Those of us in Collections and Recoveries have seen plenty of regulatory change over the last few years. Industry regulators, such as the FCA and OFCOM, have been very active in UK as have others around the world.
Most of us are now fully familiar with these process changes and implications, with many of us transforming our strategy to be both compliant and maintain performance. It has been hard work, but we are mainly the better for it.
More regulation – a change to how impairment for loss is calculated
However, in January 2018 there is another set of regulatory standards due to go live, impacting financial losses … specifically, the implementation of International Financial Reporting Standard 9 – Financial Instruments (IFRS 9), the new accounting standard for financial loss impairment calculation from the International Accounting Standards Board.
Now, admittedly most of us, especially in Collections Operations, do not spend our time reading accounting publications; however, we often do have responsibility for, or input to, bad debt losses for the company. This is one you also need to be aware of.
Why the change?
Under the previous accounting standard (IAS39), recognition for credit losses was delayed until there was evidence of impairment. Additionally this was calculated only on past events and considered only current conditions.
This process led to a couple of issues:
- It did not necessarily recognize potential losses from assets that have not currently seen deterioration in credit risk (even though a proportion of them undoubtedly will)
- Nor did it recognize the potential impact of future changes in conditions.
IFRS9 has, in part, been designed to adjust for this.
So what will change?
Under the new standard, credit losses will need to be recognized at each stage of the customer lifecycle, even if no credit loss events have taken place, and market conditions taken into account as follows.
The calculation is now tiered, split as follows:
- No significant increase in credit risk since inception – Impaired at 12 month expected credit loss
- Significant increase in credit risk (a risk event) – Impaired at lifetime expected credit loss.
Expected credit losses now need to consider future default events, charges and be discounted for the time value of money.
The approach explicitly requires consideration of deterioration of market/economic conditions, and development of triggers to determine when risk has increased (these should not be just default criteria). Once triggered impairment is at the lifetime expected credit loss rates.
This new process is significantly more involved and complex.
Who does this apply to?
As an accounting standard, this new approach pretty much applies across industries and products. Consumer loans, commercial loans, leases and receivables (including contracts, even without a significant financing component, under the associated new standard IFRS15) are all included. It covers financial services, telecommunications and utilities.
IFRS9 is effective from 1st January 2018
What does this mean for us in collections and recoveries?
The changes will mean that the impairment charge will no longer only reflect current and past performance, but also overlay future performance too.
Together with the requirement to reflects losses from all stages of the customer life cycle, it will make it likely the impairment charge for bad debt will increase.
How much it will increase will depend on a company’s exact situation, determining the exact accounting treatment, but it is most likely there will be additional reserve need to be charged to the P&L.
And, should market conditions deteriorate, loss charges will need to quickly increase rather than waiting for history to build in key performance indicators. It will be more real time.
Good News – Bad News?
The good news, especially for those with bad debt responsibility, is that this new approach will more accurately reflect the entire book of accounts, including new originations.
In theory there will be improved linkage between the performance quality of customer accounts and actual results. It should mean less time delays between events and actual impacts being seen in the P&L.
This should result in greater accountability and transparency on results, clearly demonstrating how each process in the customer lifecycle is linked.
The bad news is this methodology requires additional analysis and can quickly get complex.
Bad debt impairment losses are likely to increase, and in the future, be heavily impacted by methodology or changes in forward looking assumptions rather than underlying performance.
Explaining results in a clear manner is going to get harder.
So what do I need to do?
This is primarily a financial accounting standards change, however, there are a couple of things you need to do now.
- Be aware of the change, brief your stakeholders… they need to be fully aware too.
- Talk with your financial accounting team, ask them about the implications for your business and your results… make sure they are working on this and have a plan.
- Develop a robust set of operational and portfolio measures that accurately reflect underlying performance, talk to these on a regular basis… do not rely on financial results as sole measures of performance.
- Review your collections strategy… are you doing as much as you can as early as you can to minimize the impact of this change to the P&L?
We are just coming up to the six month time frame until required implementation, so getting involved now will help ensure there is not an unpleasant surprise looming this time next year.
(Remember GDPR is also due for implementation in May 2018 … but more on this another time).
Chris Warburton, Lead Consultant