The final Advisory from OSFI on accounting and capital matters related to the conversion to International Financial Reporting Standards (IFRS) by Federally Regulated Entities (FREs) was released in March 2010.
After reviewing and commenting on the draft Advisory, PwC has reviewed the final Advisory in the context of changes from the draft version. The notes which follow reflect on these changes and some of the impacts on noninsurance FREs as a result of this Advisory. These should be considered in IFRS conversion implementation plans.
Key principles or philosophies articulated by OSFI that governed their approach to determining the final Advisory
- OSFI, under their jurisdiction, has the ability to make specifications for additional disclosures or to specify an IFRS option that is preferred, or make an IFRS option not available. They will not modify Generally Accepted Accounting Principles (GAAP) or interpret GAAP in such a way that it puts FREs offside from getting a "clean opinion" from their auditors as to the application of IFRS as globally interpreted and applied.
- With the above ability in mind, it is still recognized that such specifications should be kept to a minimum where required, in OSFI's view, for prudential regulatory monitoring.
- OSFI understands the importance of not creating operational inefficiencies or risk by creating differences between IFRS reporting and regulatory reporting.
- As a user of financial information where their focus is on regulatory monitoring and supervision, it is preferred to have comparability amongst FREs in the same sector.
- As accounting standards may derive differing balance sheet treatments for FREs, OSFI may determine that capital metrics could be adjusted in certain circumstances.
Early adoption of standards
OSFI had previously communicated that no early adoption of new IFRS standards would be allowed. Based on feedback received on the draft Advisory, the position has been slightly modified so that OSFI will consider allowing early adoption by FREs on a standard-by-standard basis once a particular IFRS is issued in final form. Therefore, as standards are issued over the course of the next two years, OSFI will look at each one individually and assess whether early adoption will be allowed. Currently, there should be no early adoption of standards which are issued but not yet in effect. This includes IFRS 9 which considers the classification and measurement of financial assets.
Therefore, entities should consider that IFRS conversion project plans will not cease once the transition is complete as the first two years after conversion are likely to see significant changes in accounting standards. The most significant area of change for lending institutions is likely to be the proposed change from an incurred loss model to an expected loss model, the changes to consolidation, derecognition and hedging, all part of a refresh of IAS 39: Financial Instruments, Recognition and Measurement.
OSFI maintains a number of disclosure Guidelines which are being revised to align with IFRS requirements. OSFI issued revised guidelines for comment in May. The revised Guideline D1 does not require any additional disclosures. However, it has been streamlined to remove duplication of the requirements already included in IFRS and it includes some specific requirements around disclosures of the loan loss allowance.
The overall principles from the draft Advisory have not changed; the accounting treatment of these transactions will drive the components of the ACM. So many FREs will see higher assets after transition to IFRS. However, there is also an indication that OSFI will start to consider an FRE's actual exposure in securitization transactions, irrespective of accounting treatment. This could mean that in the future, certain assets which currently qualify for derecognition may need to be included in the ACM. The Advisory does not indicate which types of transactions could fall into this category.
Historic securitizations done through the CMHC programs (NHA MBS, CMB and IMPP transactions) are grandfathered up to March 31, 2010. This means that assets now on balance sheet for accounting under IFRS on the financial statements which arose from these transactions before March 31, 2010 will not have to be included in the ACM, regardless of the accounting treatment. The draft Advisory outlined December 31, 2009 as the grandfathering date.
The final version also gives more specifications around reinvestments; for example, all future reinvestment assets for the grandfathered CMB or IMPP transactions will be excluded from the ACM.
The grandfathering rules do not apply to any other kind of securitization transaction so entities which have entered into significant transactions in the past outside of the CMHC programs may face significant transition challenges.
The exclusion of mortgages sold through the CMHC Programs up to March 31, 2010 from the ACM calculation will require each FRE to have the capability to track and report two views of assets. One view will include those assets which have been brought back on to the balance sheet pursuant to IFRS standards for consolidation, derecognition and related IFRS 1 provisions. The second view, required to calculate the ACM, will exclude those mortgages sold through the MBS/CMB Programs up until March 31, 2010 that are otherwise required to be re-recognized under IFRS. This will become even more complex should OSFI require certain assets which pass the derecognition test to be included in the ACM.
OSFI will require continued separate disclosure of individual and collective allowances by providing a reconciliation of changes to each of these accounts during the period. IFRS 7.37(b) also requires entities to disclose an analysis of accounts that are individually considered to be impaired. As part of this analysis, entities would typically show the balance of the allowance account related to those impaired loans, so the guideline does not appear to be asking for anything additional to what is required by IFRS 7 related to individually assessed impaired assets. This request by OSFI stems from the fact that greater transparency in a financial crisis helps to instill market confidence.
The existing OSFI guideline C-5: General Allowances for Credit Risk might be interpreted to state that FREs maintain a minimum level of general allowance. This methodology is a departure from the definition of incurred loss in IAS 39 paragraph 59. FREs will have to recognize a collective allowance based on the incurred loss approach under IFRS. Revised Guideline C-5 has been issued which removes the minimum general allowance requirement.
