Assessment Item 2: Review of Current Accounting Issues Report

This report, prepared for a senior accountant, analyzes current accounting issues and upcoming standards. Part 1 examines an article on the impact of AASB 9 on Australian banks, focusing on the Expected Credit Loss (ECL) model and its implications for profitability due to declining housing prices and stricter lending standards. It evaluates the article's assumptions using accounting theories and the conceptual framework. Part 2 reviews the upcoming IFRS 17 standard on insurance contracts, comparing it to IFRS 4, addressing major issues in the exposure draft, and analyzing comment letters regarding the proposed changes. The report assesses the arguments for and against the regulation and its application of regulation theories, providing a comprehensive overview of the evolving landscape of accounting standards and their effects on financial institutions.

Assessment item 2
Review of Current Accounting Issues
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Contents
Part 1................................................................................................................................................3
Introduction..................................................................................................................................3
Analysis of the Selected Accounting Article...............................................................................3
Evaluation of the Assumptions and Implications of the Article with reference to Accounting
Theories........................................................................................................................................4
Conclusion...................................................................................................................................5
Part 2: Review of Upcoming Accounting Standard........................................................................6
Brief Information on upcoming accounting standard (IFRS 17: Insurance Contracts)...............6
Major Issues that are covered in the exposure draft.....................................................................6
Views present in the comment letters and areas of agreement and disagreement with the
exposure draft...............................................................................................................................8
Arguments presented in the comment letters are “For” or “Against” the regulation...................9
Application of regulation theories................................................................................................9
References......................................................................................................................................11
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Part 1
Introduction
This report is developed to provide an analysis of the current accounting issues from the
perspective of a senior accountant working for major firm. In this context, it has presented a
discussion related to a news article in the context of accounting news for providing its deeper
theoretical understanding to the CEO of the firm. The article selected for the purpose is entitled
as ‘Australian banks should prepare accordingly for stricter accounting standards on risky home
loans’ from Business Insider published on 23rd October, 2018. The article can be accessed from
the following web link: https://www.businessinsider.com.au/australian-banks-risky-mortgage-
loans-accounting-standards-2018-10 (Copy is attached).
Analysis of the Selected Accounting Article
The selected accounting article has presented a discussion in relation to the impact of
changes in the accounting standards AASB 9 on the home loans of banking sector. The
Australian banks are already facing challenge in the context of declining housing prices with the
ending of 25 year mortgage bull market. As such, in these challenging conditions of property
market, the Australian banks also need to get prepared for complying with Australian accounting
standard for financial instruments (AASB 9). The bank needs to make relative changes for
making provisions to account for credit losses in their financial statements. The banking
institutions within Australia make provision to account for credit losses on the basis of estimates
that has been incurred. However, the new accounting standards adopted within Australian banks
in relation to the financial instrument would require implementing an Expected Credit Loss
(ECL) model. The model requires the banks to make decisions whether the loans that have not
yet been recovered are risky or not. Thus, the model requires banking institutions to accurately
identify the risk with their future lending decision for assessing the probability of default of loans
in future context (Jacobs, 2018).
It has been analyzed from the information provided in the news article that as assessed
from the use of ECL model if loans are at more risk of default then it could further negatively
impact the banking profitability. This is because the new accounting standard requires
recognition of these changes during the financial reporting that could reduce the profitability
reported in the bank’s financial statements. The new accounting standard requires bank to
account for the expected financial losses associated with their future lending decision. The banks
were required to account only for the incurred losses under the previous accounting standard
established for the financial instruments (Poljak, 2018). This is mainly done for increasing
provisions of banks to reduce the possibility of future default. However, this can result in banks
reporting additional losses with the reduced prices in housing market that are expected to further
decline with the ending of the bull market in housing sector in Australia. The negative gearing
and capital gain tax are further expected to reduce the prices in the housing market by about 9
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per cent. Thus, all such regulatory pressure is presenting tough times for the Australian banks in
the future context. This is because the failure of the big banks of Australia to comply with the
new accounting standard could result in causing unexpected write-downs if the decline in prices
in the housing market continues to occur (Jacobs, 2018).
Evaluation of the Assumptions and Implications of the Article with reference to
Accounting Theories
The article has presented a discussion in relation to the assumption of declining
profitability of the Australian banks with the adoption of new accounting standard of AASB 9.
This has been supported with reference to the likely changes in the financial reporting system of
the banks in relation to recognition of credit losses that requires reporting of likely loses to be
incurred assessed with the use of ECL model (Jacobs, 2018). The changes have been introduced
within the accounting standards in relation to improving reliability and faithful presentation of
information principle of conceptual framework. The accounting theory of conceptual framework
has been introduced by the AASB (Australian Accounting Standard Board) within the financial
reporting system of the Australian business entities to protect the interest of the key stakeholders.
