Accounting standards and risk · RiskAtoms Academy

By the end you will be able to

1Explain the roles of the IASB and the FASB, and how accounting standards differ from prudential rules.
2Explain IFRS 9's expected credit loss model and its three stages, and compare it with the old incurred loss model and US CECL.
3Explain how IFRS 17 measures insurance contracts, and what the contractual service margin is.
4Describe how accounting figures feed into regulatory capital, and where the two part ways.

Why it matters

In 2007 many banks could see a recession coming, yet their accounts were not allowed to provide for loan losses until borrowers actually stopped paying. The rule that forced them to wait was an accounting standard, and the fix came from accountants too.

Core explanation

The accounts are a risk measure too

L1.8.01: Accounting basics introduced the three statements and the two families of rules behind them: IFRS and US GAAP. This lesson looks at who writes those rules, and at three standards that bring risk straight into the accounts of banks and insurers.

Who writes the rules

IASB (London)

The International Accounting Standards Board took over from an earlier committee in 2001. It writes IFRS Accounting Standards, which jurisdictions adopt into law: in the EU, listed groups have used them since 2005. It is independent and privately organised, overseen by the IFRS Foundation.

FASB (Norwalk, Connecticut)

The Financial Accounting Standards Board, set up in 1973, writes US GAAP. The Securities and Exchange Commission recognises its standards for US public companies. Changes come as Accounting Standards Updates, numbered by year, such as ASU 2016-13.

Both aim to give investors a faithful picture of a company. That is not the same goal as a supervisor's, which is to keep the firm safe. So prudential rules take the accounts as a starting point and adjust them: CET1 starts from accounting equity and deducts goodwill (L1.8.06: Capital, equity and leverage), and Solvency II revalues an insurer's balance sheet on its own basis (L2.7.05: Solvency I to Solvency II). Still, accounting choices flow straight into capital, which is why regulators care about them.

IFRS 9 and CECL: providing for credit losses

A provision sets money aside for loan losses; it cuts profit and so equity and capital. Under the old standard, IAS 39, a bank used the incurred loss model: no provision until a loss event, such as a missed payment. After the crisis the G20 called for provisioning that looks ahead, and the critique of “too little, too late” stuck.

IFRS 9, issued in its final form in July 2014 and effective from 1 January 2018, uses expected credit losses in three stages:

Stage	When	Provision
1	Performing, no significant increase in credit risk	12-month expected losses
2	Significant increase in credit risk since the loan was made	Lifetime expected losses
3	Credit-impaired (in default)	Lifetime expected losses; interest on the net amount

The move from stage 1 to stage 2 is triggered by a significant increase in credit risk, and it can make provisions jump. The US chose a simpler route: CECL (ASU 2016-13, issued June 2016) provides for lifetime expected losses on every loan from the day it is made, with no stages. The largest US public companies applied it from 2020, others from 2023. Step through one loan's life:

TimelineOne €1,000k five-year loan, 40% loss given default

1 / 3

Day one

12-month PD 1%, lifetime PD 5%

IAS 39: €0k. IFRS 9 (stage 1): €4k. CECL: €20k.

IAS 39 books nothing for a performing loan; IFRS 9 books a year's expected loss; CECL books the whole life's.

IFRS 17: insurance contracts at current value

Before 2023 insurers reported under IFRS 4, an interim standard that let them keep many local practices, so their accounts were hard to compare. IFRS 17, issued in May 2017, amended in June 2020 and effective from 1 January 2023, measures each group of contracts with current estimates:

fulfilment cash flows: the present value of future premiums, claims and expenses, plus a risk adjustment for non-financial risk;
a contractual service margin (CSM): the profit expected on the contracts, held back and released as cover is given, so no profit appears on day one.

A group expected to lose money is onerous, and the loss shows at once. Because estimates are current, changes in claims assumptions and interest rates reach the accounts quickly. US GAAP did not adopt IFRS 17; it made its own, narrower changes for long-duration contracts.

Sort itAccounting or prudential?

Is each item part of an accounting standard or a prudential rule? Watch for look-alikes.

Stage 2 lifetime expected credit losses.
The contractual service margin.
The risk margin in technical provisions.
Deducting goodwill to reach CET1.
Lifetime expected losses on every loan from day one.
The 99.5% one-year SCR.

The formal version

With the probability of default $PD$ , loss given default $LGD$ and exposure at default $EAD$ , and ignoring discounting:

\text{ECL}_{\text{stage 1}} = PD_{12\text{m}} \times LGD \times EAD, \qquad \text{ECL}_{\text{stages 2, 3}} = PD_{\text{life}} \times LGD \times EAD

For IFRS 17, at the start of a group of contracts:

\text{FCF} = \text{PV(claims, expenses)} + \text{RA} - \text{PV(premiums)}, \qquad \text{CSM} = \max(-\text{FCF},\ 0)

Shown in full: products and sums. Real ECL models discount the losses and weight several economic scenarios; real CSMs are adjusted every period. The detail belongs to M4.7: Accounting for risk.

Try it

Start in stage 1, then move the loan to stage 2 without changing anything else. How big is the cliff? Now raise the lifetime PD and see which rule reacts first.

Try itA €1,000k loan under three rulebooks

IFRS 9 stage

Probability of default, next 12 months1.0%

Probability of default, remaining life5.0%

Loss given default40%

IAS 39€0.0k

IFRS 9€4.0k

CECL€20.0k

IAS 39 (incurred loss, before 2018)

IFRS 9 (expected loss, staged)

US CECL (lifetime from day one)

Stage 1, performing: IFRS 9 provides for losses from defaults in the next 12 months.

