India is moving to the Indian Accounting Standards (Ind-AS), that substantially converge with the International Financial Reporting Standards. The implication of this on banks and other financial services entities is expected to be significant, in terms of reporting requirements and technology needs and changes in capital adequacy adherence norms. Banks must migrate to Ind-AS from FY19 onwards with recasted comparatives for FY18 and a transition-date opening balance-sheet for April 1, 2017. Other financial service entities must follow suit in a phased manner, starting FY 19.
A key area where Ind-AS’s impact will be felt is the adoption of financial instruments accounting and related disclosures.Some others are discussed here.
Impairment of loans to customers
At present, loan-loss provisions for banks’ loan portfolios are computed on a past-due basis as per RBI-prescribed provisioning methodology. Under Ind AS, the provisioning has to be done using a forward looking ‘three-stage’ expected credit loss (ECL) model for impairment, in line with the expected changes in global standards. This would have an impact on the banks’ NIIs, as interest income/expense recognition would be on an effective interest basis on all financial instruments carried at amortised cost and fair-value through other comprehensive income, including for those financial assets that have increased credit risk and those that are credit-impaired.
For stage-1 or performing assets, 12-month expected credit losses (ECL) are recognised. Interest income is calculated on the gross carrying amount of the asset, without deduction for credit allowance.
For stage-2 or under-performing assets, lifetime ECL are recognised. Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the financial instrument. ECL are the weighted average credit losses with the probability of default as the weight. Interest income is calculated on the gross carrying amount of the asset.
For stage-3 or non-performing assets, lifetime ECL are recognised. Interest income is calculated on the net carrying amount, net of credit allowance.
Under the current Indian Generally Accepted Accounting Principles (GAAP), the interest is calculated on normal accrual basis for good loans and on a receipt basis for impaired loans.
The RBI Implementation Committee has evaluated various alternatives which RBI will look at before finalising the norms. One of the recommendations is that banks make provisions as per ECL or RBI prudential norms, whichever is higher. The excess provision, over the ECL model, to meet the minimum threshold rate of RBI would be parked in special reserve. It is expected that RBI would come up with detailed guidelines for banks after assessing the impact on the pro forma financial statements required to be submitted by the banks for the half-year ended September 30, 2016, latest by November 30, 2016.
Financial assets: Classification and measurement
At present, RBI regulation measures financial instruments mostly at cost, unless it is categorised at Available for Sale (AFS) and Held for Trading (HTM); MTM loss is recorded, but not the gain. Ind AS significantly changes this.
Under Ind AS, all investment in equity instruments held for trading will be classified as Fair Value through Profit and Loss (FVTPL), with fair-value changes recognised in profit-and-loss. For all other equities, the management has the ability to make an irrevocable election on initial recognition, on an instrument-by-instrument basis, and classify them as Fair Value through Other Comprehensive Income (FVOCI), fair-value changes recognised in equity as part of OCI (OCI) rather than profit or loss required for FVTPL. If FVOCI is preferred, all fair-value changes, excluding dividends that are a return on investment, will be included in OCI. There will be no recycling of amounts from OCI to profit-and-loss.
Investment in debt instruments is also fair-valued unless it meets certain criteria. The classification for debt instruments is dependent on the business model assessment, as determined by the bank managment, and is based on whether it would meet the ‘Sole Payment of Principal and Interest’ (SPPI) criteria. There was a similar model in the erstwhile regulations; however, it is likely that under the new framework, there will be more flexibility on determining the business model. If the SPPI condition is met and the business model is to collect contractual cash-flows, the instrument would be classified at amortised cost. If it is to collect contractual cash-flows and also retain the ability to sell, the instrument would be classified as FVOCI. Under the FVOCI model, movements in the fair-value will be taken through OCI, except for the recognition of impairment gains or losses, interest revenue and foreign exchange gains and losses, which are recognised in profit-and-loss. Where the financial asset is derecognised, the cumulative gain or loss previously recognised in OCI is reclassified from equity to profit or loss. All debt instruments for trading would be classified as FVTPL with fair-value changes recorded in profit-and-loss.
Under the Indian GAAP for banks, interest-rate swap that hedges for interest-bearing assets or liabilities should be accounted for on accrual basis. Under Ind AS, all derivatives will be fair-valued. Further, both positive gains and negative losses resulting from changes in fair-value of derivatives will get recognised. Whether the change in fair-value gets recognised as profit or loss or OCI will depend on whether hedge-accounting has been followed and also on the nature of the underlying derivative instruments.
Presentation and financial risk disclosures
Ind-AS introduces additional disclosure requirements relating to credit risk and ECL allowances. Understanding the data and systems needed to meet these will be critical to ensuring the implementation of the new standards.
From an investor perspective, it would take some time to benchmark the changes as the new standard would be adopted only from January 1, 2018. Also, the model of impairment under ECL provides significant flexibility in terms of designing the ECL. This will worry investors and regulators who are habituated to look at consistent, straight-forward norms, ones that leave very less to the judgement of the management of the banks. Finally, extensive disclosure under Ind AS will enhance the understanding of the banks’ financial statements.
The author is partner, PriceWaterhouse & Co.
Views are personal