The implications of IFRS adoption on the valuation of loan loss allowances

1. The implications of IFRS adoption on the valuation of loan loss allowances Zoltan Novotny-Farkas / Joao Toniato Goethe University of Frankfurt INTACCT Workshop Varna 4 March 2010

2. Research question • How does the switch to IFRS and the application of the so called incurred loss approach change the value relevance/information content of loan loss accounting amounts (LLA, LLP, NPL)? => Are loan loss figures prepared under IFRS more useful to investors?

3. Motivation • IFRS adoption represents a major change in loan loss accounting • Diversity in loan loss accounting practice before IFRS adoption, sometimes influenced by supervisory authorities (Spain, Portugal, Denmark) • IFRS adoption introduces incurred loss approach • IFRS rules reduce income smoothing but also hamper anticipation of expected (loan) losses (Gebhardt/Novotny-Farkas (2009)) • IASB plans to switch to an expected loss approach; ED Amortization and Impairment =>Do IFRS loan loss disclosures provide more useful information about default (risk) to investors than local GAAP?

4. Hypothesis development (I) • Findings of prior literature (US): Market reacts positively to increased accounting recognition of loan default • Beaver/Engel (1996), Wahlen (1994), Liu and Ryan (1995), Liu/Ryan/Wahlen (1997) find that the market values the discretionary portion of the LLA/LLP positively • However, for a more recent time period Ahmed et al. (1999) do not find a positive valuation of DLLA This positive valuation of DLLA is conditional on • the bad news component of loan loss allowances is preempted by more timely changes in non-performing loans • in contrast, the good news signalled by the act of increasing loan loss allowances (making loan loss provisions) cannot be preempted by changes in non-performing loans

5. Hypothesis development (II) General IFRS effect Non-discretionary component of LLA (NLLA) • NLLA will be more (value) relevant relative to competitive measures of credit risk (NPL) in post IFRS period if it provides more useful information • If NLLA is less informative due to exclusion of anticipated credit losses, it will be less (value) relevant relative to NPL

6. Hypothesis development (III) General IFRS effect Discretionary component of LLA (DLLA) • The valuation of DLLA is conditional on the valuation of the non-discretionary portion • If the market assesses the amount of the non-discretionary portion as sufficient to cover all expected losses and interprets the discretionary portion as a signal of future cash flows or as a measure of conservative accounting, then the valuation coefficient of the discretionary portion will be positive • Otherwise, the valuation coefficient of DLLA will be zero or negative

7. Sample • 12 Mandatory IFRS adopter countries within the EU (90 banks)

8. Methodology Two stage procedure: 1.) Decomposition of the LLA LLAit = a0(1/GBVit ) + a1NCOit + a2ΔLoansit + a3NPLit + a4ΔNPLit+1 + zit 2.) Valuation regression MVit = a0 + a1LLAit + a2DALLit + a3NPLit + εit

9. Descriptive statistics

10. First stage results

11. Next steps (I) • Clustering of countries • Valuation effect of regulatory regimes • Of particular interest: Denmark, Spain and Portugal • Stringency of capital regulation and supervision • Include IFRS transition effects in regressions • How does valuation differ if GLLA is (not) part of regulatory capital? • Valuation of Specific LLA versus General LLA • Alternative specifications • Returns versus price • LLP versus LLA

12. Next steps (II) • Short window returns tests (Wahlen 1994) • Later we will include further “specific” countries to increase our sample size and thereby statistical power (e.g. Jamaica) • Further, we will include the US as benchmark • How does the change in loan loss accounting affect the value relevance of bottom line earnings?

13. Thank you!