It is believed that Luca Pacioli, a Franciscan monk known as the father of accounting, was the first to codify the double-entry system of bookkeeping in his mathematical textbook titled Summa de arithmetica, geometria proportioni et proportionalita which was published in Venice in 1494. The celebrated German writer Johann Wolfgang von Goethe sang the praises of this system and described it as the finest invention of the human mind as it allowed the merchant to survey the whole of his business activities at any time; he even suggested that ‘every prudent master of a house should introduce it into his economy.’
As any system, however, this system also has its challenges and shortcomings, and the renowned investor Warren Buffet warns that financial accounting is an imperfect language and that to understand accounting one needs to understand its nuances. Buffet further warns that, ‘in the long run, management’s stressing of accounting appearance over economic substance usually achieves little of either’. It is therefore critical that, to extract the most from the system of financial accounting, one is mindful of the inherent shortcomings of the system.
In order to address some of the challenges in this area, much progress has been made towards the ideal of developing a set of high-quality international accounting standards that are widely used. In this regard, international standard-setting bodies, such as the International Financial Reporting Standards Foundation, play a vital role in working towards this goal. This Foundation has as its mission the development of standards that bring transparency, accountability, and efficiency to financial markets around the world and serving the public interest by fostering trust, growth, and long-term financial stability in the global economy. The International Accounting Standards Board (IASB), an independent private sector body which was established in 2001 and operates under the oversight of the International Reporting Standards Foundation, has been tasked with the development and approval of IFRSs, as well as the issuing of interpretations of these IFRSs. IFRSs are now required in 125 jurisdictions.
IFRS 9 and the G20
On 24 July 2014, the IASB issued a new accounting standard on financial instruments called IFRS 9, which replaced the existing standard, namely International Accounting Standard (IAS) 39, and which has a mandatory effective date of 1 January 2018. IFRS 9 inter alia specifies how an entity should classify and measure financial assets and liabilities. One of the fundamental changes that IFRS 9 introduces is the concept of Expected Credit Loss (ECL) provisioning. This new principle replaces the current incurred losses model and will materially change the way in which companies, and in particular banks, are required to approach and account for impairments for credit losses.
According to the Bank for International Settlements (BIS), the great financial crisis of 2007-09 highlighted the systemic costs of a delayed recognition of credit losses on the part of banks and other lenders, and the application of the prevailing standards at the time was seen as having prevented banks from provisioning appropriately for credit losses likely to arise from emerging risks. These delays resulted in the recognition of credit losses that were widely regarded as ‘too little, too late’, and gave rise to questions of procyclicality by spurring excessive lending during the boom and forcing a sharp reduction in the subsequent bust.
The development of the ECL accounting framework is consistent with the call by the leaders of the Group of Twenty (G20) in April 2009 to strengthen accounting recognition of loan loss provisions by incorporating a broader range of credit information. One of the consequences of this new framework is the fact that while, in the past, a loss event had to have occurred before an impairment was raised by a bank. The standard now requires that loss provisions be raised earlier and take into account not only past and present information but also forward-looking information, which emphasises the future probability of credit losses in determining them. This standard is aimed at resolving the weaknesses identified during the global financial crisis of ‘too little, too late’ referred to above, and this will hopefully result in a more robust financial system that is more resilient and hence better able to withstand shocks.
The adoption of IFRS 9 will give rise to higher levels of credit impairments. A study undertaken by the European Banking Authority estimated that the implementation of IFRS 9 would give rise to an average increase of 13% in loss provisions compared to the current levels under IAS 39; it is further expected that the Core Equity Tier (CET) 1 ratios will decrease by an average of 45 basis points. Smaller banks, which mainly use the standardised approach to measuring credit risk, estimate a larger impact on their own fund ratios than the larger banks. Estimates of the exact impact differ, however, and only time will tell which of these estimates was accurate.
There are those that argue that the adoption of IFRS 9 may in fact increase procyclicality, because during recessionary conditions there may be a sharp fall in CET 1 capital levels and this, in turn, may lead to a sharp easing in credit extension due to the so-called ‘cliff effect’ of the staged approach prescribed by IFRS 9. Others, notably the BIS, reject this argument on the basis that banks, after the global financial crisis, are now better capitalised with higher buffers and thus are better able to absorb losses. They further argue that the early loss recognition of credit losses enables a quicker ‘clean-up’ of banks’ balance sheets, thus enabling them to support economic recovery.
This debate is clearly not yet settled and we will need to wait and see how this plays out during the next recession. The economic impact is, however, not only limited to the level of losses and the timing of the recognition; the implementation of IFRS 9 is also likely to impact on the pricing of products which may thus impact on overall credit extension within the economy and ultimately consumption and hence economic growth.
It is furthermore likely that banks’ earnings will be more volatile in the future due to the effect of the forward-looking approach that is required under IFRS 9. Therefore, disclosure and the education of stakeholders on how to interpret financial information under IFRS 9 will be imperative and an important consideration.
Over the past two years, many seminars, workshops, and training sessions have been provided by a range of organisations. However, very few of these have focused on jurisdictions from the African continent. There are factors that are unique to Africa that need to be taken into account. With this workshop, we want to fill this gap and provide a platform for African regulators to discuss the specific issues and concerns that may affect them in the implementation of IFRS 9. In this context, we are very much looking forward to the presentation from the Bank of Zambia on its in-country regulator perspective.
The BIS correctly points out that the effectiveness of the new standards will not only depend on how banks implement them but will also depend on the contributions of central banks, supervisors, and other stakeholders, such as auditors. The BIS highlights that supervisors can play a very important role in promoting sound bank implementation practices through their banking supervision activities in a manner that complements the efforts of accosting standard setters.
The auditing profession, as mentioned, is an important stakeholder when it comes to the implementation of IFRS 9, so a discussion of IFRS 9 would not be complete without reference to their role. There is little doubt that the audit profession is likely to be challenged with the introduction of IFRS 9. The reason is that the audit of accounting estimates, such as impairments, has always been a very complex area and the introduction of IFRS 9 will further add to that complexity.
The saying goes that change is the only constant in life. IFRS 9 certainly represents a major change for the banking industry. It is certainly a change that needs to be embraced. The regulated sector will be looking towards their regulators for guidance, hence we need to be up to date and well versed in order to be able to provide effective guidance. To this end banks, auditors and regulators will have to work together to ensure that the implementation of IFRS 9 will be a success.
By Francois Groepe,
Deputy Governor of the South African Reserve Bank.