Banking Portfolio Impairment Test Outcomes According to IFRS

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This paper addresses challenges to the successful implementation of International Accounting & Auditing Standards in commercial banks resident in Albania.

The objective of this research paper is to identify, assess and manage the translation and transplanting process from current accounting framework of banking system with the International Financial Reporting Standards (IFRS).

Our focus regarding IFRS in banks is restricted in the context of the risk of incurred but not reported in a loan portfolio, which may distort the reporting of financial position and performance by risking the readers to undertake wrong decisions.

The IAS 36 'Impairment of Assets' and IAS 39 are of the more complicated standards. This makes getting the accounting and disclosures right more of a challenge.

So far, through this paper we suggest some accounting updates to mitigate the risk of asymmetric information and moral hazard in a commercial bank loan portfolio. It is arguably the case that, these issues are regarded as unique to emerging/developing markets, because of accounting information not in compliance with international standards.

The accounting criteria and policies used in commercial banks within Albania may compromise banks financial statements, and may contain discovery risk regarding the loan portfolio quality, capital adequacy, etc.

It is an imperative goal for all the banks and supervisors, to avoid that loans be quoted as being higher than their achievable value. In this respect, the required input parameters are defined consistently and fully compliant with international accounting standards serving to mandatory bank risk identification, measurement and mitigation, by finding out in time the signs of impairment.

The study has been implemented in BIS Banca Albania and being extended in four stages:

Stage 1, is based on diagnostic development of the current status through identification of sources for loan impairment.

Stage 2, involves a detailed assessments on all ingredients of loans portfolio, by discriminating cases with incurred but not identified and incurred but not reported losses.

Stage 3, deals with the recognition of impairment loss, recoverable amount and/or asset's cash-generating units, interrelating the 'impairment and uncollectibility financial assets' with the identification of differences of estimated recoverable amount, fair value of collateral up to carrying amount of the loan.

Stage 4, concludes with issues on rating scales according to risk identification per each asset portfolio ingredient. The main findings regard with transition matrix, Migration Rates, Categorization as per Private Individuals, Micro SME's, Corporations, and as per class, subclass, analytic, etc.

Introductory Issues

This paper addresses challenges to the successful implementation of international accounting standards in commercial banks, by dealing with asset quality issues focused on impairment loans presence.

It describes and outlines the methodological approach followed, diagnoses the identified problems and makes suggestions for initiatives that could enhance the implementation of international accounting standards.

The International Financial Reporting Standards are the assurance framework to produce and provide relevant information to a broader set of interested parties interrelated with a commercial bank activity. The principles of full information and periodic profit calculation are governed by the basic principles of clarity, relevance, comparability and reliability [accurate, objective, prudent and complete] to give true international comparability.

Valuing the loan portfolio of a commercial bank is an increasingly important enterprise for a number of reasons. Actually all the banks in Albania are mostly structured with foreign capital. The merger wave during the last 5 years was an impregnable force within the banking industry of Albania. Both acquiring and target banks needed an overall loan portfolio assessment according to market value in order to negotiate reasonable terms of the business combination. Our banking system experienced an intensive campaign of acquisitions motivated by a perception of a positive capital base, market opportunities and sustainable profitability.

The commercial banks in Albania are required by Ministry of Finance (MoF) to translate existing accounting according to the International Financial Reporting Standards [IFRS]. This implies to examine the total asset portfolio quality for the presence of Loan Impairment.

Commercial banks are unique, compared to other financial institutions and corporates, because they play a pivotal role in the payments system, enjoy tremendous leverage in balance sheet structure, and by the recent crisis development should be supervised more intensely. Further, financial and regulatory accounting standards now require a disclosure of the fair value of financial assets and liabilities. It is a practical response to a latent call for greater transparency coming out from shareholders, depositors/creditor and other stakeholders, and regulatory authorities [Bank of Albania].

In contrast to Bank of Albania Manual of Accounting, the idea of creditor protection is served through transparent and economically relevant information rather than through conservative accounting, which tends to understate assets, and consents the formation of undisclosed reserves.

