IFRS 9 Bridges the Gap Between Accounting and Risk Management

For years, accounting and risk management have not always been fully in sync. Limitations in the prevailing accounting standard meant that firms were not always able to accurately reflect their risk management activities in financial statements. While the emphasis of accounting was on the forensics of company finances, risk management was traditionally focused on the prospective future. IFRS 9 will help to clarify the role and outcome of risk management in the accounting output.

IFRS 9’s impact - and opportunity - will be in encouraging clarity among stakeholders and providing a common language and framework that finance, treasury, risk functions and the CFO can use. Closer collaboration across multiple functions should improve the information flowing to the treasurer and CFO, and enable them to better communicate financial performance to investors in a way that helps them understand the risks a company faces.

Key changes introduced to achieve closer alignment

The global financial crisis exposed many problems with IFRS 9’s predecessor, IAS 39. It was viewed as complex, challenging to implement, inflexible and confusing to investors in its treatment and reporting of risk management. The crisis highlighted the deficiencies of the incurred loss impairment model, whereby a provision is booked after a loss event has happened, resulting in delayed credit-loss recognition. This was commonly referred to as ‘too little, too late’. A further criticism of IAS 39 was the complicated and restrictive nature of the hedge accounting requirements. Companies often found themselves unable to achieve hedge accounting for common hedging strategies. The inability to achieve hedge accounting and postponement of credit losses resulted in financial statements not necessarily reflecting the true status of risk management application.

Key changes under IFRS 9 aim to address the weaknesses found in IAS 39. IFRS 9 sees a general shift from a prescriptive to a principle-based approach, changes to the way financial assets are classified and measured based on their nature and how they are managed, changes to the impairment model based on expected rather than incurred credit losses, and a move to hedge accounting guidelines that are less rigid and more aligned to the underlying transactions.

Adopting the new expected credit loss (ECL) model will require companies to consider multiple, probability weighted scenarios and macroeconomic factors in order to apply a forward-looking approach. Credit losses will be recognised earlier, from the point a loan is issued, and will be based on the expectation of losses over the life of the instrument. Credit risk modelling is likely to be a key feature in the assessment of credit risk and the subsequent tracking of credit risk. However, equally as important, ECL calculations will require significant management judgement. Both must be accompanied by enhanced disclosure, covering amongst other things provisioning policies, definitions of key concepts impacting ECL estimation and performance ratios.

The need for increased judgement and disclosure is an opportunity for CFOs to explain their reasoning and strategy because it creates a need for more discernment and explanation of assumptions. Under an ECL approach, financial statements will reflect the credit risk management process more closely; therefore they must be prepared with evidence and justification for decisions such as the threshold to indicate a ‘significant increase’ in credit risk. These changes create an opportunity for treasurers and CFOs to open the dialogue with investors about how risk is managed in a company.

Fig 1 - Sample airline key performance indicators and impact of IFRS 9

While the new impairment model presents numerous challenges, implementation of the new hedge accounting guidelines is expected to cause the most significant challenge for corporations. More hedging strategies are likely to qualify for hedge accounting application under IFRS 9, which will not only result in less income-statement volatility from existing hedging strategies, now permissible for hedge accounting under IFRS 9, but firms may also opt to transact new strategies previously curtailed due to the restrictions present in the current rules. Both outcomes will allow stakeholders to see more meaningful information, not only in the headline numbers but through the new detailed disclosure requirements. Corporate managers have an opportunity to convey what these changes mean, how they align accounting more closely with risk management, and how results compare between periods pre and post IFRS 9.

The hedge accounting model will also permit greater flexibility by introducing and expanding on concepts such as rebalancing, aggregate exposure, layers and net positions. Hedge accounting, based on collaboration between accounting, risk functions, the treasurer and the CFO, mitigates income statement volatility and shows exactly what is being hedged to provide a clear view of risk management across the firm.

These should be welcome changes for most companies that manage their risk well. Before, the risk package results against the accounting package would show a mismatch and a mark-to-market loss or gain and unwanted income statement volatility. With the combined reporting of accounting and risk management, investors have a clearer view of the company’s financial results.

A new benchmark for financial reporting

IAS 39 is considered complex and confusing for investors to fully understand the risk management practices of a company and how they relate to their accounting results. Some companies have adopted non-GAAP metrics in their annual report to aid communication of accounting impact.

The changes introduced by IFRS 9 will bring fresh challenges to investors in understanding a company’s financial statements and the key metrics affected. The numbers generated under IFRS 9 may look quite different, and as such, significantly more disclosures are needed to help communicate these changes and help investors understand the risks a company faces. CFOs and treasurers will play a key role in actively managing the communication around how best to disclose them.

Figures 1 and 2 highlight some of the key performance indicators that could be impacted under IFRS 9, for both a corporation and a financial institution. The type of ratios disclosed by corporations will have a different focus to those provided by financial institutions; nonetheless all component parts are subject to the possible effects of IFRS 9. Consider an airline and the return on capital employed: EBITDA is sensitive to fair value movement from FX or fuel hedges, this volatility can be reduced with hedge accounting; while capital employed could be affected by reserve movements from hedge accounting or the transition to ECL. For debt to equity ratios, fair value hedge accounting will impact the carrying value of debt, while equity could be affected by the hedge accounting impact on reserves (the additional split on foreign currency basis being one example). From a bank’s perspective, the asset quality ratio is impacted by the impairment charge, which under an ECL approach is expected to increase and could be more volatile. The effect on the net interest income ratio is harder to predict: profitability is expected to be impacted and loan pricing could change as a consequence. Understanding the potential impact on primary reporting measures and what might drive them to change, and being able to effectively communicate them, will be key.

Fig 2 - Sample bank key performance indicators and impact of IFRS 9

The first or second financial reporting periods will require extra care to ensure differences that exist because of IFRS 9’s accounting changes are fully explained. Firms will need to prepare for analysts or reporters who skim columns looking for significant changes, such as to P&L or key ratios, and provide an explanation in the table or in footnotes. They will also need to prepare investor-relations staff to articulate the changes and impact on ratios/accounting numbers.

Initially, firms may try to carry out much of this risk management and reporting manually, but this will place more burden on operations and compliance. Instead, they should seek to develop standard approaches that can be written into software and automated as quickly as possible. Manual work is expensive, and the experts who can understand the requirements are in short supply as banks and corporates scramble for their skills. In addition, moving the principles into software ensures consistency across the organisation and provides a single point of evidence for regulators. For the first year or two, however, companies will be required to monitor and test systems while documenting the results.

IFRS 9 builds a bridge between accounting and risk management, but that’s just the beginning. Ensuring a coherent and joined-up message is conveyed to users of financial statements, that reflects the risks a firm faces and the actions taken to mitigate them, is the next challenge.