It’s been a long while in the making, but the global accountancy profession has now completed its response to the 2008 financial crisis, culminating in the next few months with the publication of the Impairment, Classification and Measurement chapters of IFRS 9 on Financial Instruments.
“They represent the final elements of the IASB’s response to the global financial crisis” says Hans Hoogervorst, Chairman of the International Accounting Standards Board.
He notes that the International Financial Reporting Standards framework that existed prior to the crisis was in fact fit for purpose. “It delivered all the essential information for market participants to see that trouble was brewing”.
Addressing a policy forum in India this month, the IASB chairman highlights that pre-crisis IFRS required just about everything to be put on the balance sheet, including special purpose vehicles and derivatives. “So everybody could have seen that the banks were leveraged 30, 40 or even more than 50 times. Everybody could have seen that the banks had next to no tangible capital.”
If accounting information was clearly shouting out the huge fault lines in the financial system at that time, then why could we not have averted the crisis being triggered by pervasive delinquent lending? “These dangers were so big and manifold that most people simply closed their eyes to them” says Hoogervorst. “Accounting in itself cannot overcome the periodic collective madness of financial markets.”
Over the past few years, IASB reforms have been significantly concentrated on impairments of financial assets, including how to determine loan loss provisioning. We saw how the banks got this badly wrong – and even more recently, some have still not mastered this technique and continue to post nasty downside earnings surprises.
To examine the technical specifics, accounting standards around the world use the incurred-loss impairment model when writing down financial assets. This model was designed to limit management’s ability to create hidden reserves during the good times that could then be used to dress up earnings when conditions turned sour.
But Hoogervorst admits the incurred-loss model does have several flaws and it has been accused of resulting in impairment charges being recognised ‘too little, too late’. “During the 2008 crisis it was being applied so that impairment was only recognised just before a loan defaulted. This meant that loan losses were often recognised far too late.”
And in yet further criticism, Hoogervorst points out that the incurred-loss model tempted many banks to ‘extend and pretend’, as he calls it. “They continued providing credit to entities that were in big difficulties, while loans to companies with growth potential were being choked off.”
And adding to the flaws of this particular model, when something was impaired there were different ways in which it could be measured. “Two entities could own the same asset and recognise completely different impairment amounts, depending on how they measured the asset on the balance sheet” says Hoogervorst.
The global accountancy profession has now addressed this problematic and inconsistent loan loss provisioning by introducing a more forward looking expected-loss model. Hoogervorst explains the crux of the new impairment model -that whenever an entity buys a financial asset or lends money, some level of expected losses will always be associated with it. Good accounting would require that the full lifetime expected losses associated with such financial instruments need to be recognised when significant credit deterioration has taken place. The intention under this new regime is that loss provisioning should happen long before an actual default takes place. The moment there are changes in credit expectations, these will be reflected in loan loss provisions on a much more timely basis.
Also, under this new single impairment approach, any financial instrument subject to impairment accounting will have its impairment measured in exactly the same way. And the new provisioning model better reflects the reality of lending decisions.
A further precaution built into this methodology is that it limits opportunities for earnings ‘management’ (a.k.a manipulation) by compelling various disclosures on the assumptions used in the model, as well as information on what has caused provisions to change from one balance sheet date to the next.
As they have been a long time in the drafting pipeline, there will also be a long lead time until the classification, measurement and impairment chapters (plus hedge accounting) of IFRS 9 kick in. The IASB recently decided (in an 11-5 vote) that the effective date will be annual reporting periods starting 1 January 2018. This is a long way off.
IFRS 9 was originally scheduled for implementation on 1 January 2013, later amended to 1 January 2015, and then put on hold until all phases of the project were complete and a final version produced. It has been nothing short of an impressively mammoth task.
Hoogervorst is positive that the IASB’s work on financial instruments will contribute towards avoiding another crisis. “I think that the good news is that if our measures are properly applied there should be far fewer surprises. It should be clearer what risks an entity is exposed to.”
Besides its hard work on loan loss provisioning, the IASB has also addressed problematic Fair Value Measurement, including mark-to-market accounting, when there is no active or well-functioning market. Additionally it has improved disclosures regarding exposures to off-balance sheet items.
And a further financial instrument reform relates to accounting for an entity’s own liabilities when they are measured at fair value. Hoogervorst describes the prior accounting treatment for this as being counter-intuitive. “Previously, if an entity’s credit quality deteriorated so that the value of its debt fell, that resulted in a gain being booked. This has been fixed.”
He cautions on expecting too much from accounting standards, no matter how reformed and revamped they are. “Accounting standards could contribute to financial stability by providing transparency. But we should not expect them to provide a veneer of stability by ignoring volatility when it is really there.”