International Financial Reporting Standard (IFRS) 9 – Financial Instruments Key Components Explained

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The Financial services sector is one of the most important drivers of a country’s economy. However, unlike other sectors, the sector is fragile and care needs to be ensured in its management. One of those factors that management of financial institutions should take a keen interest in is financial reporting. Proper financial reporting not only attracts investors, but also ensures that nothing wrong happens in due course.

The most important factor contributing to bank fragility is credit and the risks involved. It is argued that the 2008 Global financial crisis was as a result of fraudulent financial reporting as well as failure to detect and manage risk on time. It is upon this that a need arose for an amendment in the International Financial Reporting Standards (IFRS), particularly relating to financial instruments.

In 2014 therefore, the International Accounting Standards Board (IASB) issued the International Financial Reporting Standard (IFRS) 9, Financial Instruments replacing the old standard, International Accounting Standard (IAS) 39, and Financial Instruments: Recognition and Measurement with a mandatory effective date for annual periods beginning on or after 1 January 2018 but earlier application encouraged. Financial instruments are contracts that evidence financial assets and financial obligations or equity instruments between parties. They can take the form of bonds, Bills, Cheques, Shares and Cash.

In his speech at the 2017 Financial Reporting Awards on 9th November 2017, the Deputy Governor, Dr. Louis Kasekende recognised the importance of financial reporting in accordance with internationally recognized standards, as an enabler of investor confidence. He further hinted on the fact the IFRS 9 would be mandatorily implemented by all financial institutions in Uganda with effect from 1st January 2018.

Therefore, the introduction of IFRS 9 is designed to address loopholes that were noticed in IAS 39 and to avoid a repeat of the 2008 events, but also improve information availability for investors and their confidence.
The IFRS 9 is unique in many ways and a big shift from the old standard. It is a complete package that brings together all the aspects of classification and measurement, accounting for impairment and hedge accounting for financial instruments. It also recognizes the microeconomic factors that affect the profitability of financial assets. IFRS 9 is built on a logical, single classification and measurement approach for financial assets that reflects the “business model” in which they are managed and their ‘cash flow characteristics.

 

The most important improvement of the standard being the introduction of an impairment credit losses model. The old standard (IAS 39) allowed for recognition (inclusion in the financial statements) of losses when they had already occurred. It deferred the recognition of credit losses on loans and receivables until too late in the credit cycle. Worse still even at recognition stage, only the effects of events that had already occurred could be considered in measuring the impairments on loans and receivables. This will not be the case anymore.

IFRS 9 establishes a new approach for loans and receivables, including trade receivables—an “expected loss” model that focuses on the risk that a loan will default rather than whether a loss has been incurred. Credit losses especially in financial institutions will now be recognized at the determination of whether “there has been a significant increase in credit risk since initial recognition of the financial asset” and if yes the entity is required to recognize the 12 months expected credit losses immediately through profit or loss and if not, then recognize lifetime expected credit losses (as has always been done).

IFRS 9 also gives an elaborate criteria for evaluating ‘significant increase in credit risk’ most of which may not be easy for an ordinary reader to understand. The most simplistic criteria for evaluating ‘significant increase in credit risk’ will require comparing the default risk at initial recognition with the risk at reporting date. If the risk is low at reporting date, then assume that risk has not increased; and if for example loan repayments are more than 30 days overdue (read portfolio at risk –PAR>30 days) the credit risk has increased and IFRS 9 requires the entity to recognize the 12 months expected credit losses immediately in the profit or loss.

IFRS 9 incorporated the aspect of hedge accounting. Under this requirement, financial institutions will also have to report and include risk management and its effects in the financial statement. This will help investors, analysts and auditors to assess the impact of the institution’s risk management strategies on the profitability or non-profitability of that institution. For years, accounting and risk management have not always been fully in synchronization.

IFRS 9 introduces a simpler business model. In this model, all assets held to collect principal and interest that is where the institution’s oobjective to hold the assets is to collect contractual cash flows, such assets will be measured at amortized cost and where an institution holds assets with the objective of realising cash flows through the sale of assets, measurement would be at Fair value through other profit or lossOn the other hand, if the financial institution’s objective to hold assets is both to collect contractual cash flows and sell the financial assets then measurement would be at fair value through other comprehensive income.

