Now that most (or hopefully all) the banks in Australia have now completed their AASB139 implementation projects, perhaps it is time for a look back to see where the major challenges were. Considering that many of our neighbours to the near north are about to go through the same process, some guidance and assistance would be in order. Those needing to look at FAS 133 can also read on – the effects are very much the same.
Fair Value
Perhaps that first, big, one was that fair value did not turn out to
be the bogeyman that had been expected. Yes, it was a pain in the umm…
posterior. Quite a few of the positions held by the banks were difficult
to value – particularly in the more illiquid markets. Overall, however,
this was not the worst area and generally it was handled well. Some of
the spreadsheets did get to a huge size and the auditors got upset over
several issues on valuations, but overall it was not as bad as
originally thought.
The only real pain was in the breaking out of the treatment of the fair
value through P&L category from the fair value through equity
(Available for Sale) instruments, particularly where hedging was
involved. Getting that documentation into order, and dealing with the
consequences where it was not, was just plain hard work. It was time
consuming, but the causes, targets and effects were clear.
Held to Maturity / Loans and Receivables
This was more difficult. The HTM investments were not too bad – there
are actually not that many out there – and their valuations were
comparatively trivial with the ability to hold them essentially at cost.
The difficult bit was getting a genuine effective interest rate (EIR).
Normally, the expected life was a fairly easy calculation. This sort of
thing is normally meat and drink to marketing and is basic product
information that the product managers should have. That said, it now
needs to be checked by Finance and the auditors so the documentation
standards around the models suddenly needed to improve.
The real trick was working through all the fees and costs to determine
which were directly related and which were not. Once they were
identified they had to be broken out and treated separately – creating a
need for a calculation engine of some sort to get that as well as
extensive work in the general ledger. These sorts of changes are not
trivial and the testing effort is quite large. Along with collective
impairment (see the next section) this also had the most material impact
on the balance sheet. Overall, not fun.
Impairment – Specific
Specific impairment of the bad or doubtful debts in the loan
portfolio was tricky – involving retraining staff in the collections
area to understand the impact of the time value of money. A reasonable
amount of IT spend also had to happen here to allow for the net present
value (NPV) calculations to be done, but, once the IT changes were put
in and the training completed the actual process did not take too long.
If arranging the project now I would be looking to run this one early in
the process to get comfortable with change management and training
before getting on to some of the chunkier issues.
The element that many got worked up about here was using the EIR to do
the NPV calculations, but, once a quick sanity check is done, using the
rate marked on the account, shorn of penalties, normally was close
enough as made no material change.
Impairment – Collective
I have never seen so much debate over an accounting number as I have
over this one. Much of the debate was political and regulatory related.
For years, APRA (the Australian prudential regulator) have effectively
mandated a percentage of risk weighted assets (0.5%) as the number to be
used for the old general provision. Under the old standards all
auditors accepted this number, provided it could be justified as
“conservative”. As banks did not lose more that 0.5% of RWA assets each
year it was easy to do so – it was overstated. APRA essentially used the
general provision as further capital and, as it counted towards tier 2
capital, the banks simply wore it. This was then included in the numbers
published in the US under US GAAP – which the board had to sign off as
correct.
The problem was that the number was conservative, not, in most cases,
correct. A quick glance at the specific impairment numbers will confirm
that. Once the more rigorous methodology mandated under IAS 39 was used
it was obvious that the numbers signed off last year were not correct.
Writing it up as a transition issue was not going to be acceptable – the
difference in many cases was large and obvious. The models producing
the numbers had to be altered.
What happened was what you would expect – a fudge. This will have to be
unwound over the next few years and will represent an increase in
pre-tax profit. It will be managed as improving the accuracy of the
models as they mature.
Just in case you interpret this as a slur on the banks or the auditors –
it is not. It is just unwinding some cumulative stupidity on the part
of the regulators, who effectively forced the banks to lie in their
financial statements.
Summary
This was always going to be a big issue for the banks. It just did
not create the work in the areas expected. Fair valuation – the big
scary issue – was a comparative pussycat. It was the loans and
receivables, and their impairment, which created the issues. For other
countries about to implement the standards, the only real advice I could
give, apart form the above, is to look to the areas where the
regulators are making you do things you know to be incorrect – or at
least suspect are incorrect – and work out how you manage their
transition to a sane set of standards.
If you have anything to add, or further comments, please let me know.
[UPDATE]
Hmm – publish in haste and repent at leisure. A few missed points here.
Securitisations
Most of the vehicles used for securitisation by the Australian banks prior to AASB 139 simply did not comply with the criteria for derecognition – and so most came back onto the balance sheets. Not a real problem as they still worked under APRA rules, but this was an area that caused some real headaches until APRA cleared up its guidance.
No Interest loans
While banks generally do not grant these to their customers, what was
discussed in the context of the non-FS firms above is still relevant. I
will therefore just copy it in.
The problem arose from all of the loans that typically flow between
entities in a consolidated group. Under the old standards these could be
held at face value and were effectively ignored as long as there were
no real signs that there were major problems at the sub that the parent
could not handle.
