preparing for ifrs accounting changes crucial developments for banks

Preparing for IFRS accounting changesCrucial developments for banksApril 2011

The first three months of 2011 have seen the International Accounting Standards Board (IASB) propose profound changes to the accounting for financial instruments. Moreover, planned changes to many other standards will likely impact the financial statements of banks.

1Crucial developments for banks

The first three months of 2011 have seen the International Accounting Standards Board (IASB) propose profound changes to the accounting for financial instruments. Moreover, planned changes to many other standards will likely impact the financial statements of banks.

The most significant change for the banking sector will be the new financial instruments standard, IFRS 9. It will replace the current IAS 39 Financial Instruments: Recognition and Measurement and consist of three phases: classification and measurement, impairment, and hedge accounting.

The impact of IFRS 9 for banks will be considerable. Almost the entire asset side of the balance sheet will be affected, while the processes for determining the loan loss provision for items at amortized cost will be dramatically different. However, a greater use of hedge accounting should be possible. It should also be noted that the issues related to macro (portfolio) hedging will only be addressed by the IASB when it publishes a separate exposure draft (ED) in the second half of 2011.

In addition, in January 2011, the IASB and the US FASB (the Boards) issued a joint ED, proposing new rules for offsetting to address the differences in the offset requirements of US GAAP and IFRS. These proposals are similar to the current offsetting requirements of IAS 32 Financial Instruments: Presentation. This exposure draft clarifies that the right to offset should be unconditional and that settling ‘simultaneously’ means ‘at the exact same moment’. Consequently, this could impact IFRS reporters who execute contracts through clearing houses.

There are other significant proposals to change the accounting standards that will have further consequences for banks. These proposals, when finalized, will revise the accounting for a number of areas, including: leases; consolidation; revenue recognition; fair value measurement; insurance contracts; and pensions.

Although the effective dates for all these changes are still uncertain, given the far-reaching nature of the proposals, the banking industry cannot afford to be complacent. Other than the provisions for macro hedging, the IASB’s work plan1 indicates that the period to the end of 2011 is crucial, as all major decisions are expected to be made by then. As these decisions are made by the IASB, so too will the final impact on the banking sector be determined. Entities in the European Union (EU) should note that the EU has not yet started the endorsement process for IFRS 9. The EU has suggested on several occasions that it will only do so when the IASB has a final version of IFRS 9 that includes macro hedging. Thus, EU entities will not be able to early adopt the various phases of IFRS 9 as they are issued.

Introduction

1 The IASB’s project work plan can be found on their website (www.ifrs.org/Current+Projects/IASB+Projects/IASB+Work+Plan.htm). This is updated on a regular basis by the IASB.

2 Preparing for IFRS accounting changes April 2011

The first phase of IFRS 9, which has been finalized, considers the classification and measurement of both financial assets and financial liabilities. IFRS 9 replaces the four measurement categories for financial assets under IAS 39 with two categories: fair value and amortized cost. The requirements for financial liabilities remain largely unchanged; as before, these will be classified into fair value and amortized cost categories.

IFRS 9 allows financial assets that are non-derivative debt instruments to be recorded at amortized cost, provided that they meet two criteria. First, the entity employs a business model to hold the assets, not sell them. Second, the characteristics of the assets are such that the cash flows only represent principal and interest. All other financial assets are recorded at fair value through profit or loss, with only one permitted exception. This exception relates to any non-trading equity investments that an entity holds. For these non-trading equity investments, there is a choice to record changes in fair value in Other Comprehensive Income (OCI). In adopting this approach, the IASB has dropped the IAS 39 requirement for financial assets to identify and separate embedded derivatives that are not closely related to the host financial assets.

One significant change has been made to the existing IAS 39 requirements for financial liabilities in order to address the much-criticized issue of entities recording a profit when their credit quality worsens. Where the fair value option has been elected, IFRS 9 requires that changes in the fair value of financial liabilities, which relate to the entity’s own credit risk, are recorded in OCI rather than profit and loss. All other requirements relating to the classification and measurement of financial liabilities have been carried over from IAS 39. This includes the separation of embedded derivatives in financial liabilities. Therefore, most financial liabilities will continue to be accounted for at amortized cost.

