Toxic loans and what the new accounting standard might mean
The 2008 financial crash is history and nothing to do with my ICAS course, right? Not exactly. Changes that were put in place in the wake of the banking collapse are yet to be adopted, but you need to know about them.
What’s IFRS 9?
IFRS 9 is one of the latest international accounting standards to be updated and issued afresh. It deals with the complex area of financial instruments (financial assets, financial liabilities, equity instruments and derivatives). Financial assets include the likes of cash, trade receivables and investments in equity or debt. Financial liabilities include, for example, loans payable. Equity instruments include ordinary and preference share capital.
What’s likely to happen with IFRS 9?
Should the European Union endorse the newly updated IFRS 9, as is widely expected, strict impairment requirements will be placed upon companies who hold financial assets.
Companies will be required to be forward-focussed when considering potential impairments (or expected credit losses) on their financial assets. The current situation is that they wait for objective signs of impairment – that is, an event actually taking place which shows their financial asset to be worth less.
The move from incurred loss to expected loss - which could happen in 2018 – means that banks will account for the possibility of losses before they actually happen, which should help to keep banks properly capitalised for the loans they have made and make it less likely that they have overvalued assets on the balance sheet.
This means that we can hopefully avoid some of the pitfalls of the financial crisis
This means that we can hopefully avoid some of the pitfalls of the financial crisis – like the financial institutions that had billions of dollars of investments in ‘toxic’ assets such as mortgages and loans receivable, which all of a sudden were wiped off the face of the balance sheet.
Instead of one sudden write-off, companies should be providing for (potential) expected credit losses right from the inception of an investment. The impact of credit losses on companies should be predicted, and therefore, less drastic if or when they do occur.
Why do I need to know?
In the Financial Reporting section of Test of Professional Skills, you will be spending a whole day discussing financial instruments – using IFRS 9 amongst other standards. We will also discuss derivatives during the Financial Reporting course.
You will be told in class which elements of IFRS 9 to concentrate on. Financial instruments are a highly complex area in practice, but, don’t worry as we will only be covering a portion of the standards and at a relatively high level. You won’t cover the more complex issues that companies face.
A recent New York Times article discusses the potential danger that is lurking around the globe from large amounts of “toxic” debt that has not been accounted for.
In theory, it makes sense for banks to swiftly recognize the losses embedded in bad loans
The journalist says: “In theory, it makes sense for banks to swiftly recognize the losses embedded in bad loans…”
If IFRS 9 is endorsed, companies in Europe will have to recognise the losses embedded in bad loans and, as you can see, both long and short-term effects will be significant.
However, the figures in the accounts will only be as good as the predictive models for losses used by companies.