So far, the subject matter of the work was 'the identification, measurement and posting into accounts of the impaired loans' by performing a full range impairment test on loans portfolio of BIS Banca [Veneto Group]'. It covered a time segment by the end of 2008 and the first semester of 2009'.

It assembled a tutorial profile, designed to resolve the complexities of impairment loans assessment in general and the application of IFRS eligible models in particular.

What worked out do not intends to make the reader an expert in the field but at least equip with the working tools and applications used and awarded to be very factual.

Diagnostics Prerogatives

It is very important to find out that market forces are diverting all banking structure to be highly responsive in full compliance with high standards of international accounting, but our experience advises that there are some countervailing disincentives operate to discourage such compliance. More emphasis should be placed on effective accounting and auditing translation process into IFRS to underpin such institutionalized regulation.

Any reader of this prose must keep in mind that international accounting and auditing standards themselves do not set out requirements as to how such effective regulation should be exercised. Guidance is not provided on how to "import" international standards into national legislative and regulatory systems, on the design and operation of appropriate regulatory frameworks, or on the interfaces with other regulatory instruments and institutions (such as those for banking and securities regulation) which could contribute to the monitoring and enforcement of international standards.

As currently drafted, international accounting and auditing standards implicitly assume the existence of legal, institutional and policy conditions ("preconditions") which are often undeveloped or still absent in Albania.

The IFRS concerns should be prioritized towards bank assets quality, and to this point we have to endorse the proactive role of high-quality external financial reporting, and prompt the efforts to promote the implementation of most prominent operational course.

There is an urgent need the BoA and MoA, we propose to specify by scaling up the circumstances in which the use of "full" IAS/IFRS is appropriate, and to develop different standards that would meet the needs applicable to the users of financial statements of other entities, particularly on loans quality.

Many of us continue to have misunderstandings with respect to the very nature of international standards, which complicates efforts to plan, define and measure progress towards successful implementation.

Lack of human and financial resources is a significant impediment to the

implementation of international standards. Mobilizing the necessary resources on a sustainable, long-term basis is a major challenge.

The model introduced in BIS Banca may be applicable in all commercial banks portfolios within Albania, where the relative compatibility of the ingredients converges, and where exists an propensity to easy access to emerging international best practice and consensus. Such tenets should explicitly consider these inherent limitations.

Taking into account this climate we started up by designing and putting into operation an examination process, which involved:

(a) Identification Approaches;

(b) Measurement Techniques;

(c) Defining the Loan Loss Provisions [LLP];

(d) Correct Posting into Accounting;

(e) Checking and measuring the Effects on Loans Portfolio;

(f) Re-examination of the Bank's Equity Position;

(g) Disclosing in full compliance with IFRS;

Impairment Identification Approaches

The International Financial Reporting Standards (IFRS) require a periodic audit of the possible indicators for a sustained impairment. The polygonal goal of this requirement includes the following most crucial concerns:

To avoid that loans be quoted higher than their attainable value;

To determine the Mandatory Risk Identification & Loan Loss Provision magnitude;

To customize the Procedures on Risk Measurement, and Risk Audit on loans portfolio;

To find out systematically the Signs of Impairment on Every Balance Sheet Date;

The widespread arguments that emerged from the study findings shed light on the most common categories of obstacles encountered. Fundamental to the identification of the impairment loans was a clear understanding of what an impairment is, what approaches and benchmarks requires, and what it means to adopt them. Failing this, the banks are unable to set concrete implementation targets or to measure progress in reaching those targets.

The paper suggests that clarity of understanding helps to explain the significant gaps between prior self-assessments of compliance and those required by IFRS.

The First Step was dedicated to the identification of sources for loan impairment on qualitative and quantitative premises, taking into account the assessment of BIS Banca's financial standing, history of transactions, and legal/contractual risk [shareholders, CB, Depositors, Borrowers].

