David Webber CEO of Whistlebrook Limited explores how the complexity has evolved in income recognition for loans and how business insight could be derived from effective interest rate calculations.

Before considering the challenges lenders face today in consistently and compliantly recognising interest and fee income and cost, it is worth reflecting on how best practice of recognition has evolved over the last fourteen years.

International Accounting Standard 39 Financial Instruments: Recognition and Measurement (“IAS39”) was adopted in 2004 and as such, the basis of the recognition of interest using the effective interest method was established.

Since the adoption of IAS39, the standards have evolved through interpretations by the IFRS Interpretations Committee, consolidation under FRS102 (reporting periods beginning after 1^st January 2015) and replacement with IFRS 9 (accounting periods commencing after 1^st January 2018.)

As we know, key to the correct recognition of interest income is the calculation of an effective interest rate (“EIR”) and it is the burgeoning challenge of the calculation of EIR that this article is going to consider.

A simple spreadsheet calculation?

The effective interest rate is computed on the estimated cash flows that are expected to be received over the anticipated life of a loan, by considering all of its contractual terms. Certain, fees paid or received, transaction costs, and other premiums or discounts are deferred and amortised over the expected life of the loan.

When the effective interest rate method was first introduced, the logical assumption was that this was a series of calculations ideally suited to a spreadsheet. In fact, that is how the vast majority of finance organisations have approached the challenge.

What is now apparent is just how complex the spreadsheet solutions can become.

This is not just because of the accumulation of loan data on a period-by-period basis or the growth, for many organisations, of the types of lending or even the plethora of innovative new products they are launching.

The complexity is also driven by the accumulated assumptions on anticipated reversion behaviour, prepayments, repayments and loss provisions. The calculation of EIR has become a significant task within the finance department and our recent survey of UK Building Society Finance Heads found that for more than 25% of respondent organisations, that effort was equivalent to 2 to 3 man months per annum.

Even when an organisation has developed a spreadsheet of sufficient sophistication to model the EIR on an ongoing basis, the complexity will need to be copied into multiple versions so that different reversion assumptions can be tested under varied economic scenarios.

When our survey participants responded as to the largest operational challenge they have in currently calculating EIR, they identified providing management information as the largest challenge, closely followed by recalculating cash flows over the anticipated future life following a base rate change.

Audit and governance

Consistently when financial organisations’ auditors are disclosing key audit matters within the annual statutory accounts of an organisation, they identify the calculation of EIR as being subject to significant material assumptions on the expected behaviour of a loan. The anticipated reversion period and borrowers’ prepayment behaviour are particularly important.

Our conversations with both lenders and auditors have identified a greater focus on the materiality of adjustments to income recognition by assumptions underpinning EIR calculations.

Executive Boards or Non-Executive Directors have a reasonable expectation that the organisation’s finance team can determine if income recognition will materially change when reversion assumptions have materially shifted. They would expect consideration of scenarios that for instance may cause an economic recession such as a hard BREXIT.

The Bank of England Prudential Regulation Authority (“PRA”) has been reviewing EIR accounting across banks and building societies. In the PRA’s letter in June 2018 to CEO’s it reinforced its concern as to the potential for material EIR income recognition risk and recommended that the risk should be monitored not only through auditor and supervisor dialogue but also expressly addressed within a firm’s ICAAPs.

External auditors are not just focusing their attention on the material impact of changing assumptions on reversion behaviour, but also on the risk and controls in place with regard to the spreadsheets themselves.

Typically, in an organisation, one, or maybe two, individuals are the architects or experts in what have become complex spreadsheets. Apart from the key man risk there is also the challenge of the validity and accuracy of the calculations within the spreadsheet itself. It is common for auditors to identify little or no version control or documentation on spreadsheets being used for calculations that can demonstrate period on period volatility on income or cost recognition as key assumptions change.

Our survey respondents clearly identified reliance on key individuals as the number one challenge in their current approach to EIR calculation.

