The Accounting Standards Board (the Board/ASB) received an enquiry about the application of provisioning requirements for Non-Banking Finance Companies (NBFCs) under IFRS 9, Financial Instruments (IFRS 9) and Non-Banking Finance Companies and Notified Entities Regulations, 2008 (the NBFC Regulations).
The fact pattern is summarized below:
(a) In the NBFC Regulations, regulation 25 states that a lending NBFC shall observe the criteria for classification of its assets and provisioning as provided in Schedule X. NBFC Regulations also state that “provided that after adoption and implementation of IFRS 9, the requirements of IFRS 9 shall be applicable.”
(b) ASB, issued the Accounting Guidance – Application of IFRS 9 by Non-Banking Finance Companies(IFRS 9 Application Guidance), in May 2021. Annexure 1 of this Guidance:
•describes the mechanism to be applied for mapping of time-based criteria. It is based on the time-based criteria outlined in the NBFC Regulations and the Expected Credit Loss (ECL) staging requirements set out in IFRS 9.
•outlines that provision for impairment shall be higher of IFRS 9 ECL model and the NBFC Regulations.
(c) On the above guidance and requirements of Annexure 1 of IFRS 9 Application Guidance, enquirer had sought clarifications from the Securities and Exchange Commission of Pakistan (SECP). SECP had advised the enquirer to follow the IFRS 9 Application Guidance for calculation of provision (i.e. higher of IFRS 9 ECL and the NBFC Regulations).
(d) Regarding the practical implementation of IFRS 9 Application Guidance, SECP advised the enquirer to obtain clarification from the ASB. The enquirer had accordingly requested for Board’s opinion on whether the calculation of higher provisioning (between IFRS 9 or the NBFC Regulations) would be assessed by an NBFC on the overall portfolio level or it would be assessed on the level of individual borrower.
The Accounting Standards Board comments and conclusion1.The Board noted that the SECP, through S.R.O. 800 (1)/ 2021 (dated June 22, 2021) has further deferred the application of IFRS 9, for Non-Banking Finance Companies (NBFCs). For NBFCs, SECP has made IFRS 9 applicable from June 30, 2022 (with earlier application permitted).
IFRS 9 ECL Model2.The Board noted that IFRS 9 impairment model is based on changes in ECL and involves a three stage approach.
•Stage 1 includes financial instruments that have not had a significant increase in credit risk since initial recognition or that have low credit risk at the reporting date.
•Stage 2 includes financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment.
•Stage 3 includes financial assets that are credit impaired, having objective evidence of impairment at the reporting date.
Provisioning requirements of the NBFC Regulations3.The Board observed that the NBFC Regulations specify the requirements for NBFCs to maintain ‘Specific’ and ‘General’ provisions for their financial assets.
•Regulation 25 of the NBFC Regulations, prescribes specific provisioning requirements for nonperforming assets. Regulation 25 requires that a lending NBFC shall observe the criteria for classification of its assets and provisioning as provided in Schedule X.
Schedule X of the NBFC Regulations, outlines a time based criteria for classification and provisioning of loan/lease assets (separately for microfinance portfolio and all financing facilities other than micro-finance).
•Regulation 25A of the NBFC Regulations, prescribes the requirement to maintain General provision.
Under regulation 25A, an NBFC with micro-finance portfolio and unsecured finance portfolio shall maintain a general provision equivalent to 0.5 per cent of the net outstanding micro-finance portfolio and 1 per cent of the net outstanding unsecured finance portfolio.
Accounting Guidance ‘Application of IFRS 9 by Non-Banking Finance Companies’4.The Board with the objective to facilitate NBFCs in the implementation and transition to IFRS 9, issued an Accounting Guidance titled ‘Application of IFRS 9 by Non-Banking Finance Companies’ (IFRS 9 Application Guidance).
5.It is relevant to mention that the Board, for the development of this accounting guidance, formed a Working Group which included representation of SECP. Further, IFRS 9 Application Guidance was issued in consultation and concurrence with SECP.
6.IFRS 9 Application Guidance (in Annexure I) outlines the principle that after adoption of IFRS 9 the provision for impairment shall be at the amount that is higher of IFRS 9 ECL and the NBFC Regulations. Annexure I outlines the calculation mechanism as under:
(a)IFRS 9 stage 1 and stage 2 ECL should be compared with provision calculated as per regulation 25 A of the NBFC Regulations; and
(b)IFRS 9 stage 3 ECL should be compared with provision calculated as per regulation 25 of the NBFC Regulations.
7.The Board noted that in IFRS 9, stage 3 ECL is linked with the ‘default’ of the borrower. In general, this stage reflects the increase in credit risk to a stage where a loan is considered as credit-impaired.
While, under the NBFC Regulations, default is a time-based criteria and such loans/portfolio is considered as non-performing.
IFRS 9 stage 3 portfolio would be credit-impaired and in principle it would be similar to the nonperforming portfolio of NBFC Regulations.
8.The Board considered that it is important to highlight the rationale for the approach of maintaining a provision that is higher of IFRS 9 and the NBFC Regulations.
The Board also noted that various regulators have outlined an approach of maintaining a provision that is higher of the IFRS 9 ECL and local prudential regulations.
The Board observed that the regulatory approach of maintaining the provision under IFRS 9 and the NBFC Regulations is to avoid under-provisioning of classified financial assets, after implementation of IFRS 9.
