The end of 2018 spelled out relief for most accounting and financial modelling experts responsible for the implementation of IFRS 9: all necessary changes to accounting policies, models and methodologies were designed and enforced, all in time for a lovely Christmas break at the end of 2018!
But for another group of professionals, namely auditors, the extensive work needed only begun… Just like non-auditors dealing with the implications of new standards IFRS 9, IFRS 15 and IFRS 16, some auditors might also find themselves asking ‘do we really need more standards?’
As at 31 December 2018 entities applying International Financial Reporting Standards prepared their first annual financial statements in accordance with IFRS 9, the new standard, thus embracing its principles of financial instruments accounting.
Accounting for financial instruments as a process
Compared to the old standard, IAS 39, it can be noticed that under the new standard IFRS 9, the accounting treatment of financial instruments is strongly aligned with how an entity actually manages its positions in financial instruments.
There are fewer “bright line rules” and strict thresholds that entities have to apply.
In contrast, accounting has to mirror the business reality of financial instruments application and the way an entity manages its exposures in financial instruments.
There are two evident examples of this trend:
- Impairment of financial assets
To apply the three-stage general approach to impairment, an entity is required to model not only credit risk parameters of exposures and portfolios, but also include in the modelling the best available estimates of future changes, referred to as “forward-looking information”.
As both risk parameters and expectations regarding the future change constantly, the impairment model has to undergo testing, validation and re-parametrisation.
As a result, the impairment model resembles a living being, evolving from one reporting period to the next, which in fact makes the calculation of impairment charges an ongoing process.
- Classification of debt financial assets
Under IFRS 9 entities classify debt instruments to a given category in accordance with a business model, which reflects the purpose that those assets economically serve in an organisation.
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Although business models are not expected to change frequently, neither are they determined once and forever.They are adjusted by entities to the fluctuating business reality, which may eventually require reclassification of financial assets maintained within a changed business model.
As shown by both examples above, accounting for financial instruments under IFRS 9 is an on-going process, where changing model assumptions and judgements may change from one reporting date to the next one.
This phenomenon will have an impact on internal auditors.
When they when examine an entity’s transition to IFRS 9, they will have to assess all control mechanisms surrounding the accounting processes and ensure that adapting assumptions and judgements to changing business conditions does not reduce their quality.
The importance of judgement
As mentioned, IFRS 9 requires an entity to align the methodology used for calculation of credit allowances with the credit risk management model used.
As a result, approaches to calculation of credit allowances will differ from entity to entity, and the results of calculations will depend on the quality and reasonableness of assumptions and judgements made by entities.
Impairment of financial assets is not the only area of IFRS 9 where judgement will have an essential impact on the quality of reported numbers.
The choice of criteria applied to determining if a modification of contractual terms of a debt instrument should result in derecognition of such a modified asset, is only one example of such areas.
Changes for internal and external audit processes
Obviously, the 2018 year-end financial statements is the subject to external audit processes, and it is expected that auditors of financial statements will add value to the final implementations by helping their client achieve a higher degree of comparability with peer entities.
It can also be expected that in the first half-year of 2019 implementations of IFRS 9 will be undergoing internal audit scrutiny both in financial institutions and non-financial corporations.
The main difference in the approach to auditing IFRS 9 implementation between an external audit firm and an entity’s internal audit team is that:
- External audit will assess the implementation from the point of view of the methodology applied and the information disclosed in the financial statements, but
- Internal audit will primarily examine and evaluate internal processes put in place.
Internal auditors will have an even more difficult task to perform than external auditors of financial statements.
The main reason is that IFRS 9 only provides information on what must be calculated, recognised and disclosed, and says nothing about the underlying processes in an organisation.
Independent of that, the scope and magnitude of changes required by IFRS 9 make it necessary for both internal and external auditors to fully understand not only the requirements of IFRS 9, but also its logic, mechanics and appropriate measures needed for proportionate implementation in entities of different complexity and exposure to financial instruments and risks, which they generate.
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