An-Najah National University Faculty of Graduate Studies The impact of the adoption of IFRS 9 on the related financial statements of the banks operate in Palestine and Jordan By Raja Nayef Ismail Awawda Supervisor Dr. Muiz Abu Alia This Thesis is Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Accounting, Faculty of Graduate Studies, An-Najah National University, Nablus - Palestine. 9102 iii Dedication This thesis is present to my sister‟s soul, may God has mercy on her To my parents, my wife and my children For their unlimited love and continued encouragement To my brothers and sisters for continued encouragement To my teachers who supported me To my friends for their support To all whom I loved iv Acknowledgments In the beginning, I thank God who helps me to achieve my studies and to get the Master‟s degree I would like also to thank my supervisors Dr. Muiz Abu Alia for his continues support through this long journey to get my Master degree I am also thankful to all doctors in accounting departments at An-Najah National University for their continuous support At the end, my parents, my wife, my children, my family Without all of you, this dream will never become true!! v اإلقرار انا الموقع أدناه, مقدم الرسالة التي تحمل العنوان: The impact of the adoption of IFRS 9 on the related financial statements of the banks operate in Palestine and Jordan أقر بأن ما اشتممت عميو ىذه الرسالة انما ىو نتاج جيدي الخاص. باستثناء ما تمت االشارة اليو م من قبل لنيل أية درجة عممية أو بحث عممي دحيثما ورد, وأن ىذه الرسالة ككل أو جزء منيا لم يق أو بحثية اخرىأو بحثي لدى أي مؤسسة تعميمية Declaration This work provided in this thesis, unless otherwise referenced, is the researcher‟s own work, and has not been submitted elsewhere for any other degree qualification Student Name: اسم الطالب: Signature: التوقيع: Date: التاريخ: vi Table of Contents No. Content Page Dedication Iii Acknowledgments Iv Endorsement V List of Tables Viii List of Figures X List of Abbreviations Xi Abstract Xii Chapter One: Introduction 1 1.1 Introduction 2 1.2 Problem Statement 8 1.3 Research Questions 9 1.4 Importance of the study 9 1.5 Objectives of Study 11 1.6 Contribution of the Study 11 Chapter Two: Literature Review 12 2.1 Introduction 13 2.2 History and background on accounting standards for financial instruments 13 2.3 International Accounting Standard 39 "Financial Instruments: Recognition and Measurement" 20 2.4 International Financial Reporting Standard 9 "Financial Instruments" 30 2.5 Classification and measurement of financial instruments under the IFRS 9 50 2.6 The expected effect of applying phase Ⅰ of IFRS 9 “Classification and Measurement” on earnings and owners' equity 53 2.7 The expected effect from applying phase Ⅱ of IFRS 9 “Impairment Model” on earnings, specific & general provisions and capital adequacy ratio (CAR) 58 2.8 Difficulties in implementing of IFRS 9 by banks 68 2.9 Research Hypotheses 73 Chapter Three: Research Methodology 74 3.1 Introduction 75 3.2 Research Approach 75 3.3 Study population and sample 76 3.4 Data of the study 77 3.5 Statistical methods used to analysis data 80 vii Chapter Four: Results and Discussion 84 4.1 Introduction 85 4.2 Descriptive statistics of variables 85 4.3 Hypotheses Test 114 Chapter Five: Conclusion and Recommendation 130 5.1 Introduction 131 5.2 Theses review 132 5.3 Implication of the study 133 5.4 Limitation of the study 134 5.5 Conclusion 134 5.6 Recommendations 137 References 139 Appendix 147 ب الملخص viii List of Tables No. Table Page 1. The expected effect on earnings from applying IFRS 9 55 2. Expected effect from applying ECL on CAR 61 3. Summary of PMA instructions number (01/2008) 64 4. Summary of PMA instructions number (06/2015) 65 5. Summary of JCB instructions number (47/2009) – SP 65 6. Summary of JCB instructions number (47/2009) – GP 66 7. Summary of PMA and JCB instructions to distinction ECL provisions as GP and SP 66 8. The researcher sample for the first part 76 9. The researcher sample for the second part 77 10. Measurements for the second section of the questionnaire 79 11. Measurements for the third section of the questionnaire 80 12. Descriptive statistics - First part 87 13. Questionnaire respondent 87 14. Respondent personal information - Qualifications 88 15. Respondent personal information - Specialization 89 16. Respondent personal information - Professional Certificates 90 17. Respondent expected effect from applying phase Ⅱ of IFRS 9 - Palestine 91 18. Respondent expected effect from applying phase Ⅱ of IFRS 9 - Jordan 93 19. The direction of respondent expected effect from applying phase Ⅱ of IFRS 9 - Palestine 95 20. The direction of respondent expected effect from applying phase Ⅰ of IFRS 9 - Jordan 97 21. Scaling Degrees 99 22. Difficulties in implementing Business model under IFRS 9 100 23. Difficulties in implementing solely payments of principal & interest under IFRS 9 102 24. Difficulties in preparing information for IFRS 9 purposes 103 25. Difficulties in the availability of resources for IFRS 9 purposes 105 26. Difficulties in determined significant increases in credit risk for IFRS 9 purposes 106 27. Difficulties in collective assessment basis under IFRS 9 107 28. Difficulties in applying the processes, systems, models, data collection and risk management practices for IFRS 9 purposes 109 ix 29. Difficulties in governance and internal controls for IFRS 9 purposes 110 30. Difficulties in disclosures for IFRS 9 purposes 111 31. Difficulties in the term of costs of implementing IFRS 112 32. ECL model development to deliver IFRS 9 113 33. Summary of Statistics – Paired Samples Test 115 34. Summary of Statistics – One-sample Binomial test - Palestine 118 35. Summary of Statistics – One-sample Binomial test - Jordan 122 36. Difficulties in implementing IFRS 9 127 37. Summary of reclassification between IAS 39 and IFRS 9 135 x List of Figures No. Figure Page 1. Reclassification of financial instruments under the amendment to IAS 39 15 2. Classification under IFRS 9 for financial asset 33 3. Classification under IFRS 9 for financial asset 34 4. Classification and measurement of financial liabilities under IFRS 9 37 5. Classification of an embedded derivatives under IFRS 9 38 6. Reclassification of financial assets under IFRS 9 40 7. Overview on the General (or three-stage) impairment approach 43 8. Overview on impact of a significant increase in credit risk 44 9. Overview on impairment of modified financial assets under IFRS 9 45 10. Comparison of classification and measurement under IAS 39 and IFRS 9 53 xi List of Abbreviations AC Amortized Cost AFS Available For Sale AOCI Accumulated Other Comprehensive Income SFP Statement of Financial Position BCBS Basel Committee on Banking Supervision CAR Capital Adequacy Ratio CECL Current Expected Credit Loss CTE1 Common Equity Tier-1 EAD Exposure At Default ECL Expected Credit Loss EIM Effective Interest Method FASB Financial Accounting Standard Board FSB Financial Stability Board FVTOCI Fair Value Through Other Comprehensive Income FVTPL Fair Value Through Profit or Loss GP General provision HFT Held For Trading HTM Held To Maturity IAS International Accounting Standards IASB International Accounting Standards Board IASC International Accounting Standards Committee IFRS International Financial Reporting Standard IRB Internal Rating Based IT Information Technology JCB Central bank of Jordan KPIs Key Performance Indicators L&R Loans and Receivables LGD Loss Given Default OCI Other Compressive Income PD Probability of Default PMA Palestine Monetary Authority RR Recovery Rate RWA Risk weighted assets SP Specific provision SPPI Solely Payments of Principal and Interest UKCGC United Kingdom Corporate Governance Code xii The impact of the adoption of IFRS 9 on the related financial statements of the banks operate in Palestine and Jordan By Raja Nayef Awawda Supervised by Dr. Muiz Abu Alia Abstract Following the global financial crisis, a lot of criticism has raised against the accounting standard for financial instruments. For example, IAS 39 was criticized as the main cause of the global financial crisis, because it classifies financial instruments in a way that enables management to hide the real financial position of the holder. In addition, it creates provisions that is too little and too late. As a result, the IASB issued IFRS 9 to overcome that weakness. IFRS 9 introduces a new method for classification and measurement of the financial instruments. The entity business model and cash flow characteristics of the financial instruments were used as a basis instead of management intent, as required by previous standards. The adoption of the new classifications model affects comprehensive income and owners' equity statements, since the treatment of financial instruments gain or loss and fair value evaluation differs if compared with how it treated under the previous standards. Furthermore, IFRS 9 introduces a new impairment model to address any changes in the fair value of financial instruments, some times before it‟s xiii acutely occurs, which replaced the incurred loss model. Applying the new impairment model is expected to result in a huge change in the financial statements, as higher provisions are possible with the lifetime loss concept and the inclusion of forward-looking information in the assessment and measurement of ECL (BCBS, 2017). The main objective of this thesis is to examine the impact of IFRS 9 adoption on the related financial statements of banks that operate in Palestine & Jordan. To achieve this objective, the researcher divided the objective of the thesis into the following sub-objectives: First, examine the impact of applying phase Ⅱ of IFRS 9 “classification and measurement” on comprehensive income and owners' equity statements of the banks that operating in Palestine and Jordan. The researcher collected data from the annual reports of the banks that were operated in Palestine (16 banks) and Jordan (15 banks) in the first year of implementing this phase (2011-2012). Using the Paired Sample test to address the impact of applying phase Ⅰ of IFRS 9, the study observed that implementing phase Ⅰ of IFRS 9 has no effect on comprehensive income or on owners' equity statements of the banks that operate in Palestine and Jordan. Second, examine the expected effect of applying phase Ⅱ of IFRS 9 “new impairment model” on the comprehensive income statement, specific provision (SP) and general provisions (GP) and capital adequacy ratio (CAR) of the banks that operate in Palestine and Jordan. The researcher xiv collected data from the banks that operate in Palestine (14 banks) and Jordan (24 banks) through a questionnaire. The One-Sample Binominal Test was used to investigate the expected effect of applying phase Ⅰ of IFRS 9. The study observed that implementing phase Ⅱ of IFRS 9 is expected to have a material effect on the comprehensive income statement, SP and GP and CAR of the banks that operate in Palestine and Jordan. However, the expected effect differs from bank to bank depending on the bank profile, capital level and financial instruments held by each bank. Third, examine the difficulties associated with the implementing of IFRS 9 by the banks that operate in Palestine and Jordan. The researcher collected data from the banks that operate in Palestine (14 banks) and Jordan (24 banks) using a questioner. The One-Sample Test was used to address the difficulties of implementing IFRS 9. The study observed that implementing IFRS 9 has many difficulties in different areas, such as, implementing Business model, implementing solely payments of principal & interest basis, preparing information, determined significant increases in credit risk, collective assessment basis, applying the processes, systems, models, data collection and risk management practices, governance and internal controls, disclosures and the costs of implementing. The results of the research provide early evidence on the impact of early adoption of IFRS 9 for a small sample of banks in emerging capital markets. As a result, the regulator may need to further analyse the effect of applying IFRS 9 to see the effect on bank’s comprehensive income statement, SP and GP and CAR, and take corrective actions if needed, such xv as, apply the transition period to reflect the effect from applying IFRS 9 on CAR according to BCBS (2017) recommendations. In addition, issue further instructions to assist banks to overcome the difficulties in implementing IFRS 9. 