The implementation of IFRS 9 and the associ-ated impairment requirements relating to expected credit loss calculations are forcing companies to make a series of organizational changes. This article summarizes the most important challenges.
Corporate entities are currently engaged in intensive debate about how to implement the new approach to impairment. Specifically, they want to know how to use what is known as the "simplified approach" to switch from the incurred loss model to the expected loss model. The new standard aims to align accounting practice more closely with actual corporate management processes. Accordingly, by making adequate provision for credit risks, IFRS 9 seeks to make the information disclosed in financial statements more useful as a basis for managerial decisions.
For the entities affected, this leads both to the extensive restructuring of existing systems and processes and to deeper integration of the interface between credit risk management and accounting. In IAS 39-based accounting practice to date, widespread use has been made of global valuation allowances with a standard impairment component, depending on the pattern of (excess) maturity, and of a strong leaning toward tax rates. This practice will now be replaced by forward-looking calculation models at the level of individual instruments or portfolios.
In the future, impairments will thus affect entities' financial statements as soon as receivables are entered in the accounts, i.e. before they become overdue. As a result, actual expected losses can be calculated more accurately not only in cases where a specific event leads to a probable loss. Instead, such expected losses must be calculated for all financial assets that are measured at amortised cost. The five most important challenges corporate entities face in adapting to the new impairment approach are discussed below:
To calculate the expected credit loss (ECL), it is necessary to obtain, at reasonable expense, sufficient and reliable information about past events, current conditions and forecasts about future economic developments (IFRS 126.96.36.199). Historical credit loss data collected for a representative period thus forms the basis for calculating the ECL. The data thus collected must then be enriched by information on current conditions and forecasts about future developments. Depending on the prevailing circumstances, however, historical data alone may already constitute the best available information in some cases (IFRS 9.B5.5.52). The entity's own empirical values derived from customer relationships are the primary source of data. This data can, for example, be collected in scoring models and then documented and evaluated accordingly.
Forward looking information, for which IFRS 9 quotes examples such as unemployment rates, property prices, commodity prices and the payment status, should be combined with historical data to lay an adequate foundation for the calculation of expected losses. It is also important to ensure that estimates of changes to ECLs should reflect such data in a consistent manner (IFRS 9B5.5.52). Corporate entities are thus called on to implement appropriate processes and controls to ensure that the latest forward looking information is factored into these calculations. As a general rule, a distinction is drawn between the requirements for large corporations which may have their own economic research department and the requirements placed on small and medium-sized enterprises (SMEs).
Regular backtesting of the parameters used in such estimates is a central requirement of the impairment model. The aim is to minimise discrepancies between expected and actual losses, and thus to optimise the quality of information (IFRS 9.B5.5.52).
Depending on the diversity of the customer groups and the inventory of receivables, as well as on internal credit risk controls, suitable portfolios can be created as a basis for calculating ECLs. The standard cites regions and product types as examples of criteria for portfolio formation (IFRS 9.B5.5.35). When seeking to determine whether credit risk has increased significantly, it is likewise possible to base estimates on homogeneous portfolios (IFRS 9.B5.5.5). Apart from the examples, though, the standard defines no minimum requirements. It is therefore left to each entity to decide what constitutes adequate portfolio formation in line with the need for credit risk management.
Besides making provision for expected credit losses from the moment a financial asset is first booked, the new approach also prescribes specific impairments in response to identified events that have a detrimental impact on estimated future cash flows (IFRS 9, Appendix A – Defined Terms). As examples of such events, IFRS 9 cites significant financial difficulties or breach of contract by a counterparty. Once again, however, each entity must decide for itself what events are considered to carry such weight. These qualitative criteria must equally be complemented by quantitative criteria, which primarily involves assessing the extent by which receivables are overdue. The standard posits 90 days overdue as a basis for assuming impairment, although this presumption can be rebutted by furnishing verifiable evidence to the contrary.
Especially in the context of impairment, IFRS 9 forces corporate entities to make far-reaching changes. In-depth analysis of loss risks and profound adjustments to process and system structures will be needed if entities are to meet the requirements for forward-looking risk provision for financial instruments. The closer link between credit risk management and accounting in particular presents a significant challenge to entities' processes and systems – a challenge which needs to be tackled as quickly as possible. On the upside, the new accounting rule can also be seen as an opportunity to further develop and standardise corporate credit management systems which are, in many cases, still rudimentary and piecemeal.
Source: KPMG Corporate Treasury News, Edition 55, May 2016
Author: Dr. Christoph Lippert, Manager, email@example.com
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