Items to consider:
- FREs still need to consider how they will reconcile their methodology to ensure that it is compliant with both IFRS and OSFI requirements;
- FREs must consider the modifications to C-5 relative to terminology of collective and individually assessed which are embedded in IFRS;
- FREs should not lose sight of the fact that bright line tests found in Guideline C-1 should not be the sole consideration of impairment in a principles-based IFRS world. There may be instances where objective evidence of impairment is noted prior to the dates set out by OSFI (i.e. prior to 90 days past due) and as a result these additional loans should be considered as impaired under accounting rules. Conversely, a full write-off at 180 days may be inappropriate from an accounting perspective in certain circumstances, including where FREs have a history of recoveries, yet the OSFI requirement for writeoff remains in the draft Guideline.
- OSFI has included concepts found in the BCBS paper on Sound Credit Risk Assessment and Valuation for loans. FREs should consider if their internal policies meet these requirements.
Financial Instruments—Fair value option
Guideline D-10 will remain due to OSFI's concern around the use of the Fair Value Option and the need to have a clearly documented risk management strategy.
The revised guideline states that FREs must follow the guidance in IAS 39 if opting to use the Fair Value Option. Revised D-10 does note however that the Fair Value Option should not be used for loans and mortgages to companies having annual gross revenues below $62.5 million, unless such loans and mortgages are in aggregate, immaterial. D-10 does not override the obligation to use fair value through profit and loss treatment for those loans and mortgages that by nature meet the definition of held-fortrading. Loans which are originated with the intent to sell in the near term are "held-for-trading" by nature and must be carried at fair value. They do not fall into the fair value option category.
Transition to IFRS
Recognizing the full net impact of the IFRS transition on retained earnings in available capital in the first quarter after adoption may cause some entities to breach capital ratios.
The final Advisory permits and gives clearer guidance on the phase in rules. Entities may elect to phase in the impact on retained earnings as a result of transition adjustments. However, this election must be made at the time of conversion and is irrevocable (the conversion date for a calendar year end FRE is January 1, 2011). Only certain items can be phased in and the items excluded relevant non-insurance entities are:
- Gains and losses on own use property, if FREs elect to use the fair value model
- the reversal of gains or losses on sale related to securitizations other than CMHC programs The phase in must start on conversion to IFRS and end in the quarter ending on or after December 31, 2012 (for calendar year FREs) and be done on a straight line basis.
Disclosures that this election has been made must be included in the audited financial statements as well as what the regulatory capital position would have been had the election not been taken.
Summary of reporting to OSFI in 2010 and 2011
In the progress report due by July 30, 2010 (for calendar year end entities), a report must be included which shows a reconciliation of equity at January 1, 2010 to equity previously reported under Canadian GAAP. There is no requirement for this report to be audited and OSFI recognizes that although the reconciliation should be based on fair estimates, the numbers are subject to change. Any changes should be notified to OSFI as they become known. This is essentially real-time reporting and FREs should have appropriate mechanisms to ensure that internal stakeholders are aligned prior to such communication.
The requirement to file semi-annual progress reports with OSFI will cease after the first quarterly reporting after conversion to IFRS (March 2011 for calendar year end entities).
Watch this space
The Advisory alludes to a number of things that will be coming which FREs need to have on their radar screen:
- Standards that may change with effective dates after 2012 may allow early adoption by the IASB in the transition rules. Will OSFI allow early adoption? OSFI will consider allowing early adoption on a standard by standard basis once they have a chance to evaluate it in its final form.
- Guidelines, including those impacting disclosures, are still being aligned with IFRS requirements. Amended guidelines have been issued and comments were due by June 15, 2010. Final guidelines are targeted for issue in July 2010.
- The Basel Committee on Banking Supervision (BCBS) has announced its intention to create a leverage test applicable to all internationally active banks. There were a number of references in the final Advisory where the final views by the BCBS may impact the conclusions therein.
- Tactical instructions will be issued on certain regulatory capital returns and forms.
Call to action
FREs should prepare their opening balance sheet and use this to evaluate the capital requirements on transition and develop a process to evaluate the differences on the tier 1 and total capital calculations and the ACM ratio going forward. Internal stakeholders need to be engaged to ensure that all aspects of the business are aware of the impact on the business model and internal processes.
It will be important for FREs to develop internal controls over processes to capture the data for accounting purposes, management reporting purposes and regulatory capital requirements, especially where assets may be recorded in the financial statements but excluded from the ACM due to the grandfathering rules and the phase in rules.
FREs should consider their credit risk processes such that they take into account BCBS practices and disclosure expectations.
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PricewaterhouseCoopers has extensive experience in helping banks and financial institutions adopt IFRS. We have assisted with IFRS conversion projects for a wide range of financial institutions both in Canada and globally. When implementing IFRS, we can help guide you through an effective IFRS conversion.
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