The challenges of IFRS convergence for Indian Banks

Summary


The implementation of International Financial Reporting Standards (IFRS) for Indian Banks has been postponed to April 2012. In spite of extended timeline, the implementation challenges for convergence with IFRS for the banks in India would be daunting. The financial impact on the balance sheet and P&L account of banks would also be significant on account of convergence with IFRS particularly in areas relating to loan provisioning and fair value accounting of financial Instruments.
Analysis


Due to banking industry operating in a highly regulated environment, banking companies are subject to regulatory supervision and also require to maintain minimum capital adequacy requirements. IFRS requires increased use of management judgment and extensive use of fair valuation inputs & assumptions. The regulatory review & control process needs to be adjusted to factor in the inherent judgments involved in the application of IFRS. Additionally, application of IFRS may also result in higher loan impairment losses, thereby adversely impacting the available capital and capital adequacy ratios of banks.


Major Accounting Changes under IFRS:

In addition to the accounting changes between IFRS and Indian GAAP that have to be generally addressed by all companies along the path to convergence, banks in India face the following major additional accounting challenges.


Loan Impairment Losses:

IFRS prescribes an impairment model that requires a case by case assessment of the individual facts and circumstances surrounding the recoverability and timing of future cash flows for all major credit exposures. Based on the assessment of the facts of individual loan accounts, if there is an expectation that all contractual cash flows towards repayment or contracted full applicable interest would not be recovered, a loan account would be classified as impaired and impairment loss is to be measured on present value basis using the effective interest rate of the loan account as the discount rate. As per IFRS, provisions are permitted only to the extent that they relate to specified impairment losses that can be measured reliably and incurred. No general provisions are permitted for future or expected losses.

Hence under IFRS, loan losses are to be calculated based on an objective impairment assessment of the specific facts & circumstances of the credit exposures and based on the use of informed judgment. However under the current Indian GAAP / RBI guidelines, loan losses are provided for the non performing assets based on prescribed provisioning rates in a mechanical manner, without any such impairment assessment.


Fair value accounting of financial Instruments:

Under Indian GAAP, fair value accounting is rarely used. As per RBI guidelines, the entire investment portfolio of banks is to be classified under three categories, Held to Maturity, Available for Sale and Held for Trading. The investments under the Available for Sale and Held for Trading categories should be marked to market at prescribed intervals. The investments under the Held to Maturity category need not be marked to market.
Under IFRS, Held to Maturity classification, (which is currently valued at amortized cost) is unlikely to be available leading to fair value measurement for this substantial category of investment portfolio also, resulting in more volatility in the income statements of banks. Further fair values may be represented by market transaction prices, but the onus will be on the banks to prove that market prices represent fair values.


Derivatives Accounting:

Under IFRS, all derivatives are to be recognized on the balance sheet at fair values with changes in fair values being recognized in the profit & loss account, leading to more volatility in the income statements of banks. However if hedge relationship for the qualifying cash flows can be established, fair value measurement need not be applied to such derivatives.

Banks in India need to beef up their IT systems train their staff across all departments, re engineer their processes and take certain strategic decisions to minimize the volatility of income statements for seamless convergence to IFRS.
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