1 Chapter One Introduction 2 Chapter One Introduction 1.1 Introduction At the end of 2008, the global financial crisis highlighted the deficiency of existing accounting standards for financial instruments (Miu & Ozdemir, 2016, p.3). Barth & Landsman (2010, p.1) mention that accounting standards for financial instruments; especially loan loss provisioning, asset securitizations and derivatives as the main source of the global financial crisis. Accounting standards that deal with financial instruments were criticized, for example, International Accounting Standard 39 “Financial Instruments: Recognition and Measurement” (IAS 39), as a main source of the global financial crisis. The IAS 39 has been considered as insufficiently transparent for investors to assess properly the values and riskiness of companies' assets and liabilities (Barth & Landsman, 2010, p.1). Therefore, it played an important role in creating the global financial crisis. For example, the classification basis under IAS 39 enables managers to designate the financial instrument into a class that is favourable for recognizing gains and losses, but not according to real management intent (Knežević, Pavlović & Vukadinović, 2015, p. 23). In addition, impairment losses under incurred loss model recorded only when it supported by objective evidence, which result in recording too little impairment provisions in late stages. As a result, provisioning under IAS 3 39, as practiced, often does not meet supervisory requirements from the perspective of credit risk review and capital adequacy assessment (IMF, 2014, p.3; BCBS, 2016). As a result, many international sovereign authorities and international bodies (e.g. G20, Financial Stability Board (FSB), Basel committee on Banking supervision (BCBS), etc.) have identified that IAS 39 and related standards as a main source of the global financial crisis (Huian, 2012, p.28). The International Accounting Standard Board (IASB) was forced to introduce an accounting standard that have a forward looking in recognizing credit loss provision and take fair value measurement issue into consideration when classifying and measuring the financial instruments (BCBS, 2016, p.1). As a response, the IASB issued the International Financial Reporting Standard 9 “financial Instruments” (IFRS 9) to overcome the weakness in IAS 39. The IASB issued the complete standard in July 2014. The standards issuance have divided into three phases. The first phase is related to the classification and the measurement of the financial instruments. The second phase is about the impairment model for financial instruments based on expected credit losses (ECL) model. Finally, the third phase focuses on hedge accounting. 4 Phase I: Classification and Measurement The new method for classification and measurement depends on both: the entity business model and the cash flow characteristics of the financial instruments instead of management intent, which was applied under the previous standard. The financial instruments will be measured at amortized cost (AC), or fair value (either; Fair value through profit or loss (FVTPL), or fair value through other comprehensive income (FVTOCI)). The adoption of the new classifications model will affect (increase or decrease) the comprehensive income and owners' equity statements, since the treatment of financial instruments gain or loss and fair value evaluation differs if compared with how it was treated under IAS 39. Furthermore, the large size and the importance of the financial assets and liabilities in the financial statements, especially in the bank's financial statement, are expect to be effected by applying the new method to classify and measure the banks’ financial instruments. Phase II: Impairment model The new impairment model depends on the forward-looking impairment model to address any changes in the fair value of financial instruments, some times before it is acutely occurred, instead of incurred loss model, which records impairment loss only after the default had already occurred. Appling phase Ⅱ of IFRS 9 is expected to change the financial statements, specially the banks’ financial statements. According to BCBS 5 (2016a, p.1), applying the new impairment model is expected to result in higher provisions, because of using the forward looking information in the ECL model. Applying the new impairment model will result in higher provisions in the banking sector because the provisions under the old accounting provisioning model were made after the impairment test match (after the changes had occurred). For example, specific provisions (SP) for loan made only after the borrower cannot pay his commitment (BCBS, 2016, p.1). Moreover, provisions will have to be made for each financial instrument, such as, indirect (Off- Statement of Financial Position "Off- SFP") facilities, equity instruments …etc. As a result, the new accounting provisioning models will result in higher provisions in banking sectors, which will have negative effects on bank capital, and capital base. Phase III: Hedge Accounting The entities have the option to continue applying IAS 39 - hedge accounting requirements instead of IFRS 9 – hedge accounting requirements. Many researchers, regulatory bodies, standard setters, accounting organizations, bankers, etc. try to analyse the expected effect from applying IFRS 9 on company's financial statements, including banks’ financial statements. In general, all of them agree that the effect of applying IFRS 9 will enhance the financial statements ' ability to present fair value, especially in distress situations. 6 Many previous studies, such as Lopes & Rodrigues (2003), Detilleux & Naett (2005), Fifield, Finningham, Fox, Power, &Veneziani(2011), Jarolim & Oppinger (2012), Huian (2012), Girbina, Minu, Bunea, & Sacarin (2012), Onali & Ginesti (2015), Onali, Ginesti & Ballestra (2017) try to analyse the companies accounting practices for financial instruments and compare the companies' compliance with the measurement, recognition and disclosure requirements. However, they found that companies have a quite long way to go through in terms of accounting and disclosure of financial instruments activity, namely derivatives. On the other hand, a few studies try to analyse the companies accounting practices for financial instruments and compare the company‟s compliance to the measurement, recognition and disclosure requirements for financial instruments according to IFRS 9. However, Al Hayek & Abu El Haija (2011) assess the Jordanian accountants' knowledge in IFRS 9 requirements, especially, classification and measurement, impairment model, hedge accounting, etc. They found that the Jordanian accountants have sufficient overall knowledge regarding IFRS 9 requirements. Onali & Ginesti (2015) evaluate the market reaction to the IFRS 9 announcement. They found that IFRS 9 has a positive reaction from the market. The IFRS 9 will be beneficial to shareholders who have a weak rule. The investors expected that IFRS 9 would enhance and support the comparability between entities. In Onali, et al. (2017) study, they evaluate the market reaction IFRS 9 setting process. They found that IFRS 9 is affected by firm information quality and asymmetry. 7 According to Girbina, Minu, Bunea & Sacarin (2012), the use of IFRS, such as IFRS 9, as reporting standards would increase the firm's ability to collect capital. Also, it increases the comparability, reporting transparency, quality, better information for decision making, information disclosed, understanding of performance and risks. Many large Norwegian banks expect IFRS 9 to have little or no impact. Until now, the effects from IFRS 9 implementation, have not yet fully observed in practice, and therefore present policy challenges. The implementation of IFRS 9 could change credit portfolio compositions and impact capital calculation approaches employed under Basel standards (Stefano, 2018). This thesis aims to address the impact of the adoption of IFRS 9 on the related financial statements for banks that operate in Palestine & Jordan. For this reason, the researcher divided this study into two main parts. The first part focuses on the impact of applying phase Ⅰ of IFRS 9 on comprehensive income and statement of changes in equity. The second part, focuses on the expected effects of applying phase Ⅱ of IFRS 9 on the comprehensive income statement, SP and GP and CAR. In addition, the difficulties of implementing IFRS 9 requirements have explored using a questionnaire developed based on previous studies. The remaining of this introductory chapter includes six sections. Section 1.2 discusses the research problem. Section 1.3 presents the research questions. Section 1.4 explains the importance of the study. Section 1.5 8 explains the objectives of the study and section 1.6 discusses the contribution of the study. 1.2 Problem Statement According to Girbina, et al. (2012), International Monetary Fund (IMF) (2014), European Parliament (2015), Beerbaum & Piechocki (2013), the major change in International Accounting Standard (IAS) and International Financial Reporting Standard (IFRS) regarding accounting for financial instruments since 1988 until now; was changing the methodology of accounting for financial instruments from historical cost to fair value accounting; based on risk management concept. IFRS 9 became based on the risk management concept (forward-looking) to address any changes in fair value of financial instruments. IFRS 9 was the first accounting standard that merges accounting with risk management that took the expected effects of the future event into consideration. It depends on recording historical economic events using historical cost or fair value. However, a lack of research addressing the effects of implementing IFRS 9 on financial statements in emerging economies exists, especially, the effects of implementing phase Ⅰ of IFRS 9 on comprehensive income and equity statements and the effects of applying phase Ⅱ of IFRS 9 on comprehensive income statement, SP and GP, CAR in such economies. In addition, there are insufficient researches addressing the difficulties of implementing the requirements of IFRS 9. Thus, this study addresses the 9 effects of the adoption of the IFRS 9 phases on the financial statements of the banks that operate in Palestine and Jordan and the difficulties of applying this standard from the perspectives of these banks. 1.3 Research Questions Based on the above discussion; this study introduces three main research questions as the following:  What is the impact of implementing phase Ⅰ of IFRS 9 “classification and measurement” on comprehensive income and owners‟ equity statements in the banks that operate in Palestine and Jordan?  