News Column

IASB moves from incurred to expected loss model

July 27, 2014

The International Accounting Standards Board (IASB) reached a milestone by publishing new accounting requirements for loan loss provisioning, moving from an 'incurred loss' to a more forward-looking, 'expected loss' model.

The new requirements, which form part of the now-complete new standard on financial instrument accounting, IFRS 9, will provide more timely information about expected credit losses. But it should not be seen as a panacea, says ICAEW.

Dr Nigel Sleigh-Johnson, Head of ICAEW's Financial Reporting Faculty, said: "The new loan loss requirements will provide earlier indications of potential losses on loans made by banks and other financial institutions, and that is a major and long over-due step forward. However, those who think that provisions made in the run-up to the global financial crisis were 'too little, too late' should not see the change as a panacea. Even an expected loss model won't result in provisions being made for unexpected losses."

The new model focuses more on the level of credit losses expected in the future and allows for earlier recognition of losses than was previously possible under the IASB's standards. It introduces a three-stage approach to loan loss provisioning, based on on-going assessment of the level of credit risk.

Iain Coke, Head of ICAEW's Financial Services Faculty, said: "We expect the new model will increase the loan loss provisions on banks' balance sheets by about 50 per cent on average, although this will vary substantially between institutions. It will reduce profits in the year of implementation, but it may not have a major impact on the income statement in future years. That doesn't mean banks got it wrong before it only means banks will measure provisions differently.

"Increasing the accounting provisions will also reduce regulatory capital. Regulators have adjusted the reported accounting numbers since before the financial crisis to take account of some expected losses. However, the new standard will go further still in providing for expected losses. Banks will need to consider the impact of the new standard on their regulatory capital, taking into account the results of regulators' stress-testing and asset quality review exercises."

Iain continued: "It is important to remember that this accounting change will not change the cash flows of underlying loans. However, when combined with tougher regulatory capital requirements, it may force banks to hold more capital for the same risks. This may make banks safer but may also make them more costly to run."

The standard will have a wide-reaching impact beyond the financial services sector too.

Nigel Sleigh-Johnson continued: "All companies holding financial assets such as loans and bonds, trade debtors and lease receivables will have to consider the new requirements. There will be considerable costs involved in meeting the new requirements for some, involving at one end of the scale the re-building of information systems and processes."

After several years of trying to agree a joint solution with the US Financial Accounting Standards Board (FASB), the publication of the new requirements firmly marks the end of the effort to converge standards in this area.

Nigel said: "While almost everybody has agreed that moving to a more forward-looking model would provide more useful information, it's been very difficult to agree on the precise details of the new accounting model. It is regrettable that the IASB and the FASB have been unable to agree on all aspects of their models, but ultimately it is more important that we finally have a standard in place that will provide global investors with more timely information about increases in credit risk and expected credit losses."

The loan loss provisioning changes complete the three phases of the longstanding project to replace the IASB's much-maligned financial instruments accounting standard, IAS 39. IFRS 9 is mandatory from 1 January 2018, although companies in the European Union will not be able to adopt it until it has been legally endorsed, which will take some time.

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Source: CPI Financial

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