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THE KOSOVO BANKER | JULY 2017 EXPERTS CORNER 12

IFRS 9 & KEY CHANGES WITH IAS 39

Ms. ARTA LIMANI Mr. ARIAN META


SENIOR MANAGER MANAGER
DELOITTE KOSOVA DELOITTE KOSOVA
SH.P.K. SH.P.K.

The introduction of new requirements strong governance and internal controls to


in IFRS 9 Financial Instruments will be a give all stakeholders confidence in resulting
significant change to the financial reporting financial information. For many banks, the
of banks. It will impact many stakeholders adoption of expected credit loss accounting
including investors, regulators, analysts and will be the most momentous accounting
auditors. Given the importance of banks in change they have experienced, even more
the global capital markets and the wider significant than their transition to IFRSs.
economy, the effective implementation
of the new standard has the potential to The key changes between IFRS 9 and IAS
benefit many. Conversely, a low-quality 39 are summarized below.
implementation based on approaches
that are not fit for purpose has the risk of
undermining confidence in the financial Changes in Scope
results of the banks.
t Financial instruments that are in the
The International Accounting Standards scope of IAS 39 are also in the scope
Board (IASB) published the final version of of IFRS 9. However, in accordance with
IFRS 9 Financial Instruments in July 2014. IFRS 9, an entity can designate certain
IFRS 9 replaces IAS 39 Financial Instruments: instruments subject to the own-use
Recognition and Measurement, and is exception at fair value through profit or
effective for annual periods beginning on loss (FVTPL); hence, IFRS 9 will apply to
or after January 1, 2018. Earlier application these instruments.
is permitted. The new standard aims t The IFRS 9 impairment requirements
to simplify the accounting for financial apply to all loan commitments and
instruments and address perceived contract assets in the scope of IFRS 15
deficiencies which were highlighted by the Revenue from Contracts with Customers.
recent financial crisis.

Time is running out. Banks that report under Changes in Classification and
IFRSs must apply IFRS 9 Financial Instruments Measurement
in their 2018 financial statements. To be
ready, banks must complete a large multi- t The classification categories for
disciplinary project combining the skills of financial assets under IAS 39 of held to
finance, risk and IT. The project will require maturity, loans and receivables, FVTPL,
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and available-for-sale determine their FVTPL. In such instances, IFRS 9 requires


measurement. These are replaced in the recognition of all changes in fair
IFRS 9 with categories that reflect the value in profit or loss.
measurement, namely amortized cost, t Reclassification of financial assets
fair value through other comprehensive under IFRS 9 is required only when
income (FVOCI) and FVTPL. an entity changes its business model
t IFRS 9 bases the classification of financial for managing financial assets and is
assets on the contractual cash flow prohibited for financial liabilities; hence,
characteristics and the entity’s business reclassifications are expected to be vary
model for managing the financial asset, rare.
whereas IAS 39 bases the classification
on specific definitions for each Impairment
category. Overall, the IFRS 9 financial
asset classification requirements are t IFRS 9 applies a single impairment model
considered more principle based than to all financial instruments subject to
under IAS 39. impairment testing while IAS 39 has
t Under IFRS 9, embedded derivatives are different models for different financial
not separated (or bifurcated) if the host instruments. Impairment losses are
contract is an asset within the scope of recognized on initial recognition, and at
the standard. Rather, the entire hybrid each subsequent reporting period, even
contract is assessed for classification if the loss has not yet been incurred.
and measurement. This removes the t In addition to past events and current
complex IAS 39 bifurcation assessment conditions, reasonable and supportable
for financial asset host contracts. forecasts affecting collectability are
t Under IAS 39, derivative financial also considered when determining the
assets/liabilities that are linked to, amount of impairment in accordance
and settled by, delivery of unquoted with IFRS 9
equity instruments, and whose fair
value cannot be reliably determined The impairment requirements under IFRS 9
are required to be measured at cost. are significantly different from those under
IFRS 9 removes this cost exception for IAS 39. The followings highlights the key
derivative financial assets/liabilities; differences between the two standards.
therefore, all derivative liabilities will be
measured at FVTPL.
t IAS 39 allows certain equity investments IAS 39 Incurred Loss Model
in private companies for which the fair
value is not reliably determinable to be t Delays the recognition of credit losses
measured at cost, while under IFRS 9 all until there is objective evidence of
equity investments are measured at fair impairment.
value t Only past events and current conditions
t For certain financial liabilities designated are considered when determining the
at FVTPL under IFRS 9, changes in the amount of impairment (i.e., the effects
fair value that relate to an entity’s of future credit loss events cannot
own credit risk are recognized in other be considered, even when they are
comprehensive income (OCI) while expected).
the remaining change in fair value is t Different impairment models for
recognized in profit or loss. Exceptions to different financial instruments subject
this recognition principle include when to impairment testing, including equity
this treatment creates, or enlarges, an investments classified as available-for-
accounting mismatch and also does not sale.
apply to loan commitments or financial
guarantee contracts designated as
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IFRS 9 Expected Credit Loss Model What are ‘credit losses’?

