Accounting standard tests the level of preparedness for banks and regulators

Wednesday February 7 2018

Implementation of the International Financial

Implementation of the International Financial Reporting Standards (IFRS) 9 will impact the profitability and capital reserves for commercial banks. PHOTO | FILE 

By MACHARIA KIHURO
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So much has been written about implementation of International Financial Reporting Standards (IFRS) 9 and its likely impact on global financial markets.

The magical date was January 1, 2018, when formal adoption of the standard came into force to replace the International Accounting Standard 39. But let’s face it, the exceptional interest in this standard has largely to do with determination of the loan loss provisions for bank loan and credit facilities.

This is a delicate topic and fodder for big debate.

The debate has, however, swiftly shifted from the “when” into “how” successfully the new provisions under the standard are implemented.

Abraham Lincoln, once said, “Give me six hours to chop down a tree and I will spend the first four sharpening the axe”. Similarly, for regulators, banks and other players, this will be the right time to ascertain the level of preparedness.

For starters, IFRS 9 was an idea that emerged after the financial crisis of 2007/2008 that saw many large financial institutions crumble like a house of cards.

The G20 London Summit in April 2009 impressed upon the accounting standards-making bodies to abandon the then loss-incurring provisioning model to a more futuristic-based expected loss model.

Three-pronged

Since then a lot of work has been done after that proverbial first step. The IFRS 9 addresses three main areas: classification and measurement of financial instruments; impairment of financial assets and hedge accounting. This article will concentrate more on the impairment of financial assets.

So how have the global financial markets received the new standard? How are the central banks or regulators guiding implementation of the provisions of the standard?

Lack of harmony

Globally, there are two major accounting standard setting bodies: the US Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).

Of course, as pundits have always argued, this is perhaps the major reason there is lack of harmonised accounting standards.

For instance, the US has never adopted or intergraded IFRS into its accounting reporting which effectively means adoption of the IFRS 9 is not a big topic over there.

Japan advocates voluntary adoption of IFRSs while China has not formally embraced them, although their national standards are considerably converged with IFRS Standards.

In the US the FASB has also issued a new current expected credit loss model which will be based on expected credit losses. Although the spirit is the same, the two standards have some differences in approach. It will be interesting to see how some of these will impact on companies with foreign operations but are expected to carry out dual reporting.

Many countries are struggling with how to roll out the standard that is expected to have substantive impact on loan loss provisions for commercial banks and other lenders. This will obviously, and by extension, impact the profitability and capital adequacy of these financiers.

Impacting revenues

Tax authorities are taking keen interest as the amount of loan provisions that hit the income statement will have a direct impact on collectible tax revenue. There may be need to adjust tax projections, which means, governments might also have to do same to their annual budgets.

Jurisdictions like Canada adopted the IFRS 9 even before the January 2018 deadline. Indeed, banks in Canada adopted the new standard in November 2017 while European banks adopted it at the start of this year.

As mentioned above, the US banks under the FASB’s new standard, the current expected credit loss model will take effect on January 1 2020 for certain public banks.

All others are expected to have migrated to the new standard by 2021 although early adopters could do it as early as 2019.

Case for Kenya

Back in Kenya, the CBK issued a draft guideline on the implementation of the IFRS 9 few weeks ago. Yes, the regulator acknowledges that the implementation will impact the profitability and capital reserves for commercial banks.

Firstly, the CBK proposes that any incremental loan provisions under the new expected credit loss (ECL) model to be charged to the income statement.

However, the amount should be added back over a five year period while computing core capital. This is a systematic step to minimise the pressure of the additional provisions, likely to reduce profits, on core capital.

Secondly, the guideline also stipulates that during the transition period, institutions ought to disclose the core and total capital ratios before and after the ECL provisions are added back. Of course this will be critical in measuring or assessing the impact of the new provisioning methodology.

Finally, it is also proposed that where the CBK’s provisions will be more than under IFRS 9, the excess shall be treated as an appropriation of retained earnings and not expensed in the calculation of profit or loss. This seems crafted in a way to also address the needs of the tax authorities and probably, government revenue.

In a nutshell, many players accept that the new standards are progressive. The incurred loss approach was more backward-looking as opposed to the forward leaning expected loss approach. However, to fully actualise and meet the new requirements will come at a cost.

The bottomline?

A recent study of global banks by Deloitte estimated that allowances for credit losses could increase by an excess of 50 per cent. The European Central Bank estimated the increase to lie between 18 and 30 per cent.

For financial institutions to weather the tide, the following investments will be critical: a robust and effective risk modelling platform, a reliable technological system and thorough clean-up of data. Failure to invest in these might cause surprises.

With the challenging macroeconomic environment that has seen a sharp rise in the number of non-performing loans, it will be interesting to review the impact of these provisions in the near future.

Macharia Kihuro is a financial risk practitioner working with a pan African financial institution and currently pursuing doctoral studies in Finance.

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