By Josphat Irura
IFRS 9 – Financial Instruments became effective on January 1, 2018 and immediately replaced IAS 39, Financial Instruments – Recognition and Measurement. It was meant to respond to criticisms that IAS 39 was too complex, inconsistent with the way entities managed their businesses and risks and that it deferred the recognition of credit losses on loans and receivables until it was too late in the credit cycle.
The International Accounting Standards Board (IASB) had always intended to reconsider IAS 39, but the global financial crisis of 2007 – 08 and ensuing credit crunch brought to light the unparalleled level of financial risk that was being carried around the world in loan books and increasingly complex financial instruments.
The IASB developed IFRS 9 in three phases, dealing separately with the classification and measurement of financial assets, impairment and hedging. The IASB released updated versions of IFRS 9 as each phase was completed or amended, and, as each phase was finished, entities had the opportunity of adopting the version. The final standard was issued in July, 2014 but only became effective on January 1, 2018.
Contrary to widespread belief, IFRS 9 affects more than just commercial banks. Any entity could have significant changes to its financial reporting as the result of this standard including SACCOs and Micro-finance Institutions (MFIs).
Consequences of IFRS 9 so far:
- More income statement volatility – IFRS 9 requires that more assets are measured at fair value with changes in fair value recognized in profit and loss as they arise.
- Earlier recognition of impairment losses on receivables and loans, including trade receivables – Entities have had to start providing for possible future credit losses in the very first reporting period a loan starts manifesting indicators of default even if it is highly likely that the loan will be fully collectible.
- Significant new disclosure requirements–The volume of disclosures required in the financial statements has significantly increased. This has brought in the need for new systems and processes to collect the necessary data.
- Involvement of experts in assessing credit losses –The introduction of the Expected Credit Loss (ECL) impairment requires involvement of experts in other sectors i.e. Actuaries and statisticians for model development and economists for assessment of relevant macro-economic factors likely to have an impact on the current default rates.
- A review of SACCO’s business models – To remain competitive, SACCOs will be required to review their product catalogues and identify suitable measures to reduce the size of risk provisions and the profit and loss volatility.
Anticipated benefits of IFRS 9:
With careful planning, the changes that IFRS 9 has introduced might provide a great opportunity for balance sheet optimization, or enhanced efficiency of the reporting process and cost savings.
With IFRS 9, it is expected that financial statement users will be better able to compare financial institutions nationally and globally than under IAS 39.
It is also expected that regulators will find IFRS 9 ECL (Expected Credit Loss) model information more appropriate for supervision purposes than that prepared under IAS 39 regarding impairment requirements.
Key implementation challenges being encountered by SACCOs:
Clarity around acceptable interpretation of the new rules – IFRS 9 introduces a “three – stage” model (‘general model’) for impairment based on changes in credit quality since initial recognition. Determining whether a significant increase in credit risk has occurred can require considerable judgment. This approach differs from the regulatory guidelines provided by the Sacco Societies Regulatory Authority (SASRA) where loans were classified as; Normal, Watch, Sub-standard, Doubtful or Loss depending on their DPDs (Days Past Due). Ensuring that the IFRS 9 impairment results can be reconciled to regulatory and other internal credit risk measurement results is likely to pose process – related challenges in the SACCO fraternity.
From a tax perspective, the increase in loan loss provision as a result of a higher general provision being held is not allowable for tax purposes. This only translates to a higher deferred tax amount.
Internal co-ordination between finance, credit, risk and IT functions – Calculating expected credit losses requires information that is relevant in the management of credit risk and SACCOs therefore should be looking to integrate accounting and credit risk management systems and processes rather than treating the calculation as an independent accounting exercise. IFRS 9 thus provides an opportunity for reassessing whether existing credit management systems could, or should, be improved.
Division of labor between Risk and Finance departments – There will be need for clear division of labor between Risk and Finance departments in terms of; Data collection, data gathering and interpretation, data upload and validation, data transfer and system administration, reporting data preparation, disclosure preparation, non – modeled provisions, provision sign-off, disclosure submission and data posting (journals).
Availability of data – Data remains to be one of the most challenging parts of the IFRS 9 implementation process. This includes, historical default rates for the past 3 – 5 years for assessment of PD (Probability of Default) ratios, collateral realizability and valuation for assessment of LGD (Loss Given Default) ratios and identification of key economic variables impacting credit risk and expected credit losses for each portfolio. Examples of key macro-economic factors that can be evaluated include; Non-performing loan (NPL) ratios, exports of goods, GDP, inflation, foreign currency fluctuations and impacts of any regulatory, legislative or political changes.
Project budgeting and technical resources – The IFRS 9 model is likely to require new systems or enhancements to existing systems as well as involvement of experts in developing the ECL models (actuaries, statisticians and credit review experts). Majority of the SACCOs lack the internal capacity to develop these models and will therefore be required to outsource this technical expertise from the external market. This is expected to come along with financial implications.
Need for new systems, processes and associated internal controls –To meet the ECL model’s extensive new data and calculation requirements e.g. estimates of 12-month and lifetime expected credit losses, SACCOs will be required to upgrade their existing systems and processes including staff numbers and skills. Information will also be required to determine whether a significant increase in credit risk has occurred or been reversed.
2019 being the second year of application of the standard, it is now evident that IFRS 9 is a momentous accounting change for SACCOs. If left too long, there could lead to some nasty surprises to the organization and the SACCO industry at large. Either way, there is enough at stake that if you have not begun assessing the implications of IFRS 9, now is the time to start – while you still can deal with its consequences to financial statements, systems, processes, controls and so on in a measured and thoughtful way.
Irura is an IFRS Technical expert at Comperio Financial Management Services. He has over 10 years of audit and IFRS expertise having worked with Big 4 audit firms and multiple financial institutions in Kenya and globally.