IFRS 9

IFRS 9 is the International Financial Reporting Standard that governs how companies account for financial instruments. Think of it as the rulebook for how assets like loans, bonds, and derivatives are reported on the balance sheet and how changes in their value flow through to the income statement. Rolled out by the International Accounting Standards Board (IASB), it fully replaced the previous, more reactive standard, IAS 39, in 2018. The change was a direct response to the 2008 financial crisis, where the old rules were criticized for delaying the recognition of massive loan losses, hiding the scale of the problem until it was too late. IFRS 9 introduces a more forward-looking approach, forcing companies—especially banks—to account for losses they expect to happen, not just those that have already occurred.

At first glance, IFRS 9 might seem like a topic only an accountant could love. But for an investor, it’s a game-changer. It fundamentally alters how a company's financial health, particularly for banks and financial institutions, is presented. The core principle shifted from reacting to the past to anticipating the future. This means the financial statements you read today are built on a completely different philosophy than those from before 2018. Understanding this shift is critical to avoid misinterpreting a company's profitability and risk profile. It provides a clearer, though sometimes more volatile, picture of a company's financial reality.

IFRS 9's revolution rests on three key pillars that dictate how financial instruments are handled from birth to death.

This is the sorting hat of IFRS 9. It decides which bucket a financial asset goes into, which in turn determines how it's measured and where its value changes are reported. The classification depends on two key things: the company's business model for managing the asset (e.g., hold it to collect interest payments) and the asset's contractual cash flow characteristics (e.g., does it pay a simple principal and interest?). The main categories are:

• Amortised Cost: Used for simple debt instruments like loans that a company intends to hold to collect payments. The asset is recorded at its initial cost and adjusted over time for repayments and interest. This is a stable, predictable method.
• Fair Value: The asset is marked-to-market, meaning its value on the balance sheet is updated to its current market price at each reporting date. Where the changes go depends on the sub-category:
  • Fair Value Through Other Comprehensive Income (FVOCI): Changes in value are parked in a section of equity called Other Comprehensive Income and don't immediately hit the main profit and loss statement. This is often for assets that might be sold, but aren't actively traded.
  • Fair Value Through Profit or Loss (FVTPL): This is the default category. All changes in value, up or down, directly impact the company's net income. This can make earnings per share (EPS) much more volatile.

This is the most significant change and the one value investors must master. It completely overhauled how companies account for potential bad debts.

• The Old Way (IAS 39): Previously, a company operated on an “incurred loss” model. It could only recognize a loss (create a provision) when there was objective evidence a borrower was in trouble, like a missed payment. This was like waiting for smoke to appear before looking for a fire.
• The New Way (IFRS 9): IFRS 9 institutes the Expected Credit Loss (ECL) model. This is a forward-looking model that requires companies to provision for losses from day one, based on what they expect to lose in the future. The model has three stages:
  1. Stage 1: As soon as a loan is issued, the company must book a provision equal to the expected losses over the next 12 months, even if the loan is perfectly healthy.
  2. Stage 2: If the loan's credit risk has increased significantly since it was issued (e.g., the borrower's industry is facing headwinds), the company must increase the provision to cover all expected losses over the loan's entire life.
  3. Stage 3: If the loan is officially “credit-impaired” (e.g., the borrower is in default), the company continues to provision for lifetime expected losses, but the calculation for interest income also changes.

This is a more technical area, but the goal is simple: to make the financial statements better reflect a company's risk management activities. When a company uses a derivative (like a futures contract) to hedge a specific risk (like fluctuating fuel prices), IFRS 9's rules for hedge accounting aim to match the timing of gains or losses from the hedge with the gains or losses on the item being hedged. This prevents wild, misleading swings in reported earnings that are just due to accounting mismatches, not genuine business performance.

Like any accounting rule, IFRS 9 is a tool for analysis, not a gospel truth. For a value investor, it presents both challenges and opportunities.

The ECL model is forward-looking, but it relies heavily on management's assumptions about the future—economic forecasts, unemployment rates, property prices, etc. This introduces a huge element of subjectivity. A skeptical investor should ask:

• Are management's economic assumptions too rosy? An overly optimistic management team might under-provision for losses, making current profits look better at the expense of future pain.
• Is the bank being overly conservative? A prudent bank might over-provision, depressing current earnings but creating a hidden cushion for the future. This could be a sign of a high-quality, conservative culture.

Diligent analysis of a bank's loan loss provisions and the assumptions behind them can reveal a lot about management's quality and foresight.

The increased use of fair value accounting and the forward-looking ECL model can make reported earnings and book value more volatile. An investor must not be spooked by these short-term fluctuations. The goal is to distinguish between mere accounting noise and a genuine deterioration in the business's intrinsic value. As Benjamin Graham taught, the market in the short run is a voting machine, swayed by reported earnings, but in the long run it's a weighing machine, focused on true economic substance. IFRS 9 can make the voting machine jumpier, but the weighing machine still works.

Ultimately, IFRS 9 provides more timely and relevant information than its predecessor. However, it also demands more critical thinking from the investor. It forces you to look “through” the numbers and evaluate the quality of the judgments that produced them. It’s a powerful standard, but it's the investor's job to use it as a starting point for investigation, not as a final answer.