Bank Loan Loss Accounting - Essay Example

Bank loan loss accounting Introduction Over the years, there has been what could be termed as a weakness or a limitation on banks’ financial statements in that they present a figure which does not provide for potential losses due to defaulters (Damant Pg. 14). This has led to the need for changing the current model from incurred loss model and makes it an expected loss model. The international Accounting Standards Board set a new standard known as IFRS 9 Financial Instruments which describes the expected loss model. This was a replacement of IAS 39: Financial Instruments: Recognition and Measurement (Christian and Norbert, Pg. 39). According to IAS 39, a firm is supposed to recognise its financial assets as well as liabilities and also some contracts regarding financial instruments (Kawai and Eswar, Pp. 148). According to this standard, a financial instrument should be recognised for the first time once a firm has become part of a contractual provision of that instrument (Anagnostopoulos and Buckland, Pg. 367). The amendment that was made in the year 2004 explained on how transitions should be made and when profits and/ or losses should be recognized initially. The IFRS 9 was established in the year 2014 and is expected to take effect in the year 2018 hence replacing IAS 39. This essay focuses on the changes that are set to be implemented following the enforcement of IFRS 9. It will specifically focus on bank loan loss accounting. Proposed changes in accounting standards for bank loan loss accounting IFRS 9 Financial Instruments is set to become effective by the year 2018. However, the new standard has already been developed and its likely changes to the IAS 39: Financial Instruments: Recognition and Measurement have already been proposed. It is a move that could see the financial statements of banks become more accurate as compared to the way they are presented currently. The overall effect will be that the statements will present a true image of the banks to investors and hence investors will have more confidence investing in the banks (PricewaterhouseCoopers LLP, Pg. 97). Following its implementation, banks will be setting a side a relatively higher amount of reserve which will be used to cover for potential losses. Therefore, the profits or loss stated in the income statement of the bank will have a high degree of accuracy. In the current system, banks would still record a profit in their income statement even in the event that they are aware that the borrower will not pay back the loan and hence they overstate the profits or in other words they prepare a financial report which does not present the true position of the bank at the time a factor that could negatively influence the decisions made by the investors. According to the International Accounting Standards Board (IASB) chairman Mr Hans Hoogervorst, the changes are significant in that they will help in increasing the investor confidence in both the financial statements as well as the financial systems as a whole. Among the changes that IFRS 9 will bring are discussed as follows; Asset Impairment First, the clause in IAS 39 which depicted that financial asset impartment should be recognised after a loss has been incurred was changed. According to this clause, evidence has to be provided about the impairment of such asset has to be provided prior to any provisions being made (Christian and Norbert, Pg. 46). IFRS 9 however is set to bring a change in this clause. The financial asset impairment will be recognised before the actual loss occurs (International Monetary Fund, Pp. 374). It will be recognised once the loss is expected to occur. In other words, a loss should be provided for in the financial statement of a period regardless of whether it has actually occurred or not. Therefore, the losses are recognised before they actually occur. It is not easy to determine precisely whether a loss will actually occur or not. Hedge accounting The other change that will come with the implementation of IFRS 9 will be on hedge accounting. This is concerned with the risks that are associated with the various assets. There will be an overhaul change in hedge accounting (IFRS foundation, Pg. 23). In the new standards, there was to be enhanced disclosures regarding the activities carried out for risk management. As a result, the users of financial statements will be able to get more information regarding the risks of the assets and the effects that hedge accounting will have on the statements. They are in turn able to make decisions that are well guided. In general, this change will help investors in making good decisions in regard to banks as the financial statements will indicate the risks associated with the venture. Credit risks The final change will be on the credit risks. Under this, any gains that will emanate from the deterioration of a bank’s own credit risk on loans and other liabilities will not be included in the profits and/or losses (IFRS foundation, Pg. 4). Therefore, in the event that a bank’s loan increases in value, the difference will not be recognised as a profit. Similarly, if the value of the loan decreases, the difference will not be recognised as a loss. The difference in change in value of a loan was being recognised as a loss or profit in the old regime. Wharton Research data Services (WRDS) This is a database that is used by scholars, researchers, and other academicians as well as business people to get information that can help them in their research and can guide them in decision making. The kind of data that can be obtained from this storage system is information on marketing activities, commerce, economics as well as any financial related information. Among the information that can be gotten from this data base is information regarding whether banks have been effective in determining and/or disclosing the fair value of their assets. The following formula can be used for this purpose; LNSFV/LNSGBV = α0 + α1LNSIV/LNSGBV + α’x + ε1 The figure obtained here is the disclosed fair value of loans that have been provided. It compares to the book value of the asset before the loan has been given. Other fomulas that can be used are; 1 LNSFV/LNSGBV = α0 + α1LNSIV/LNSGBV + α2ROA + α3CL+ α4GROWTH +α5T1CR + α6NLNS/TD+ α7LOGLNS + α8LOGTA + ε1 (1) 2 CEMV/LNSGBV = β0 + β1LNSIV/LNSGBV + β2(CNLIA × NLIA)/LNSGBV+ β3NLIA/LNSGBV + ε2 (2) 3 LNSIV/LNSGBV = γ0 + γ1RLNS + γ2NPL/LNSGBV + γ3CL + ε3 (3) Form 10-K and other Public Disclosures The areas that should be filled in this form are; The accountant report; this is a report whereby the accountant gives his/her view regarding the asset. The report should include the date and the name of the city where the it was issued. It should be signed by the accountant and should include all financial transactions related to