Convergence

Even though the IASB and the Financial Accounting Standards Board (FASB) have announced their intention to converge standards, there are still significant differences between phase 1 of IFRS 9 and the FASB proposals for accounting for financial instruments. In its proposals, the FASB has effectively retained an available for sale (AFS) category for debt securities. The IASB plans to publish the FASB proposals on their website, together with a request for comments on this treatment for debt securities. It is currently unclear how this will impact IFRS 9, if at all.

It should also be noted that the European Financial Reporting Advisory Group (EFRAG), the technical advisory committee for the EU, has suggested retaining the embedded derivatives rules

Phase 1: Classification and measurement

for financial assets, the available for sale classification, as well as relaxing the business model test.

Significance

Compared with IAS 39, there is little doubt that IFRS 9 contains fewer classification and measurement categories for financial assets. The changes that IFRS 9 brings also eliminate the complex, rule-based requirements for separating embedded derivatives from financial assets, the tainting rules for held-to-maturity investments and the difficulties in determining impairment for AFS assets. Entities that hold impaired AFS debt securities will no longer need to recognize the full fair value decline in profit or loss, as they currently do upon impairment of those assets under IAS 39, provided they meet the criteria for amortized cost. For equity instruments recorded at fair value through OCI, all declines in fair value will be recorded in OCI. Although many items in the current AFS portfolio might be measured at amortized cost under the new rules, other instruments in the AFS portfolio will likely be recorded at fair value (through profit or loss or OCI). Entities will need to apply judgement in determining the appropriate classification.

The effects of applying the new standard will differ from one entity to another. In order to determine the correct accounting treatment under IFRS 9, companies will potentially need to assess their different business models and segment their asset portfolios accordingly.

In some cases, adopting the new standard prior to the mandatory application date will be beneficial (where local endorsement rules permit this), for example, when IFRS 9 is applied in 2011 comparative numbers do not need to be changed, but banks need to assess the operational implications of the new accounting requirements. As such, systems and processes need to change significantly in order to calculate and record changes in fair value along with adjustments to the financial instrument disclosures required under IFRS 7. A concern for banks will also be the impact on regulatory capital and taxation.

Ernst & Young publications

The following Ernst & Young publications contain details of the new rules and can be downloaded at www.ey.com/ifrs.

Supplement to IFRS Outlook Issue 89• IASB completes Phase 1 of IFRS 9: Financial Instruments — Classification and Measurement

Supplement to IFRS Outlook Issue 60• IASB publishes IFRS 9: Phase 1 of new standard to replace IAS 39

Implementing phase 1 of IFRS 9•


In January 2011, the IASB published an important supplementary document (SD) to the exposure draft (ED) that was originally issued in November 2009, which proposed a model based on expected losses arising from the impairment of financial assets. In effect, this concept will require banks to anticipate future losses, including the assessment of future economic conditions.

The SD is a joint effort by the IASB and the FASB to seek a more pragmatic approach to the issue of impairment based on comments received on the initial ED. The SD provides guidance on how to determine and account for impairment losses on loans recorded at amortized cost that are managed in open portfolios. The joint approach should be easier to apply to open portfolios than the expected cash flows approach set out in the initial ED. For example, the proposal now decouples the impairment losses from the effective interest calculations.

Good book/bad book

The joint approach requires that financial assets are assessed for impairment in portfolios of assets with similar characteristics. Portfolios are divided into a ‘good book’, for which management expects to receive regular payments from the assets, and a ‘bad book’, for which the objective is changed to recover all or a portion of the assets.

The allowance recorded for the good book at any reporting date would be the higher of: (i) the ‘time-proportional’ amount of the total lifetime expected credit losses; and (ii) the amount of credit losses expected to occur within the ‘foreseeable future period’ – the ‘floor’. Consider, for example, for a five year loan for which losses of CU 2 are expected in the foreseeable future (say 12 months) and total losses of CU 6 are expected over the life of the loan. In this case, a loan loss provision of CU 2 is recorded in the period the loan is granted for the expected loss in the foreseeable future. In the following years, assuming the expectations are unchanged, CU 1 is added to the loan loss provision in each year.