What are the expected effects of applying phase Ⅱ of IFRS 9 “new ECL model” on comprehensive income statement, SP and GP and CAR in the banks that operate in Palestine and Jordan?  What are the difficulties of implementing IFRS 9 requirements? 1.4 Importance of the study According to Beerbaum & Piechocki (2013), modifications on accounting standards become clear to investors only when the new standards are first used for external reporting. From the previous discussion, applying phase Ⅰ of IFRS 9 to measure and classify financial instruments will affect the company's financial statements. Also, applying phase Ⅱ of IFRS 9 will result in higher provisions. 11 However, IFRS 9 is effective for external reporting since 1st January 2018 or after. However, the Palestine Monetary Authority (PMA) and Central bank of Jordan (JCB) enforced the banks to early implementation of phase Ⅰ of IFRS 9 in 2011-2012 due to global improvement in accounting standards. Completing such a study provides an opportunity to determine the impact of implementing phase Ⅰ of IFRS 9 before IFRS 9 became effective for external reporting. In addition, banks were at the centre of the financial crisis and many international bodies (e.g. BCBS, central banks, etc.) expected that applying IFRS 9 would increase in impairment provisions, which in many cases will reduce the capital ratios of banks. Therefore, completing such a study provides an opportunity to determine the expected impact of implementing phase Ⅱ of IFRS 9 on the comprehensive income statement, SP and GP and CAR. As a result, the importance of this study comes from its purposes and expected results. It may assist to determine the effects of implementing phase Ⅰ of IFRS 9 on the comprehensive income and equity statements in the banks that operate in Palestine and Jordan before the IFRS 9 became effective for external reporting. Moreover, the study is also important because it will try to determine the expected effects from applying phase Ⅱ of IFRS 9, which will help the Palestinian and Jordanian authorities and banks to take corrective actions if needed, such as, a transition period to reflect the effect of implications on banks‟ capital. 11 1.5 Objectives of the study Due to the large size, the importance of financial instruments in the institution‟s financial statements (especially in banks - which expected to be larger, affected by applying IFRS9), this study was conducted. The overall objective of the study is to try to identify the expected effect of implementing IFRS 9 before the standard became required for external reporting since 1 st , January 2018; using the case of Palestine and Jordan were part of standard 9 are required since the end of 2011-2012. 1.6 Contributions of the Study The lack of studies address the expected effect of applying IFRS 9, this study provides significant contributions to the existing financial instrument literature particularly in emerging economies such as Palestine and Jordan. Specifically, the study addresses the impact of applying phase Ⅰ of IFRS 9 on comprehensive income and owners' equity statements. In addition, the expected effects of applying phase Ⅱ of IFRS 9 will result in higher provisions. Moreover, the difficulties of applying IFRS 9 are also addressed. The results of this study are of considerable importance for the regulators and other related parties in Palestine and other developing countries, which have similar regulations. 12 Chapter Two Background & Literature Review 13 Chapter Two Background & Literature Review 2.1 Introduction This chapter aims to provide a clear view of accounting for financial instruments and how it is addressed in the accounting literature. The chapter structure is formatted in a manner that reflects the study objectives. It includes nine sections. The following section provides a brief history of accounting standards for financial instruments. The third section discusses the IAS 39 requirements. The fourth section discusses the IFRS 9 requirements and the major differences with IAS 39. The fifth section discusses the classification and measurement of financial instruments under IFRS 9. The sixth section discusses the expected impact of applying phase Ⅰ of IFRS 9. The seventh section discusses the expected effect of applying phase Ⅱ. The eighth section discusses the difficulties in implementing IFRS 9 by banks. The last section presents the research hypotheses. 2.2 History and background on accounting standards for financial instruments The International Accounting Standards Committee (IASC), the predecessor body of the IASB, started its work on accounting for financial instruments since 1986. The IAS 25 “Accounting for Investments” - issued in March 1986 - was one of the first accounting standard issued by the 14 IASC that addresses accounting for financial instrument. However, IAS 39 and IAS 40 superseded IAS 25 (IFRS Foundation, 2013a, p.1373). The IAS 32 “Financial Instruments: Disclosure and Presentation” was another accounting standards issued by the IASC, which outlines the presentation requirements for financial instruments. In addition, it sets a guidance for classification of related interest, dividends, gains/ losses (Deloitte, 2019). The objective of IAS 32 was to improve the user ability to evaluate the on and off-SFP financial instruments and how it is important to the entity. IAS 32 was seen as starting point to use fair value measurement for financial instruments, because it show both recognized and unrecognized information about fair value evaluation (Lopes & Rodrigues, 2003, p.6). However, the IASC limited this standard to presentation and disclosure issue, not measurement issues (Al-Hayek & Abu El-Haja, 2011, p.39). In 1990, the credit and savings institutions used historical cost to measure the value of the financial instruments instead of fair value, which led to the saving-loan crisis at that time. As a result, IAS 39 was issue by the IASC in December 1998. IAS 39 define the rule for recognition and measurement of financial instruments. IASC introduced fair value measurement for financial instruments because they believe that fair value is better and more objective than historical cost (Knežević, et al, 2015, p.22). 15 However, the later financial crises have increased the debate on measurement bias for financial instruments (Paananen, Renders & Shima, 2012, p.208). In addition, accounting standards on financial instruments were often seen too complex, not working with real business models due to their rule based natural and difficult to understand (IASB, 2014, p.6). In addition, the standard setters faced a lot of criticism from the preparers and the users of the financial statements about IAS 39 application. They argued that IAS 39 needs improvements regarding the complexity of financial instruments standards and when fair value measurement is used (Huian, 2012, p28). The IASB issued an amendment to IAS 39 in October 2008 (Paananen, et al, 2012, p.209). The new amendment allowed reclassification of financial instruments as follow: . Figure 1: Reclassification of financial instruments under the amendment to IAS 39Source: Snapshot from Guo & Matovu, 2009, p.3. (1 to 4) are newly permitted by the amendment to IAS 39 and the other two (5 and 6) are already permitted by IAS 39. 16 The new amendments were introduced as a direct reaction to the financial crisis (Guo & Matovu, 2009). It is seen as an attempt from the IASB to make accounting standard related to financial instruments useable and can deal with it during financial crisis. However, under the new amendments, the financial instruments became measured using fair value instead of historical cost or a mix of both. After the global financial crisis, a lot of debate was raised on the use of fair value accounting. Many parties have voiced against the fair value accounting because they believe that fair value was responsible for the financial crisis by allowing managers to manipulate financial statements users by recognizing more change in fair value in other compressive income (OCI) (Huian, 2012, p.29, Jarolim & Öppinger, 2012, p.70). In addition, using fair value reduces the information value by enabling companies to avoid reporting unrealized fair value losses (Paananen, et al, 2012, p.211). On the other hand, many standard setters still favour of fair value accounting instead of historical accounting even after financial crisis. They questioned the role of fair value in the financial crisis since the number of the financial instruments reported using fair value during the crisis was too small. They argued that most of the failures were caused by poorly performing loans (Huian, 2012, p.29). In addition, fair value information provides early warnings to investors and regulators of changes in current market expectations - when asset prices are declining and risk levels for financial institutions are increasing-. However, they argued, historic cost 17 accounting provides insufficient warning of these changes (Al Hayek & Abu El Haija, 2011, p.40). As a result of the above debate, the IASB issued IFRS 9. The standard outlines the accounting requirements for recognition and measurement, impairment and general hedge accounting. The standard completed in three phases, as follow (IFRS Foundation, 2013b, p.299):  Phase I: classification and measurement of financial assets and liabilities. - Issuing chapters on how to classify and measure financial assets in November 2009. - Adding chapter on how to classify and measure financial liabilities in October 2010. - Making Limited modifications to the classification and measurement chapters in November 2011. - Issuing an Exposure Draft “Classification and Measurement: Limited Amendments to IFRS 9” in November 2012. - IASB reissued IFRS 9, including classification and measurement requirements in July 2014.  Phase II: impairment methodology. - Publishing a request for information on the feasibility of an ECL model in June 2009. 18 - Issuing an Exposure Draft “Financial Instruments: AC and Impairment” in November 2009. - Issuing an Exposure Draft “Financial Instruments: Impairment” in January 2011. - Issuing an Exposure Draft “Financial Instruments: ECL” in March 2013. - IASB reissued IFRS 9, including impairment requirements in July 2014. The major reason for replacing incurred loss model with ECL model was that incurred loss model delayed impairment provision until the default occurs, which was ccriticized as a major reason for the financial crisis. This conversion is the most important changes and the ECL model has to be applied retrospectively. (UniCredit, 2015, p.2)  Phase III: hedge accounting. - The hedge accounting chapter was issue in November 2013. - IASB reissued IFRS 9, including hedge accounting requirements in July 2014 The IFRS 9 - hedge accounting requirements are optional which give the user the option to continue applying IAS 39 hedge accounting requirement. Therefore, the expected effects of phase Ⅲ will be minimum, and will be out of scope of this thesis. 