The Second Step, was centered on Data Base Configuration for all the following components:

(a) Level of the Loans Portfolio at Risk,

(b) Inventory of Loss-Incurring Events,

(c) Inventory/Segmentation of Loans per Debtor/Risk Category [breach of agreement/contract, bankruptcy, dormant, ecc.];

(d) Reconfiguration and Checking with Bank of Albania provisions standards [Past Due, Special Attention, Sub-standards, Doubtful, and Default].

The Third Step, was the construction of a guideline for the Detailed Assessments by discriminating cases With No Objective Evidence Of Impairment (in line with IFRS 39).

During these stage of the project we faced with confusing interpretation of the impairment concept because the IFRS 36 covers impairment in physical/material assets and IFRS 39 deals with impairment in financial assets, which was our case.

Another concern is that the non standard way of IFRS interpretation may hamper rigorous and uniform application of them. From our contacts with other banks risk managers we deduced that some of them have adopted only selected standards or selected paragraphs of a standard, by advocating the thesis that adopted IFRS should enter in force as of a particular date in the past, with no account taken of changes since then.

These misunderstandings provide high risk of a false understanding of the actual standards gap and the true implementation challenges they face.

Also fundamental to the identification of impairment according to IFRS and Basel II should be an unequivocal relationship between the Prospective Risk [expectations] and actual risk present in the loan portfolio. This forwards a special attention to measurement techniques.

Measurement Technique Selection: The Algorithm

The optimal decision regarding which is the proper measurement technique on impairment loans led to a detailed design of the Algorithm.

The drafted protocol included these ingredients:

1-The risk detection per individual loan contract made up the transition from initial risk perception to a real one.

2-Objective Evidence of Impairment was developed in accordance with §59 IAS 39], by finding out each individual credit exposure.

3-The review of the optimal decision and shifting up to a rational decision by putting as the most emergent objective the Asset Impairment Test for each credit file in detailed reference and compliance with IFRS 36, IAS 39, IAS 38, etc.

4-The impairment loss recognition and calculation process has included:

(a) the 'impairment and uncollectibility financial assets',

(b) the estimated recoverable amount plus fair value of collateral with the carrying amount of the loan.

(c) the posting protocol and the display of the difference in the Balance Sheet [Acc., 'Provision for Possible Losses On Loans and Advances' (i.e. the result of impairment test].

(d) the opening and activating the account 'Allowance for loan losses' and providing the protocol how to review periodically the effect of impairment in loan loss provision.

5-The Measurement/Calculation of the impairment was correlated with the paths based on the following itinerary:

(a) The decision to implement 'The Accrual Interest Measurement/Calculation Approach' in full compliance with IAS 18;

(b) The application of Appropriate Valuation Model as described in IAS 28.23 in connection with impairment test.

(c) The categorization of Loan Loss Provisions,

(d) The Alternative Valuation of Individual Asset,

(e) The Reversal of Impairment Loss,

(f) The Non- Recognition of Impairment Losses,

(g) The Allocation of Individual Loan Loss Provisions,

(h) The Allocation of Portfolio Based Loan Loss Provisions, and

(i) The Back Testing.

6-Preparing the conclusive stage, by redesigning and/or restructuring:

(a) The Data Flow [Input, Processing and Information Output] between Risk Department and Accounting Department;

(b) A Sustainable Standard/Systematic Procedure on impairment testing

There are some discrepancies amongst company law, accounting law and IFRS. The company law does not authorize a company to account for the amount of the correction of an error retrospectively. IAS/IFRS require retrospective accounting so that the correction of an error is excluded from the determination of profit or loss for the period in which the error is discovered. Such inconsistencies generate difficulties to divert on IFRS, even more it risk to become unable to comply with both domestic law and international standards.

Despite this, there is also another concern, because it is not clear that the company law may authorize a statutory auditor to disclaim his or her opinion. This would conflict with ISA, which requires an auditor to disclaim an opinion when the possible effect of a limitation on scope is so material and pervasive that the auditor will not been able to obtain sufficient appropriate audit evidence.