The foreseeable future period is not specifically defined in the SD, but is proposed to be at least 12 months. Consequently, entities with different views on the foreseeable future period could arrive at significantly different loan loss allowances.

Recording a loss

The floor requirement will usually result in entities recording a loss in the period that a loan is granted. For portfolios of shorter term assets this loss could represent the entire lifetime expected loss.

When the collectability of an individual asset (or a group of assets) becomes so uncertain that the entity’s credit risk management objective changes from that of receiving regular payments to recovery of all or a portion of the financial asset, it is separated from the portfolio of assets in the good book and transferred to the bad book. The lifetime expected losses on all assets transferred to the bad book are fully provided for immediately on transfer.

The IASB and FASB’s SD does not mandate a specific approach for estimating lifetime expected losses. In practice, entities may develop projections for expected losses on the basis of specific inputs, such as forecast information, for shorter-term periods, and they may use long-term average loss rates based on historical data for more distant periods. Under the proposals, estimates of lifetime expected losses could vary significantly, depending on how the bad book is defined and what is deemed to be the foreseeable future period.

The impairment of short-term receivables and debt securities is not addressed in the SD.

Significance

The proposed changes to impairment standards are far-reaching as they apply to every loan reported at amortized cost, and not just to loans with incurred losses as under the current IAS 39. Judgement will need to be exercised in assessing and updating expected future credit losses. The comparability of reported figures between different entities will also be affected by the subjective nature of the judgements made in determining the floor and defining the bad book.

Estimating the amount and timing of cash flows over the entire lives of all financial assets at amortized cost will also require significant new processes and controls to be introduced. This will create changes to both key performance indicators and procedures for impairment assessment. Even though the proposals decouple the impairment losses from the effective interest calculations for open portfolios, systems will still have to be assessed and modified in order to be able to provide the relevant information in a more effective manner.


The following Ernst & Young publication contains details of the proposals and can be downloaded at www.ey.com/ifrs.

Supplement to IFRS Outlook Issue 95 • IASB and US FASB propose a joint approach to accounting for credit losses

Phase 2: Impairment


In an effort to substantially simplify hedge accounting, the IASB issued an ED in December 2010. The ED only sets out the basic hedge accounting model, but it does not address macro hedging. The most significant proposed change is that the ‘bright line’ test of 80-125% for hedge effectiveness testing will be eliminated, though ineffectiveness is still to be measured and included in profit or loss when it occurs. Under IAS 39, banks may have to frequently de-designate and re-designate hedge relationships, for example, because of a reduction in the expected ‘highly probable’ cash flows, or a change in the basis between hedging instrument and hedged item such that the hedge is no longer ‘highly effective’. The proposals in the ED will make it possible to rebalance the hedge relationship without such discontinuation, provided that there is no change to the risk management objective.

Hedging of risk components will be permitted for both financial and non-financial items, if these are separately identifiable and measurable. Furthermore, voluntary de-designation will not be permitted if the risk management objective continues to be met. However, it will not be possible to apply hedge accounting to equity instruments recorded at fair value through OCI. Significant new disclosure requirements will also be required from preparers of financial statements.

Significance

The simplification of the current hedge accounting requirements is welcome. The current IAS 39 hedge accounting requirements create a number of challenges for banks with respect to designation, documentation, measurement and effectiveness testing. Therefore, banks should start to consider what further hedge accounting opportunities exist under the proposals (e.g., using options), where these are less attractive or not possible under the current IAS 39. Moreover, the relaxation of the hedge accounting rules might result in greater demand for derivatives. Bank customers, for example, will be able to hedge components of non-financial risks and apply hedge accounting under the new rules.

Phase 3: Hedge accounting

Macro hedging

Macro hedging, or portfolio hedging for interest rate risk, was not included in the ED for hedge accounting. The IASB has only now commenced its discussions on a macro hedge accounting model for open portfolios.

