NAB an AASB 9 early adopter

National Australia Bank will be the first of the Big Four to change its treatment of impairments from the current incurred loss approach to an expected loss approach, as spelled out in a new accounting standard AASB 9.

Companies must adopt the standard, which also includes changes to the classification and measurement of financial instruments, no later than the first reporting period beginning on or after January 1, 2018.

NAB has already adopted the standard, effective from October last year, and will report under AASB 9 when it presents its half-year results.

AASB 9 replaces AASB 139. The old standard required that losses be recognised in the accounts only when they had been incurred.

This approach came under fire during the financial crisis, when it became clear that banks' bad debt problems were coming to light too late. When the International Accounting Standards Board started reviewing the standard in 2009 it said: "The global financial crisis has led to criticism of the incurred loss model for presenting an initial over-optimistic assessment of no credit losses, only to be followed by a large adjustment once a trigger event occurs."

The advantage of the expected loss approach is that it allows banks to include an evaluation of the likely direction of the economic cycle in the impairment calculations, which make the impairment figure more forward looking.

It will also make change in a bank's collective provision less volatile through an economic cycle.

The criticism of the expected loss approach has always been that it introduces a large element of subjectivity into the process and could, in extreme circumstances, leave financial statements open to be gamed by management.

NAB held a briefing for analysts last week to explain the impact of the change. It has increased its collective provision by A$725 million and made an offsetting reduction in its general reserve for credit losses, with no impact on the bottom line.

Under the incurred loss approach the bank could provision in overlays for economic downturns but under the new rule the bank will look three to five years ahead and make an assessment of expected losses.

The increase in the collective provision creates a deferred tax asset, which has an impact on capital.

The bank will report a pro forma 13 basis point reduction in its common equity tier one capital ratio, due in part to the change in the treatment of impairments and in part to the change in the classification of financial instruments.

The second part of AASB 9 creates a more streamlined approach to classification of financial instruments, reducing the number of classifications to two - amortised cost and fair value.

Classification is aligned with the way the company manages its financial assets (its business model) and with their contractual cash flow nature.

This approach has been welcomed as an improvement on the old approach, which was considered overly complex and full of exceptions and exclusions.

One benefit for NAB in this change is that the majority of its held-to-maturity assets will be reclassified to "other assets" at amortised cost. The new standard removes the restriction on selling held-to-maturity assets, which will allow NAB to dispose of certain assets, such as old special investment vehicles.