19  IFRS 9 and US GAAP The IFRS 9 project was initially carried out as a joint project with the Financial Accounting Standard Board (FASB). However, in January 2011, after a lot of common efforts, the FASB decided to make its ECL model (EY, 2014, p.5). The FASB made limited changes to the classification and measurement of financial instruments (BDO,2016, p.6). FASB issued the Current Expected Credit Loss (CECL) standard, which is broadly in line with the IFRS 9, which seeks to address this by (CRISIL, 2016, p.4):  Replacing incurred credit loss with ECL, and,  Introducing lifetime of financial instruments. The major difference between CECL and IFRS 9 can be summarized as follow (CRISIL, 2016, p.4): - CECL mandates provisioning for lifetime ECL, while IFRS 9 uses a dual measurement approach (12 months‟ and lifetime ECL). - CECL is more practical than IFRS 9, it allows the use of existing credit loss models as long as they can be modified to estimate expected lifetime losses accurately, while IFRS 9 mandates explicit use of probability of default (PD), loss given default (LGD) and exposure at default (EAD) to calculate ECL. 21 2.3 IAS 39 "Financial Instruments: Recognition and Measurement" 2.3.1 Overview IAS 39 was originally issued in March 1999 by the IASC. However, the original IAS, which had been issued in December 1998, replaced some parts of IAS 25 that issued in March 1986 (IFRS Foundation, 2013a, p.1373). The IASB adopted IAS 39 in 2001. However, many amendments to the standard were conducted until 2008, such as (IFRS Foundation, 2013a, p.1373): a) Allow to use fair value hedge accounting for a portfolio hedge of interest rate risk, March 2004; b) Determined when fair value option should be applied, June 2005; c) Issuing application guidance for applying hedge accounting requirements, July 2008; d) Allowing reclassification for a certain type of financial assets, October 2008; e) Determining how to measure reclassified embedded derivatives, March 2009. 21 This section presents an outline of IAS 39 (version of IAS 39, which was in force in 2008). 2.3.2 Objective and Scope The IASB has issued the revised IAS 39 in Dec. 2006 to improve IAS 32, by issuing recognition and principles for financial instrument [IAS 39.1]. The new standard tries to reduce complexity by providing guidance, improve internal consistencies to the standard [IAS 39, IN2-3]. The scope of IAS 39 (which is the same scope for IFRS 9, with some additions) shall be applied by all entities to all types of financial instruments, except the following [IAS 39.2]: a) Interests in subsidiaries, associates and joint ventures accounted for under IAS 27 “Consolidated and Separate Financial Statements” or IAS 28 “Investments in Associates” or IAS 31 “Interests in Joint Ventures”. b) Rights and obligations under leases to which IAS 17 “Leases” applies. c) Employers‟ rights and obligations under employee benefit plans, to which IAS 19 “Employee Benefits” applies. d) Financial instruments issued by the entity that meet the definition of an equity instrument in IAS 32 (including options and warrants) are within the scope of IAS 39, unless they meet the exception in (a) above. e) Rights and obligations arising under insurance contract. 22 f) Contracts for contingent consideration in a business combination, only to the acquirer. g) Contracts between an acquirer and a vendor in a business combination to buy or sell acquire at a future date. h) Loan commitments issued by the entity, to which IAS 37 “Provisions, Contingent Liabilities and Contingent Assets” applies. i) Rights to payments to reimburse the entity for expenditure. j) Financial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 “Share-based Payment” applies. 2.3.3 Recognition and derecognition 2.3.3.1 Initial recognition Financial assets and liabilities shall be recognized when, and only when, the entity becomes a party to the contractual provisions of the instrument [IAS 39.14]. 2.3.3.2 Derecognition of a financial asset and liability Derecognition is the removal of a previously recognized financial asset or liability from an entity‟s SFP [IAS 39.9]. An entity shall apply derecognition requirements to a financial asset (or a group of similar financial assets) in its entirety. The entity shall apply derecognition requirement when and only when (a) contractual rights expire or (b) 23 transfer of assets is qualifies for applying derecognition requirements [IAS 39.17]. However, an entity shall apply derecognition requirements to a financial liabilities (or a group of similar financial liabilities) when, and only when, it is extinguished [IAS 39.39]. 2.3.4 Classification and measurement 2.3.4.1 Initial measurement of financial instruments At initial recognition, the financial instruments shall be measured at fair value plus transaction costs (if not at FVTPL). 2.3.4.2 Subsequent measurement of financial assets For measurement and profit recognition purposes, financial assets are classified under the following four categories [IAS 39.45]: 1. Financial assets at FVTPL, which meet the following conditions [IAS 39.9]: a) Held for trading (HFT), if: - Acquired or incurred to be selling or repurchasing in the short term; - Part of a portfolio that have short-term profit taking purposes; or - Derivative. 24 b) FVTPL, without any deduction for transaction costs [IAS 39.46]. A gain or loss on it shall be recognized in profit or loss [IAS 39.55a, 46c]. 2. Held to maturity investments (HTM), which are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity [IAS 39.9]. 3. Loans and receivables (L&R), which are non-derivative financial assets with fixed or determinable payments that are not quote in an active market [IAS 39.9]. Under (2 and 3) category, financial assets should be measured at AC using the effective interest method (EIM) [IAS 39.46 a, b]. A gain or loss shall be recognized in profit or loss through the amortization process [IAS 39.56]. 4. Available for sale (AFS), which are those non-derivative financial assets that are designate as AFS or are not classify as (a) L&R, (b) HTM investments or (c) financial assets at FVTPL [IAS 39.9]. A gain or loss on under this category should be recognized directly in equity, through OCI statement. However, interest calculated using the EIM is recognized in profit or loss. Dividends recognized in profit or loss [IAS 39.55b]. All financial assets (except those measured at FVTPL) are subject to review for impairment. 25 2.3.4.3 Subsequent measurement of financial liabilities An entity shall measure all financial liabilities; after initial recognition; at AC using the EIM, except for [IAS 39.47]: a) Financial liabilities at FVTPL, at fair value. b) Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies. c) Financial guarantee contracts [IAS 39.9]. d) Commitments to provide a loan at a below-market interest rate. e) Financial liabilities that are designate as hedged. 2.3.5 Embedded derivatives An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract - with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative [IAS 39.10]. An embedded derivative shall be separated from the host contract and accounted for as a derivative under IAS 39 if, and only if [IAS 39.11]: a) The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract; 26 b) A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and c) The hybrid (combined) instrument is not measured at fair value with changes in fair value recognized in profit or loss. 2.3.6 Reclassifications Under IAS 39, the entity can reclassify financial instrument between HTM to AFS [IAS 39.51, 52], but not from or to FVTPL. 2.3.7 Impairment At each SFP date, the entity should ensure if there is an objective evidence that the financial instrument is impaired, which occurred only when there are an event (s) that has an impact on estimated future cash flows that can be reliably measured [IAS 39.59]. Objective evidence of impairment may include [IAS 39.59-61]: a) Significant financial difficulty of the issuer or obligor; b) Breach of contract; c) Probable borrower bankruptcy or reorganization; d) Disappearance of an active market; or e) Measurable decrease in the estimated future cash flows f) A downgrade of an entity‟s credit rating. 27 g) A significant decline in the fair value. 2.3.7.1 Impairment of financial assets at AC For L&R or HTM, impairment loss equals to difference between (a) carrying amount and (b) present value of estimated future cash flows discounted at the financial asset‟s original effective interest rate. Impairment losses shall be recognized in profit or loss [IAS 39.63]. The reversal is allowed, but should not exceed the origin-carrying amount [IAS 39.65]. 2.3.7.2 Impairment of financial assets at cost For unquoted equity instrument, impairment loss equals to difference between (a) carrying amount and (b) present value of estimated future cash flows discounted at the current market rate of return [IAS 39.66]. 2.3.7.3 Impairment of AFS financial assets For AFS, impairment loss equals to difference between (a) acquisition cost and (b) current fair value, less any impairment loss previously recognized in profit or loss [IAS 39.68]. The reversal allowed, but should not exceed the origin cost [IAS 39.70]. 28 2.3.8 Hedge accounting 2.3.8.1 Qualifying items For hedge accounting purposes, only assets, liabilities, firm commitments or highly probable forecast transactions that involve a party external to the entity can be designated as hedged items [IAS 39.80]. 2.3.8.2 Qualifying criteria for hedge accounting If and only if, all of the following conditions are met [IAS 39.88]: a. The hedge is formal designation and documentation of the hedging relationship and the entity‟s risk management objective and strategy for undertaking the hedge. b. The hedge expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. c. For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss. d. The effectiveness of the hedge can be reliably measured. e. The hedge assessed on an on-going basis. 29 2.3.8.3 Hedge accounting A. Fair value hedge: a hedge of the exposure to changes in fair value of hedge item. B. Cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction and could affect profit or loss. C. Hedge of a net investment in a foreign operation. A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge [IAS 39.87]. 2.3.8.3.1 Fair value hedges - Gain or loss from re-measuring the hedging instrument shall be recognized in profit or loss [IAS 39.89]; and - Gain or loss on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized in profit or loss [IAS 39.89]. 2.3.8.3.2 Cash flow hedges - The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognized directly in OCI; and [IAS 39.95] 31 - The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss [IAS 39.95]. For all other cash flow hedges, amounts that had been recognize directly in OCI shall be recognize in profit or loss in the same periods during which the hedged forecast transaction affects profit or loss [IAS 39.100]. 2.3.8.3.3 Hedges of a net investment Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is account for as part of the net investment shall be account for similarly to cash flow hedges [IAS 39.102]. 2.4 IFRS 9 "Financial Instruments" The following paragraphs explain IFRS 9 requirements. References to the third section are used where IFRS 9 requirements remain the same as IAS 39. 2.4.1 Effective date and transition IFRS 9 was required to be applied at the beginning of the 1st of January 2018 or after [IFRS 9.7.1.1]. However, early adoption is allowed depending on local jurisdiction. For example, banks that operate in Palestine and Jordan were forced early adopt IFRS 9, especially phase Ⅰ at the end of 2011-2012. 31 Accordance to IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors”, IFRS 9 should be applied retrospectively [IFRS 9.7.2.1]. 