It is expected that provisioning as per IFRS 9 requirements would generally be higher than provision calculated under the NBFC Regulations. However, in initial years of IFRS 9 implementation, from a supervisory and regulatory perspective, an inefficient ECL model could lead to under-provisioning for impairment.
9.The Board observed that as the objective of above-noted approach is to ensure the recognition of provision under the NBFC Regulations as a bare minimum, therefore, the comparison between IFRS 9 ECL and the NBFC Regulations is to be done at portfolio level rather than individual borrower level. Portfolio-based analysis would ensure that the total provision recognised by the NBFCs will not be less than provision required under the NBFC Regulations.
IFRS 9 application approach adopted by local and international banking sector regulators10.In context of the enquired matter, a limited desk research about the IFRS 9 application and implementation guidance issued by following local and international regulators also provided relevant information.
•State Bank of Pakistan
•Central Bank of United Arab Emirates
Approach followed by the State Bank of Pakistan11.The Board noted that State Bank of Pakistan (SBP) has issued IFRS 9 Financial Instruments Application Instruction for banks.
•The Board noted that SBP requires the financial institutions to concurrently compute the total provisions for impairment as required by existing instructions (i.e. Prudential Regulations) and IFRS 9 guidelines on performing, underperforming and non-performing credit exposures.
•Further, the provision to be accounted for by the banks should be higher of IFRS 9 ECL or Prudential Regulations requirements.
12.The Board also noted that, SBP under the IFRS 9 Application Instructions (Annexure-I) has also outlined an approach for comparison of provision as higher of IFRS 9 ECL and the Prudential Regulations. This approach is similar to one set out by the Board in the IFRS 9 Application Guidance for NBFCs. SBP in Annexure–I of the IFRS 9 Application Instructions, outlined that:
•IFRS 9 stage 3 ECL would be compared with the total amount of specific provision calculated as per the Prudential Regulations; and
•Aggregate of IFRS 9 stage 2 and stage 1 ECL would be compared with the total amount of general provision calculated as per the Prudential Regulations.
Approach followed by the Central Bank of United Arab Emirates13.The Board also noted that Central Bank of United Arab Emirates has also issued Guidance Note on IFRS 9 application. The Guidance note mentions that:
“In the initial years of IFRS 9 implementation, the existing CBUAE regulation on provisioning will be maintained in parallel. Banks and FIs should recognise any shortfall in IFRS 9 impairments when compared to the CB UAE provisioning regulation.
If the general or specific provision as per the CB UAE regulation is higher than the impairment allowance computed under IFRS 9, the difference should be transferred to an Impairment Reserve from retained earnings. The Impairment Reserve should be split to the difference in general provisions and to the difference in specific provisions.”
14.The Board also noted that Central Bank of UAE has adopted IFRS 9, however, it also requires provisions as per the local Regulations. This provision should be maintained in parallel with IFRS 9 ECL based provision.
Further, a desk study of audited financial statements of a Central Bank of UAE’s financial statements showed that for financial reporting purposes the practical application and calculation is based on below:
•IFRS 9 stage 3 ECL is compared with the total amount of specific provision; and
•Aggregate of IFRS 9 stage 2 and stage 1 ECL is compared with the total amount of general provision (calculated as per local provisioning regulations/requirements).
Conclusion15.The Board, based on the understanding of enquirer’s submission and above detailed discussion and analysis, concluded that:
(b)NBFCs shall recognise impairment at an amount that is higher of IFRS 9 Expected Credit Loss (ECL) and the NBFC Regulations. An NBFC would be recognizing any shortfall in IFRS 9 impairment when compared to the provisioning requirements of the NBFC Regulations. In this way, total provision for impairment, consequent to the adoption of IFRS 9 by an NBFC, would not be less than provision that was being recognised as per the NBFC Regulations.
(c)The NBFC Regulations, under regulations 25 and 25 A, require ‘specific’ and ‘general’ provisions. The specific provision (on a time-based criteria) is required for the ‘nonperforming’ financial assets, while general provision is for the ‘performing’ financial assets.
IFRS 9 ECL outlines a ‘three-stage’ model for impairment. This three-stage model is based on changes in credit quality of a financial asset, since its initial recognition. Stage 3 is considered as ‘non-performing’ (i.e. credit impaired) category of financial assets, while stage 1 and stage 2 are considered as performing and underperforming financial assets.
(d)The IFRS 9 ECL impairment should be compared with the provision calculated under the NBFC Regulations, at the portfolio level (rather than at individual borrower level).
For this purposes, the portfolio should be based on the level of aggregation, principally outlined in the NBFC Regulations. Based on this portfolio approach:
i.IFRS 9 stage 3 ECL should be compared with the specific provision calculated as per regulation 25 of the NBFC Regulations; and
ii.Aggregate of IFRS 9 stage 1 and stage 2 ECL should be compared with the general provision calculated as per regulation 25A of the NBFC Regulations.
It is relevant to mention that the NBFC Regulations specify different requirements of general and specific provisioning for ‘micro-finance’ and ‘other than micro-finance facilities’, the aggregation and comparison (between IFRS 9 ECL and provisioning as per the NBFC Regulations) based on above approach, therefore, should be done separately for micro-finance and other than micro-finance facilities.
(Issued in October, 2021)