The EU created a ‘carve-out’ in 2005 from certain aspects of the IAS 39 hedge accounting rules to ease hedge accounting. These aspects included: hedges of prepayment risk in macro fair value hedges; hedges where the hedged risk is lower than that represented in the hedge instrument (also known as the sub-libor issue); and also to enable fair value hedge accounting on demand deposits. It is expected that the IASB will attempt to address these issues when discussing macro hedge accounting. However, it is not yet clear whether the new proposals will have the same broad effect as the EU carve-out had.

Significance

The impact of any change to the current macro hedge rules would be significant. Most banks apply the macro hedge either in a fair value alternative or a cash flow alternative. Several European banks apply the carve-out to resolve the prepayment and/or sub-libor issue. These models are usually implemented through the substantial use of bespoke software solutions that will need to be modified.


The following Ernst & Young publications which contain details of the proposals can be downloaded at www.ey.com/ifrs.

Supplement to IFRS Outlook Issue 91• Hedge accounting under IFRS — all set for change

Hedge accounting under IFRS 9• — a closer look at the changes and challenges


Offsetting

The proposals presented in the ED are similar to the offsetting requirements in IAS 32, but there are certain important differences. The IASB and FASB have proposed that an entity should offset a recognized financial asset and a recognized financial liability, and present the net amount in the balance sheet, when (and only when) the entity:

Has an unconditional and legally enforceable right to set off the • financial asset and financial liability, and; Intends either to settle the financial asset and financial liability on • a net basis, or to realize the financial asset and settle the financial liability simultaneously.

In all other circumstances, financial assets and financial liabilities are presented separately from each other according to their nature as assets or liabilities.

Even though these requirements are very similar to the current IAS 32, the proposed rules appear to be stricter in certain circumstances. They clarify that the legal right to offset should exist under all circumstances (including bankruptcy of the counterparty) and that ‘simultaneously’ means ‘at the exact same moment’. The latter requirement is likely to create a significant change for IFRS reporters who currently apply netting to contracts with the same counterparty which settle on the same day through a clearing house that processes transactions in batches rather than at the exact same moment.


See our Supplement to IFRS Outlook Issue 94 for details of the proposals, this can be downloaded at www.ey.com/ifrs.


Timing of all the changes

A key concern for banks is the effective dates for applying the new standards. In October 2010, both the IASB and FASB issued a consultation document seeking views about the time and effort that would be involved in implementing the proposed new standards, including IFRS 9. The IASB is currently considering the responses. At present, it remains unclear what the effective date will be for these standards. It would appear that a majority of IASB respondents favoured a single date no earlier than 1 January 2015, provided that the final standards are issued in 2011. This would include the effective date for IFRS 9.

Irrespective of the date that is eventually agreed upon by the IASB for implementing IFRS 9, banks will need substantial time to assess the impact on systems and processes and to implement new solutions. Estimates suggest that a six-month assessment period and a 30-month implementation timeline, or possibly more, would not be unusual. Furthermore, initial estimates show that the implementation could cost almost as much as the conversion from local GAAP to IFRS in 2005. It is worth stressing that if the mandatory date for the adoption of IFRS 9 remains unchanged at 1 January 2013, then the earliest comparative period has already begun for SEC registrants who must present comparative information for two years.

Other significant changes in IFRS impacting banks

In addition to the replacement of the current IFRS guidance for financial instruments, there are several other significant accounting changes that banks will need to address.

Other relevant changes to IFRS expected to be finalized in 2011 by the IASB are:

Group entities:• A consolidation standard is anticipated to be issued in April 2011. This standard will state that consolidated financial statements include all controlled entities using a single control model. This is a change from the current two-model approach that exists under IAS 27 and SIC-12. Banks will need to reassess which entities, especially structured entities, it controls under the new standard. Furthermore, banking clients that create structured entities in order to implement specific products offered by banks may be affected by these changes. The changes would not only result in reassessments of consolidation when the new standard is implemented, but continuous re-assessment would also be required as facts and circumstances change. This standard will be accompanied by a new standard on joint arrangements.