2.4.2 Objective and Scope IFRS 9 introduces principles for the financial reporting which expected to disclose relevant and useful information to users in order to help them in their evaluation of the amounts, timing and uncertainty of the entity‟s future cash flows [IFRS 9.1.1]. An entity shall apply IFRS 9 to all items within the scope of IAS 39 (see Chapter2 - paragraph 2.3.2) [IFRS 9.2.1], with the following additions: - A contract to buy or sell a non-financial item [IFRS 9.2.5]. - The IFRS 9 impairment requirements apply to all loan commitments and contract assets [IFRS 9.2.2]. 2.4.3 Recognition and derecognition There is a little change in the recognition and derecognition requirements under IFRS 9 compared with IAS 39 requirements (see Chapter 2 - paragraph 2.3.3). However, the standard adds the following indications: - A write-off is considered as a derecognition event when there is no reasonable expectations of recovering the value of financial instruments [IFRS 9.5.4.4]. 32 - Renegotiation or modification may be considered as derecognition event [IFRS 9. B5. 5. 25]. 2.4.4 Classification and measurement If we compare the new classification requirements, we can notice that they are more principle based than classification requirements under IAS 39 (MNP, 2016, p.2). 2.4.4.1 Initial measurement of financial instruments There is a little change in the initial measurement requirements under IFRS 9 compare with IAS 39 requirements, see Chapter 2 - paragraph 2.3.4.1 (BDO, 2016, p.27). However, if the fair value differs from the transaction price, then the accounting treatment at that date as follows: [IFRS 9.5.1.1A, B5.1.2A]: a) If fair value is measured based on a quoted market price or the valuation technique uses observable markets, the difference recorded as a gain or loss. b) Otherwise, the gain or loss are recode up to market evaluation. c) Trade receivables should be measured using their transaction price [IFRS 9.5.1.3]. 33 Classification under IFRS 9 for financial asset 2.4.4.2 Classification and subsequent measurement of financial assets Financial assets should be measure at AC, FVTOCI or FVTPL, based on [IFRS 9.4.1.1]: 1. The entity‟s business model for managing the financial assets and 2. The contractual cash flow characteristics of the financial asset. Figure 2: Classification under IFRS 9 for financial asset Source: Snapshot from EY, 2015, p.5.  The Business model The Business model is how an entity generate cash flows from their assets [B4.1.1, B4.1.2, B4.1.2A, and B], [IFRS 9.B.4.1.2A]; which: - Determined by top management, based on how to achieve a specific business objective by using the entity financial assets. - Does not depend on management‟s intentions, and one entity may have more than one business model for managing its financial instruments. 34 - Is a matter of fact, which requires management judgment.  Solely payments of principal and interest (SPPI) - SPPI are consistent with a basic lending arrangement, which take the time value of money (which require judgment, EY, 2015, p.11), and credit risk into consideration. - Interest covers basic lending risks (e.g. liquidity risk), costs (e.g. administrative costs) and profit margin [IFRS 9. B4.1.7A]. In other worlds, interest mean what the entity is being compensated for their investment (EY, 2015, p.11). - Principal is the fair value of the financial asset at initial recognition" [IFRS 9.B4.1.7B]. However, it is not the instrument contractual cash flows (KPMG, 2014, p.15).The entity should compare contractual cash flow with amount invested (EY, 2015, p.10). Figure 3: Classification under IFRS 9 for financial asset. Source: Snapshot from IASB, 2016. 35 According to IFRS 9, the financial assets are classified as follows: A. AC: if [IFRS 9.4.1.2]: 1. Held to collect contractual cash flows and - The entity should consider the frequency, value, timing (prior sales), reasons for sales and expected future sales [IFRS 9. B4.1.2C]. - If credit risk increase, the entity may sale it and remain within this business model [IFRS 9. B4.1.3, 3A]. 2. The SPPI tests are met. Impairment requirement applied for this category [IFRS 9.5.2.2]. A gain or loss should be recognized in profit or loss when the asset is derecognized or reclassify [IFRS 9.5.7.2]. The major difference between financial assets classified at AC (under IFRS 9) and HTM (under IAS 39) is that: under IFRS 9, AC allow assets to remain measured at AC even if there is an infrequent sale (BDO, 2016, p.11). B. FVTOCI, if [IFRS 9.4.1.2A]: 1. Held to collect contractual cash flows and selling financial assets and 2. 2. The SPPI test are meet. 36 Impairment requirement applied for this category [IFRS 9.5.2.2]. A gain or loss should be recognized in OCI until it is derecognized or reclassified, then should be recognized in profit or loss [IFRS 9.5.7.10]. The major differences between financial assets classify at FVOCI (under IFRS 9) and AFS (under IAS 39) is (EY, 2015, p.6): - AFS was the residual classification election, while FVOCI is not. - FVOCI apply the same impairment model. - Simple debt instruments will be measure at FVOCI.  Investment in an equity instrument The entity has the option to classify this instrument at FVTOCI [IFRS 9.5.7.5]. The dividends should be recognized in profit or loss, but this option is not available to investments in subsidiaries, associates and joint ventures [IFRS 9.5.7.6]. C. FVTPL. At initial recognition, the entity has irrevocable option to measure a financial asset at FVTPL, which will eliminates or reduces a measurement inconsistency [IFRS 9.4.1.5]. IFRS 9 remain only one of the requirement for applying fair value option as IAS 39, which is applying the option reduce the accounting mismatch. That because IFRS 9 does not require embedded derivatives to be separated (KPMG, 2014). 37 2.4.4.3 Classification and subsequent measurement of financial liabilities There is a little change in the classification of financial liabilities under IFRS 9 (compare with IAS 39 requirements, see Chapter 2 - paragraph 2.3.4.3) because the benefits of changing will not outweigh the cost of changing (KPMG, 2014, p.34). However, IFRS 9 require entity to separate change in the fair value due to change in the credit risk (presented in OCI and not transfer to profit or loss) from the remaining amount of change (presented in profit or loss), unless this separation will create an accounting mismatch (all change presented in profit or loss) [IFRS 9.5.7.7, B5.7.9]. Figure4: Classification and measurement of financial liabilities under IFRS 9. Source: Snapshot from KPMG, 2014, p.35. 38 2.4.5 Embedded derivatives There is a little change in accounting for embedded derivatives under IFRS 9 (compare with IAS 39 requirements see Chapter 2 - paragraph 2.3.5). The new requirements enable the embedded derivative to be not separated from an asset host contract (KPMG, 2014, p.38; BDO, 2016, p.24) in order to simplify the accounting requirement for embedded derivatives by elimination of bifurcation rule under IAS 39 (Sichirollo, 2015; MNP, 2016, p.2). However, this simplification does not apply to the financial liabilities (BDO, 2016, p.26). Figure 5: Classification of an embedded derivative under IFRS 9. Source: Snapshot from UniCredit, 2015, p.8. 2.4.6 Reclassifications Reclassification for financial assets (not liability) is allowed under IFRS 9 only when the entity changes its business model [IFRS 9.4.4.1-2]. 39 Reclassification should be applied prospectively from the reclassification date [IFRS 9.5.6.1]. The reclassification of financial assets occurs between the following [IFRS 9.5.6.2-7]: 1. From the AC into: - The FVTPL, fair value should be measured at the reclassification date; any gain or loss should be recognized in profit or loss. - The FVTOCI, fair value should be measured at the reclassification date; any gain or loss should be recognized in OCI. 2. From the FVTPL into: - The AC, fair value should be measured at the reclassification date which becomes its new gross carrying amount [IFRS 9.B5.6.2]. - The FVTOCI, fair value evaluation still used [IFRS 9.B5.6.2]. 3. From the FVTOCI into: - The AC, fair value should be measured at the reclassification date; any cumulative gain or loss previously recognized in OCI should be transferred from equity to the new fair value of the instruments. - The FVTPL, fair value should be measured at the reclassification date; any cumulative gain or loss previously recognized in OCI should be transferred form equity to profit or loss. 41 Figure 6: Reclassification of financial assets under IFRS 9 Source: Snapshot from UniCredit, 2015, p.6. 2.4.6 Impairment IFRS 9 introduces ECL model, which applies to all assets that applicable for impairment, expect: 1) Purchased or originated credit-impaired assets. 2) Trade receivables, contract assets and lease receivables. However, the single general impairment model had three applicable approach to be implemented depending on the type of asset or exposure; which are: a) General (or three-stage) approach, which applied to all financial assets except those (1, 2) above. b) Simplified (lifetime expected loss) approach, which applied to trade receivables, contract assets and lease receivables. 41 c) Change of lifetime expected loss approach, which applied to purchased or originated credit-impaired financial assets. All credit exposures (expect FVTPL) will have a loss allowances (E&Y, 2014, p.8). 2.4.6.1 The General (or three-stage) approach According to general approach under IFRS 9, all companies shall recognize an impairment loss allowance for ECL on [IFRS 9.5.5.1-2]: 1. Financial asset at AC. 2. Financial asset at FVTOCI, which recognized in OCI. 3. Lease receivable. 4. Contract asset or a loan commitment. 5. Financial guarantee contract. Equity investments (event at FVTOCI) or financial instruments at FVTPL are not subject to ECL. Meanwhile, gains or losses recognized in OCI will never be transfer to profit or loss (MNP, 2016). At each reporting period, the companies should apply ECL model and evaluate if credit risk of the financial instruments have been significantly increased since initial recognition, then measure impairment loss equal to [IFRS 9.5.5.3-5]: 42 1) 12-month ECL; if the credit risk remains low since initial recognition. 2) Lifetime ECL; if the credit risk increased significantly since initial recognition. The entity should apply ECL model retrospectively [IFRS 9.7.2.17]. However, after measuring ECL, the entity should recognize impairment loss in in profit or loss. The reversal of impairment loss is allowed if credit risk is decrease [IFRS 9.5.5.7, 8]. IFRS 9‟s general (or three-stage) approach (which depend on credit quality) to apply ECL model include (Thornton, 2016, p.6). - Stage 1: for financial instruments that have low credit risk since initial recognition. The 12-month ECL is applied at this stage. - Stage 2: for financial instruments that have a high credit risk compared with their credit risk at initial recognition, but not defaulted. The lifetime ECL is applied at this stage. - Stage 3: for defaulted financial instruments (as IAS 39). The lifetime ECL is applied at this stage. 43 Figure 7: Overview on the General (or three-stage) impairment approach. Source: Snapshot from Thornton, 2016, p.8. 2.4.6.2 Determining significant increases in credit risk At each reporting period, an entity should determine if the credit risk have increased significantly since initial recognition by comparing current risk of default with the risk of default at initial recognition using reasonable and supportable forward-looking information, which is available without undue cost or effort. This information should be relevant for assessment [IFRS 9.5.5.9, 10,B5.5.16]. 