| IFRS for banking and financial service companies |
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| The new International Financial Reporting Standards (IFRS) regime will transform the way the banking and financial services organisations judge performance and value writes John McDonnell, in his analysis of the implications for Irish organisations. |
Listed companies in Ireland will have to apply IFRS in 2005. In addition, unlisted companies may also have to face the prospect of IFRS in the future. The move to IFRS is far more than a technical accounting issue. In fact the key provisions could substantially change the profitability of products, services and even the business as a whole, forcing organisations to re-engineer their entire trading, investment and value creation strategies. Institutions will also need to gauge how the new IFRS ‘numbers’ might affect taxation, mergers and acquisitions and the basis of performance-related pay.
Fair valuation
One of the key issues is how to keep pace with movements in fair value across a diverse range of contracts and how to incorporate these changes into reporting systems and overall business planning. Under IFRS, all derivatives will need to be fair valued and, in most cases, movements in such valuations recorded in the income statement unless designated and effective as cash flow hedges. Certain types of valuation adjustments currently applied for reasons of prudence may no longer be permissible. While this will improve transparency for the users of financial statements, it increases the potential for income volatility. IFRS introduces numerous significant systems requirements for banks and financial service companies, (including many organisations that may lack the sophisticated trading functions used for marking to market on a real-time basis). Implementing IFRS system changes will require careful planning, a systematic approach to project management and the full participation of business units outside the finance function.
Further complication comes from the requirement to split out and separately fair value so-called ‘embedded derivatives’ - items within existing contracts that have a value that is not closely linked to the ‘host contract’. Companies that have already undertaken this exercise have been surprised by the sheer level of effort required simply to identify, let alone value, such items across all existing contractual relationships.
Hedging/income volatility
Hedge accounting under IFRS is complex and the resulting restriction on its use will increase volatility in reported earnings. Achieving hedge accounting for some risks may be too difficult or costly, although even if a hedge does not qualify for hedge accounting treatment under IFRS, it may still of course present an effective economic hedging strategy and still be worthwhile.
Organisations will need to consider the cost benefit equation in developing systems to achieve hedge accounting. This will be an extensive exercise and potentially involves a complete overhaul of existing group balance sheet management and macro-hedging approaches.
IAS 39 requires key information about the hedging relationships to be formally documented prior to the hedge accounting treatment being applied. For organisations holding significant numbers of hedging instruments with respect, for example, to loan portfolios this will be a burdensome exercise. Failure to establish this documentation will mean hedge accounting cannot be adopted regardless of how effective the hedge actually is in offsetting risk.
IAS 39 also requires rigorous hedge effectiveness testing to be conducted. Institutions will need to prove numerically on both a prospective and retrospective basis that their hedging instruments are indeed ‘effective’ in mitigating the risks being hedged.
IFRS does not permit macro-hedging, i.e. the hedging of net balance positions rather than one-to-one hedging of individual risks. For companies that are not able to undertake micro hedging, IAS 39 in its Implementation Guidance gives a method whereby entities designate as the hedged item a single asset or liability with the same characteristics as the whole portfolio. The proposal is not straightforward and banks and other financial service companies will need to enter into a cycle of designation, de-designation and re-designation of hedges as the profile of the portfolio changes.
Classification of assets
IAS 39 requires financial assets to be classified into one of four categories dependent on the intention for which they are held. There are detailed rules but the broad categorisations are:
• Assets held for short-term gain - ‘held for trading’.
- Assets where there is a positive intention to hold to maturity - ‘held to maturity’.
- Assets occurring as a result of the provision of monies - ‘originated loans and receivables’.
- Assets held for resale but not in the short-term - ‘available for sale’ - in practice this is likely to contain everything else.
The classification is important as assets in the first and last categories are treated on a fair value basis whereas the other two categories are held at amortised cost. The distinction between the ‘held to maturity’ and ‘originated loan’ is also important as the whole held to maturity portfolio will become tainted if assets are sold or transferred prior to maturity (other than in certain specified, limited circumstances). One other important consequence is that it will potentially no longer be possible to account for purchased loan portfolios on an accruals basis.
• Credit provisioning: Most banking institutions currently gauge their potential loan losses on a reasonably effective case-by-case assessment. However, for historical reasons their general provisioning is likely to be much less ‘scientific’. Loan loss provisioning under IAS 39 is seeking to ensure that the framework for measuring impairment is linked to observable, measurable and current data. General provisions under IFRS will require far more thorough analysis, including the use of historic default ratios and sophisticated scenario modelling, to gauge the impact of market fluctuations and other credit default risks. Institutions will need to demonstrate and document the statistical validity of their evaluations.
• Impairment of securities: Impairments in ‘available for sale’ and ‘held to maturity’ investments result in charges to the income statement. IAS 39 requires objective evidence of such impairments. Many organisations are developing internal guidelines as triggers, since a temporary fall in market value below cost is not, in itself, adequate evidence of impairment under IAS 39. Such guidelines include investments being >X per cent below cost and/or remaining below cost, say for Y months.
• Derecognition & special purpose entities: Organisations will need to prove that any off balance sheet special purpose entities (SPEs), such as securitised mortgage books, are operated at genuine arm’s length. If the substance of the relationship indicates any type of control, or ‘continuing involvement’ under the proposed IFRS amendments, then the SPE will need to be consolidated under IFRS. Although this so-called ‘sticky fingers’ principle has long been applied in Ireland, many of the cases where separation had previously been accepted may not qualify under IFRS and more evidence will be required to prove that risks and rewards have been transferred.
The road ahead
IFRS is a daunting prospect. However, the key issue is not what, but when. Organisations will need to provide 2004 comparatives, which will require the preparation of an opening IFRS balance sheet by the end of 2003. Banks and other financial service companies need to address this issue now and consider the likely impact on their profitability and operations. They should identify any potentially damaging earnings surprises, product weaknesses and difficulties in meeting the new fair value, hedging, recognition and provisioning requirements. This will allow them to begin to assess the systems, personnel and other resource requirements for conversion to IFRS. |
John McDonnell is IFRS partner with Pricewaterhouse Coopers.
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| Article appeared in the May 2003 issue.
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