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.

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