The framework has stated that accounting professionals need to comply with reliability,
relevancy, neutrality, faithful presentation, comparability and understandability during
development of financial statements (Henderson, 2015).
As such, in relation to this accounting framework AASB has introduced changes within
the accounting standard of AASB 9. The standard is developed in response to the occurrence of
global financial crisis as it will enforce the accounting for recognition of losses in an accurate
manner. The standard has required the business companies to account for realistic expectations
of impairment that might occur over the whole portfolio of loans over their entire life. The major
drawback of the old accounting standard is that it does not recognize a loss until it is actually
incurred and therefore can inaccurately present the financial information to the stakeholders
(Poljak, 2018). As such, the new accounting standard of AASB 9 requires the companies to make
estimates regarding the future financial loses assonated with the entire life of a loan to help
investors to assess their accurate profitability. However, the banking institutions as a result of
these changes need to make more provisions and therefore will strengthen the risk management
policies of the banks. It will reduce the volatility in earnings and thus helpful in providing more
accurate information to the financial investors.
However, this has also presented challenges in front of the banks to comply with the
changes introduced by the new accounting standard of AASB 9. This is because banks are
required to collect accurate data for determining the expected losses with their lending decisions.
In addition to this, the ending of bull market within the Australia housing market is expected to
cause a decline in the prices of the houses. The housing debt is expected to rise with the increase
in mortgage rates and stricter lending standards within Australia. As such, the Australian big
banks earning potential is expected to decline and therefore it can be tougher for them to comply
with the new accounting standards for AASB 9 (Jacobs, 2018). The compliance of the changes in
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the financial reporting system and policies of the big banks as per the new accounting standard
will further reduce their profitability to larger extent. This could result in having a negative
impact on their goodwill within the capital market at a global level and thereby affecting their
long-term sustainability and growth (Banks, 2016).
In response to the changes introduced by AASB 9, the big banks of Australia need to
implement the use of models that are able to evaluate the credit losses on the basis of taking into
consideration the forward-looking information. As such, it is required that the models such as
ECL are required to be implemented across the Australian banking sector to accurately assess
whether the future loans are risky or not. This will ensure that profitability reported by the banks
is not largely negatively impacted and also accurate financial information is presented to its key
stakeholders. As such, the banks can comply effectively with the new accounting standard
changes and also with the principles of conceptual framework of financial reporting. This
requires the banks to accurately assess the factors such as relative population growth and the
change within the housing sector so that they can accurately determine the risk associated with
their future loans. The more accurate is the information collected in relation to the riskiness of a
loan portfolio the better it will be the bank as they can correctly determine their profitability by
estimates of the expected losses (Tyler, 2018).
Conclusion
It can be said from overall analysis of the article that changes within the accounting
standard AASB 9 present a major challenge before the Australian banks. This is because it could
result in declining their profitability margin to a larger extent. The impact could be more sever
with the reduction in the housing prices with the end of the bull period within the Australian
property market.
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Part 2: Review of Upcoming Accounting Standard
Brief Information on upcoming accounting standard (IFRS 17: Insurance Contracts)
The purpose of this section of the report is to analyse the upcoming accounting standard.
For this purpose current accounting standard IFRS 17: Insurance Contracts has been selected that
will replace IFRS 4: Insurance Contracts. This accounting standard has been under review by
IASB and has an effective date of 1 January, 2021 but it can be applied later also.
When using IFRS 4, many insurance companies in different countries make use of
different accounting models for processing of insurance contracts. There is also difference of
using the accounting model for processing insurance contracts in same country but different
industries. This creates a trouble for the investors and regulators to compare the financial
performance of the companies in different countries. It is the main reason IASB has decided to
issue new accounting standard IFRS 17 that will replace ongoing accounting standard IFRS 4.
There are many issues faced in IFRS 4 that have been resolved in IFRS 17. The existing
accounting models provided in IFRS 4 fails to provide investors with the accounting information
that is needed to evaluate the insurer’s financial position, financial performance and risk
exposure (Exposure Draft, 2010).
The accounting standard IFRS 17 was formerly introduced by the IASB on 18 May, 2017
that aims to provide only single accounting model to measure the insurance contract. The
accounting model provided in the new accounting standard IFRS 17 will help the investors in
providing correct estimates so that investors from all over the world make uniform judgments for
estimating the correct financial position and financial performance.
The exposure draft issued by IASB for new accounting standard has received many
comment letters reflecting their opinions on proposed changes. In this context 4 comment letters
will be selected for review and provide feedback on their agreement and disagreement on the
proposed change in exposure draft on IFRS 17.