Leases: • The IASB has outlined a single model (the ‘right-of-use’ model) for leases instead of using two separate models for operating and finance leases. This new approach would

result in all leases being included in the statement of financial position of lessees. Potentially, this could have a significant impact for the leasing business of banks. The potential impact on solvency ratios of lessees could result in other forms of financing being more attractive.

Revenue recognition:• The IASB proposes a single revenue recognition model for all revenue transactions arising from contracts with customers, (i.e., contracts for goods, services, licences or fees). This will impact the revenue recognition of various fees earned by entities in the financial sector, where these fees are not within the scope of IAS 39 and/or IFRS 9. The IASB is currently re-deliberating certain aspects of this model, including how revenue should be recognized for services.

Fair values:• The IASB will publish a separate standard on fair value measurement. This will clarify the definition of fair value and establish a single source of guidance for all fair value measurements required or permitted by different IFRS standards. The IASB’s objective is to reduce complexity and improve consistency in the application of IFRS. The proposals could affect the way banks determine fair value of financial instruments and other items. The proposals will result in additional disclosures in the notes to the financial statements.

Insurance contracts: • The current standard for insurance contracts, IFRS 4, contains very little recognition and measurement guidance. The IASB has proposed one comprehensive measurement approach for all types of insurance contracts issued by entities (and reinsurance contracts held by entities), with a modified approach for some short-duration contracts. Insurance liabilities would be recorded at the present value of the fulfilment value cash flows. This is closer to fair value and is made up of an unbiased probability-weighted average of the future cash flows expected to arise as the insurer fulfils the obligation to its policyholders. In addition to the above elements, the proposed model, through a residual margin, recognizes profitability over the life of the contract. For banks that sell insurance contracts, it is likely that the proposals will significantly affect the accounting for those contracts.

Financial guarantee contracts and loan commitments:• The IASB had originally proposed to bring financial guarantee contracts within the scope of the insurance standard. As many banks issue financial guarantee contracts the current proposals relating to insurance contracts are not only relevant for insurance companies but also to these banks. However, the Board is now exploring whether these contracts could


be accounted for under the new impairment model for financial assets. Finally, the IASB is considering whether loan commitments should also be accounted for under the impairment model.

Employee benefits:• The IASB has proposed to remove both the corridor approach from IAS 19 for defined benefit pension plans, and the option for entities to recognize all changes in defined benefit obligations and the fair value of plan assets in profit or loss. Although the processes for obtaining the information might not be substantially different from that which is required under current rules, the financial impact on profit will be substantial if all actuarial differences and fair value movements are recorded in OCI.

What is the business impact?

The IFRS changes will impact the business, systems and processes, as well as the investor communications, of banks. Entities will need to evaluate these implications and plan their responses. In addition, entities should consider the timing of the adoption of any new standards. The benefits provided by the transitional relief, such as the requirement not to restate comparatives if applied in 2011, could prove beneficial.

In parallel with assessing the impact of the IFRS changes, entities will need to consider the interaction between the accounting changes and wider regulatory and macro-economic challenges. These include:

Basel III•

Markets in Financial Instruments Directive •

Dodd-Frank Act•

Foreign Account Tax Compliance Act (FATCA)•

Jurisdictional banking levies and taxes•

Examples of some of the commercial, financial, regulatory and organizational challenges that exist for banks are:

How to manage expectations and educate external • stakeholders during the period of change

Understanding the decisions made by their industry peers•

Product restructuring where current products and business • models may no longer be viable for a bank or its counterparty

How reclassifications will impact key ratios, regulatory capital • and tax

What improved systems capability and data will be required to • meet the more onerous disclosure requirements

Assessment of the increased operational risk caused by • changes to systems and processes

Organization-wide change management: increased • competition for resources, systems, data and process alignment, and management of quality and cost

In order to make an informed assessment, entities will need to understand what are the significant accounting and operational business impacts. Some of the new or proposed standards, in particular, those relating to the classification, measurement and impairment of financial instruments, are less rules-based and, hence, management will be required to exercise considerable judgement in implementing the changes to IFRS.


