Companies following international accounting rules now have a comprehensive new standard to follow for how to recognize financial instruments in their financial statements, with counterpart U.S. rules expected by the end of the year.

The International Accounting Standards Boards issued IFRS 9 Financial Instruments to overhaul the accounting for all financial instruments starting in 2018. The standard, one of the cornerstone efforts with the Financial Accounting Standards Board to converge U.S. and international accounting rules, will require banks to take a new approach to financial instrument accounting, most notably recognizing expected losses in their loan portfolio to alert investors earlier to signs of trouble.

"The reforms introduced by IFRS 9 are much needed improvements to the reporting of financial instruments and are consistent with requests from the G20, the Financial Stability Board and others for a forward-looking approach to loan-loss provisioning,” said IASB Chairman Hans Hoogervorst in a statement. “The new standard will enhance investor confidence in banks’ balance sheets and the financial system as a whole.”

In the U.S., FASB also is developing an expected loss model that would accelerate notice to investors when a particular loan or pool of loans will not perform as originally intended, but FASB and IASB chose different approaches to eliciting those early warnings.”The FASB is completing its proposed current expected credit loss model, which would require companies to reflect on day one when they put a loan on the balance sheet any losses they expect to incur over the lifetime of the loan, even if the loan is fully performing,” says FASB spokesman Chris Klimek. FASB also is working on a new approach to classification and measurement. Both standards are expected to be issued at the end of 2014, she says.

IASB and FASB alike felt significant pressure to revise the way banks report loan values after the financial crisis demonstrated the flaw in existing rules that generally prohibited entities from reflecting loan losses until they actually occurred. The IASB says its standard requires entities to account for expected credit losses from when financial instruments are first recognized. The IASB plans to form a transition resource group to address the new impairment requirements. Although IASB and FASB chose different paths to elicit more timely recognition of loan losses, both standards are expected to achieve that objective.

Under IFRS 9, the IASB chose to roll impairment, hedging, and classification and measurement into a single comprehensive standard. Under classification and measurement, IFRS 9 maps out a new method of determining the value of a particular instrument based on the characteristics of the cash flow it produces and the business model under which the instrument is held. With respect to hedging, the new standard overhauls hedge accounting to align the accounting treatment with an entity’s risk management activities. IASB says users will get better information about risk management and the effect of hedge accounting on the financial statements as a result.

IASB says IFRS 9 also removes the volatility companies experience when measuring their own increasingly risky liabilities at fair value. Where a company elects to record liabilities at fair value, a deterioration in credit risk generally led to an improvement in earnings, a result generally seen as illogical.  Under the new standard “gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognized in profit or loss,” IASB says.

The Institute of Chartered Accountants in England and Wales says the new model will increase the loan loss provisions on bank balance sheets by about 50 percent on average and will reduce profits in the year of implementation, but it will not change the cash flow associated with the underlying loans. 

“Increasing the accounting provisions will also reduce regulatory capital,” said Iain Coke, Head of ICAEW’s Financial Services Faculty, in a statement. Since before the financial crisis, regulators have adjusted the reported accounting numbers to take account of some expected losses, he says, but the new standard will go further. “Banks will need to consider the impact of the new standard on their regulatory capital, taking into account the results of regulators’ stress-testing and asset quality review exercises,” he says.

Ultimately, when the effect of new accounting standard is combined with tougher regulatory capital requirements, “it may force banks to hold more capital for the same risks,” said Coke. “This may make banks safer but may also make them more costly to run.”

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