Change is coming-Are banks and financing firms ready for it?

The most significant accounting change, bigger than the initial adoption of IFRS in 2005, is coming! International Financial Reporting Standards (IFRS) 9—Financial Instruments, a new accounting standard that will take effect on January 1, 2018, carries a provision where impairment losses will be measured based on expected credit loss model (ECL), a measurement method significantly different from the currently-used incurred credit loss model.

Under the old model, impairment loss is recognized retrospectively—when the default event occurs—so it is relatively easy to determine. The ECL model, on the other hand, is prospective, since the financial asset is provided with impairment loss at origination or purchase based on the expectation of what will happen to the financial asset over its life, making it more complex because of the involvement of estimates and judgment of future events.

The most affected industries such as banks and financing companies need to prepare now, as the implementation is less than 17 months away. It is expected that the implementation would be complex and costly so the adopters would have to consider the following:

1. Profitability and capital—It is expected that the amount of impairment loss under the ECL model will be higher than that under the current model, consequently resulting in reduced profitability and maybe even leading to additional capital infusion for entities with regulatory capital requirements.

2. Organizational involvement—Collaboration from different units across the organization is critical as some of the needed information or expertise may not be provided by the Accounting or Finance department alone.

3. Methodologies, policies and procedures—Most entities may not have the necessary existing methodologies, policies and procedures to determine and obtain critical information needed for this upcoming impairment model. Some of these policies include establishing its own definition of default, coming up with procedures to determine the probability of default, assessing the stage of the financial asset and incorporating forward-looking information.

4. Information systems—The standard may entail enhancing the existing system or acquiring a new system particularly for entities with significant financial assets such as banks. The system is needed to ensure that appropriate data are gathered for proper pooling of financial assets with shared risk characteristics for staging assessment and collective impairment computation as well as generate information about default, the probability of default, discount rate, loss-given default and exposure at default. Some of the data needed for the impairment computation may not yet be available in the current system and the management would need to identify what are lacking.

At the core of this implementation is the support and commitment of the board of directors and management or whoever is in charge with governance.

To highlight the criticality and importance of the successful implementation of IFRS 9—Financial Instruments, the Global Public Policy Committee (GPPC), a global forum of representatives of the six largest international accounting networks including Grant Thornton International, in a rare move, released The Implementation of IFRS 9 Impairment Requirement by Banks (the paper). Although the paper focuses on banks as it is among the heavily affected industry, the guidance provided in this paper is also applicable to other industries.

The paper is organized into two main sections. The first section covers the areas of focus for those charged with governance and addresses the following key areas: (a) The importance of strong governance and controls surrounding ECL models and processes, (b) Considerations regarding sophistication and proportionality—the paper noted that the GPPC networks believe that there is no one-size-fits-all approach and do not expect the same level of sophistication of implementation across all institutions and all portfolios, (c) Key issues on transition—the paper acknowledges that IFRS 9 builds upon existing credit practices, but may also require the development of new processes specifically for the estimation of ECLs pursuant to IFRS 9 and (d) Ten questions that those charged with governance may wish to discuss to help assess the quality of management’s implementation of IFRS 9’s impairment.

The second section deals with modeling principles and covers the following: ECL methodology, default, the probability of default, exposure at default, loss-given default, discounting, staging assessment, and forward-looking information. Each of the areas within the modeling principles section presents the discussion in terms of a sophisticated approach that may be appropriate for more complex or material institutions or portfolios; a simpler approach that may be appropriate for less complex or material institutions or portfolios; and also approaches that would be inconsistent with the high-quality implementation of the standard.

Participation, support and commitment from those charged with governance are critical for the successful implementation of this new standard. Seventeen months is such a short time. It is better for the company to start doing the necessary impact assessment now as the implementation can be complex and costly. This assessment covers not only the impact on profitability and capital but also its effects on system, policies and organizational architecture needed for the implementation.

Boyet Murcia is Partner, Audit & Assurance of P&A Grant Thornton. P&A Grant Thornton is one of the leading Audit, Tax, Advisory, and Outsourcing firm in the Philippines, with 21 Partners and over 700 staff members.

As Published in The Manila Times dated August 17 2016