The way the new standard works requires that the loan be fair valued –
i.e. if the loan could not be repaid now, or at least soon, and it
carried no interest it had to be written down and the difference between
the face value and the written down value taken as an equity injection,
with the difference unwinding as “interest” through the P&L. This
had several ugly effects that I will not go into here. Suffice to say
that, on a standalone basis, you do not want any of these lying around.
11 comments
30 September, 2006 at 20:59
penguinunearthed
From what I saw of the impairment stuff, the international situation was quite different. For example, the UK had the opposite mix from Australia of general vs specific provisions for impaired loans (Australian banks had a small specific and large general, and the UK the other way around, I think it was), but in both countries, banks were trying very hard to justify little change in provisions.
It’s sad that international accounting standards still don’t seem to be very international.
30 September, 2006 at 23:59
ozrisk
Penguin,
I have some inside knowledge on that one, but the main reason was the differences in both the legislative and economic picture between there to here.
The regulator in the UK (now the FSA) did not do the (silly?) thing that APRA / the RBA did here and mandate the 0.5% of RWA as the general provision – so there was less to write back when the change came.
The increase in the specific provision reflects the differing tax treatment that they used to get – in the UK you could take the tax deduction as soon as you provided specifically – not, as is the case here, when you finally wrote it off. The incentive in the UK, then, was to specifically provide ASAP to bring forward the tax deduction.
In this case, therefore, the new standards actually forced the correct outcome from the stupidity that came before – and did act to standardise the treatment.
You can also see why the banks were fighting to maintain the old treatment in the UK as the new now reduces their early tax deduction.
19 May, 2008 at 17:39
Akshay Kakar
From what I read of the latest IAS 39 clauses (and corresponding clauses in AS 30 – Derivative accounting standard for India; produced below), there seems to be no requirement to seperate -‘all the fees and costs to determine which were directly related and which were not’. If so, why was this a problem in Australia…??? (Refer Heading – Held to Maturity / Loans and Receivables of Article). Another case of different applcation in different countries?
(Clause A23. When calculating the effective interest rate, an entity should estimate cash flows
considering all contractual terms of the financial instrument (for example, prepayment, call and similar options) but should not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the
effective interest rate, transaction costs, and all other premiums or discounts.)
19 May, 2008 at 18:13
Andrew
No, unfortunately. The difficulty was to seperate out the ones that were purely contractual from the ones that were not. A good example would be an annual fee paid in advance. Normally this would be seen as not included in the EIR (as it is an annual fee, not related to the interest rate) but if it was noon-refundable on early closure then it may well be seen as an inception fee, and therefore included in the EIR.
Previously, most banks had just lumped them all together under “fees”. Breaking these out needed a lot of work to understand and categorise the fees, followed by a process to ensure they were dealt with correctly in the back end systems.
It was a lot of work.
19 May, 2008 at 19:19
Akshay Kakar
Have there been any cases where the fair value of derivatives as calculated by banks (if the bank is the calculating agent in the ISDA schedule for MTM losses) and the fair value calculated by companies / valuation agents been different and this leading to legal entanglements?
19 May, 2008 at 23:28
Andrew
On the specific ISDA point – I am not aware of legal entanglements that have arisen. As the basic calculation methodologies for most derivatives are well understood it normally comes down to an argument about parameters where there is a difference. These then can come down to experts at 10 paces, but rarely legal entanglements.
Of course, someone else may know better. Clive – any experience of this?
21 May, 2008 at 16:53
Akshay Kakar
Andrew,
Just continuing with the previous discussion, in case of fees which are not attributed directly to loan and so cannot be carried in EIR, where is such income reflected on the income statement? Is it to be taken lumpsum in the first year of origination itself in a heading ‘fees’…???
21 May, 2008 at 18:07
Andrew
Akshay,
They are taken immediately to the income statement – as all fees were prior to IAS 39.
28 June, 2008 at 02:16
Bruce M
I have seen some utter nonsense for impaired/not impaired/ past due in accounts this year (uk banks).
Can’t believe the auditors signed it off.
22 November, 2008 at 23:25
Ahyee
I can testify your comments about the effective interest rate calculation. My company has a large portfolio of mortgage loans. We have developed a model to calculate the effective interest rate and a method of amortisation. It is a big project. The worse part is that the auditor does not agree with our method of amortisation and has imposed a “portfolio approach” for amortisation,i.e assume all loans saty in the portfolio for the same period of time even in reality the loans discharges at different points of time.
I was amazed by this suggestion. Based on your knowledge is this an industry norm in Australia ? In your view is the “portfolio approach” a sound base to be applied in this situation ?
23 November, 2008 at 20:35
Andrew
Ahyee,
This is one method of calculating the EIR – but it is inferior to one that correctly calculates the correct expected life.
It does have one advantage, though – it is easier to understand. Despite being inferior (as it is less precise) it should not be materially wrong over a portfolio. My suggestion would be to use your method for internal reporting and then the other one for your audit reports. Once the auditor has seen it over a year or two they will then come to understand it and then should accept its use.
Let me know how you go and if you would like some further help.