The EBF asked Sondra Tarshis, Chair of the EBF Classification & Measurement Working Group and Senior Manager, Accounting Policies at HSBC whether IFRS 9 – the package including a logical model for classification and measurement, a single, forward-looking ‘expected loss’ impairment model and a substantially-reformed approach to hedge accounting – was in line with EU legislation.
Some have indeed questioned whether IFRS 9 is compatible with EU law. This is because they see the standard as only requiring recognition of 12 months expected losses resulting in the possible statement of loans at above their recoverable amount or an understatement of losses, which may result in the financial statements not giving a true and fair view or being prudent. Do you share these concerns Ms Tarshis?
No, I don’t. These concerns seem to be based on a misunderstanding of the requirements of IFRS 9 and indeed the requirements of the IAS Regulation which results in the application of IFRS in the EU.
We believe IFRS 9 is clearly response to the calls from the G20 and others for loan loss provisions to incorporate a broader range of credit information. It also the result of much discussion and due process on the part of the IASB with more than 1000 comment letters considered and more than 100 outreach meetings, including with users of financial statements.
While the requirements cannot be described simply, they result in a practicable application of the IASB’s original proposal which would measure loans at the expected cash flows (credit adjusted) discounted at the original (credit adjusted) effective interest rate. This would have resulted in initial expected credit losses being recognised over the life of the financial asset as a reduction in interest income. If the initial expectations were borne out in practice, no loan loss allowances would be needed. Allowance would only be raised where expectations of credit losses increased from those originally anticipated.
The IFRS 9 requirements separate interest recognition from impairment, which is necessary for cost effective application, and provide useful information by:
- Recognising a portion of the lifetime expected credit loss from initial recognition as a proxy for recognition over the life of the financial asset the original estimate of expected losses (the 12 month ECL), and
- Recognising lifetime expected credit losses when credit risk has increased since initial recognition (when recognising only a portion is not appropriate because there is a significant economic loss) so the credit losses have increased from those originally anticipated.
The 12 month ECL is not limited to the expected cash shortfalls over the 12-month period, but represents the life time expected loss weighted by the probability that the loss will occur in the next 12 months. Lifetime expected losses are the expected losses that result from all possible default events over the expected life of the financial asset and are recognised for financial assets that have significantly deteriorated.
While the 12 month ECL is essentially arbitrary, it is in fact considered to be appropriate and cost effective for financial instruments before a significant increase in credit risk has occurred. It is a pragmatic solution, that has received wide spread support, because it achieves a good balance between faithfully representing the economics and the cost of implementation. Any expected loss model requiring immediate recognition of life time losses at initial recognition would not faithfully represent the underlying economics, or provide information useful for economic decisions.
Therefore, we see IFRS 9 as not over or understating loans, which are properly measured at amortised cost, and appropriately recognising losses that have arisen in the financial year or earlier years determined using all reasonable and supportable information available, including forward-looking information. As a result, IFRS 9 would contribute to financial statements providing a true and fair view.
We do not consider a single aspect of financial reporting, such as prudence, should be considered in isolation. True and fair is an over-arching concept which often involves coming to a judgement balancing all qualitative characteristics including understandability, relevance, reliability and comparability required of the financial information needed for making economic decisions and assessing the stewardship of management. However IFRS 9 would appear to result in prudent financial reporting in terms of measurement of assets and recognition of losses.
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