t Expected credit losses (ECLs) are Credit losses are defined as the difference
recognized at each reporting period, between all the contractual cash flows that
even if no actual loss events have taken are due to an entity and the cash flows
place. that it actually expects to receive (‘cash
t In addition to past events and current shortfalls’). This difference is discounted
conditions, reasonable and supportable at the original effective interest rate (or
forward-looking information that is credit-adjusted effective interest rate for
available without undue cost or effort is purchased or originated credit-impaired
considered in determining impairment. financial assets).
t The model will be applied to all financial
instruments subject to impairment
testing. What are ‘12-month expected
credit losses’?

t 12-month expected credit losses are a


The general (or three-stage) portion of the lifetime expected credit
impairment approach losses
t they are calculated by multiplying the
IFRS 9’s general approach to recognizing probability of a default occurring on the
impairment is based on a three-stage instrument in the next 12 months by the
process which is intended to reflect the total (lifetime) expected credit losses
deterioration in credit quality of a financial that would result from that default
instrument. t they are not the expected cash shortfalls
over the next 12 months.
t Stage 1 covers instruments that have
not deteriorated significantly in credit They are also not the credit losses on
quality since initial recognition or financial instruments that are forecast to
(where the optional low credit risk actually default in the next 12 months.
simplification is applied) that have low
credit risk
t Stage 2 covers financial instruments What are ‘lifetime expected credit
that have deteriorated significantly in losses’?
credit quality since initial recognition
(unless the low credit risk simplification Lifetime expected credit losses are the
has been applied and is relevant) but expected shortfalls in contractual cash
that do not have objective evidence of a flows, taking into account the potential for
credit loss event default at any point during the life of the
t Stage 3 covers financial assets that have financial instrument.
objective evidence of impairment at the
reporting date. IFRS 9 draws a distinction between financial
instruments that have not deteriorated
12-month expected credit losses are significantly in credit quality since initial
recognized in stage 1, while lifetime recognition and those that have. ‘12-month
expected credit losses are recognized in expected credit losses’ are recognized for
stages 2 and 3. the first of these two categories. ‘Lifetime
expected credit losses’ are recognized
for the second category. Measurement of
the expected credit losses is determined
by a probability-weighted estimate of
credit losses over the expected life of the
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financial instrument. An asset moves from about its credit risk, it may not be possible
12-month expected credit losses to lifetime to identify significant changes in credit
expected credit losses when there has risk at individual instrument level before
been a significant deterioration in credit the financial instrument becomes past
quality since initial recognition. Hence the due. It may therefore be necessary to
‘boundary’ between 12-month and lifetime assess significant increases in credit risk
losses is based on the change in credit risk on a collective or portfolio basis. This is
not the absolute level of risk at the reporting particularly relevant to financial institutions
date. with a large number of relatively small
exposures such as retail loans. In practice,
Finally, it is possible for an instrument for the lender may not obtain or monitor
which lifetime expected credit losses have forward-looking credit information about
been recognized to revert to 12-month each customer. In such cases the lender
expected credit losses should the credit risk would assess changes in credit risk for
of the instrument subsequently improve appropriate portfolios, groups of portfolios
so that the requirement for recognizing or portions of a portfolio of financial
lifetime expected credit losses is no longer instruments. Any instruments that are
met. assessed collectively must possess shared
