IAS 39 brings changes in treatment of loan impairment

Trade date or settlement date accounting?

IAS 39 permits either trade date or settlement date accounting for "regular way" purchases and sales. A "regular way" contract is defined by IAS 39 as the contract for purchases or sale of financial assets that requires delivery of the assets within the time frame generally established by regulation or convention in the market place concerned. For example, the foreign currency market, in general, delivers spot purchases within two days. IAS 39 requires that the method used by the bank be applied consistently for all purchases and sales of financial assets that belong to the same category of financial assets.

Required use of effective interest method

IAS 39 requires the use of the effective interest method in amortizing the premiums and discounts of financial assets and liabilities that are carried at amortized cost. The effective interest method for a fixed-rate instrument is a method of calculating amortization or accretion of premium or discount using the effective interest rate for a financial asset or liability. Effective rate is the rate that exactly discounts the expected stream of future cash payments through maturity or the next market-based repricing date to the current net carrying amount. The effective interest method matches the release of amortizations against the underlying movement in capital value of the asset being amortized, thereby achieving a curved rather than straight-line release of profit and loss.

For example, assume that a bond with a face value and bullet payment of P50-million and bearing interest of 10-percent per annum is issued for P49-million. The amount of amortization under the effective interest method is lower than that of the straight-line method in the early years, but increases in subsequent years at an increasing rate as the capital value of the bond increases.

IAS 39 requires that transaction costs be included in the initial measurement of financial assets and liabilities, and that these costs also be amortized using the effective interest method for financial assets carried at amortized cost. To implement the effective interest method, several current operational procedures will need to be revisited and amended.

For instance, several areas of data capture would be impacted. In the case of fees, for example, some banks capture such fees as facility level and not at deal level. For IAS 39, it will be necessary to capture fees at trade level upon booking of the transaction.

Treatment of repos and securities borrowing and lending IAS 39 applies the control test in determining whether a financial asset should be de-recognized. For instance, a transferor is considered not to have lost control if it has the right to reacquire the transferred asset on terms that effectively provide the transferee with a lender’s return. Instead of de-recognizing the financial asset and recording a sale, such transaction will be treated as collateralized/secured borrowings. Most repos and securities borrowing and lending transactions are, in substance, secured borrowings. IAS 39 requires such transactions to be treated as secured lending/borrowing transactions. The seller/borrower retains the securities lent out on its balance sheet and recognizes a liability to return the cash proceeds received. The buyer/lender recognizes a financial asset for the right to receive "sold" or lent under a repo or securities lending transaction is not derecognized.

Loan impairment

A bank converting to IAS should consider how it calculates its allowances for loan losses. IAS 39 requires that a bank determine whether a cost-based financial asset is impaired at each balance sheet date and, if so, estimate the cash flows expected to be received and discount them based on the contractual interest rate applicable to the loan. Currently, Philippine banks provide an allowance for loan losses based on certain percentages based largely on the classification of loans according to guidelines set by the Bangko Sentral ng Pilipinas (BSP). The requirement to discount future cash flows using a loan’s original contractual interest rate and subsequent amortization of the discount to interest income will likely have a significant effect on the level of current loan loss allowances. Additionally, it is not clear how a company will capture the necessary statistical data to calculate losses based on historical experience as opposed to expected future losses. Banks should therefore assess their current data gathering and systems capabilities to address the requirements of IAS 39.

IAS 30 will also bring another change in the treatment of loan impairment. IAS 30 requires that amounts set aside for losses on loans and advances in addition to those losses that have been specifically identified should be accounted for as appropriations of retained earnings. Philippine banks now provide for one percent of the general reserves on their total loan portfolio as a charge against current income. Banks should consider the impact of this new requirement on regulatory capital levels, important ratios, and the formulation of their dividend policy.

Deferred tax assets

The nature of the business of banks, as well as existing tax, accounting, and regulatory rules, generally result in substantial temporary differences often in excess of total taxable temporary differences. Under ED 52, a deferred tax asset is recognized if it is probable that taxable profit will be available against which the deferred tax asset can be used. Financial institutions, banks in particular, have many of the same temporary differences as companies in other industries, but also have some temporary differences that are unique to the banking industry. Further, the magnitude of certain deductible temporary differences may be much greater than for companies in other industries.

One of the most common sources of deductible temporary difference is the loan loss provision. Banks in the Philippines have significant deferred tax assets attributable to loan loss provisions. With the implementation of ED 52, banks may have to revisit their recorded deferred tax asset. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income. By its very nature, future taxable income requires estimates and judgements about future events that, although predictable, are far less certain than events that have already occurred and can be objectively measured. It is this judgement on future taxable income that will pose the greatest challenge for management in determining the amount of deferred tax asset to be recorded. (To be continued)

(Reprinted from The SGV Review, December 2003 issue)