Explanation of IFRS 9

Praveen Bajaj — Fri, 05 Mar 2010 18:03:30 +0000

IFRS 9: FUTURE FINANCIAL INSTRUMENT

IFRS 9 has been issued for financial assets
Standards relating to financial liability, impairment, derecognition and hedging will be issued in a phased manner
Impact of IFRS 9 on banks are significant

Banks have to invest in government securities to comply with RBI’s prudential norms
As per current RBI rules, such investments are accounted for at ‘amortized cost’.
Under IFRS 9, these securities may have to be accounted for on a ‘fair value’ basis, with the fair value changes taken to the income statement.
Under IFRS 9, when there are more than an infrequent number of sales in a portfolio, the entire portfolio would have to be accounted for at fair value, since the bank’s business model is not to hold the securities to maturity

Under IFRS 9, loans and receivable portfolio are accounted on amortized cost basis, provided these loans do not contain any exotic embedded derivatives
Basic embedded derivatives, such as caps and floor or normal prepayment or extension terms, do not taint amortization accounting
A loan with a convertible option is also not eligible for amortization accounting and will have to be accounted for on a fair value basis with changes taken to the income statement
Loan portfolio is accounted for on a fair value basis in cases where banks transfer/securitize their loan portfolio
Amortization accounting is also not allowed for certain non-recourse loans
For example : when a loan to a real estate developer states that the principal and interest on the loan are repayable solely from the sale proceeds of a specific real estate
In such cases, the ‘contractual cash flow characteristics’ is not met and hence, such loans are accounted on a fair value basis.

Under RBI norms, investment in equity instruments (other than subsidiaries, joint ventures), are marked to market
Net losses are recognized but net gains are ignored
Under IFRS 9, investments in equity instruments are fair valued
The gains or losses are either recognized in the income statement or in a reserve account
That choice is required to be made at the inception, on an instrument by instrument basis, and is irrevocable

The IASB’s proposed standard on Impairment of loans is looking at a model that is based on expected losses rather than incurred losses
In other words, the proposed standard requires estimated credit losses to be included in the determination of the effective interest rate, for purposes of amortization accounting
It will lead to significant increase subjectivity and judgment
Estimation of future cash flows after adjusting for credit losses would be operationally challenging and would need significant modification to the IT systems
To meet the requirements of regular fair valuation (where amortization accounting test is failed), banks would need to employ in-house valuation experts
Adoption of the expected cash flow approach would, potentially, reduce profitability for expanding loan books in earlier years due to the inclusion of expected credit losses in the computation of interest revenue and would thus diminish banks ability to pay dividends

Author: CA Shalini Tibe, IFRS Consultant