Ever since the 2008 global economic collapse, the International Accounting Standards Board has been hard at work creating new standards of accounting that have far-reaching effects. As of Jan. 1, 2018, those financial reporting standards are in place, but what does that mean for Canadian financial institutions and their accountants?
Why Do We Need IFRS 9?
The 2008 global financial crisis showed the world the danger of overvaluing assets when the subprime mortgage market in the United States collapsed and took the world economy with it. Banks had been offering mortgages to borrowers using lax lending requirements, and it resulted in millions of homeowners who could not afford mortgage payments. Evictions and foreclosures began to follow, but investors were slow to grasp the problem. Banks had packaged these mortgages into complex investment instruments that looked valuable on paper but were often much riskier than their book value suggested. Investors gobbled up these supposedly valuable subprime investment funds. And you know what happened next.
The IASB believes that failing to properly value those subprime investments was a major contributor to the crisis. IFRS 9 is its attempt to create an international standard for valuing assets to make sure this doesn’t happen again. This includes standard policies for handling impairment, or the permanent reduction in value of an asset, and reining in the types of reckless accounting practices that led investors to make big bets on bad odds.
Changes to Valuing Assets
The new guidance doesn’t change the basic methods for accounting for financial assets. You can either amortize them, or adjust the value at set amounts over set intervals, or value them at fair, or market value. What IFRS 9 adds is more stringent requirements for assigning a method. Most instruments are amortized, but your clients should use fair value methods if the instrument passes a contractual cash flow test and a business model assessment.
The cash flow test requires that all cash flows from the instrument come from principal and interest. The business model assessment looks at how your client intends to use the instrument. If it doesn’t intend to sell it, for example, it cannot use fair value methods. But if your client intends to sell or trade the asset, then IFRS 9 requires fair value reporting. This ensures that instruments with more exposure to the market have values that more closely reflect their real-world values in that market.
Again, there are strict guidelines for how to measure impairment, but the key principle is timeliness. In the previous guidance, there was some leeway to allow companies to delay reporting an impairment of assets. Now the guidelines require your clients to report all expected losses at the end of each financial period. If a company sees a risk of credit defaults, it can no longer wait for the defaults to happen. It must note the risk as an impairment of the value of the asset as soon as it’s aware of that risk.
Hedge accounting by its very definition masks the presence of risk evening out the appearance of volatility over time. The goal of the IASB here is to ensure more transparency by forcing banks to disclose more about their risk management activities on financial statements. In turn they can hedge, or offset, their exposure to risk with other financial instruments. This way, they can continue to get the benefits of the stable appearance of a hedge financial report while being more open about the risks behind it. But unlike the other parts of IFRS 9, this requirement is optional. You can still advise your clients to follow the old guidance. With your expertise, your clients decide which is right for them and adapt to the other requirements to improve the accuracy of their asset reporting.