IFRS 9 - Why be sensitive about sensitivities?

04 July 2018

After four long years, pens have finally started to go down on the IFRS 9 transition. Despite expectations to the contrary, provisions have been relatively stable so far (save for transition adjustments), thanks in large part to stable economic outlooks. Nevertheless, analysts, regulators and others are already asking 'what if' questions, seeking to understand the new approach and its inherent sensitivities. So far, we’ve seen few such disclosures - probably due to first-mover reluctance, post-transition exhaustion and uncertainty about what disclosures might actually be meaningful. Even so, it wouldn’t be our approach. Here’s why…

Two things are critical when thinking about what disclosures to provide – firstly, how IFRS 9 came to be, and secondly, why they’re required to begin with. On the former, the new expected loss model is meant to provide an earlier warning to financial statement users about management’s perception of changes in the risks underlying the portfolio by reflecting them in impairment provisions on a forward looking basis each period. On the latter, IFRS requires disclosure of information about the assumptions about the future and other major sources of estimation uncertainty. This is so as to help users to understand the imprecision in an estimate, its sources and the possible magnitude of any change in the estimate within the next financial year. While much of this disclosure is naturally qualitative, the standard gives examples that make it difficult to argue that qualitative disclosures alone are sufficient. What quantitative disclosure to provide is a matter of judgment, though they may often include a range of possible outcomes. Think of it as laying out management’s view of the fairway.

Some argue that sensitivities that show the effect of changing only one economic variable would be misleading since there would never be an isolated change in one variable without corresponding changes in others (in the real world, that is). We agree. Indeed, the real world is complicated and so coming up with meaningful sensitivities won’t be easy. There is no ‘magic bullet’. That said, something is likely better than nothing. So, what then? One approach might include showing your math, or summarized versions of it. Expected losses are probability-weighted estimates that already contemplate multiple alternative outcomes, so, you could provide those outcomes, the probabilities assigned to them and the expected losses (i.e. unweighted) were they to arise. Remember too that sensitivities should consider all variables, not just macroeconomic ones. There are two key advantages to presenting this information – that it doesn’t require additional analysis, and that (hopefully) it aligns with information that’s already being prepared and reviewed internally by management and audit committees. On the other hand, a significant disadvantage of this approach is that disclosing scenarios might be misleading if they aren’t reasonably possible of occurring in the coming year. The math is only half the story too. Like most aspects of IFRS 9, the models themselves are extremely complicated (even for those who built them), so ensuring you tell the whole story – including the methodology applied and its limitations, will be key.

Why take the leap now? For starters, because there’s safety in transparency. As we often hear from our own clients, bad news might not be avoidable – surprises usually are. During the financial crisis, fingers pointed quickly at shortcomings in disclosures and accounting, so better to build the ark before the storm. Remember too that these disclosures take time to assess, debate, develop and embed (not to mention, audit).

For those who wait to find out what others are doing, it may be too late by the time they see.

Chris wood

This month's guest blogger is Chris Wood, Banking Partner and IFRS 9 specialist, connect with him on LinkedIn here.  

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