credit risk characteristics. This is to prevent
significant increases in credit risk being
What is the definition of “default” obscured by aggregating instruments that
have different risks. When instruments
IFRS 9 explains that changes in credit risk are assessed collectively, it is important to
are assessed based on changes in the risk remember that the aggregation may need
of a default occurring over the expected life to change over time as new information
of the financial instrument (the assessment becomes available.
is not based on the amount of expected
losses). ‘Default’ is not itself actually
defined in IFRS 9 however. Banks must Collateral
instead reach their own definition and IFRS
9 provides guidance on how to do this. The While the existence of collateral plays
Standard states that when defining default, a limited role in the assessment of
an entity shall apply a default definition that whether there has been a significant
is consistent with the definition used for increase in credit risk, it is very relevant
internal credit risk management purposes to the measurement of expected credit
for the relevant financial instrument losses. IFRS 9 states that the estimate of
and consider qualitative indicators (for expected cash shortfalls reflects the cash
example, financial covenants) when flows expected from collateral and other
appropriate. However, there is a ‘rebuttable credit enhancements that are integral to
presumption’ that default does not occur the instrument’s contractual terms. The
later than when a financial asset is 90 days estimate of expected cash shortfalls on a
past due unless an entity has reasonable and collateralized financial instrument reflects:
supportable information to demonstrate
that a more lagging default criterion is t the amount and timing of cash flows
more appropriate. that are expected from foreclosure on
the collateral
t less the costs of obtaining and selling
Individual or collective the collateral.
assessment for impairment
This is irrespective of whether or not
Depending on the nature of the financial foreclosure is probable. In other words, the
instrument and the information available estimate of expected cash flows considers
both the probability of a foreclosure and the
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cash flows that would result from it. t explanation of gross carrying amounts
A consequence of this is that any cash flows showing key drivers for change
that are expected from the realization of the t gross carrying amount per credit risk
collateral beyond the contractual maturity grade or delinquency
of the contract are included in the analysis. t write-offs, recoveries and modifications
This is not to say that the entity is required t quantitative information about the
to assume that recovery will be through collateral held as security and other
foreclosure only however. Instead the entity credit enhancements for credit-
should calculate the cash flows arising impaired assets.
from the various ways in which the asset
might be recovered and assign probability- To conclude, the classification and
weightings to those outcomes. measurement based on IFRS 9 rules
will achieve increased comparability
internationally in the accounting for financial
Key Disclosures instruments and paint a fairer picture of
the entity’s unique risk management policy
The disclosures added to IFRS 7 are intended and strategy.
to enable users of the financial statements
to understand the effect of credit risk on
the amount, timing and uncertainty of
future cash flows.

IFRS 7 has been amended to include both


extensive qualitative and quantitative
disclosure requirements. Some of the more
important disclosures include:

Qualitative disclosures

t inputs, assumptions and techniques


used to:
- estimate expected credit losses (and
changes in techniques or assumptions)
- determine ‘significant increase in
credit risk’ and the reporting entity’s
definition of ‘default’
- determine ‘credit-impaired’ assets
t write-off policies
t policies regarding the modification
of contractual cash flows of financial
assets
t a narrative description of collateral
held as security and other credit
enhancements.

Quantitative disclosures

t reconciliation of loss allowance accounts


showing key drivers for change

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