We must consistently take into consideration that IAS/IFRS are standards for the preparation of general-purpose financial statements, aimed at meeting the needs of a wide range of users, but predicated on the assumption that placing primary emphasis on the needs of shareholders will result in measurement, recognition and disclosure requirements that also meet the needs of other users.

The banking industry in Albania is more than 70% owned by foreign shareholders and almost from EU countries with accounting standards converging progressively with IFRS. Lack of appropriate linkages between general-purpose financial reporting and regulatory reporting [Bank of Albania reporting] in banking system within Albania creates an inconsistency, because BoA has the power and authority to impose different special-purpose financial reporting obligations designed to meet its specific needs on the quintessence of prudential and supervisory purposes reporting.

The Approach for Loan Loss Provisions & Risk Index

What emerged from the selection of measurement technique was the apprehension how to manage the interface between general-purpose and regulatory reporting.

It is customary to encounter cases where rules designed by BoA for regulatory reporting on loan loss provisioning in the banking sector, or on the timing of income recognition, have an impact on the general purpose accounting information, particularly when a single set of financial statements is intended or required to meet both objectives.

Hence, the requirements of regulatory reporting we expect to conflict with those of IFRS, thereby precluding conquering implementation.

A temporary solution may be the convention that the banks should have the option of preparing additional financial statements in which full compliance with IFRS. This may threat for high cost implications, may breed significant uncertainties among users as to which are the "real" figures.

In addition, financial statements prepared and audited on a deliberate basis typically fall outside the scope of BoA regulatory regimes, thereby often reducing the reliance users can place on them. The advancement is promising when, instead of inserting special-purpose requirements in the rules governing general purpose reporting, the regulatory authorities [BoA and MoF] acknowledge the existence of parallel systems, and seek to minimize differences between them. To this point, it was highly probable to face a gap between portfolio at risk according to BoA criteria, which is quite similar with Basel II and relatively far away from IFRS viewpoint. Bank of Albania uses 5 categories on risk segmentation of loans portfolio [1-Past Due, 2-Special Attention, 3-Sub-standards, 4-Doubtful, and 5-Default].

Alternatively, we proposed 10 categories Risk Rating Scales according to risk identification & measurement per each asset portfolio ingredient.

0.5 Minimal Risk: Externally top rated corporate (AAA) (e.g. government linked companies in externally AAA-rated OECD countries)

1.0 Excellent credit standing: Best rating that can be achieved from a customer. The company has a very strong equity base and a healthy financing structure.

1.5 Very good credit standing: All payments - capital and interest - can be fulfilled also in the long run is very high. The company has a strong equity base and healthy financing structure.

2.0 Good credit standing: All financial obligations can be expected to be fulfilled in the medium term. Good equity base and healthy substance.

2.5 Average credit standing: No interruptions of the servicing of principal and interest payments. Reasonable financing structure with satisfactory equity base.

3.0 Mediocre credit standing: No interruptions of principal and interest payments, however increased sensitiveness to economic environment. Limited financing flexibility.

3.5 Weak credit standing: Weak profitability and has only Limited Financial Flexibility, which could negatively affect timely servicing of principal and interest payments.

4.0 Very weak credit standing: (resp. no information): Company with very weak profitability and inadequate financing structure. Can prevent full and timely servicing of financial obligations.

4.5 High probability of default: Company with very weak profitability and problematic financing structure. Partial loss of principal or interest has to be factored in. Work out case.

5.0 Default (definition based on Basel II (EU Paper, Annex VII, Part 4, § 44)): Financial obligations could not be completely fulfilled in time.

UNRATED−Loans which are not rated yet

Transition Matrix, Migration Rate and Posting

The above suggested risk rating scales are the guideline for the Transition Matrix and Migration Rates. It is also co-dependent with respective class arrangement as per Private Individuals, Micro/ SME's, Corporations going further as per class account, subclass account, analytic account, etc.

Checking all loan contracts files to examine the risk rating scale class insertion was correlated with the status of collateral presence, its quality and market value recent history. Consequently, a reassessment of collateral on all inventorized Collateral Dependent Loans [recommending TeGOVA standards] enriched the incorporation of loan loss provisions for contingent liabilities and commitments. All loan origination contract hosted a collateral sub-contractual component.