44 However, low credit risk option which enable entities to assume that credit risk for a specific financial instrument have not been increased since initial recognition [IFRS 9.5.5.10]. Low credit risk option apply to financial instruments that have (1) Low risk of default and (2) strong capacity (for borrower) to fulfil contractual cash flow obligations [IFRS 9.B5.5.22]. In applying the low credit risk option, the entity may use its internal credit risk or external rating [IFRS 9.B5.5.23]. However, external rating should be used as lagging indicator because external rating may not reflect factor that affect credit risk, which occurs after assigning the rating. In addition, the external definition of default might be different from internal definition (UniCredit, 2015, p.12). When forward looking information is not available, the entity may use the 30 days past due presumption, which indicate that the credit risk has increased when contractual payments are more than 30 days past due [IFRS 9.5.5.11]. Figure 8: Overview on impact of a significant increase in credit risk. Source: Snapshot from Thornton, 2016, p.9. 45 2.4.6.3 Modified financial assets Renegotiated or modified the contractual cash flows, require entity to evaluate whether credit risk have been increased by comparing the risk of default after renegotiation or modification with risk of default at initial recognition [IFRS 9.5.5.12, B5.5.25-27]. Figure 9: Overview on impairment of modified financial assets under IFRS 9. Source: Snapshot from KPMG, 2014, p.76. 2.4.6.4 The Simplified approach This approach applied for trade receivables, contract assets and lease receivables, which use lifetime ECL [IFRS 9.5.5.15]. 2.4.6.5 Changes in lifetime ECL Approach This approach applied to purchased or originated credit-impaired financial assets which use changes in lifetime ECL since initial recognition [IFRS 9.5.5.13] 46 2.4.6.6 Measurement of ECL 2.4.6.6.1 ECL - ECL are a "probability-weighted estimate of credit losses over the expected life of the financial instrument". A cash shortfall is the difference between contractual cash flows expected cash to be receive [IFRS 9.B5.5.28]. ECL model applied should reflect the following [IFRS 9.5.5.17]: a) Unbiased and probability-weighted of possible outcomes; not a worst-case nor best-case scenario, but a probability-weighted of possible outcomes [IFRS 9.5.5.18, B5.5.41]. b) Time value of money; discounted expected cash flow to the reporting date using EIM [IFRS 9.B5.5.44], c) Using reasonable and supportable forward-looking information which is available without undue cost or effort about past, current and future events. 2.4.6.6.2 ECL calculation model The ECL is obtained by multiplying, the PD, the LGD and the EAD, as following: EL = PD* LGD * EAD 47 According to Deliotte (2016, p.22; Đurović, 2018, p.210), ECL calculations based on four components: 1. The PD, which is "an estimate of the likelihood of default over a given time horizon". However, there is two types of PDs: a) 12-month PDs occurring within the next 12 months, which used in stage 1. b) Lifetime PDs, which is "the estimated probability of a default occurring over the remaining life of the financial instrument", which used in stage 2 and 3. 2. The LGD, which is "an estimate of the loss arising on default. It is based on the difference between the contractual cash flows due and those that the lender would expect to receive, including from any collateral". 3. The EAD, which is "an estimate of the exposure at a future default date, taking into account expected changes in the exposure after the reporting date, including repayments of principal and interest". - LGD can also be computed by using the recovery rate (RR), as follow: LGD = 1 – RR; Where RR = Value of Collateral / Value of the Loan 48 4. The Discount Rate, EIR at initial recognition. Discount Rate = 1 / (1 – r)^i Where r = number of years, i = EIR 2.4.6.6.3 Period over which to estimate ECL The maximum period for ECL equals to the maximum period where the entity exposed to credit risk [IFRS 9.5.5.19-20, B5.5.38]. 2.4.6.6.4 Collateral The expected cash flow from the realization of collateral are used as a part in the ECL calculation [IFRS 9.B5.5.55]. This consider as a main difference between IFRS 9 and IAS 39 (UniCredit, 2015, p.16). 2.4.6.6.5 Collective and individual assessment basis Collective assessment basis are allowed under IFRS 9 for singles financial instruments that have the same credit characteristics when information on individual bias are not available [IFRS 9.B5.5.1,4, B5.5.5]. 2.4.6.6.7 Definition of default The default definition for IFRS 9 purposes should be comply with internal default definition for risk management [IFRS 9.B5.5.37]. 49 2.4.7 Hedge accounting The IASB introduce a new principle hedge accounting model under IFRS 9 to overcome the weakness in IAS 39 hedge accounting model. The new model is less complex and representing the entity risk management. Also, it increases the scope of hedge accounting (Sichirollo, 2015, p.80; BDO, 2016, p.49). The entity has the ability to continue to apply the hedge accounting requirements under IAS 39 [IFRS 9.7.2.21]. 2.4.7.1 Hedging instruments IAS 39 does not restrict how to designate a derivative as a hedging instrument [IAS 39.72]. On the other hand, IFRS 9 determined the qualifying instruments (under a certain conditions) as: a) A derivative measured at FVTPL[IFRS 9.6.2.1, B6.2.4]. b) Embedded derivatives is not a hedging instrument if not separated from the host contract [IFRS9.B6.2.1] c) A non-derivative financial asset or liability measured at FVTPL [IFRS 9.6.2.2]. d) The foreign currency risk component of a non-derivative financial asset or liability [IFRS 9.6.2.2]. e) Contracts with external party [IFRS 9.6.2.3]. 51 2.4.7.2 Hedged items Remain the same as IAS 39 (see Chapter 2 - paragraph 2.3.8.1). However, the requirement under IAS 39 to consider a group of items as a hedge items no longer required under IFRS 9 (UniCredit, 2015, p.20). 2.4.7.3 Qualifying criteria for hedge accounting By applying a principle-based rules to determine the qualifying criteria for hedge accounting under IFRS 9, the scope of the new model increases the number of items that qualifying for hedge purposes (MNP, 2016, p.16; BDO, 2016, p.53). 2.4.7.4 Accounting for qualifying hedging relationships There are three types of hedging relationships under IFRS 9 as IAS 39 (see Chapter 2 - paragraph 2.3.8.2) 2.5 Classification and measurement of financial instruments under the IFRS 9 Classification of financial instruments under IAS 39 "were criticized as being too numerous, complex and rule-based" (Sichirollo, 2015, p.8), which based on management intent without providing any guidance to how apply this intent. This leaves management with a great ability to exercise professional judgment. However, sometimes, management changes their intent in order to affect the treatment of gains and losses, which made financial statement element more volatile (Knežević, et al, 2015, p.22). 51 In addition, classification of financial instruments under IAS 39 enables managers to designate the financial instrument into the profitable category (earning management) not into the category that reflects real management intent (Knežević, et al, 2015, p.24). After the global financial crisis, the IAS 39 classification criteria came to the attention of standard setters as a main weakness in accounting standards related to financial instruments. As a result, IFRS 9 introduce the business model as a classification base (EY, 2015; MNP, 2016, p.2). The new business model under IFRS 9 reduces the complexity in the classification of financial instruments. Only two categories (AC and fair value) under IFRS 9 replaced the 4 categories under IAS 39 (Huian, 2012, p.39). Business model presents “the way the entity manages its financial assets in order to generate the cash flow”. United Kingdom Corporate Governance Code (UKCGC) characterizes the business model as “the basis on which the company generates or preserves value over the longer term” (Page, 2012). According to the classification model under IFRS 9, what became important is the business strategy risk not the asset risk (Huian, 2012, p.40). According to classification and measurement rules under IFRS 9, financial instruments should be classified based on the entity business model and the financial instruments contractual cash flow characteristics. 52 As a result, financial instruments will be measured at AC or fair value (IFRS 9). The business model used under IFRS 9 is "well-structured, objective and easily implemented" (Knežević, et al, 2015, p.22). The new classification model makes accounting information "more relevant, comparable, objective and transparent for users". However, changing classification criteria in IFRS 9 may reduce the comparability of company‟s financial statements, because it depends heavily on professional judgment. In addition, applying professional judgment may increase the volatility of earnings (Knežević, et al, 2015, p.22). In addition, the business model built on principle rules, which may the subjectivity in the classification of financial instruments. Moreover, IFRS 9 does not provide sufficient guidance to implement the new model, which will increase the difference between entities in the application of that model and reduce the ability to compare between companies (Huian, 2012, p.40). 53 Figure 10: Comparison of classification and measurement under IAS 39 and IFRS 9. Source: Snapshot from Mojca & Gornjak (2018, p.151). 2.6 The expected effect of applying phase Ⅰ of IFRS 9 “Classification and Measurement” on earnings and Owners equity In order to understand the expected effects from applying Phase Ⅰ of IFRS 9 – the new classification and measurement model - on the corporation financial statements, we will start by analysing the effect from applying the amendment of IAS 39 on corporate financial statements, spicily banks financial statements. IAS 39 enables the corporation to reclassify out of AFS to HTM category. However, the amendment provides four additional types of reclassifications. From trading assets to AFS or HTM or L&R. Also, from AFS to L&R. The reclassification option under the amendment to IAS 39 produces both favourable (week banks will not record fair value loss and comply with capital requirements) and unfavourable (increase information 54 asymmetry) effects. In addition, the new amendment will affect banks equity, profit, and key performance indicators (KPIs) (Bischof, Brüggemann & Daske, 2010; Knežević, et al, 2015, p.25). According to Bischof et al. (2010, p.11), the effect of applying the new amendments will be as follows: 1) Reclassifications from HFT to HTM or L&R category affects both net income and equity, because the company will recognize fair value gains and losses in profit or loss, which will transfer to equity. 2) Reclassifications from HFT to AFS affect only net income, because the company will recognize fair value gains and losses in the revaluation reserve. 3) Reclassifications from AFS to L&R or HTM affect only equity (OCI), because the company will recognize fair value gains and losses in the revaluation reserve. Paananen, et al (2012, p.208) found that banks made the reclassification of financial instrument under the new amendment when: 1. CARs close to the minimum requirement. 2. Exposure to fair value measurement increase. 3. Investors rely less on earnings and book value will increase. 