The implementation of Ind AS 109 in India was a significant step towards modernizing the country’s financial reporting framework and aligning it with global standards. However, the transition was not without its challenges. Operational complexities, data issues, increased costs, and potential volatility in financial statements were major obstacles, particularly for smaller institutions and corporations.

Chandigarh (ABC Live): The International Monetary Fund (IMF) on November 20, 2024, released the Review and Evaluation of the Reserve Bank of India’s Stress Test Model Framework.

The IMF report purpose was for the IMF to provide a thorough review of the Reserve Bank of India (RBI)’s analytical capacity and model suite for solvency risk analysis, liquidity risk analysis, and balance sheet connectedness of banks (alongside non-bank financial institutions, NBFIs).

 The RBI provided the IMF team with all available documentation, in the form of documents and through slide shows and detailed discussions during a meeting series that spanned ten working days.

 Toward the later phase of the mission window, the IMF team provided RBI staff with an overview of what it considers best practice (at the Fund and by drawing on practices in other countries) in the above-mentioned areas.

The IMF also provided the RBI with a primer on climate risk analysis. At the request of the RBI, the team delivered a three-hour session on climate risk analysis. It served to provide the RBI with an understanding of how to go about climate risk analysis, including data, analytical tools, and models; including with India-specific research conducted ahead of the meeting by IMF staff, to place all discussions in an India-specific context.

The IMF suggested that most recommendations should ideally be addressed within a two-year window, i.e., by 2025. Addressing them before the beginning of 2025 will be beneficial because a new accounting regime (akin to IFRS 9 in other jurisdictions in 2018) will be implemented in India in 2025 and will imply new tasks and analytical development needs.

ABC Research team writes an in-depth report on Indian Accounting Standard 109(Ind AS 109) the indigenous adaptation of IFRS 9 (International Financial Reporting Standard 9), which has already in force in other countries but will be implemented in India in 2025.

Introduction

To bring India’s financial reporting framework in line with international standards, the Indian government implemented Ind AS 109 (Indian Accounting Standard 109), a domestic adaptation of IFRS 9 (International Financial Reporting Standard 9). This marked a significant shift in the accounting treatment of financial instruments, focusing on their classification, measurement, and impairment. The introduction of this standard was part of India’s broader transition to Ind AS, which aimed to align Indian companies with global financial reporting practices, particularly for those that are listed on international stock exchanges or have global operations.

Ind AS 109 introduces several key changes that have affected the financial services sector, corporate entities, and others with significant exposure to financial instruments. These include a forward-looking impairment model (the Expected Credit Loss model), the classification of financial instruments based on their business model and cash flow characteristics, and the application of hedge accounting practices that reflect actual risk management practices. However, the transition has been fraught with challenges related to implementation, operational readiness, cost implications, and the degree to which it improves financial reporting and risk management.

1. Framework of Ind AS 109 and Key Provisions

Before delving into the challenges and implications of the implementation of Ind AS 109, it's important to understand its core components:

Classification and Measurement of Financial Instruments: Under Ind AS 109, financial assets are classified into three categories based on the business model and the nature of the contractual cash flows:

Amortized Cost: For assets held with the intent to collect contractual cash flows.

Fair Value through Other Comprehensive Income (FVOCI): For assets held for both collecting contractual cash flows and selling.

Fair Value through Profit or Loss (FVTPL): For assets held for trading or those that do not meet the criteria for the other categories.

Expected Credit Loss (ECL) Model: One of the most significant shifts brought by Ind AS 109 is the ECL model for impairment. The ECL model requires businesses to recognize credit losses earlier (even on performing assets) by estimating expected losses over the life of the asset, rather than waiting until a loss has been incurred. This proactive approach aims to reduce the risk of significant, sudden financial shocks that could stem from under-provisioning.

Hedge Accounting: Ind AS 109 also introduces significant changes to hedge accounting. It aligns the accounting treatment of hedging instruments with the underlying risk management activities of entities, thus providing a more accurate reflection of the economic reality of hedging strategies.

2. Implementation Timeline in India

India's implementation of Ind AS 109 was part of a broader effort to converge with global accounting standards (IFRS) and started with listed companies and larger entities in 2016. However, due to its complexity, the transition was phased out over several years:

2016-2017: Ind AS became mandatory for listed entities and large public companies (those with net worth exceeding ₹250 crore) to ensure that India’s financial reporting practices were aligned with global standards.

2018: The RBI initially mandated banks to adopt Ind AS by April 1, 2018, but this was delayed for operational and preparedness reasons. The ECL model posed a particular challenge for banks, which were still grappling with large Non-Performing Assets (NPAs) and insufficient infrastructure to support the new standard.

2019-2020: The RBI extended the timeline to April 1, 2019, for larger Non-Banking Financial Companies (NBFCs) and Housing Finance Companies (HFCs). For other smaller NBFCs and financial institutions, adoption was mandated by April 1, 2020.

The delay in adoption highlights the challenges faced by financial institutions in implementing a model that required major changes in risk management, data collection, and provisioning systems.