Finally a Risk Index was calculated based on the following formula:

RI = [E(ROA) + CAP] / σROA

where

RI = f (credit risk, interest-rate risk, liquidity risk,…..)

Before going beyond to posting operations were disclosed all accounting definitions dependent to the IFRS translation standpoint.

The crucial accounting concepts referred to impairment are:

Impaired Assets

An asset is considered an Impaired Asset when its Carrying Amount[1] > its Recoverable Amount[2].

[1].CARRYING AMOUNT =the amount at which an asset is recognized in the balance sheet after deducting accumulated deprecia­tion and accumulated impairment losses.

[2]RECOVERABLE AMOUNT=The higher of an Asset's Fair Value less costs to sell (sometimes called net selling price) and its value in use.

â-¬The Fair Value =the amount obtainable from the sale of an asset in a bargained transaction between knowledgeable, willing parties.

â-¬Value in Use=the discounted present value of estimated future cash flows expected to arise from the continuing use of an asset, and/or from its disposal at the end of its useful life.

The Contractual Cash Flows & Historical Loss Experience claim the difference between Basel II and IFRS-reporting, because Basel II encourages the usage of 'probabilities of default' in order to quantify 'expected losses' whereas IFRS requests that only 'incurred losses' may be reported (IAS 39.BC1 09).

The IAS/IFRS key reference for tangible assets impairment is the IAS 36 'Impairment of Assets', which states that the impairment has to be identified at each balance sheet date. The proposed/accepted formula:

Carrying Amount >Net Selling Price and its Value In Use

The impairment examination approach was based according to external sources and internal ones.

In the asset impairment from External Sources we included the following indices:

The market value declines [non available in Albania];

The negative changes in technology, markets, economy, or laws [non measurable];

The increases in market interest rates [questionable]

The bank stock price is below book value [[non available because there is not a Stock Market in Albania];]

Meanwhile in In the asset impairment from Internal Sources the following indices were included:

The obsolescence or physical damage;

The asset item is part of a restructuring or held for disposal;

The presence of worse economic performance than expected;

Assessment and Recognition Norms

According to IAS 39 the Bank should assess at each balance sheet date any indication that an asset may be impaired. If Yes, IAS 39.63 (for financial assets CARRIED AT AMORTIZED COST), IAS 39.66 (for financial assets carried at cost) or IAS 39.67 (for available-for-sale financial assets).

Impairment Loss should be recognized as an expense in the income statement!

The assessment is done for Assets Held to Maturity or Loans Receivable carried at amortized cost and the formula applied is:

Effective Interest Method minus Use of Allowance account.

The Amount of the Loss here is the difference between the asset's carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset's original effective interest rate! [(see IAS 39.46(c) and IAS 39.AG80 and AG81) ].

It is very important to accentuate that Assets available for sale were excluded from impairment test.

Taking into consideration that there is no active market for financial instruments, we suggested fair value assessment by using a Valuation Technique (VT).

The valuation technique we selected was configured one which contains parameters of recent arm's length market transactions, the current fair value of similar instrument, DISCOUNTED CASH FLOW and OPTION PRICING MODELS [Our Suggestion].

The Objective for this selection is To establish what the transaction price would have been on the measurement date in an arm's length exchange on normal business considerations.

From impairment loss examination were exempted Short term loans (<1 year) /fair value = carrying amount [including accrued interest]. A comprehensive approach was devoted to Floating Interest Rate Loans & Advances (IAS 39.AG6-8) and Fixed Interest Rate Loans & Advances (IAS 39.AG6-8).

The Decision Tree Scheme for Loans and Advances to Banks and/or to Customers

IAS 39, 58 is as following:

Imperative Tenets:

Impairment loss is recognized only when it has been incurred (IAS39.IN20). Loan Loss provisions are categorized as:

Individual loan loss provisions (individual value adjustments) for claims in the balance sheet (IAS 39.63) and for off-balance sheet items and

Portfolio based loan loss provisions for groups of financial assets with similar credit risk characteristics (IAS 39.64).

