Recently, I had the opportunity to attend a discussion on International Financial Reporting Standards (IFRS) which was attended by chartered accountants and key financial stakeholders. In my years as an accountant, I have never come across such heated debate or such polarized views on an accounting topic.
Based on these discussions and my reading of IFRS, I am listing below a few important points which may occupy a pivotal role in Banking -IFRS conversion. These points are not exhaustive and comprehensive but cover most important aspects on the topic.
1. Income recognition
2. Definition of Debt vs Equity
3. Identification of Impaired loan
4. Impairment provision
5. Presentation of financial statements and disclosures of financial instruments
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 ‘amortised 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 is high turnover in the 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. Currently, Indian banks account for loans and receivable at amortised cost. Under IFRS 9, loans and receivable portfolio are accounted on amortised 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 amortisation accounting.
However, amortisation accounting is not possible if a loan has a contractual interest rate that is based on a term that exceeds the instrument’s remaining life. Similarly, a loan with a convertible option is not eligible for amortisation 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/securitise their loan portfolio. Amortisation 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.
Cash Flow Characteristics :
IFRS 9 requires an entity to assess the contractual cash flow characteristics of a financial asset. The concept is that only instruments with contractual cash flows of principal and interest on principal could qualify for amortised cost measurement. IFRS 9 describes interest as consideration for the time value of money and credit risk associated with the principal outstanding during a specific period. Therefore, an investment in a convertible debt instrument would not qualify because of the inclusion of the conversion option, which is not deemed to represent payments of principal and interest.
The cash flow characteristics criterion is met when the cash flows on a loan are entirely fixed (e.g., a fixed interest rate loan or zero coupon bond), when interest is floating, or when interest is a combination of fixed and floating.
Financial assets that do not meet the above criteria are required to be measured at fair value, including all equity investments, all derivative assets, all trading assets, and those loans, receivables, and debt securities that do not meet the two criteria described above.
Under RBI norms, investment in equity instruments (other than subsidiaries, joint ventures), are marked to market. Net losses are recognised but net gains are ignored. Under IFRS 9, investments in equity instruments are fair valued. The gains or losses are either recognised 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. With regards to impairment of loans (not covered by IFRS 9), the IASB in a proposed standard 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 amortisation accounting.
There has been a lot of criticism regarding the complexity of the IFRS on financial instruments.. Taking a cue, the International Accounting Standards Board (IASB) is in the process of simplifying them. Needless to say, the impact of IFRS 9 on banks will be significant. As India is on the path of IFRS adoption/ convergence, Indian banks will have to closely examine the impact of IFRS 9 not only on their financial statements but also on their capital adequacy, IT systems, taxes and product design, among others.