By Donald MacDonald
Having been a relatively stable or improving measure of company performance during the “good times,” the approaches used to measure impairment for credit losses are firmly in the spotlight, with major changes expected in the accounting standards.
If our expectations are correct, reserves for credit losses will increase as we move to an expected loss model forecasting future losses. This is an issue which not only affects banks, but also entities with receivables and associated credit risk, such as utilities and oilfield service companies. These challenges will be more pronounced in the Middle East and are discussed further below.
To date most companies have measured impairment or provisions for credit losses in accordance with the strict requirements of International Accounting Standards (IAS) 39, a strict incurred loss approach, which only allows the recognition of losses at the balance sheet reporting date, or the date at which the provision is being reported. Put simply, no provision is allowed under IAS39 for any future losses.
During the global financial crisis significant increases in losses were witnessed in the provisions for the banking sector, resulting in banks reducing the availability of credit as provisions were increasing, thereby restricting the liquidity in the market and exacerbating liquidity issues during the downturn. Increases were so large this culminated in the collapse of some banking groups and government intervention in a number of countries, but also resulted in a questioning of the approach used to identify and measure losses/provisions.
We witnessed the Financial Stability Forum (FSF) at their meeting in London requesting of the accounting standards boards to revisit the approaches to calculating provisions. The aspiration of the FSF, and other parties in the debate, was that provisioning regulations be changed fundamentally. In essence, they felt a measure which was less pro-cyclical was required, where during the good-times provisions did not decrease as rapidly which would result in a lower increase in provision as we enter a downturn or economic deterioration. In addition it was felt the accounting standards must recognize provisions for future expected losses, instead of only incurred losses at the reporting date.
This resulted in both the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) revisiting their provisioning approaches. Both boards released proposals in the form of exposure drafts, seeking feedback on the proposed approaches. There was criticism of a number of aspects of the original proposals released by both accounting standards boards. This resulted in further joint deliberations and the release in January 2011 of a supplement with revisions to the original proposals.
Criticism of the IASB proposals centered around operational challenges of the approach being proposed, the manner in which losses would be accounted for, as well as concerns over the complexity and subjectivity of some of the assumptions required to be used in the calculation. The supplement sought to address key areas of concern. The final model proposed by the IASB is essentially an expected loss model, where the IASB would like banks to record provision for all losses they can forecast in the portfolio. This will in practice mean two types of provision.
The first relates to the “bad” assets, interpreted to be those customers in impairment where the organization is pursuing a recovery strategy. For the “bad” assets we need to recognize the full expected loss, recording this in the financial statements. This would be broadly consistent with the current approach under IAS 39.
The more challenging calculation is that for the “good” assets, or those customers who are currently up to date, but where we know a proportion of them will enter difficulty. For this portfolio entities will need to develop a forecasting approach to estimate the losses expected over a foreseeable time window and to allocate losses based on when they will materialize. There are a number of very detailed requirements around the allocation of the losses, but in principle we will likely be moving to a new approach where we forecast future expected losses even though they have not yet occurred.
The timeline for the implementation of the new standard is for the consultative process to close end March, with a new standard released mid-year, becoming effective end of year. Adoption will then be based on the implementation timetable within each jurisdiction. The new regulations will be included within International Financial Reporting Standard (IFRS) 9 and will supersede the existing requirements in IAS39.
So what impact will the new regulations have for companies and specifically those in the Middle East?
Whilst we await ratification and release of the new standard, a picture is emerging around the likely requirements and what will be required to calculate provision. The movement to an expected loss model will place greater emphasis on the need for robust and reliable data relating to default and loss experience, which will then form the basis of predictions around portfolio loss expectations.
In addition, the role of management in determining provision requirements increases as they will be expected to understand the historic performance, the rating processes applied, and to factor in management expectations into assumptions around portfolio projections. We are moving further towards a risk-based and data-driven assessment of provision requirements.
Within the Middle East this will likely be a bigger change, as many banks have not yet invested in the development of risk infrastructure to the same extent as banks in Asia, Europe and Australia have. The data and rating systems required will not yet be in a position to drive the provision assessment under the expected loss model. Our experience is that a number of banks are using regulator defined provision rates, as well as many banks not having implemented the advanced standards for Basel II and are now starting to focus on this. The availability of data and ratings are critical to forecasting expected losses. The new standard will likely require provisions to be aligned to the inherent risk within the entities portfolio.
Thereafter, banks in the Middle East will need to ensure the review and governance frameworks are in place to demonstrate understanding of the rating processes, control of the rating process and management input into the assumption setting processes.
So what will all of this mean for the balance sheet and the income statement?
The expected loss model will result in banks maintaining a higher level of provision for credit losses in the balance sheet, where we will now book provision once losses are expected as opposed to when they are incurred. With the increased provision coverage it is hoped that provisions will become less pro-cyclical and when we enter any unexpected downturns the scale of provision increase will be lower, given we are starting from a higher base provision.
Changes in expectations will be recognized in full through adjustments in the profit and loss statement. In addition, the disclosures on credit losses and assumptions used to determine will need to be included within the financial statements, thereby placing increased disclosure requirements on preparers, in the interests of increasing transparency.
We await the final standard with interest, but the following is clear, the regulation is changing fundamentally and entities should consider the impacts now and commence with preparation for transition.
Donald MacDonald is Director of PricewaterhouseCoopers Middle East Capital Markets and Accounting Advisory Group. This article was written exclusively for Daily News Egypt.
