Aon Risk Solutions Aon Credit Solutions Trading Perspectives Special edition: Important upcoming changes to accounting standards November 2017
Table of Contents IFRS 9 - Financial Instruments 1 IFRS 15 - Revenue from contracts with customers 3 References 5 About Aon Credit Solutions 5 Key contacts 6
IFRS 9 - Financial Instruments Recognition and measurement, impairment, de-recognition and general hedge accounting. The new IFRS 9 rules effective January 2018, and equivalent US GAAP standards (ASU 2016-13) effective in 2019, are aimed at increasing the accuracy and transparency of how credit risk is represented on a company s Balance Sheet and P&L. Both new standards include requirements around the use of both historic as well as forward looking credit information in order to calculate the provisions for credit losses (Expected Credit Losses). Under the new regulations, companies will have to start making bad debt provisions for possible future credit losses in the first reporting period even if it is highly likely that the asset will be fully collectible. IFRS 9 requires an entity to base its measurement of expected credit losses on reasonable and supportable information that is available without undue cost or effort, including historical, current and forecast information. Expected Credit Losses (ECL) is a probability weighted estimate of a credit loss. The ECL should be forward looking and consider current and future projections, not solely historical data. The ECL has to be revised if any new information is made available. In focus The ECLs are calculated by: i) identifying scenarios in which a receivable (or loan) defaults; ii) estimating the cash shortfall that would be incurred in each scenario if a default were to happen; iii) multiplying that loss by the probability of the default happening; and (iv) summing the results of all. Estimated future cash flows at initial recognition Estimated future cash flows if default occurs Cash shortfall $100 million $10 million $90 million Probability of default 0.5% Expected credit loss $450k For ease of illustration this example assumes only one default scenario. Under the accounting standards, companies would need to model multiple scenarios in order to define the right bad debt provision levels. 1
Related Credit Solutions IFRS 9 - Financial Instruments Your company is planning for the implementation of the accounting standard changes and it is likely that the provisioning of doubtful receivable will increase as compared to current levels, especially due to the fact that probabilities of default will need to be applied across the trade receivables ledger. Your company is looking for opportunities around balance sheet optimisation, reporting efficiencies and cost savings. How may credit solutions help your company? Quantifying the (new) amount of trade provisions required. Aon has experience in modelling expected credit losses based on client information available. Optimising the credit risks. Our teams can perform actuarial analysis to help assess the financial statements impact of purchasing credit insurance. This would include considerations around optimal structure and potential costs. Coordinating with your auditors. Aon teams have experience in communicating on credit risk financial statement treatment with our clients external auditing firms. Risk modelling illustration Buyer A Sales volumes Rating of Buyer A Receivables Loss Given Probability of default (yes/no) Gross Loss Net Loss to ABC from Buyer A Buyer B Sales volumes Scenario Generator Rating of Buyer B Receivables Loss Given Expected Credit Loss Probability of default (yes/no) Gross Loss Net Loss to ABC from Buyer B Buyer C Sales volumes Rating of Buyer C Receivables Loss Given Probability of default (yes/no) Gross Loss Net Loss to ABC from Buyer C 100,000 trials 2
IFRS 15 - Revenue from contracts with customers Nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts. The IASB and the FASB have jointly developed new revenue standards, IFRS 15/ASC 606 Revenue from Contracts with Customers, which will replace all existing IFRS and virtually all US GAAP revenue recognition requirements. These have a 1 January 2018 effective date. The unit of account for revenue recognition under the new standard is a performance obligation. A contract may contain one or more performance obligations. Revenue will be recognised when an entity satisfies each performance obligation by transferring control of the promised goods or services to the customer. Goods or services can transfer at a point in time or over time depending on the nature of the arrangement. Specific criteria are provided for when a performance obligation is satisfied over time. Depending on an entity s existing business model and revenue recognition practices, the new standard could have a significant impact on the amount and timing of revenue recognition, which in turn could impact key performance measures. Bad debt reserves are likely to be larger and more volatile. In focus Under the new accounting method, a company selling a 3 year software license should account for the licenses and services together as a single performance obligation. Revenues related to the 3 year client contract may be fully recognised in the first year if: The multi-year contract cost of the service or product is not variable or subject to discounts or change; and/or The vendor is providing the license software and Post Contract Services exclusively to the buyer. 3
Related Credit Solutions Your company sells a 3 year software license to a buyer. The agreement also includes Post-Contract Customer support (PCS), meaning access to future updates of the software throughout the agreement. Under the new standards, revenues from the licenses will be fully recognised in year 1. The PCS will be recognised separately on a year by year basis. How may credit solutions help your company? Credit protection for multi-year contracts. A risk attaching credit insurance policy will cover current and non-current (future) recognised revenue for the entire length of the contract upfront. Especially, unearned, but recognised revenue relative to the non-current portions of the multi-year contract will be covered. Bad Debt Reserve. The new standards may lead to companies to increase their bad debt reserves to cover the length of the contract. The flow-on-effect will impact key performance indicators, particularly the return on equity metric. Credit insurance can serve as contingent capital which will allow your company to reduce its allowance for bad debt reserve associated with these long term deals. Competitiveness. In a highly competitive environment, credit Insurance can enable your company to offer improved commercial terms to clients, whilst being able to mitigate the related credit risks. 4
References https://www.pwc.com/us/en/cfodirect/assets/pdf/in-depth/2014-01-revenue-from-contracts-with-customers.pdf http://www.pwc.com/gx/en/audit-services/ifrs/publications/ifrs-9/ifrs-9-understanding-the-basics.pdf http://www.ey.com/publication/vwluassets/financial_instruments:_a_summary_of_ifrs9_and_its_effects/$file/ey-ifrs-9- financial-instruments.pdf https://home.kpmg.com/xx/en/home/services/audit/international-financial-reporting-standards/revenue/ifrs15-transition-toolkit. html About Aon Credit Solutions Aon is a leading international credit insurance broker providing our clients with key solutions against non-payment risks, while facilitating their business growth and improving access to trade finance. Our local specialised teams are united and coordinated at a country, regional and global level by experienced market thought leaders. We are passionate about leveraging credit insurance to support our client s business growth. Our objective is to be regarded by our clients as their preferred broking partner and trusted risk advisor, fully committed to delivering a proposition that is built around traditional values of personal service, combined with access to the full breadth and depth of Aon s global resource and capabilities, including our constant monitoring of regulatory challenges and trends. Managed Premium $800m $725bn of trade supported Trusted advisor No. 1 Global credit broker in terms of premium placement 57 countries 490+ 100+ people locations Integrated Multi-Debtor & Single Risk 5
About Aon Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance. FPNAT345 Aon Credit Solutions is part of Aon UK Limited which is authorised and regulated by the Financial Conduct Authority. Key contacts Remco Beuvens Chief Development Officer Aon Credit Solutions EMEA t +31 (0) 10 448 7879 m +31 (0) 655 163 026 remco.beuvens@aon.nl Fraser Bunn Associate Director Aon Credit Solutions US t +(1) 305 961 5936 m +(1) 786 375 7448 fraser.bunn@aon.com Helen Clark Head of Asia Aon Credit Solutions t +65 62 39 7604 m +65 91 78 9032 helen.m.clark@aon.com Innokenty Smorchkov Actuarial Consultant Aon Global Risk Consulting t +41 58 266 86 41 m +41 78 765 39 63 innokenty.smorchkov@aon.ch Aon UK Limited 2017. All rights reserved. The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Aon UK Limited is authorised and regulated by the Financial Conduct Authority. For more details, please visit aon.co.uk/ professional services aon.co.uk 6