Major Issues that are covered in the exposure draft
There are many changes highlighted in the exposure draft and there are some new
additions to the ongoing accounting on Insurance Contracts. Some of the major issues that have
been located in the exposure draft are as under:
A: Measurement Model
The earlier accounting standard provides different accounting models for various types of
insurance contracts but the exposure draft proposes to make use of single measurement model for
all types of insurance contracts. Here contracts include insurance as well as reinsurance
contracts. The exposure draft proposes direct measurement methods that make use of current and
discounted estimates of cash flows of future years. As per the new measurement method value
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reported in balance sheet get revised on reporting date in order to adjust the effects of uncertainty
of the amount and timings of such future cash flows. It is referred to as risk adjustment as it helps
in reducing the overall risks associated with the insurance contracts. Risk adjustment is important
as it helps to estimate the maximum amount that insurer will rationally pay in order to get
relieved the risk. It means there is adjustment required to make as per new measurement model
in case ultimate fulfillment exceeds the expected cash flows. Risk adjustment is performed on
each reporting period and it decline over the time when slowly the insurer get released from the
upfront risk (Exposure Draft, 2010).
B: Use of risk adjustment and residual margin (As proposed by IASB) or composite
margin (as FASB proposed)
There is major problem occurred between IASB and FASB as both do not come at
conclusion on using composite margin or risk adjustment together with residual margin. As per
the information given in the exposure draft, FASB has not given green signal for implementing
the risk adjustment and residual margin separately, but they want to combine both as composite
margin. Residual margin refers to the amount is executed at the time of entering into the contract
that means insurer recognizes no gains while entering into the contract. The residual margin is
divided into over the coverage period of insurance policy in the systematic manner and based on
passage of time. There can be change in residual margin in case there is change in pattern of
claims and also the benefits arising from the policy make another pattern more beneficial. On the
other hand composite margin as proposed by the FASB is released over both coverage period
and as well as claim handling period. This method uses insurer’s exposure from the provision of
insurance coverage period and uncertainties which is associated with future cash flows
(Exposure Draft, 2010).
C: Issues related to the measurement value of residual margin and risk adjustment
Exposure draft provides various issues that have been a question in previous accounting
standard on Insurance Contracts. Value of risk adjustment was question mark for many of
accountant all over the world as there are different views regarding its measurement. Exposure
draft on this provide that risk adjustment should be maximum amount that insurer rationally pay
in order to get relieved the risk. Exposure draft proposes to limits the choice of techniques for
estimating the value of risk adjustment. These techniques are confidence level, cost of capital
and conditional trail expectations. There is issue related to the use of these techniques and there
is also question regarding any other technique to be used for valuing the value of risk adjustment.
Measurement if residual margin is also a major issue while measuring the insurance contract.
Some accountants prefer that insurer should not recognize any gain at the initial recognition of
the contract and it should not be less than zero. All these issues are point out in the exposure
draft and have been questioned with general public to get the response on such issues (Exposure
Draft, 2010).
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Views present in the comment letters and areas of agreement and disagreement with the
exposure draft
Comment Letter 1: Insurance Australia Group
Link to the comment letter:
http://eifrs.ifrs.org/eifrs/comment_letters//
85/85_7328_AndrewKitchenInsuranceAustraliaGroupLtdIAG_0_ED201008_CL09IAG.pdf
Note: Comment Letter is also attached
The Insurance Australia Group supports the proposed changes introduced by IASB in
their exposure draft on Insurance Contract. There are in agreement to support that the propose
measurement model will be helpful in providing the relevant information to the users. They
support the IASB approach for splitting the risk adjustment and residual margin as it helps in
presentation of insurance contract and also helps in measuring the insurance contract in correct
manner (IAG, 2010).
Comment Letter 2: The American Council of Life Insurers (ACLI)
Link to the comment letter:
http://eifrs.ifrs.org/eifrs/comment_letters//
85/85_9044_MichaelMonahanTheAmericanCouncilofLifeInsurersACLI_0_ED201008_CL02A
CLIcollated.pdf
Note: Comment Letter is also attached
ACLI is an agency registered in America that act as a council on all the insurance
companies registered in America. On the question asked on single composite margin or splitting
them between risk adjustment and residual margin, ACLI replied that they favor composite
margin over splitting method as single composite margin method is more consistent with the new
definition of liability. In case IASB prefers splitting method then they suggest making some
changes in the wording of exposure draft so that risk adjustment should simulate with market
price of risk (The American Council of Life Insurers (ACLI), 2010).
Comment Letter 3: Accounting Standard Board (ASB) UK
Link to the comment letter:
http://eifrs.ifrs.org/eifrs/comment_letters//
85/85_7523_SeemaJamilONeilAccountingCouncilformerAccountingStandardsBoardUKASB_0
_ED201008_CL92ASB.pdf
Note: Comment Letter is also attached
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ASB agrees with the proposed changes by the IASB but they suggest some change that
helps to improve the accounting standard. However they oppose the single measurement method
but in lieu to provide better picture of financial statements they agree with propose changes.