the asset. The other part that should be filled is information about the participation in sanctionable activities and finally the consent of Independent Registered Public Accounting Firm. SAP ERP This is a software used in enterprise resource planning and was developed in a Germany by a company known as SAP SE. the software has a number of modules which are applied in various business sections. It is able to collect and combine data from the various modules and provide the whole data package to the organization. This gives the organization an enterprise resource planning. The company should be in a position to integrate its data using this software. In fact, integration is the major factor to the success of implementing this software. Therefore, the expertise of the company in integrating this software is a major factor to success and also its ability to integrate the modules. It should be noted that the SAP ERP has cost benefits to the company and therefore aids in the profitability of the company. For a company to fully implement and install all the modules of this software, it can take a relatively long time like years. It also spends a considerable amount of money. However, the long term benefits that the software offers to the company are worth the initial costs. System Application Product (SAP) is software that is used in organization to increase the efficiency of their operations. It can be integrated with ERP to help in insight of organizational activities. The ERP gives room for universal integration and unity of the organizational activities. The information it gives is up to date and can be used for the purposes of valuing the assets. The updating of information using this software is done once. It can increase the accuracy of valuing assets. SAP ERP has a number of advantages and disadvantages. Some of them are discussed as follows; Advantages; SAP ERP is very essential when it comes to globalization. The world today has trended towards globalization. SAP ERP allows for global integration. For instance, the software is able to bridge the differences that exist in currency exchange rates, cultural differences as well as language barriers. These are some of the factors that negatively affect globalization. The update can be done just for one time. Once this has been done, implementation can be done to the whole company. This makes it easy to implement and update the software. In the long run, it actually lowers the costs of implementation. The other advantage is the manner with which this software provides information. Real time information can be obtained through the help of SAP ERP. In other words, information is received as it happens. This is important in that the possibilities of errors are reduced significantly. The accuracy of resultant data is therefore high level. The software is also important in that it provides a more efficient environment for workers. When employees have an efficient work environment, they are able to give their best. In other words, their productivity is high. The overall benefit is that the company will have a better productivity and hence profitability. Finally, it is possible to customize the user interface. Therefore, the end users have a chance to influence the operational structure of the software and or the product. The fact that the interface can be customized means that the users can design it according to their preference. Disadvantages; There is a risk in implementation the software. The project may fail and not go in the direction it was intended to. This might have high and very negative costs implication on the company and will affect profitability. The pay back period of the company is usually long. The company will take relatively long time before it starts getting profits from return on investment. This is a disadvantage considering that companies will always opt for a project that gives them profits fast. The software is not highly flexible. For instance, business organizations have different business models. There are some models which SAP ERP may not fit in. This calls for customization. Despite the fact that it is possible to customize, it is also very expensive to successfully customize. Finally, there is a contract that bids the management and the vendor of the software. This contract bids until it expires. In the event that the company wishes to change the vendor, it might become impossible or it is too expensive to switch vendors. Switching vendors has cost implications on the company and hence affects profitability. Conclusion Banks hold a lot of money which belongs to their customers and at the same time they lend out a lot of money which is at risk of getting lost should the borrowers decide to default. It is therefore important that they start taking measures that will increase investors’ confidence. They should come up with measures that will help investors make the right decisions, and measures whereby the financial statements of the banks will be reflecting the true value and profits which are as accurate as possible. Over the years, the international Accounting Standards have not offered this. However, the change in IAS 39 to IFRS 9 and the changes that the later have brought are expected to increase the accuracy of financial reporting by the banks. It is expected that banks will providing a reserve that is supposed to cover up for any potential losses. This will help in increasing investors’ confidence and will also come with a host of other benefits. Works Cited Anagnostopoulos, Ioannis and Buckland, Rodger. Bank accounting and bank value: harmonising (d)effects of a common accounting culture?, Journal of Financial Regulation and Compliance, 2007. Vol. 15 Iss: 4, pp.360 – 380 Christian, Dieter, and Norbert Lüdenbach. Ifrs Essentials. Chichester: Wiley, 2013. Print. Damant, David. Accounting standards – a new era, Balance Sheet, 2003. Vol. 11 Iss: 1, pp.9 – 20 IFRS foundation, IFRS 9 Financial Instruments, 2014. Retrieved from < http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Documents/IFRS-9-Project-Summary-July-2014.pdf> on December 5, 2014 International Monetary Fund. Legal Department. Current Developments in Monetary and Financial Law: Volume 6. Washington, D.C: International Monetary Fund, 2012. Internet resource. Kawai, Masahiro, and Eswar Prasad. Financial Market Regulation and Reforms in Emerging Markets. Tokyo: Asian Development Bank Institute, 2011. Print. PricewaterhouseCoopers LLP. Illustrative Ifrs Corporate Consolidated Financial Statements for 2011 Year Ends. Haywards Heath [England: Bloomsbury Professional, 2011. Print. The Financial Times Ltd, IFRS accounting rules change forces banks to alter view of losses, Banks, 2014, retrieved from < http://www.ft.com/intl/cms/s/0/50f7aea2-1291-11e4-93a5-00144feabdc0.html#axzz3Kr5MBpI1> on December 5, 2014 Read More