55 In addition, the general findings of (Guo & Matovu, 2009) research show that the new amendment helps the banks with the declining condition and avoid further impairment losses. The banks that adopted the reclassification option took advantage of the positive effects on profits. The reclassification choice could be heavily influence by banks‟ financial position and performances. The IFRS 9 model for classification and measurement of financial instruments will result in more financial instruments measured at AC (BNP - PARIBAS FOTES, 2015). According to Knežević, et al (2015, p.25), applying IFRS 9 model for classification and measurement will increase volatility of earnings and equity. The early adopters expect the following effect: Table 1: The expected effect on earnings from applying IFRS 9. Financial Instruments Pessimistic scenario* Optimistic scenario** FVTPL Profit will decrease, because revaluation loss will be record in the income statement. Profit will increase, because of recognizing unrealized gains. FVTOCI Equity will decrease, because revaluation loss will be record in OCI. Equity will increase, because of recognizing unrealized gains. AC No effect. Source: Summary from Knežević, et al, 2015. * Pessimistic scenario - decrease in financial instruments value. ** Optimistic scenario - increase in the financial instruments value. 56 Reclassification of financial assets under IFRS 9 is different totally from IAS 39, due to different category under both standards. On the other hand, reclassification of financial liabilities under both standards is prohibited (Sichirollo, 2015, p.16). Under IFRS 9, the measurement basis for financial assets “SFP structure” is likely to remain broadly the same. Therefore, the AC will be, in most cases, the most relevant category. The overall impact of the change in classification and measurement requirements does not seem very significant for most banks. However, some banks are affected more, perhaps mainly because the special features of some of the instruments failed it in SPPI test (ESMA, 2016). Applying IFRS 9 measurement basis for financial instruments could result in reclassifications and possibly between all categories (FVPL, FVOCI and AC), but the impact of these reclassifications does not seem very significant for the vast majority of banks (ESMA, 2016). Reclassifications have been estimate as follows: 1. Banks estimate movements towards FVTPL (from AC or FVOCI under IAS 39) due to instruments failing the SPPI assessment. 2. Banks intend to reclassify equity instruments that are currently classified in FVOCI under IAS 39 as FVTPL, because IFRS 9 prohibited gains and losses transfer to profit or loss. 57 3. Banks estimate movements towards AC or FVOCI from the FVTPL or from FVOCI under IAS 39 to AC and vice versa, due to the outcome of the business model assessment. 4. Banks anticipate using of the fair value option as it before IFRS 9. 5. The majority of loans and advances expect to be continue measured at AC and those that currently being measure at FVTPL are likely to continue to be measure on that basis under IFRS 9. Capital Adequacy Standards require banks to maintain, at all times, a minimum amount of capital resources, which is typically base on a percentage of its risk weighted. The supervisory minimum required capital resources (which depend on Basel minimum requirements) may be affected by the way the banks classifies and measures its financial assets when transitioning from IAS 39 to IFRS 9 (MNP, 2016, p.15). The expected effect form IFRS 9 on capital requirements is based on the impairment requirements and the classification and measurement requirements (little decrease in the CET1 ratio) (ESMA, 2016). According to BCBS (2017) and other regulatory bodies argue that phase Ⅰ of the IFRS 9 will enable the preparation of financial statements to reflect the fair value of financial instruments more easily. Also, it will decrease the ability of company‟ managements to manipulate – in financial statements – by limiting their ability to reclassify financial instruments between different categories (HFT, AFS, and HTM) to misleading user 58 from different accounting treatments of gain and losses of each category; which may reflect in profits and losses statements or in OCI statements. 2.7 The expected effects from applying phase Ⅱ of IFRS 9 “Impairment Model” on earning, SP & GP and CAR The global financial crisis had shown how calculating provisioning for loans and other financial instruments based on historical trends under the incurred loss approach (IAS 39) can be inadequate, because it was made after the default events have already occurred and does not factor in macroeconomic cycles (CRISIL, 2016, p.4). The major problem that has been identified after the global financial crisis is that IAS 39 delay the recognition of impairment losses until the default has been occurred (Sichirollo, 2015, p.18). In addition, IAS 39 has another major problem, it used different impairment for similar assets (Thornton, 2016, p.2). The incurred loss approach has been viewed as “too little and too late” in regarding impairment losses. As a result, provisioning under IAS 39 - as practiced - often does not meet supervisory requirements from the perspective of credit risk review and capital adequacy assessment, because its leaves substantial room for judgment, which may result in insufficient, provisions (IMF, 2014, p.6). 59 According to the previous problems with incurred loss approach, the IASB introduced a “more principle based and forward looking ”ECL model (Sichirollo, 2015, p.18; Đurović, 2018, p.209). IFRS 9 have only one ECL model for all financial instruments. Impairment losses are recognized since day one of investment, and at each reporting date, even if default has not been occurred (MNP, 2016, p.3). Credit impairment under ECL modelling seen as increasing the usefulness of financial statements by conveying more accurate and timely estimates of credit losses (CRISIL, 2016, p.5). IFRS 9 is also expected to better align supervisory and accounting requirements by recognizing ECL in a timelier manner (IMF, 2014, p.4). The ECL model may represent the most significant shift in accounting since the last global financial crisis (Labat & Lemonnier, 2015, p.6). The new accounting provisioning models introduce fundamental changes to banks‟ provisioning practices in qualitative and quantitative ways, as higher provisions are possible with the lifetime concept and the inclusion of forward looking information ECL calculation (BCBS, 2016, p.12; Capgemini, 2016). In addition, the scope of IFRS 9 impairments model is wider than IAS 39; which will contribute to this increase. The initial application of the ECL may have a negative effect on equity, because equity will no longer only reflect incurred credit losses but will also include ECL (UniCredit, 2015, p.10). Moreover, the new model may cause volatility in equity and profit and loss (P&L) because external 61 information used as inputs may be volatile and any movement between stages can result in large changes in the corresponding loss allowance (UniCredit, 2015, p.10; EBA, 2016). However, these volatilities depends on various modelling decisions, particularly the design of transfer criteria from stage 1 to stage 2, at which provisions need to be raised from a one- year to a lifetime ECL (Labat & Lemonnier, 2015, p.6). The impact on banks is expected to be particularly large. However, a bank‟s regulatory capital (which is a KPI) may also be affected via the reduction of Tier 1 (common equity Tier-1 "CET1" in Basel Ⅲ) capital and total capital ratio (UniCredit, 2015, p.10; EBA, 2016). According to Basel, Tier 1 capital comprises a bank‟s core capital and includes common shares, stock surpluses, retained earnings and accumulated other comprehensive income (AOCI). The implementation of ECL model expected to increase in provisions, which will decrease the profits of banks. As result, the retained earnings will be decrease; which will reduce equity, Tier 1 capital and total capital for banks. However, "the impact on total capital ratio is lower compared to the impact on CET1 ratio because the excess of accounting provisions over regulatory expected losses is added back to Tier 2, subject to a regulatory cap" (EBA, 2016, p.31). Another factor that influences these ratios is the increase in credit risk (when PD increase) which affects the risk weighted assets (RWA). When the Tier 1 capital decreases and RWA increases, these https://www.investopedia.com/terms/a/accumulatedother.asp 61 ratios will decrease; however, the level of impact is difficult to determine and is challenging in planning scenarios (Capgemini, 2016, p.4). Table 2: Expected effect from applying ECL on CAR. Source: Basel accord Ⅱ, 2006. In addition, the leverage ratio is affected. Under Basel III, the leverage ratio is defined as the ratio of capital measure “Tier 1 Capital (CET1)” divided by Net Exposure measure. The ratio should reach 3% at a minimum as currently proposed during the transition period. For banks that used SA (all the banks that operate in Palestine and Jordan), any impairment loss on a loan based on income statements has a direct impact on Core Tier 1 capital, as it reduces retained earnings. As Tier 1 capital and total net exposure reduce equally, leverage ratios should also decline (Labat & Lemonnier, 2015, p.7). Common shares Stock surpluses Regulatry reservs Retained Earnings General provisions (GP) (up to 1.25% of RWA) Quilling subordinated loan Others reservs Capital Base RWA CAR (1) Tier 1 capital (2) Tier 2 capital (3) Total Capital (1+2) (4) Superviser deduct (5) Capital base (3-4) 62 Changing KPIs not only affect regulatory authorities‟ requirements, but also influence the business model and internal business decisions, such as on investment activities or on business strategies in the competitive environment (Capgemini, 2016, p.5). ECL model will have also a significant effect on total assets as an increase in loss allowances is expected. As a result, banks will need to assess and manage the impact of the transition and appropriately communicate with stakeholders (MNP, 2016, p.15). IFRS 9 will have a large impact on banks from applying the new impairments model; which can be summarized as the following: - Provision will increase, specially, Loan loss provisions. - Profits will be reduced, as provisions will increase, particularly in the first year of the implementation of IFRS 9. - Retained earnings will be decrease as profit decrease. - Equity will be decrease as retained earnings decrease. - Regulatory Capital Requirements, specially CAR will be decrease. 2.7.1 Impairment provision from accounting and regulatory viewpoint According to the regulator, the provisions made to cover expected losses and capital allocate to unexpected losses. However, from an accounting perspective, it‟s a reduction in the carrying amount of a loan )Hronsky, 2010, p.55). 63 Regulators around the world have a special requirement for provision. In the banking sector, central banks (monetary authorities) such as PMA and JCB, have special instructions for classification of credit facilities and calculation of impairment provision and risk reserve (refer to GP). These instructions divide impairment provisions into two types: 1. SP, represent a contra-asset line item on the SFP that is intended to absorb against current losses. SP provision are developed over time through the accumulation of loan loss provisions, an expense item on the income statement; which reduce the banks profit (Stefano, 2018, p.3). 