The new International Financial Reporting Standards are changing the way many banks report loan losses, says Fitch Ratings.

In a special report, published today, Fitch highlights that there is a real divergence between the basic principles of IFRS on the one hand and Basel II on the other, but there will be very little difference between the levels of provisions reported under each regime – at least for 2005.

It says that the requirement under international accounting standards for, “an observable loss to have been incurred before an impairment charge is taken is being loosely interpreted by banks in order for them to retain most or all of their existing general loan loss reserves.”

“Many are, in effect, building up a buffer in the form of ‘incurred but not reported’ provisions, which are accounted for as ‘collective’ impairment allowances” said Alison Le Bras, managing director in Fitch’s Financial Institutions Group in Paris and co-author of the report. “Understanding the assumptions made in deriving these will be important when comparing the level of impairment losses between one bank and another, and Fitch strongly encourages clear disclosure of these.”

The impact of international standards on the identification of impaired loans and on the calculation of impairment charges in banks across the world is, in most cases, not that material, the rating agency says. Fitch says it sees the move to the new standards as a change in presentation (or form) rather than substance. The impact on published earnings and cash flows will be neutral over the complete cycle of a loan, it notes. And, underlying asset quality remains unaffected.

Also, application of the revised standard is unlikely to lead to any rating changes directly, it says. However, Fitch will monitor closely any subsequent change in balance sheet or capital management that may arise.

The incurred loss principle of IFRS should lead to the release of some reserves built into balance sheets of banks previously reporting under accounting standards that recognised the concept of prudence. “There is not much evidence that this has happened in the 2005 accounts but analysts need to be aware of potential changes in accounting estimates distorting numbers in future years, “said Bridget Gandy, managing director in Fitch’s Credit Policy Unit in London and co-author of the report. “If these are then paid out as dividends rather than retained as capital reserves, the credit quality of the bank will have been affected, which may result in rating downgrades.”

Unlike most other accounting systems, IFRS does not recognise the concept of non-accrual of interest on impaired loans, Fitch explains. It says this is one of the changes that will result in analysts being faced with different numbers for both interest revenue and loan loss impairment charges. Higher impairment charges are needed upfront to cover interest that will be recorded in interest revenue over the life of the loan but is not expected to be paid.

The report also stresses that different interpretations of the standards, particularly at national level, will mean that cross-border comparison of asset quality remains difficult. “Neither impaired loans nor impairment charging policies will necessarily be comparable from one country or even from one bank to another in the immediate future” says Le Bras.