Today, June 24th, as we celebrate the birth of St. John the Baptist, many children and grown-ups will parade the streets and splash passersby and commuters with water generously as part of a local custom. Apart from these water-splashing activities however, it is more important that we remember today St. John’s mission and how his life has been regarded as a preparation for the coming of Christ, which he foretold and how such coming has been met with much anticipation and great expectations.
On the other hand, changes in financial reporting have always been met with much optimism in the accounting world. A case in point is the existing standard on financial instruments, International Accounting Standard (IAS) 39 [locally adopted as Philippine Accounting Standard (PAS) 39]. IAS 39 has always been regarded as one of the most, if not the most, difficult accounting standards in recent years. It has been criticized for being difficult to understand, apply and interpret, and the global financial crisis of 2008 highlighted this observation. As such, there was a clamor from the preparers and users of the financial statements, including regulators, to rethink the current accounting for financial instruments and called for its simplification.
While certain phases have been issued in between, it took all of six years from 2009 before the final standard on International Financial Reporting Standard (IFRS) 9 [locally adopted as Philippine Financial Reporting Standard (PFRS) 9], the replacement for IAS 39, was issued in July 2014. The standard includes a model for classification and measurement of financial instruments and a relaxed approach to hedge accounting. But the most significant change in the standard relates to the impairment methodology model for financial assets.
The expected change
Under IAS 39, impairment loss is recognized if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the asset’s initial recognition. This is the “incurred loss” model, which delays the recognition of impairment losses until the impairment triggers are present, e.g. default in payment, financial difficulty of borrower, among others. During the financial crisis, the delayed recognition of impairment losses on loans and other financial instruments was identified as a weakness in the current accounting standards. In IFRS 9 however, it is no longer necessary for a credit event to have occurred before impairment losses are recognized. IFRS 9’s new impairment model is called the “expected credit loss” (ECL) model.
Key aspects of the new model include:
A three-stage general impairment model for financial assets that are performing, underperforming or non-performing;
A stage assessment that is based on relative (i.e. rather than absolute) credit risk compared with credit risk at initial recognition; as such, assets move through the three stages described above as credit quality changes and the stages dictate how an entity measures impairment losses; and
An impairment based on expected (i.e. rather than incurred) losses calculated using potential credit loss and probability of default (i.e. using 12-month ECL for the performing stage and lifetime ECL for the underperforming and non-performing stages).
In practice, this means that the new model will require entities to have a day 1 loss even upon initial recognition and on financial assets that are not credit impaired. In case of trade receivables, IFRS 9 requires entities to calculate impairment based on the losses they expect to have during the life of the instrument. That means that an entity needs to compare the present value of the cash flows based on the contract to the present value of the cash flows that the entity expects to receive. So if the entity expects to be paid later than when the cash is contractually due, an impairment loss is recognized, even if the entity expects to be paid in full. This is a change in the current practice where entities wait until the loss is incurred. The amount of expected credit losses is updated at each reporting date to reflect changes to credit risk since initial recognition. This would also mean that impairment losses are recognized earlier and would impact an entity’s bottom line.
The expected challenge
As most balance sheets contain financial instruments, IFRS 9, including the new ECL model applies to all entities – not just banks. However, banks and other entities with large portfolio of financial assets measured at amortized cost or fair value through other comprehensive income will be the most affected.
While it has been acknowledged that this single model reduces the complexity of using multiple approaches and that this forward-looking model is responsive to the changes in credit risk, the model is still very challenging to apply. Currently, most entities do not collect the amount of credit information required by the standard. Entities will need to significantly modify their credit and information systems in order to gather the required information.
Extensive disclosures also are required, including reconciliations from opening to closing amounts of the ECL provision, assumptions and inputs.
The expected simplification
But there’s good news. The standard recognized that for some entities with relatively simpler portfolios of financial assets, the general provisions of the ECL model might entail more work. Hence, it introduced some operational simplification or relief that can be applied in the case of those entities with simpler portfolios, particularly for trade receivables that do not contain a significant financing component.
To better understand the concept of a simplified model, let us take a look at this example as shown in the standard:
Company A holds trade receivables from a large number of customers that do not have a significant financing component. In order to determine the amount of ECL to be recognized in the financial statements, it has set up the following provision matrix based on its historical observed default rates, adjusted for forward-looking estimates: Current (0.3 percent); 1-30 days past due (1.6 percent); 31-60 days past due (3.6 percent); 61-90 days past due (6.6 percent) and more than 90 days past due (10.6 percent). Assuming that the gross carrying amount of the receivables are as follows: Current (P15 million); 1-30 days past due (P7.5 million); 31-60 days past due (P4 million); 61-90 days past due (P2.5 million) and more than 90 days past due (P1 million), the total impairment provision would amount to P580 thousand which is arrived at by multiplying the default rates (the lifetime ECL) by the gross carrying amounts.
As can be seen above, IFRS 9 allows for a provision matrix to be used for recognizing ECL on trade receivables. An entity needs to use its historical credit loss experience and more forward-looking information in order to establish the loss rates. This provides some relief from looking at trade receivables individually.
But wait. Not all entities get to enjoy this relief. This operational simplification is not available to those in the financial services sector.
The expected journey
Yes, the change from IAS 39 to IFRS 9 may not be within our great expectations. But since IFRS 9 would be effective beginning January 1, 2018, it is critical that entities assess the implications of the new standard as soon as possible, and having a transition plan will be key. There is a need to develop and implement a transition roadmap to ensure compliance by 2018. At this time, it is necessary for the Finance team and the Risk Office, including C-suites to be familiar with the requirements of the new standard. It is also imperative to start identifying gaps in the current accounting and the required systems, processes and data on transition, particularly in updating the entities’ modeling tools and methodologies.
Be that as it may, I am certain that despite all the challenges and the time and effort to be put in, it can be done and entities will get there.
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John-John Patrick V. Lim is a Partner from Assurance and Co-Leader of Assurance Consulting Services of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
In the report “Bosch PH expands workforce in FY2015” published on this page of the June 21 edition of The Manila Times, sales volume figures for Bosch Philippines for fiscal year 2014 and 2015 were misstated. Bosch’s sales increased by 35 percent in 2015 (not 17.6 percent as reported), and its sales volume in FY 2014 in euros was 32 million euros (not 38.25 million euros). The Manila Times regrets the error.