Collaborating Author: Victoria Redmond
By now you have heard that CECL is looming for US GAAP-compliant preparers, but have you heard about the IASB’s equivalent and even faster approaching regulation, standard IFRS 9? US entities who consolidate into a parent company that reports under IFRS must implement IFRS 9 by January 2018. IFRS 9 should also be of concern to US parent entities that consolidate IFRS-compliant foreign subsidiaries.
Like CECL, IFRS 9 represents a shift from recognizing credit losses only when they have occurred to estimating their expected amounts. Institutions required to adopt both regulations can look to leverage similar loss estimation techniques and forward-looking loss models to comply with both sets of new rules, although the credit loss methodology will differ for many instruments.
Though the expected credit loss concept is consistent in both regulations, CECL requires you to recognize an estimate of expected credit losses over the entire life of the instrument at initial recognition. Under IFRS 9, only underperforming and credit-impaired assets recognize a lifetime expected credit loss, whereas performing assets recognize an expected credit loss based on their expected credit losses occurring 12 months from the reporting date. This presents a challenge in terms of capturing increases/decreases in credit risk for modelling purposes.
IFRS 9 also requires a further analytical step prior to reaching the modelling stage. For CECL, you can evaluate financial instruments at a pool level based on similar risk characteristics, the same starting point used in the incurred loss model. In contrast, IFRS 9 includes new classification guidelines for financial assets driven by:
- The entity’s business model for managing financial assets - This assessment seeks to uncover management’s objective regarding the way cash flows from groups of assets are collected (i.e. are financial assets held in order to collect their contractual cash flows or sold prior to contractual maturity to realize changes in fair value).
- The contractual cash flow characteristics of the instrument - This assessment analyzes the characteristics of the financial instrument’s cash flows and whether the cash flows consist of Solely Payments of Principal and Interest (“SPPI”).
Accurate classification is important as it determines the subsequent measurement of instruments, namely whether it’s held at fair value or amortized cost, directly impacting the scope of impairment testing. SPPI testing is a critical component of IFRS 9 compliance, and determining what to test will set the tone for compliance.
What to test
In approaching the SPPI test, entities should think about the nature of their population of in-scope instruments. For example, retail loan contracts tend to be straightforward and contain standardized terms across instances of the same product. Commercial loans frequently contain customized and complex terms. Therefore, entities with greater exposure to commercial loans will need to dedicate more time to SPPI testing. Pool segmentation for this analysis will require some consideration and information sharing across business units. Leverage the expertise within the business unit to identify asset pools with higher risks of failing the SPPI test and allocate time accordingly.
What to test for
The SPPI test seeks to confirm that the interest rate charged reflects compensation for credit risk and the time value of money. Contracts including features such as compensation for liquidity, a profit margin and service or administrative costs (e.g. late payment fee) will also pass the SPPI test. Elements seen as introducing volatility into the cash flows (e.g. payments linked to changes in equity or commodity prices) would likely fail the SPPI test.
Entities should think about the best way to document that all aspects of IFRS 9 guidance have been considered. A standard template works well across multiple products, identifying where additional assessment should be applied due to the existence of non-standard terms or conditions.
Concluding Pass or Fail
Contracts identified as “Non-SPPI” may not need immediate re-classification. Pass or fail conclusions should follow the following steps:
- If a non-SPPI contractual cash flow characteristic can be considered de minimis in each reporting period and cumulatively over the life of the financial asset, this feature will not affect the classification. This application requires significant judgement as de minimis is not defined in IFRS 9.
- If a non-SPPI cash flow characteristic is deemed more than de minimis, it is time to consider if it is “not genuine.” Per IFRS 9, a cash flow characteristic is not genuine if it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare and very unlikely to occur. Data inputs required to conclude on this test can be difficult to attain. For example, the number of occurrences where a certain clause was triggered or resulted in a specific action is relevant data that can be stored and managed differently across many platforms throughout organizations.
Though completion of the classification and measurement testing is a significant milestone in the IFRS 9 journey, it is important to keep the broader implementation demands of the standard in mind throughout this phase to avoid unforeseen issues further down the line.