IFRS 9 eliminates impairment assessment requirements for investments in equity instruments because (under IFRS 9) they can only be measured at fair value through the profit or loss or fair value through other comprehensive income without recycling of fair value changes to profit and loss. This means that fair value of investments in equity will only be determined in accordance with IFRS 13 ‘fair value measurement’

IFRS 9 is important in that, unlike in the ISA 39, it considers risk management in accounting for financial instruments. This therefore gives auditors and investors an opportunity to assess the impact of risk management to the growth of a business.
However, there are is also a possibility of institutions feeling a pinch as a result of the application of the new standard.

Unlike in the ISA 39, IFRS 9 raises the risk that more assets will have to be measured at fair value with changes in fair value recognized in profit or loss as they arise. This means that the entity profit or loss may be significantly hit in cases where credit risk has been assessed to be high at reporting date, (income statements volatility.)

In order to ensure smooth transition from the old to the new standard, financial institutions need to start providing (likely in full) for possible future credit losses in the very first reporting period a loan goes bad even if it is highly likely that the asset will be fully collectible. The Institutions also may need new systems and processes to collect the necessary data on which the assessment of risk is to be based.

IFRS 9 will make some products and business lines structurally less profitable, banks will need to review their portfolio strategy at a much more granular level than they do today.

IFRS 9 will reduce profitability margins, especially for medium- and long-term exposures, because of the capital consumption induced by higher provisioning levels for stage 2. In particular, exposures with low-rated clients and poor guarantees will require higher provisions for stage 2 migration. For loans longer than ten years, provisions for lifetime expected credit losses may be up to 15 to 20 times higher than stage 1 provisions, which are based on expected loss over 12 months. To offset this negative impact on their profitability, banks can adjust their commercial strategies by making changes in pricing or product characteristics.

Under IFRS 9, the behavior of each credit facility after origination is an important source of profit or loss volatility regardless of whether the exposure eventually becomes nonperforming. Banks therefore need to enhance performance monitoring across their portfolio and dramatically increase the scope of active credit management to prevent credit deterioration and reduce stage 2 inflows. Different approaches can be used to do that, including an early-warning system or a rating advisory service.

IFRS 9 will prompt banks to reconsider their appetite for credit risk and their overall Risk Appetite Framework (RAF), and to introduce mechanisms to discourage credit origination for clients, sectors, and durations that appear too risky and expensive in light of the new standard.

For example, if banks consider global project finance to be subject to volatile cyclical behavior, they may decide to limit new business development in such deals. To react quickly and effectively to any issues that arise, they should also adjust the limits for project finance in their Risk Appetite Framework (RAF), review their credit strategy to ensure that new origination in this area is confined to subsegments that remain attractive, and create a framework for delegated authority to ensure that their credit decisions are consistent with their overall strategy for this asset class.

As banks are forced to provide for fully performing loans that migrate to stage 2, their commercial network will need to take on new responsibilities. In particular, relationship managers (RMs) will assume a pivotal role, becoming responsible for monitoring loans at risk of deterioration and proposing mitigation actions to prevent stage 2 migration, as noted above. However, most relationship managers have sales and marketing backgrounds, and though they typically originate loans, they do not actively manage them thereafter. As a result, they will need to be trained in new skills such as financial restructuring, workout, and capital management to help them deal with troubled assets effectively.

In addition to introducing training programs to build these capabilities, banks should review their incentive systems to ensure that RMs are held accountable for any deterioration in credit facilities in their portfolio. The RMs should be evaluated and compensated on an appropriate risk-adjusted profitability metric, such as return on risk-weighted assets, return on risk-adjusted capital, or economic value added, with clear accountability for how well stage 2 costs are managed.

Therefore, the amendment and introduction of the IFRS 9 presents an opportunity for the banking sector in particular, and other entities to improve how they do business. It is a business growth approach that attempts to anticipate losses that might be incurred on investment, and as a result, appropriate solutions developed to avert what would be catastrophic. It is however important to note that the standard is not only meant for the banking sector alone. It cuts across all entities that would have financial instruments as defined – a contract which simultaneously gives rise to a Financial Asset to one entity and a Financial Liability or Equity Instrument to another.

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