The importance of EIR calculations seems to be moving up the agenda of priorities within the lending sector. In our recent industry survey 25% of respondents said that EIR was a high priority in the finance department’s consideration of business priorities.

Business insight and product design

Spreadsheets are great tools for executing calculations and fulfilling the function for which they were designed. Unfortunately, however, they are less useful when retrospectively you wish to derive insight or execute extrapolations in a manner for which the spreadsheet was not initially intended.

As previously stated an EIR calculation is materially impacted by the assumptions on reversion for a product after the special terms period has completed. Organisations spend considerable time, and thought, in determining for both the back book and new products how individual customers or groups of similar customers are likely to prepay or redeem their mortgages following the conclusion of their initial deal.

What organisations need, is to ensure they have a view on how customer or group behaviours are going to change through actual or anticipated changed economic or market circumstances.

A product, rather than a spreadsheet, approach to EIR means that actual historical reversion behaviour can be analysed for insight.

That insight can be used for future product design and for building the lenders’ business plans, as well as underpinning assumptions for forecast liquidity requirements.

Having a software product that can easily run different reversion scenarios on the same data and produce analysis of the actual reversion behaviour undoubtedly makes risk and materiality assessment, and fielding auditor’s queries, an easier task.

What about the fees?

In addition to the consideration of the expected life of a loan, lenders also give thought to the fee income from the borrower and of course any cost from an introducer of business, in product design.

Obviously, the expected life of a loan is a combination of the special terms period, (e.g. for a fixed rate product with a life of 3 years, the maximum period will be 36 months) and the reversion assumptions (i.e. how long before the borrower redeems or switches the loan).

However, borrower fees that may be contingent or non-contingent upon completion of the mortgage or early repayment charges that may be levied need to be recognised in accordance with the standards, across the product’s expected life.

Few organisations have spreadsheet models that allow them the flexibility to test different fee structures under various anticipated product lives or run multiple scenarios on the same data to analyse how their fee income or cost recognition assumptions will change

I expect that a tightening economy in the UK will lead to greater mortgage product competition, tighter margins on new products and as such a desire for improved product profitability. The contribution from fees may have greater materiality and therefore the scrutiny on margin management more focused in this area.

I do not believe the consistency of data or assumptions is in place in most organisations to enable the seamless cascade of assumptions from product design, to margin analysis, through income recognition and into liquidity and future business planning.

At some stage, organisations will need to accept that spreadsheet solutions are not fit for purpose.

What next for EIR

In our recent survey of UK Building Society Finance Heads, 50% of the respondent organisations that had not already adopted IFRS 9, said that its adoption would result in them reviewing the approach to EIR calculation. Also over one third of respondents said they expect their EIR calculations to be more complex on the one-year anniversary of their current accounting period.

There is no argument that an already complex area is expected to become more, not less complex.

It is also undoubtedly a fact that with political uncertainty from BREXIT and a general election in May 2020, or earlier, plus possible economic recession and an increasing trend for base rates, that whatever assumptions have been made historically for customer behaviour will need to change.

The only certainty from an increasing period of economic volatility is that behaviours in a reversion period will be different from those currently assumed and probably to the detriment of the lender.

I believe that lenders should take the opportunity to review the assumptions upon which their current and planned products are designed, to ensure that those assumptions they have made for an economic return over the anticipated life of the product are based on actual like customer reversion behaviour.

It is definitely the time to ensure that the same rigour that is applied to both financial accounting and the assumptions for capital adequacy planning is focused on the controls, functions and insight of EIR and the associated interest, fee and cost recognition.

There is also a great opportunity to integrate insight derived from actual reversion behaviour into future business financial planning and into product design, so that the actual return derived, more closely matches that anticipated when the product was designed.

David Webber is the CEO of Whistlebrook Limited, a member of the ICAEW and Whistlebrook’s subject matter expert for their EIR product. The survey referred to in the article was carried out online in the month of July with 20% of UK building Societies participating.