They need clear explanation for the rationale behind the proposed changes so that
implementation process goes well (Accounting Standards Board, 2010).
Comment Letter 4: PriceWaterHouseCoopers (PWC)
Link to the comment letter:
http://eifrs.ifrs.org/eifrs/comment_letters//
85/85_7526_JohnHitchinsPricewaterhouseCoopersPwC_0_ED201008_CL94PWC.pdf
Note: Comment Letter is also attached
In answering to most important question on the proposed changes, PWC has answered
that new measurement model will definitely brings the improvement in the insurance industry
and there is only single method of accounting to measure the insurance contract. The new
measurement model is helpful in providing the relevant information to the users as well as it
helps the accountant to make proper measurement of insurance contracts (PWC, 2010).
Arguments presented in the comment letters are “For” or “Against” the regulation
The arguments provided in the comment letters can be in for or can be against the
regulation. The bodies or group that has provided their views on the exposure draft will also have
personal stake in the market and will definitely make agreement with those changes that supports
them in any manner possible. As there is wide debate going on the use of single measurement
method for valuing the insurance contract as it is very difficult to judge the different methods.
Many of regulators and accounting bodies favors the proposed changes but they want some
change in wording of the exposure draft so that it is easy to implement and understand. But some
bodies and regulators totally disagree with proposed changes as it give rise to change in method
and also leads to incorrect judgment of amount of insurance contract. There was no solid
evidence that bodies and regulators have furnished that opposes the changes in the old
accounting standard on Insurance Contracts. It is vital to say that all four comments letter
discussed above are in favor with IASB and arguments are for the regulations (Deegan, 2014).
Application of regulation theories
 Public Interest Theory: This theory provides that regulation for inefficient market
practices must benefit the society as the whole. As per this theory, it can be said that
comment letters provided by Insurance Australia Group and Accounting Standard Board
(ASB) UK have provided their views in public interest and rest have shown some
personal interest while providing their opinion.
 Capture Theory: This theory provides the situation where regulation setters get
influenced by group of regulators. It can be said that comment letter by The American
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Council of Life Insurers (ACLI) will have direct impact on IASB as it suggest some
major changes and this body also governs all the insurance companies in America
(Deegan, 2014).
 Private Interest Theory: This theory focus on the self interest of the particular group as
it helps in solving the particular concern. It can be said that comment letter given by
PWC has private interest in the proposed changes as it helps them to save time in
performing the accounting.
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References
Accounting Standards Board. (2010). Comment Letter. Retrieved February 11, 2019, from
http://eifrs.ifrs.org/eifrs/comment_letters//85/85_7523_SeemaJamilONeilAccountingCou
ncilformerAccountingStandardsBoardUKASB_0_ED201008_CL92ASB.pdf
Banks, E. (2016). The Credit Risk of Financial Instruments. London: Springer.
Deegan, C. (2014). Financial Accounting Theory. McGraw-Hill: Sydney.
Exposure Draft. (2010). Insurance Contracts. Retrieved February 11, 2019, from
https://www.ifrs.org/-/media/project/insurance-contracts/exposure-draft/published-
documents/ed-insurance-contracts-standard.pdf
Henderson, S. (2015). Issues in Financial Accounting. Australia: Pearson Higher Education AU.
IAG. (2010). Comment Letter. Retrieved February 11, 2019, from
http://eifrs.ifrs.org/eifrs/comment_letters//85/85_7328_AndrewKitchenInsuranceAustrali
aGroupLtdIAG_0_ED201008_CL09IAG.pdf
Jacobs, S. (2018). Australian banks should 'prepare accordingly' for stricter accounting standards
on risky home loans. Retrieved 11 February, 2019, from
https://www.businessinsider.com.au/australian-banks-risky-mortgage-loans-accounting-
standards-2018-10
Poljak, V. (2018). Australian accounting standards in biggest shake-up since 2005. Retrieved 11
February, 2019, from https://www.afr.com/markets/australian-accounting-standards-in-
biggest-shakeup-since-2005-20180627-h11wur
PWC. (2010). Comment Letter. Retrieved February 11, 2019, from
http://eifrs.ifrs.org/eifrs/comment_letters//85/85_7526_JohnHitchinsPricewaterhouseCoo
persPwC_0_ED201008_CL94PWC.pdf
The American Council of Life Insurers (ACLI). (2010). Comment Letter. Retrieved February
11, 2019, from
http://eifrs.ifrs.org/eifrs/comment_letters//85/85_9044_MichaelMonahanTheAmericanCo
uncilofLifeInsurersACLI_0_ED201008_CL02ACLIcollated.pdf
Tyler, J. (2018). ACCT3 Financial. Australia: Cengage AU.
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