2. GP, represent an equity line item on the SFP that intends to absorb against future unexpected losses. GP provision reduces the banks retained earnings (Stefano, 2018, p.3). Basel capital frameworks (Basel I and II) have distinguished between GP and SP. "GP are provisions held against future, presently unidentified losses that are freely available to meet losses which subsequently materialize. Provisions ascribed to identify deterioration of particular assets or known liabilities, whether individual or grouped, are SP" (IMF, 2014, p.7; BCBS, 2017, p.2). Basel I permitted a limited amount of GP (up to 1.25% of RWA) to be included in total Tier 2 capital. Because of continuing differences across jurisdictions in provisioning practices under incurred loss models (IAS 39), the BCBS decided to retain its Basel I treatment of GP when it adopted the Basel II SA for credit risk (BCBS, 2016, p.4). 64 The BCBS identified varied practices made by banks in accounting and regulatory provisions under IAS 39. Specifically, there is (BCBS, 2016, p.2): 1. Variability in the levels of provisions across accounting standards and jurisdictions; 2. Variability in the levels of provisions across banks applying the same accounting standard; and 3. Variability in the classification of accounting provisions as SP or GP for regulatory purposes. 2.7.1. A-Palestinian regulation Based on the PMA Instructions number (01/2008) “Classification of credit facilities, allowances and guarantees accepted”, banks are required to classify and made SP for credit facilities based on past due status as follow: Table 3: Summary of PMA instruction number (01/2008). Classification of credit facilities Past due in payment of PI Required SP Performing Less than 30 days 0% Watch list 30-90 days 0% Non-Performing Substandard 91-180 days 20% Doubtful 181-360 days 50% Loss More than 360 days 100% 65 In addition, banks that operate in Palestine also required making GP for credit facilities. According to PMA instructions number (06/2015) “Capital, reserves and equity”, banks are required to create a risk reserve (GP) as follow: Table 4: Summary of PMA instructions number (06/2015). Credit facilities Required GP Net Direct credit facilities 1.5% Net In-direct credit facilities 0.5% 2.7.1. B-Jordanian regulations According to JCB Instructions number (47/2009) “Classification of credit facilities, calculation of impairment provision and general bank risk reserve”, banks are required to classify and made SP for credit facilities; which based also on past due states as follow: Table 5: Summary of JCB instruction number (47/2009) – SP. Classification of credit facilities Past due in payment of PI Required SP Low risk Less than 60 days 0% Acceptable risk Less than 60 days 0% Watch list 60-90 Days 1.5% Non-Performing Substandard 90-179 Days 25% Doubtful 180-359 Days 50% Loss More than 360 days 100% In addition, banks that operate in Jordan also required making GP for credit facilities. According to JCB instructions number (47/2009), banks are required to create risk reserve (GP) as follow: 66 Table 6: Summary of JCB instruction number (47/2009) – GP. Credit facilities Required GP Net Direct credit facilities 1.5% Net In-direct credit facilities 0.5% On the other hand, under IFRS 9 distinction between GP and SP does not exist. As a result, BCBS recommended the regulator to provide banks with instructions to how distinction ECL provisions as GP and SP for regulatory purposes. As a result, PMA and JCB issued new instructions to banks to how distinction ECL provisions as GP and SP. PMA issued instructions number (02/2018) “Guidelines for IFRS 9 Implementation Requirements” to inform Palestinian banks how to distinction ECL provisions as GP and SP. According to PMA instructions, Stage 1 & 2 of ECL will be treat, as SP and Stage 3 of ECL will be treat as GP. In addition, JCB issued instructions number (13/2018)“IFRS 9 Implementation” to inform Jordanian banks how to distinction ECL provisions as GP and SP. According to JCB instruction, Stage 1 of ECL will be treated as SP and Stage 2 & 3 of ECL will be treated as GP. Table 7: Summary of PMA and JCB instructions to distinction ECL provisions as GP and SP. Provision Instruction # ECL PMA General 06/2015 Stage 1&2 Specific 01/2008 Stage 3 JCB General 47/2009 Stage 1 Specific Stage 2&3 67 According to PMA instructions number (02/2018), banks should at the beginning period for applying ECL (1 st January 2018) transfer GP account from equity to ECL provisions (stage 1&2) in the SFP and if there any shortage; it will be covered from retained earnings. However, if there any surplus; it will be under GP in equity. As a result, the expected effect from applying ECL model will be less than expected (increase provisions) in others country. The income statements for the Palestinian banks (at the end of 2018) will be decreased by a little amount or not affected at all, because the PMA allows banks to use amounts accumulated in GP (before 2018) to cover provisions (stage 1 & 2) required under IFRS 9. In addition, if banks face a shortage in the beginning balance it will cover it from retained earnings. On the other hand, JCB instructions number (13/2018) informed banks that at the beginning period for applying ECL (1st January, 2018) to transfer GP account from equity to retained earnings then to ECL provisions (stage 1) in the SFP and if there any shortage; it will be covered from retained earnings. However, if there any surplus; it will be in retained earnings (restricted). As a result, the expected effect from applying ECL model will be less than expected (increase provisions) in others country. Due to different between PMA and JCB in the treatment of GP and SP for regulatory purposes (as seen in the above paragraphs), The PMA treat Jordanian banks that operate in Palestine as a branches as (standalone banks) that operate separately from their parents in Jordan. 68 2.8 Difficulties in implementing of IFRS 9 by banks The banks will use their business model and the cash flow characteristics of each financial instrument in order to classify and measure the financial assets and liabilities. Moreover, classification and measurements of the banks' financial instruments will require bank management to use their professional judgment when assessing the bank business model. However, this assessment is not determined by one factor or event; which is a challenge to the bank’s managements. In terms of business model assessment, another challenge mentioned by banks which is the clarification of the concept of „infrequent and insignificant sales‟ in IFRS 9 to classify and measure of assets in an appropriate way (EBA, 2016, p.18). In addition, more than one business model may be used by one entity for managing it’s financial instruments, which may result in a different classification for similar financial instrument. Therefore, management need to deeply analyse of which business model should use for similar assets. SPPI test on the principal amount outstanding include testing if interest provides consideration for only the passage of time. In order to assess this IFRS 9 - No distinction between GP and SP Basel - Leave distintion between GP & SP to regulater PMA IFRS 9 - Stage 1 & 2 = GP and Stage 3 = SP JCB IFRS 9 - Stage 1 = GP and Stage 2 & 3 = SP 69 consideration, the entity should applies judgment and take all relevant factors into consideration; which is also a challenge to the bank’s managements. Another challenge that face managements when dealing with financial liability under IFRS 9 is the own credit risk. banks need to determine the changes in fair value of the financial liability as a whole, and then determine the changes that are attributable to changes in their own credit status; then recorded it in OCI, while the remaining fair value changes will be record in profit or loss (BDO, 2016, p.29). The entity should reclassify financial assets when, and only when, an entity changes its business model for managing financial assets, which require entity to continue monitoring of their business model after they determined it. The new ECL model based on forward looking information to address any changes in fair value of financial instruments instead of incurred loss model. Appling the new impairment model will made banks faced by many challenges. The most important challenges in the implementation of ECL is the availability of data and the availability of resources. The new ECL approach requires both new data attributes and large amounts of data that have not historically been source for accounting and risk purposes (Capgemini, 2016, p.7; Đurović, 2018, p.209).In terms of data availability, the main issue is the availability of historical data for IFRS 9 purposes and 71 for determining the credit risk (the PD or rating). The consideration of forward looking information is anther a challenge it term of data availability under IFRS 9. The availability of resources, specially, internal resources and finding enough resources with the right skills are the major challenges (EBA, 2016, p.21). The high data requirements for IFRS 9 encourage the harmonization of finance and risk data (Capgemini, 2016, p.7). According IFRS9, banks can implement impairment model based on collective or individual basis. In collective basis assessment, the entity can collect to gather the financial instruments that have the same credit risk characteristics to determine when credit risk increases significantly. However, this collection may change over time due to change in information; which increase the challenges to continue monitoring on on- going bases (Bao et al, 2015, p.3). Most banks are considering to apply the 30 days past due criterion as indicator of a significant increase in credit risk for classifying an assets from stage 1 to 2. In other words, still using past due states to increase provision. According to BCBS (2016), banks that use Internal Rating Based (IRB) approach to calculate RWA under Basel (Ⅱ & Ⅲ) for calculation of CAR generally believe that existing processes, systems, models and data are likely to be in place and can be used - possibly after adjustment - for the 71 purposes of IFRS 9 application. However, Banks that use the SA only may not have such capabilities in place (EBA, 2016, p.21). According to the PMA and JCB instructions, all the banks that operate in Palestine and Jordan should use SA to calculate RWA under Basel Ⅱ. Therefore, these banks faced with a major challenge to modified existing processes, systems, models, data collection and existing credit risk management practices in light of the application of IFRS 9 impairment model (Bao et al, 2015, p. 9). Almost all banks around the world will use ECL model equal to PD x LGD x EAD approach to implement impairment model under IFRS 9 (BCBS, 2017). However, PD built for regulatory purposes cannot be applied directly to ECL impairment calculations under the IFRS 9 new standard, because the regulatory framework requires stressed through the cycle (TTC) probabilities, while IFRS 9 requires point in time (PIT) probabilities that include forward looking information (Conze & Finance, 2015, p.1). Therefore, banks that used IRB approach (or planning to use it) need to adjust IRB-PD to be use in ECL calculation. Implementing IFRS 9 by banks expected to have a huge impacts related to changes in information technology (IT) and risk management systems (ESMA, 2016, p.2; PWC, 2014).In term of IT, systems have to be adjust and expand to include new data feeds and data attributes ensuring an IFRS 9 compliant ECL calculation. In term of risk management systems, various 72 processes, e.g. risk assessment, postings and local solutions have to be revised or changed (Gea-Carrasco, 2015, p.1). In a