Accounting for Expected Credit Losses (ECL) under IFRS 9 (Source: ICAI Gurgaon Newsletter Sept-16)

IFRS 9 is the long awaited post-financial crisis response to accounting for bank assets and liabilities. In July 2014, the International Accounting Standards Board (IASB) introduced the final guidance on expected loss (EL) model of impairment accounting. All financial entities will mandatorily have to use this model starting January 1, 2018. This article discusses the expected loss impairment model, with specific focus on its comparison with the expected loss model under the Basel framework.

The requirements of IFRS 9 are technically complicated and will take several years to develop and implement fully. But it’s more than just an accounting change –it forces an integration of finance, risk and the business unlike any seen before.

Accounting of financial assets is currently guided by the International Accounting Standard 39 (IAS 39) that recommends the use of the incurred loss model, which recognizes a credit loss in the profit and loss (P&L) account. This approach to recognize losses after they have been incurred on a financial asset, has been widely criticized for being 'too little, too late'. International Financial Reporting Standards 9 (IFRS 9), IASB's new accounting standard for financial instruments, provides guidance on classification and measurement of financial assets, hedge accounting, and most importantly, a completely new approach on impairment accounting – one that is based on expected credit loss (ECL) instead of incurred loss (IL).

IFRS 9 defines the expected credit loss (ECL) of a financial asset as the estimated present value of all expected cash shortfalls over the expected life of the asset, and suggests the recognition of this component in the P&L statement. This holds for all financial assets, including the ones that are newly acquired. ECL module requires categorization of all financial assets into three stages of credit risk, for the purpose of estimation of expected loss. During the first stage, the impairment allowance is accounted for all finan-cial assets irrespective of the credit quality, on the basis of loss expected over a period of 12 months. The financial asset moves to the second stage if there is a significant deterioration in the credit quality, or to the third stage, if the contractual cash flows on the financial asset are not fully recoverable in the event of default. In both these stages, the impairment allowance is recognized based on the lifetime expected losses. The transfer of financial assets from one stage to another is symmetrical, which means that any financial asset can move back to the first stage (lowest risk stage) if there is a significant improvement in the credit quality

In addition to impairment provisioning, there is also change in classification and measurement. IFRS 9 changes the basis under which financial assets are measured –either at cost, fair value through the P&L account or fair value through reserves –and how impairment losses are recorded on the-se assets. Initial assessment has indicated that the total val-ue of assets changing classification is not significant. Last but not least there are some minor changes in hedge accounting as well.

Impact of IFRS 9 impairment:

After initial analysis, Industry estimates show

A. Provisions could increase by 25 -50% with varying impacts across businesses lines and/or geographies which will directly impact financial institutions retained earnings and corresponding regulatory capital.

B. Volatility may increase as IFRS 9 is more pro-cyclical,

C. Cost of implementation and increasing run-the-bank costs

D. Impairment governance and credit risk management frame work to be re-evaluated

E. Drives a different data/systems model and, possibly, people structure

F. Business planning, capital and profit forecast processes need to more integrated with how the business is run

G. Pricing models may need to be revisited & Product selection could also change

The new impairment accounting standard based on the expected credit loss is a welcome convergence between Basel and IFRS regulatory standards. However, since this convergence comes with certain challenges in terms of pressure on capital ratios due to increased impairment provisioning, financial institutions need to assess the degree of impact on their capital, and actively create a plan to implement the prescribed models, on or before the effective date of January 1, 2018.

* Note: EL – Expected Credit Loss | PD – Probability of Default | PV – Present Value