Provisions for contingent liabilities and loan commitments

The Carrying Amount of the asset shall be reduced either directly or through use of an allowance account (IAS 39.63).

The amount of the loss shall be recognized in profit or loss [Acc. Posting].

The Collateral is not recognised in the IFRS-balance-sheet as an asset separate from the impaired financial asset before foreclosure.

IFRIC 10: 'Interim Financial Reporting and Impairment'

On 20 July 2006, the International Financial Reporting Interpretations Committee (IFRIC) issued IFRIC 10 Interim Financial Reporting and Impairment. The Interpretation addresses the interaction between the requirements of IAS 34 'Interim Financial Reporting' and the recognition of impairment losses on goodwill under IAS 36 'Impairment of Assets' and certain financial assets under IAS 39 'Financial Instruments: Recognition and Measurement'.

IAS 34.28 requires an entity to apply the same accounting principles in its interim financial statements as are applied in its annual financial statements but also states that "the frequency of an entity's reporting (annual, half-yearly, or quarterly) shall not affect the measurement of its annual results. To achieve that objective, measurements for interim reporting purposes shall be made on a year-to-date basis." IAS 36, paragraph 124, states that "An impairment loss recognised for goodwill shall not be reversed in a subsequent period."

IAS 36.124, states that 'an impairment loss recognised for goodwill shall not be reversed in a subsequent period.'

IAS 39.69, states that "Impairment losses recognised in profit or loss for an investment in an equity instrument classified as available-for-sale shall not be reversed through profit or loss."

IAS 39.66, requires that impairment losses for financial assets carried at cost (such as an impairment loss on an unquoted equity instrument that is not carried at fair value because its fair value cannot be reliably measured) should not be reversed.

So far the main issue is:

Should an entity reverse impairment losses recognized in an interim period on goodwill and investments in equity instruments and in financial assets carried at cost if a loss would not have been recognized, or a smaller loss would have been recognized, had an impairment assessment been made only at a subsequent balance sheet date?

This Interpretation states that:

where an entity has recognized an impairment loss in an interim period in respect of goodwill or an investment in either an equity instrument or a financial asset carried at cost, that impairment should not be reversed in subsequent interim financial statements nor in annual financial statements.

The IFRIC concluded that:

â-¬An entity shall not reverse an impairment loss recognized in a previous interim period in respect of goodwill or an investment in either an equity instrument or a financial asset carried at cost.

â-¬An entity shall not extend this consensus by analogy to other areas of potential conflict between IAS 34 and other standards.

The Interpretation should be applied to goodwill prospectively from the date at which the entity first applied IAS 36, and to investments in equity instruments or in financial assets carried at cost, prospectively from the date at which the entity first applied the measurement criteria of IAS 39.

Therefore, the prohibitions on reversals of recognized impairment losses on goodwill in IAS 36 and on investments in equity instruments and in financial assets carried at cost in IAS 39 should take precedence over the more general statement in IAS 34 regarding the frequency of an entity's reporting not affecting the measurement of its annual results.

IAS/IFRS and Calculation Procedure and Impairment Test Results

The common calculation procedure remains unchanged and is as follows [IAS 39.63]:

1-Full Exposure of Asset's Carrying Amount = All Amounts Due [principal, interest, discounts]

Minus (−)

2-Present value of expected future cash flows [discounted at the financial instrument's original effective interest rate] = Estimated Recoverable Amount = Market Value (in case of Secondary Market price quotations)

Minus (−) Fair value of the collateral (if any; Note: fair value less costs for obtaining the collateral)

Equal= Valuation Adjustment Requirement (If >0)

The calculation is based on the days past due (dpd).

The exchange rates at the year-end used by the BIS Banca in the preparation of the consolidated financial statements are as follows:

31 June 2009

Lek/1 US Dollar 94.5462

Lek/1 Euro 131.9332

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