Adoption of IFRS in Financial Institution Essay
Adoption of IFRS in Financial Institution
The IASB describes its pronouncements under the label “International Financial Reporting Standards”, though it continues to recognise (accept as legitimate and adopted by them) the IAS issued by the defunct IASC.
With the adoption of IFRS in Nigeria, a lot stands to be gained from the seemingly distressed global economy. With successful implementation of IFRS, Nigeria will benefit economically by receiving a boost on foreign direct investments (FDIs).
In 2010, the Central Bank of Nigeria (CBN), in a bid to integrate the banking system into the global best practices in financial reporting and disclosure, commenced partial adoption of the International Financial Reporting Standards (IFRS) in the Nigerian banking system. The move, according to the CBN, was to enhance market discipline and reduce uncertainties which limit the risk of unwarranted contagion.
The basic requirement of IFRS 1 on the adoption of IFRS as at the transition date is as follows: Recognition of all assets and liabilities whose recognition is required by IFRSs; De-recognition of items as assets or liabilities if IFRSs do not permit such recognition; Reclassification of items that it recognised in accordance with previous GAAP as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity in accordance with IFRSs; and Application of IFRSs in measuring all recognized assets and liabilities.
The basics of the application of IFRS in the preparation and presentation of 1st IFRS financial statements is to retrospectively apply the relevant IFRSs to all transactions and balances as at the transition date.
SPECIFIC ISSUES FOR FINANCIAL INSTITUTIONS
1. Measurement of Unquoted equity classified as Available for sale assets: Financial Assets classified as Available for sale are to be measured at fair value and fair value differences accounted for in other comprehensive income. The challenge with unquoted equity is that they are not quoted in an exchange and as such the fair values of the instruments are not easily determinable from the market except valuation techniques are used to estimate the values of such unquoted instruments. The standards allows the use of income approach like the discounted cash flow methods, market approach like price multiple methods and other present value methods.
However, the standard does not allow the use of net asset method which financial institutions have been using under NGAAP. Financial institution would have to train staff and develop competencies in this area especially for investment entities.
2. Ability of the system to determine effective interest rate of financial instruments carried at amortized cost: Banks are known to charge certain fees on loans like processing fees, monitoring fees, management fees etc. depending on the bank. Some of these fees which are integral part of the effective interest rate are charged once and taken to the bank’s income statement. The treatment under IFRS for such fees is different. The position of IAS 39 is to spread such income over the entire life of the loan. IAS 39 seeks to achieve this through the use of the effective interest rate. The challenge here is the sheer inability of some entities to match fees charged on individual loans to each loan in the portfolio and the inability of current systems to determine the effective interest rates per loan which makes it impossible to recognize the fee income on loans evenly over the loan life. Also, some entities are forced to recognize such fees on portfolio basis due to the inherent limitation of the system to generate IFRS compliant data. Consequently, banking systems must be aligned to determine the effective interest rate based on the expected cash flows (payment pattern) from each individual loan. Interest income which until now was recognized based on the contractual rate on these loans would then be recognized using the applicable effective interest rate.
3. Measurement of collective impairment loss for loans and advances to customers and banks based on the incurred loss model: There appears to be a challenge in the aspect of collective impairment as IFRS requires that loans should be assessed for impairment individually for significant loan and/or collectively for non-significant loans. In assessing loan for impairment collectively, historical and statistical data are required in carrying out this process. For example, entities in some countries especially in Europe adopt the use of probability of defaults and loss given defaults parameters in estimating impairments on loans and receivables (provisions).
Banks would definitely encounter issues in estimating these risk parameters if they have not had a good collection of data for both their past due assets and defaulted assets. Some judgment would be required here in order to estimate impairment on loans.
4. Estimation of cash flows for loans that form part of the portfolio for specific impairment: Once a loss event have been identified and there are expectations as a result of the impairment trigger that all contractual cash flows pertaining to that financial asset would not be recovered, the entity would have to classify the asset or loan as impaired.
The bank has to estimate the recoverable cash flows from the loan on a discounted basis using the original effective interest rate. This is the area that poses the greatest challenge on impairment for most banks because most banks do not have the business process to support the collection of such data. For collateralized loans, the estimated cash flows that should be used to calculate any impairment should reflect the cash flows that might result from foreclosure, less cost of obtaining and selling the collateral.
Therefore banks must ensure that collateral records are updated and the collaterals perfected for them to qualify as cash flow recoverable for impairment computation. The time and cost involved in realizing the collateral should also be taken into account.
5. Recognition and measurement of stand-alone derivatives and embedded derivatives: Aside the requirement of the standard for financial institutions to recognize stand-alone derivatives in the books and measure at fair value, financial institutions will need to consider whether embedded derivatives reside in financial instruments and even in other contracts other than financial instruments. So aside instruments with convertible options, embedded derivatives can be found in any contract such as a lease, an insurance contract, or sale or a purchase contract. The challenge extends beyond searching for all embedded derivatives.
Once an embedded derivative has been found, it must then be determined whether the embedded derivative needs to be separately accounted for under IAS 39.
6. Recognition and measurement issues relating to liability/equity classification and compound instruments: Financial institutions are required based on the provisions of IAS 32 and IFRS 1 to consider the substance of the contract in classifying an instrument as equity or liability. This requirement is a major shift from the recognition principles under NGAAP.
Contracts that have the form of equity, but because in substance a party who issues such instrument cannot avoid the outflow of cash or another financial instrument, the contract is treated as financial liability.
However, there are other cases where a contract has both elements of equity and financial liability. These instruments are known as compound instruments and entities are required to separate the equity component which is a residual component from the liability and account for them separately.
7. Classification of financial instruments vis-à-vis management investment intention for holding the instruments: Under IFRS, management would be required to determine the classification for all financial instruments they are carrying. The expectation is that financial instrument classification must be management driven so that it can be aligned to strategic investment plans of the entity.
Management must be ready to determine which financial instrument would be held to maturity and which specific investments are to be traded. Where decision has been made to classify as HTM, management must ensure that they truly have the intention and ability to hold to maturity to avoid tainting the portfolio in future periods. Consequently, a process, control and system must exist that would enable management monitor these instruments in their various classes so that reclassification rules are not broken.
The adoption of a high quality set of harmonized accounting standards fosters trade and FDI since the improvement of accounting information, in turn, fosters financial transparency and comparability, and reduces information asymmetries and unfamiliarity among agents in different countries. IFRS has been recognised as a global reporting framework. It is wishful thinking to expect a reversal of events in over 120 countries that either require or permit its use. There is no doubt that conversion to IFRS in Nigeria is a huge task and a big challenge; its revolutionary impact requiring a great deal of decisiveness and commitment. It is in the best interest of Nigeria to adopt IFRS.
Nigeria is a significant donor to the International Financial Reporting Standards Foundation he total contributions of all donor countries in 2011 towards standard setting activities was GBP20.50million. There is need for the country to ride on this global reporting platform and investment. It is imperative to note that for Nigeria to reap the full benefits of IFRS adoption, the Government must put in place an enabling political environment as no country can achieve economic development in an atmosphere of violence and political unrest.
Subject: Financial statements,
University/College: University of California
Type of paper: Thesis/Dissertation Chapter
Date: 27 October 2016
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