Worked example

A group of motor policies under IFRS 17

A made-up insurer writes a group of multi-year contracts. At inception, the present value of premiums is €1,000m, of expected claims and expenses €820m, and the risk adjustment €60m. Cover runs for 10 years.

Measuring the group

Step 1 of 4

1
Fulfilment cash flows
820 + 60 − 1,000 = −€120m: the insurer expects to receive more than it pays out.

Explore the CSM further in the IFRS 17 CSM calculator.

Regulatory lens

Because IFRS 9 and CECL front-load provisions, they cut CET1 when first applied. The Basel Committee let jurisdictions phase that day-one hit into capital over several years, and many did, extending the relief during the COVID-19 pandemic. Supervisors also review banks' staging and expected loss models, since a slow move to stage 2 flatters both profit and capital.

For insurers, IFRS 17 and Solvency II measure the same contracts in different ways: a CSM in the accounts, a risk margin and own funds for the supervisor. Many insurers explain the bridge between them in their reports, as L1.8.04: An insurer’s balance sheet did for IFRS equity and own funds.

Sparks

SparkTwo boards, two answers

The IASB and FASB worked together on a joint credit loss model for years, but could not agree. The IASB chose stages, arguing that a loan priced for its risk should not show a day-one loss; the FASB chose lifetime losses from the start, arguing it was simpler and more prudent. The world's banks now provide for the same loan in two different ways.

SparkTwenty years in the making

Work on an international insurance contracts standard began in 1997, under the IASB's predecessor. IFRS 4 was published in 2004 as a stopgap, and IFRS 17 took effect only in 2023: one of the longest projects in the board's history.

Key takeaways

The IASB writes IFRS; the FASB writes US GAAP. Their goal is a faithful picture for investors, which prudential rules then adjust.
IAS 39's incurred loss model provided too little, too late. IFRS 9 (effective 2018) uses expected losses in three stages.
Stage 1: 12-month expected loss. Stages 2 and 3: lifetime. The jump between them is the cliff effect.
US CECL (ASU 2016-13) provides for lifetime expected losses on every loan from day one.
IFRS 17 (effective 2023) measures insurance contracts at current value; the CSM holds back unearned profit and onerous contracts show losses at once.

Reaction

Check what stuck

Question 1 · objective 2

A €500k loan is in IFRS 9 stage 1. Its 12-month PD is 2% and its LGD 50%. What is the provision, in € thousands? (Ignore discounting.)

€k

Question 2 · objective 2

Its credit risk then rises significantly, and its lifetime PD is 8%. What is the IFRS 9 provision now, in € thousands?

€k

Question 3 · objective 3

At inception, a group of insurance contracts has PV of premiums €600m, PV of claims and expenses €480m, and a risk adjustment of €30m. What is the CSM, in € millions?

€m

Question 4 · objective 1

Which statement about the IASB is right?

AIt is part of the Basel CommitteeBIt writes accounting standards for investors' information; regulators then adjust its figures for their own purposesCIt sets capital requirements for insurersDIt writes US GAAP

Question 5 · objective 2

What did the G20 and others criticise about the incurred loss model after the 2008 crisis?

AIt recognised losses too earlyBIt recognised losses too little, too late: only after a loss event, even when losses were clearly comingCIt ignored collateralDIt applied only to insurers

Glossary

IASB: International Accounting Standards Board: the independent board, overseen by the IFRS Foundation, that writes IFRS Accounting Standards.
FASB: Financial Accounting Standards Board: the private body that writes US GAAP, recognised by the SEC for US public companies.
Provision: An amount set aside in the accounts for expected or incurred losses, here on loans. It reduces profit and equity.
Incurred loss: The IAS 39 approach: a loan loss is provided for only once there is evidence that a loss event has happened.
Expected credit loss: Expected credit loss: a probability-weighted estimate of credit losses, using forward-looking information.
SICR: Significant increase in credit risk: the test that moves a loan from stage 1 to stage 2 under IFRS 9.
CECL: Current expected credit loss: the US GAAP model (ASU 2016-13) that provides for lifetime expected losses from the start.
Fulfilment cash flows: Fulfilment cash flows: the present value of future cash flows from insurance contracts plus a risk adjustment.
Risk adjustment: Risk adjustment for non-financial risk: the compensation an insurer requires for bearing uncertainty about claims.
CSM: Contractual service margin: profit not yet earned on a group of insurance contracts, released as cover is provided.
Onerous contracts: A group of contracts expected to lose money. IFRS 17 shows the loss at once.

Deep Dives & Origins

Deep Dives

IFRS Foundation, IFRS 9 Financial Instruments: Project Summary, July 2014; and IFRS 17 Insurance Contracts: Project Summary, May 2017. Intermediate.
Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected credit losses, BIS, December 2015. Advanced.

Origins

IASB, IFRS 9 Financial Instruments, July 2014 (effective 1 January 2018).
IASB, IFRS 17 Insurance Contracts, May 2017, amended June 2020 (effective 1 January 2023).
FASB, Accounting Standards Update 2016-13, Financial Instruments—Credit Losses (Topic 326), June 2016.
G20, Declaration on Strengthening the Financial System, London, 2 April 2009.
Basel Committee on Banking Supervision, Regulatory treatment of accounting provisions: interim approach and transitional arrangements, BIS, March 2017.

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