The European Securities and Market Authority (ESMA) released a statement on March 25 to enhance the consistent application of International Financial Reporting Standards (IFRS) in the European Union (EU).
The statement also aims to avoid divergence in practice on the application of the IFRS 9 Financial Instrument in the original context of the COVID-19 outbreak.
The statement wholly addresses the accounting effects of the measures taken and proposed by various national governments and EU bodies to combat the severe systemic economic impact of the coronavirus pandemic.
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The principles-based nature of IFRS 9 regulation includes adequate flexibility to reflect the particular circumstances and aftermath of the COVID-19 outbreak coupled with the associated public policy measures.
All issuers and their auditors are advised to take this Public Statement into due consideration. In that context, ESMA announced that it would continue to monitor all issuers’ practices with regards to IFRS 9, particularly concerning the application of judgment in the current context.
Although this statement focuses mainly on the financial reporting aspects, ESMA coordinated with the European Banking Authority (EBA). EBA issued a report on the prudential framework based on the COVID-19 measures on March 25, 2020.
Both of the statements issued by EBA and ESMA are consistent concerning financial reporting. Additionally, ESMA actively engaged with the European Commission before publishing the report to guarantee a coordinated response in this area.
Anyone seeking more information on the audit of financial statements touching the COVID-19 subject should refer to the CEAOB statement published on March 25, 2020.
Accounting Implications
ESMA suggests that all issuers must carefully assess the overall impact of the economic support and relief measures on the known financial instruments and their conditions.
Accounting for the modifications arising from the introduction of the support measures determines whether such actions cause alteration of the financial assets. Also, it indicates whether changes result in their derecognition.
Issuers develop their accounting policies under IAS 8 Accounting Policies, IFRS 9 principles, and Changes in Accounting Estimates and Errors while specific guidance in IFRS 9 is unavailable.
Derecognition occurrence depends on whether the alterations of the terms of the instrument involved is considered substantial or not.
Such an assessment needs to have qualitative and quantitative criteria, according to ESMA. A thorough evaluation is necessary since the situation might be dependent on a lot of judgment.
ESMA stated that if the support measures offer makeshift relief to debtors affected by the coronavirus pandemic while the net economic value of the loan is not severely affected, the changes might not be considered and substantial.
ESME also says that the issuers should disclose two things:
- Their precise accounting policy for determining when an alteration is considerable if relevant to an understanding of their financial statements.
- Judgments made that have the biggest effect on the amounts that are notable in their financial statements.
The considerations here within are relevant where the financial asset is not derecognized.
The Considerations
Assessment of a significant increase in credit risk (SICR) gives IFRS 9 the mandate to demand that issuers should assess at every reporting date whether the credit risk of a financial instrument has increased considerably since its first recognition.
ESMA is convinced that determining whether there is a SICR is a general assessment of several quantitative and qualitative indicators. Thus, it should capture all the changes in the lifetime risk of default.
The form of support is variant. But, ESMA notes that the measures used in the context of the COVID-19 outbreak that enables, need, or encourage suspension or delays in payments should never be regarded as automatically having a one-to-one effect on the assessment of whether loans have been affected by a SICR.
Thus, a moratorium under such circumstances must never in itself be considered as an automatic catalyst of SICR. ESMA suggests that analysis of the conditions under the context of the SICR assessment is important. It can determine the crucial conditions under which these measures are implemented.
The Expected Credit Loss (ECL) estimation model in the IFRS 9 compels issuers to measure the expected losses. They must also consider the forward-looking information by reflecting:
“an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes and taking into account reasonable and supportable information that is available without undue cost or effort at that date about past events, current conditions, and forecasts of future economic conditions.”
Also, when making forecasts, ESMA suggests that issuers should consider the nature of the economic shock arising from COVID-19.
They should factor in the impact that the financial relief and support measures like debt moratoria will have on credit risks over the expected instruments’ life.
The instruments’ maturities and longer-term estimates are the features that should be put into consideration.
Public Guarantees on Issuers’ Exposures and Transparency
The member states are also considering to offer public guarantees on issuers’ exposures. These measures may have a variety of features, but they share the basic one of ensuring partial or total recovery of the amounts linked to the impacted financial instruments.
ESMA acknowledges that the SICR assessment is mainly focused on the changes in the lifetime risk of default for every exposure compared to this risk at initial recognition. That is regardless of whether a loss is expected to be recognized or not.
Thus, the value of collateral or the occurrence of any guarantee never affects the SICR assessment.
ESMA also stresses the importance of providing all relevant disclosures related to the real and possible impacts of COVID-19 to comply with the needs of IFRS 7 Financial Instruments.
Disclosures, in particular, shall ensure that users of financial statements can evaluate the ECL recorded and also enable them to understand the assumptions and judgments made in their estimate.
It comprises, among other things, judgments that are made on how and the extent to which the impact of coronavirus and linked support measures have been considered and integrated into the assessment of ECL and SICR. Besides, it looks into the use of forward-looking information.
In the end, ESMA reminds all issuers about their obligations subject to the disclosure soon enough.
It also reminds them of relevant information about the effects of COVID-19 on their fundamentals and prospects or financial situation according to their transparency obligations under the Market Abuse Regulation.