Ernst & Young can bring its multi-disciplinary team of accounting, tax, systems, and IT professionals to your company to assist in assessing what the accounting changes mean to you. In the chart below, we outline issues and steps the company should consider related to accounting changes, and indicate how Ernst & Young may be able to help you from initial assessment through to adoption.

How can Ernst & Young help?

Issues and steps How Ernst & Young can help

Gain a general understanding of the new or proposed accounting standards

► Design and deliver a training session for company personnel on the accounting implications of • the new or proposed standards► Share insights of IASB views, including interpretations•

Perform a preliminary assessment of the impact of the proposal on the company’s financial statements and regulatory capital

Advise and provide input into:

► Gathering necessary scoping information to implement the new or proposed standards• ► Calculating the income statement impact of implementing the new or proposed standards• ► Assessing impact on key financial ratios and performance measures• ► Identifying shortfalls in available information to implement the new or proposed standards• ► Assessing impact on regulatory capital• ► For a non-audit client, Ernst & Young can provide support, through the use of an automated • tool, to determine the characteristics of financial assets for IFRS 9 classification. This tool is able to run queries through large data sets and identify features to help determine fair value classification using information from external data vendors. The use of this tool can reduce the time needed to analyze instruments that would require fair value classification based on characteristics of the instrument. This automated approach is also available for use on contractually linked instruments. For audit clients, Ernst & Young can use the tool to evaluate assessments made independently by company management.

Benchmark the company against peers and others in the industry

► Provide observations of how others are approaching the new or proposed standards, • problems they are identifying and solutions developed► Assist in the evaluation of peers, competitors and industry disclosures and expected impact • on the financial statements

Assess processes for data collection, internal controls, IT systems

► Provide observations and insights based on leading practices regarding ways the company • could design its business processes, IT systems, and internal controls to capture information necessary to apply new or proposed standards► Provide criteria to consider in selecting IT packages, and assist in the selection process•

Assess tax positions relating to the new or proposed accounting standards

► Assist in analyzing tax positions arising from adopting the new or proposed standards, • reducing tax exposure, and determining tax effects of any accounting changes

Plan for ultimate implementation of the new or proposed standards

► Advise on the implementation of the new or proposed standards using an established • methodology► Advice regarding your project maintenance and planning, including timeline, tasks, and • resource allocation

Advise management during the implementation ► Advise management where the new or proposed standards require careful use of judgment • ► Review and provide input into accounting manuals and policies selected by management• ► Provide coordinated support to you of the Ernst & Young subject matter resources • (Regulatory, Tax, Finance Transformation, etc.) on a global basis

Communicate effect of implementation to stakeholders − analysts, regulators, shareholders

► Advise on developing a communication plan• ► Advise on drafting communications•

ContactsEMEIA Financial Services FAAS LeaderTara Kengla+44 20 7951 3054 [email protected]

Country leadersBelgium

Sylvie Goethals+32 2 774 9518 [email protected]

Jean-Francois Hubin+32 2 774 92 66 [email protected]

Channel Islands

Chris Matthews+44 1534 288 610 [email protected]

France

Amaury de La Bouillerie+33 1 46 93 65 80 [email protected]

Laure Guegan+33 1 46 93 63 58 [email protected]

Germany

Edgar Loew+49 6196 996 29011 [email protected]

Ireland

Vincent Bergin +353 1 2212 516 [email protected]

Italy

Wassim Abou Said+39 063 247 5506 [email protected]

Ambrogio Virgilio +39 027 221 2510 [email protected]

Netherlands

Peter Laan+31 88 40 71635 [email protected]

Spain

Manuel Martinez Pedraza +34 91 572 7298 [email protected]

Jose Carlos Hernandez Barrasus +34 91 572 7291 [email protected]

Switzerland

Stefan Schmid +41 58 286 3416 [email protected]

John Alton +41 58 286 4269 [email protected]

United Kingdom

Sarah Williams+44 20 7951 1703 [email protected]

Tony Clifford +44 20 7951 2250 [email protected]

EMEIA Financial Services IFRS LeaderMichiel van der Lof +31 88 40 71030 [email protected]

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preparing for ifrs accounting changes crucial developments for banks

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