetime expected loss if the credit risk of the instruments has increased significantly.
For financial instruments in either of these buckets (initial recognition and significantly increased credit risk) income is still recognized based on the gross carrying amount of the asset. If the credit risk deteriorates even further, such that there is objective evidence of impairment, then income is recognized based on the net carrying amount of the asset.
The practical bit
Under the expected loss model the emphasis is on the future, which gives rise to several issues. For example:
- IFRS 9 must be applied for years commencing on or after January 1, 2018, if not adopted earlier. Entities will have to assess whether the credit risk has increased significantly by the date of adoption (either January 1, 2018, or an earlier date if the standard was adopted early) for any financial instruments held on the adoption date. This assessment will require a determination of the credit risk of those instruments when they were initially recognized. The standard allows some practical expedients in making these historic assessments.
- Ideally, the entity currently bases its incurred losses under IAS 39 on one or several economic variables. In that case, the change to the future loss model will require forecasts of these variables to be identified, and the forecast period should coincide with the term of the financial instrument.
- If an entity does not use economic inputs for its current loss model, time will be required to identify appropriate economic variables, and to test the correlation between changes in the past forecasts of those variables and actual losses.
- Entities will need some methodology, such as a well-defined classification system, to distinguish between varying degrees of credit quality in order to be able to identify instruments that have experienced a significant increase in credit quality.
- Practical application of the new process will also require a definition of “significant.”
IFRS 9 was created in a different world – post-2007/2008 global financial crisis, and in a time when creating accounting standards is a larger collaboration of accountants within the broader business and economic environment. The hurdle of these and other implementation issues will determine the success of that collaboration and the improvement of the resulting financial reporting. Early planning will be crucial.
Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article.