3. Key Challenges in the Implementation of Ind AS 109

3.1 Operational and Data-Related Challenges

Implementation Complexity: Ind AS 109 required companies to significantly revise their systems for classifying, measuring, and reporting financial instruments. For many companies, especially smaller ones, the transition was not straightforward. They faced issues in gathering the required data to apply the ECL model effectively. Unlike the incurred loss model used under the previous standard, the ECL model necessitates a forward-looking approach that is heavily dependent on historical data, current conditions, and macroeconomic forecasts.

Data and Systems Requirements: The ECL model requires entities to estimate the credit risk associated with all financial instruments, including performing assets. Financial institutions had to upgrade their IT systems and integrate credit risk models, which was both costly and time-consuming. Smaller NBFCs and regional banks, in particular, faced difficulties in implementing these systems, due to a lack of necessary infrastructure.

Valuation of Financial Instruments: The classification of financial assets and liabilities based on their business model (i.e., amortized cost vs. fair value) presented significant challenges, particularly in terms of fair value estimation. Many smaller entities did not have access to the market data or valuation models required to accurately measure the fair value of certain financial instruments, including complex financial products such as derivatives and non-marketable securities.

3.2 Cost Implications

Increased Compliance Costs: Ind AS 109 introduced substantial costs for organizations, particularly for those that had to make significant investments in new systems, data infrastructure, and risk models. Smaller financial institutions and corporates had to rely on external consultants and auditors to ensure compliance, further increasing costs. Additionally, the cost of training employees to understand the new provisions and implications of the standard was a financial burden for many entities.

Impact on Profitability and Capital Adequacy: The transition to the ECL model meant that financial institutions, particularly banks, had to recognize potential credit losses earlier. This resulted in an increase in provisions for bad loans, thereby impacting profitability. The increased provisions also had a direct effect on capital adequacy ratios, particularly in the context of banks with large NPAs. The Public Sector Banks (PSBs), in particular, struggled with maintaining their capital adequacy ratios due to higher provisions.

3.3 Increased Volatility and Reporting Complexity

Volatility in Financial Statements: The shift to fair value accounting, especially for certain financial assets, led to increased volatility in financial statements. The fluctuations in the market value of financial instruments, especially under market downturns, could lead to sudden changes in a company’s reported profits or losses, creating challenges in providing stable earnings guidance.

ECL and Its Implications for Financial Statements: The ECL model led to a shift in how impairment losses were accounted for, making it necessary to reflect anticipated future credit losses, even for performing loans. This change resulted in greater uncertainty in financial statements, especially during periods of economic downturn when macroeconomic factors could lead to significant fluctuations in the estimated credit losses.

4. Sector-Specific Impacts of Ind AS 109

4.1 Impact on Banks and Financial Institutions

Credit Risk Management: The ECL model fundamentally changed how financial institutions managed and reported credit risk. It required banks to estimate expected credit losses across their portfolios, including performing loans and adjust provisions accordingly. While this enhanced the forward-looking nature of credit risk management, it also put additional pressure on banks, especially those with large portfolios of NPAs.

Capital Adequacy and Provisioning: The shift to the ECL model and the early recognition of credit losses led to higher provisioning requirements, which in turn impacted capital adequacy ratios. This was particularly challenging for banks with already weak balance sheets or those dealing with legacy asset quality issues.

4.2 Impact on Corporates and Non-Banking Financial Companies (NBFCs)

Lending Operations of NBFCs: Smaller NBFCs with less sophisticated risk management systems struggled with the complexity of implementing Ind AS 109. Their ability to assess expected credit losses across their lending portfolios was limited, especially for those offering high-risk, unsecured loans. This led to a more cautious approach to lending in the post-implementation period.

Corporate Borrowers: For corporates that relied on financial instruments (such as bonds, loans, and derivatives), the implementation of Ind AS 109 impacted how these instruments were accounted for on their balance sheets. The classification and fair value measurement of debt securities, in particular, had an impact on how corporate borrowers presented their financial health to investors and creditors.

5. Benefits of Implementing Ind AS 109

Despite the challenges the implementation of Ind AS 109 brings several long-term benefits:

Enhanced Transparency: The ECL model ensures that financial institutions are more proactive in addressing credit risk, leading to earlier recognition of potential losses. This improves the overall transparency of financial statements and provides a more accurate reflection of a company’s financial health.

Global Alignment: Ind AS 109 ensures that India’s financial reporting standards are aligned with global norms, making Indian companies more attractive to foreign investors and enabling smoother cross-border capital flows.

Improved Risk Management: The move to forward-looking risk models and enhanced transparency in financial statements enables better risk management and strategic decision-making by organizations, regulators, and investors.

6. Conclusion

The implementation of Ind AS 109 in India was a significant step towards modernizing the country’s financial reporting framework and aligning it with global standards. However, the transition was not without its challenges. Operational complexities, data issues, increased costs, and potential volatility in financial statements were major obstacles, particularly for smaller institutions and corporations.