The tale of the divergence between IFRS 9 and CECL continues to provoke strong interest and opinion as those in favor of the global convergence of accounting standards are frustrated that the IASB and FASB could not reconcile their differences over the treatment of financial instruments.
U.S. banks with IFRS-compliant overseas subsidiaries (and international banks with GAAP-compliant US operations) must despair at the ongoing requirement for dual reporting. Global investors will continue to struggle for comparability of financial results across these two regimes.
Ours is Not to Reason Why, Ours But to Try and Comply
Regardless of the rationale, the result is the world must continue to deal with two distinct standards, underpinned by similar philosophies and motivations but featuring some profoundly different requirements. While both IFRS 9 and CECL reflect the fundamental shift from “incurred” to “expected” loss as the foundation for impairment provisions, each approach arguably keeps one eye blind when considering the true magnitude of expected credit losses.
Here are the three biggest differences, and my personal views on which one is better at achieving its goals:
1. Expected Loss Calculations
• CECL requires lifetime expected loss calculations for all accounts.
• IFRS 9 typically starts new accounts with just a 12-month (Stage 1) expected credit loss measure, moving them abruptly to a lifetime (Stage 2) basis only when they experience a “significant increase in credit risk since initial recognition.”
• Winner: CECL. Limiting potential losses to just the defaults expected within a 12-month window may be short-sighted and leads to a bi-directional “cliff effect” in provisions when accounts migrate between Stages 1 and 2.
2. Treatment of Undrawn Commitments
• CECL takes a purist accounting position on products with unconditionally cancellable undrawn commitments that disregards future drawdowns and treats the observation balance as an amortizing loan.
• IFRS 9 offers an exception for such products that essentially requires provisions based on expected usage of undrawn commitments.
• Winner: IFRS 9. Although the CECL approach will significantly reduce its impact on consumer credit card portfolios in particular, which often have relatively high risk and low line utilization, its short-sighted approach under-estimates the true expected credit losses and fails to address the “too little too late” criticism of today’s accounting standards.
3. Use of Forward-Looking Information
• CECL favors a single, most likely view of expected macroeconomic conditions over a “reasonable and supportable” period, after which expected credit losses must revert to historical levels.
• IFRS 9 explicitly requires an “unbiased and probability-weighted” view of expected credit losses considering a “range of possible outcomes.”
• Winner: IFRS 9. CECL models may be more efficient to run and easier to govern but they will be less sensitive to low-probability, high-impact economic scenarios with non-linear impacts on expected credit losses.
Perhaps both accounting boards worry that the complete truth will be too bright to stare at with both eyes open wide, but impaired depth perception and blind spots may cause future stumbles.
Measure Twice, Cut…Twice
Dual-reporting entities will soon need to publish results under both IFRS 9 and CECL, which may share a common data processing and reporting infrastructure but will produce sometimes very different results for the same portfolio. Such entities will face significant publication pressures and will require very efficient operations and governance in order to produce all required reporting with adequate management oversight.
Account management objectives will vary as well, depending on which measure a bank seeks primarily to manage. For example, credit line increases will result in an immediate cost under IFRS 9 but not under CECL – would issuers make different decisions depending on which accounting standard they favor?
The main advantage for dual reporters is the opportunity to take their learnings from IFRS 9 and apply them to CECL. Despite the differences in the standards themselves, the requirements for data, models, software, reporting and IT infrastructure are similar.
Planning for both projects at the same time is the ideal; failing that, at least leveraging IFRS 9 development should save time, effort and cost for CECL implementations. The IASB and FASB have missed their best opportunity so far to converge standards and drive greater comparability and simplicity in global accounting for financial instruments.
Lenders faced with reporting under either or both standards over the next few years should not miss their own opportunities to drive consistency and efficiency across their organization, which will improve portfolio insight and management in the years to come. Further, lenders should be aware of each standard’s shortcomings to manage portfolio risks with a full and honest view of potential future outcomes.