The estimated forward-looking judgements required by IFRS 9's expected credit loss model may present significant challenges as economies navigate uncharted waters.
At a glance
- IFRS 9 was released in 2014. It brought in many significant measurement changes to financial instruments, including a new "expected credit loss" model.
- The underlying thinking around IFRS 9 is sound, but there are some questions surrounding its applicability to the current economic context of heightened uncertainty.
An estimated A$220 billion in repayments due are currently in deferral by Australian banks – a consequence of the pandemic lockdown and restrictions.
This is expected to result in a heightened level of defaults, and Australia’s four major banks are hiking their provisions for loans going sour by an additional estimated A$20 billion.
Only time will tell how accurate these provisions will be, but the bigger issue confronting some in the investment community is whether today’s accounting provisions under International Financial Reporting Standards’ (IFRS) IFRS 9 Financial Instruments capture the expectations of an economic rollercoaster fuelled by COVID-19.
In response to a push for earlier crystallisation of loan losses following the global financial crisis (GFC), IFRS 9 was released in 2014.
Adding to the challenges of complying with the enhanced IFRS 9 expected credit loss recognition requirements that came into play relatively recently, for financial years ending 31 December 2018 and beyond is the added burden of doing so in the midst of a once-in-a-century health-induced financial crisis.
Not unlike during the GFC, what investors demand in the midst of the pandemic is as much clarity as possible around forward-looking estimates for loan recoverability.
The basis of IFRS 9 was to present relevant and useful information on the amounts, timing and uncertainty of an entity’s future cash flows. However, while the foundational thinking for IFRS 9 is sound in principle, what is unclear is if it is fit for purpose amid a health emergency that has triggered unquantifiable hits to future corporate earnings.
Shaun Steenkamp CPA, finance partner, enterprise property and strategic sourcing with National Australia Bank, says that while companies understand the need to book losses early, what investors don’t have a fix on is how accurate they will be.
For example, while banks are beginning to announce significant write-downs on their loan books in accordance with IFRS 9, whether these figures are overestimated or end up being quantums on that amount remains to be seen.
No early warning signs
The events of the pandemic are not a replay of the GFC.
Steenkamp points out that, with the GFC, there were clear early warning signs of pending losses, whereas the unprecedented nature of the pandemic means it is too early to tell whether or not IFRS 9 caters sufficiently to the current environment.
“As the economy emerges from its hibernation, the projected A$20 billion in impairments remains the canary in the coal mine,” Steenkamp says. “The more protracted the slowdown, the greater the uncertainty over a business’s ability to return to trading.”
While the foundational thinking for IFRS 9 is sound in principle, what is unclear is if it is fit for purpose amid a health emergency that has triggered unquantifiable hits to future corporate earnings.
As a result, he says it is more important than ever that stakeholders – be they investors, employees or customers – receive timely information about a business’s financial situation. “IFRS 9 requires expected losses to be booked on every receivable, based on a range of scenarios,” Steenkamp says. “But in this economic environment, it’s a company’s expectation of losses in the next 12 months that will be important from an accounting point of view.”
While it is still too early to tell, financial statements for 30 June 2020 year-end entities will provide the first insights into how businesses are being affected by the current economic climate.
Later in the year, all the major banks will also have released revisions to their respective expected credit loss estimates. What investors will likely be looking for is how these revisions compare to the aggregate A$20 billion announced recently, and whether the trend signals improvement or deterioration to Australian household and business debt.
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Current and future developments in IFRS
Greater frequency needed
Financial instrument disclosures will provide greater insight into the risk exposures of various industries when the majority of businesses publish their 30 June 2020 financial statements.
This will give investors their first real glimpse into the level of impact the pandemic has had on different industries, and whether provisions for future losses go far enough. While this level of detail is invaluable, Steenkamp thinks it would be beneficial for those businesses affected the most to provide more frequent voluntary updates.
The trouble is, if the crisis ends up lasting 18 months, investors will get only one major financial update. However, listed companies have continuous disclosure obligations concerning any practical information that might have a material effect on the value or price of a company’s securities.
As a result, Steenkamp sees merit in considering whether material changes to an entity’s IFRS 9 impairment assumptions be disclosed in a similar spirit during the current crisis.
While running the numbers quarterly – as in the US – could be excessive, he says six-monthly updates, complemented by the continuous disclosure regime, might provide investors with a better indication of the shift in economic activity.
While Steenkamp expects banks and non-banks alike to adhere to the spirit of IFRS 9 around transparency and timely information, he says the table-stakes for getting it wrong have gone up immeasurably for the latter, which have only applied IFRS 9 once, and not during an economic crisis.
Tell us what you know
The new requirements necessitate the use of extensive forward-looking estimates. This means a business must be keenly aware of any relevant factor that might influence the collectability of its receivables. While this is routine for banking, it is still not quite bedded in for all other sectors.
Expected credit loss provisions must reflect all relevant material information available to a business, with any changes in those provisions being recognised as impairment gains or losses. However, according to Steenkamp, these impairment gains and losses become somewhat more volatile in economic crises as assumptions change frequently.
Admittedly, while the trend of these gains and losses will provide some insight into how a business’s risk profile is changing over time, within an economic crisis, adds Steenkamp, the more frequent the disclosure, the greater the insight becomes.
“With impairments being a lead indicator for investors, it might be worthwhile flagging material impairments early,” Steenkamp says. “Instead of getting to the end of the year and disclosing what might already be outdated information, the market would be interested in your assumptions, the trend of your impairment gains or losses, and how you’re planning to mitigate and minimise risk.”
IFRS: new challenges, new opportunities for accountants