Transitions are not always easy and this one certainly comes with a rather complex set of challenges. This impact can be analyzed in the light of the new features being introduced in the IFRS regime. This paper looks at 3 key areas, the required transition process and the associated challenges, starting from simple changes to the more complicated and intricate ones:
IAS39 required classification of assets into four categories while IFRS9 requires all customer accounts in Core Banking System to be categorized in one of the following three categories-
These categories are similar to the IAS39 asset classifications of – Held till maturity, Available for sale, Held for trading and Loans & receivables. The erstwhile classifications have been merged to create three new categories. Since very few banks have been classifying their accounts as per the oldr categories (most of those who practiced IAS provisioning and classification), to most of the banks and CBS, this is altogether a new feature. Moreover, the earlier set of account classifications were meant mainly for MIS purpose and had no accounting impact. However, the IFRS categories call for specific accounting behavior for fair valuation and for any category change, accounting entries are required to be passed. In the absence of these processes, banks would end up posting wrong figures in their books of accounts.
Banks would face the challenge of drawing rule-engine for account categorization, basis the business model and SPPI test. Once that is done, listing and updating should be manageable.
With increasing risk propositions in the financial world and complex financial products, banks are becoming more and more vulnerable to financial defaults. IFRS9 brings forth ‘measurement of assets at their fair value’ as one of the anti-dotes to avert these events. Under this mechanism, all assets require to be measured at their fair value. This value is a sum of their contracted / expected cash flows discounted at current market rate. Fair value of conventional assets (held-till-maturity type – categorized as Amortized Cost) needs to be reported as footnotes to the balance sheet and hence, has no impact on accounting. On the contrary, complex / unconventional asset products like those meant for trading/ sale are required to be categorized as FVOCI / FVTPL. These assets are required to undergo accounting treatment for their fair value difference i.e. the difference between their book value and fair value.
Firstly, banks would need to define their policy on the definition of ‘market rate’. It can be taken as equivalent / correlated to some benchmark rate, bank’s prime lending rate or any rate at which similar products are offered to new customers, etc. Further, banks need to decide which type of cash flows they would like to use for fair value computation – contracted or expected, for various products. Apart from this, set-ups for fair value accounting need to be meticulously configured to ensure depiction of assets at their correct fair value in line with IFRS9.
Staff Accounts Fair Valuation (IAS19)
The concept of fair valuation already existed as part of the erstwhile IAS19 for employee benefits assessment. IAS19 is also being adopted by some nations along with IFRS9 to ensure uniformity in their fair valuation processes. As per this regulation, staff loans / deposits granted to bank employees at concessional / preferential rates are required to be fair valued at their market rate so as to bring forth clearly the interest cost borne by the bank. This cost is then required to be amortized over account tenor unitarily and interest be booked on market rate on fair value. Transition to IFRS9 (along with IAS19) would require banks to fair value their existing subsidized staff loans / deposits from the date of transition onwards, and also amortize the interest cost thus computed. It would be challenging for banks to carry out these processes for their existing accounts along with the complex accounting as required.
EIR (Effective Interest Rate) is one of the major pillars of IFRS. EIR is the real interest rate earned by the bank as it accounts in for interest and fees charged from the customer and costs paid for processing and servicing an account by the Bank. IFRS insists on inclusion of upfront fees and costs for computation of EIR. It also mandates that such upfront fees and costs should not be reported inthe profit & loss Account as income/ expense at the onset but be amortized over account tenor.
Transition for this item for existing accounts is going to be a bit of a challenge for banks’ CBS on account of the following factors. It is recommended that challenges be discussed before beginning the transition process. These challenges are: –
Many banks do not route fees through their main core banking systems
Many banks do not tag upfront fees charged to the asset account for which they have been levied
Since there was no mandate earlier, most banks have been taking all fees into their income account in the beginning while such loan accounts still run in CBS
Banks might not be using EIR method for amortizing upfront fees
Most banks do not capture processing cost components separately as of now
The transition process shall be different for different banks basis whether or not they have been routing fees through their core banking system or not. If not, then for further amortization, banks will need to procedurally calculate and supply the upfront fee and cost related details for respective accounts as on the date of transition to their CBS. In case fee is routed through the bank’s CBS but already taken into income on day one, a portion of such upfront fees would need to be reversed from income assuming it was being amortized since the beginning. However, retrieval of such an amount using EIR method would be too complex and cumbersome considering dynamically changing EIR value over a period of time. Hence, as one-time exception (for all practical purposes, banks may retrieve this amount of fee that is to be amortized in future, using Straight Line Method.
Loan disbursement date: 01-01-2010
Upfront fee amount: USD 2400
Loan tenor: 10 years (120 months)
Per month amortization amount = 2400/120 = USD 20
IFRS transition date: 01-07-2018
Months gone by till transition date: 102 months
Remaining tenor: 18 months
Amortized amount = 102 * 20 = USD 2040
Unamortized amount = 18 * 20 = USD 360
This unamortized fee thus arrived may henceforth be amortized by EIR method in the CBS. Banks currently amortizing fees using other methods will need to change their methodology going forward.
Since impairment model itself is changing, transition of Asset classification and provisioning aspects will also change significantly in the CBS.
Existing processes pertaining to asset classification, impairment marking and provisioning (normal or IAS) would need to halt.
Core banking systems will need to scale up and work in close liaison with bank’s Risk Management system / tool or carry out required statistical computations pertaining to ECL and Stage within main CBS.
The stage thus arrived at for all asset accounts will need to be mapped to them, and NPA flag updation would need to be done as per stage information. Consequently, income recognition / de-recognition (suspense balance movements) processes will need to be carried out in line with the new regulation.
Existing asset provisions would need to be reversed (hence cancelling all existing provisions) by passing the following accounting entry:
Dr. Asset Provision Cr.
Cr. Transition Reserve (parking account)
Post this, ECL accounting entry would be passed as follows:
Dr. Transition Reserve
Cr. ECL provisioning Cr.
One needs to note here that the transition reserve will not be netted off completely. Since the new norms are more stringent, they would call for higher provisioning, leading to erosion of bank’s profit reserves.
The first challenge for banks and their core banking systems would be carrying out statistical computations of ECL and stage. Since this function is already carried out by various Risk Management tools for Basel III compliance, banks may also explore integrating/ interfacing their CBS with their Risk Management system. Secondly, since IFRS does not explicitly mention processes related to income de-recognition / recognition, banks would need to devise their policy regarding this. Being a highly sensitive computation, execution of this policy would need to be handled meticulously by banks.
Local financial / banking regulators across the globe have already promulgated localized versions of IFRS applicable to respective countries. IFRS has already arrived in many countries, and will soon be adopted in the remaining ones. The industry needs to keep itself and its systems prepared to handle this regulatory ‘tsunami’. With a well-thought out policy and strategy to handle the required changes, banks can meet the challenges head-on and sail through.
IFRS: International Financial Reporting Standards
GAAP: Generally Accepted Accounting Principles
CBS: Core Banking System(s)
AC: Amortized Cost
FVOCI: Fair Value Through Other Comprehensive Income
FVTPL: Fair Value Through Profit & Loss
IAS: International Accounting Standards
MIS: Management Information System
EIR: Effective Interest Rate
SLM: Straight Line Method
TF: Trade Finance
CASA: Current Account Savings Account
CC/ OD: Cash Credit/ Overdraft
P&L: Profit & Loss
ECL: Expected Credit Loss
NPA: Non-performing Asset