Financial asset impairment - a measurement solution??
A recent announcement made jointly by the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) indicates their intention to re-prioritise the major standard convergence projects currently in progress and release shortly a new work plan and timetable. The modified strategy retains the overall target completion date of June 2011 for standards convergence for many of the projects identified by the Boards, particularly those where a converged solution is ultimately required.
The modification to the joint plan is largely in response to the concerns expressed by constituents that the large number of exposure drafts about to issue would strain their ability to provide high quality comment and therefore undermine due process in the discussion and finalisation of the various standards. Perhaps it also affords some additional breathing space to the IASB and FASB to seek out common ground on those standards where convergence is difficult to achieve. This is particularly so in the area of financial instruments accounting, a major part of which relates to an impairment model for financial assets.
The impairment model - motivators for change
There is a belief on the part of prudential regulators, and probably others, that accounting standards are one of the factors that contributed to the financial crisis, as they are seen by them to have encouraged pro-cyclicality in credit provisioning and pricing. An assertion that has gathered momentum in some quarters is 'Banks are different: should accounting reflect that fact?'. However, many securities analysts and investors hold strong the belief that accounts are primarily for investors and that they must faithfully present the financial position at a particular point in time in accordance with accounting standards and principles - which should be applied consistently to all entities.
In 2009 the Group of Twenty (G20), bringing together representatives of 19 of the world's largest economies plus the European Union, held summit meetings in April and September following which it published statements regarding the G20's principles to strengthen transparency and accountability. Among its many calls for improvement was to improve accounting recognition of asset impairment losses by incorporating a broader range of credit information and to strengthen the process of developing appropriate accounting standards for provisioning and valuation uncertainty.
G20 met again in early June and re-emphasised the importance it places in achieving a single set of high quality, global accounting standards, urging the IASB and the FASB to redouble their efforts to that end.
IASB - proposed changes
Currently, the IASB recognises impairment of financial assets using an 'incurred loss' model, which assumes that all loans will be repaid until evidence to the contrary (known as a loss or trigger event) is identified. Only at that point is the impaired loan (or portfolio of loans) written down to an amount equivalent to its expected cash flows. The model proposed by the IASB in its Exposure Draft (ED) issued in November 2009 is an 'expected loss' model under which expected losses are recognised through the life of a loan, not just after a loss event has been identified. Use of the 'expected loss' model would apply to all financial receivables accounted for at amortised cost, including trade receivables in a non-financial corporate entity. The primary focus of this article is on loans and similar financial assets in a banking environment.
The 'expected loss' model avoids what many see as a mismatch under the 'incurred loss' model - front loading of interest revenue (which includes an amount to cover the lender's expected loan loss) while the impairment loss is recognised only after a loss event occurs. The 'expected loss' model may therefore be seen as a better reflection of the lending decision.
Under the 'expected loss' model, the amortised cost of a loan or other financial asset is calculated using the effective interest rate method (EIR), as being the present value of the expected cash flows over the life of the loan, discounted at the EIR. Unlike the 'incurred loss' model, it does not wait for a loss event before recognising that a certain level of impairment will reduce the recoverable amount of the loans. In certain circumstances, particularly where there is a deterioration in underlying economic or related conditions, the basis for estimating the expected cash flows may be changed during the life of the loan and the consequent increase in loss provision would be recognised immediately. The ED includes guidance on possible sources of data for estimating the effect of expected credit losses. The ED also proposes comprehensive presentation and disclosure requirements that would enable users of the financial statements to evaluate the financial implications including the quality of assets and the related credit risk.
If adopted, the 'expected loss' model is likely to involve significant costs and an extended period of implementation given the expected significant changes required to financial systems, particularly in the financial services industry.
The IASB has established an Expert Advisory Panel (EAP) to make recommendations on the nature and extent of any additional guidance required, explore possible simplifications and practical expedients of the model and facilitate field testing of the proposals.
The IASB has recently made public some of the observations and findings arising from the work being carried out by the EAP. These include:
- Identifying that banks, and others, may have systems difficulties in correlating accounting data, particularly effective interest rate data, and risk information on expected losses because two different systems are used in many cases. The EAP has proposed practical expedient approaches to address the issue
- For many, the most practical way of estimating future cash flows is to firstly estimate lifetime expected losses
There are many other observations and comments made, many of which highlight the need for practical expedients to be used to develop best estimates of expected losses. Some believe that the need to use such practical expedients undermines the process of calculating the provisions as it calls into question the adequacy and quality of the underlying information.
FASB - approach to impairment
The FASB has recently issued a proposed Accounting Standards Update (ASU) 'Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities' which is an all embracing proposed new standard on financial instruments. This is in contrast to the phased approach being adopted by the IASB.
As part of the ASU, the FASB proposes that an entity would recognise a credit impairment when the entity 'does not expect to collect all contractual amounts due for originated financial assets and all amounts originally expected to be collected upon acquisition for purchased financial assets'. Although it is considered that the entity could not forecast future events or economic conditions that do not exist as of the reporting date in assessing a financial asset for credit impairment, the entity would consider the impact of past events and current conditions on the current and future collectability of the cash flows associated with the financial asset.
This approach is closer to the IASB 'incurred loss' model currently being used rather than the 'expected loss' model being proposed, as the assessment of collectability of expected future cash flows is based on all available information relating to past events and existing conditions. The 'expected loss' model is based on forecasting expected losses at the inception of the loan taking into account projections of relevant economic factors.
The 'expected loss' model may be more helpful to the prudential regulators who will be seeking to have additional amounts provided in excess of the accounting provisions being made under current standards and who are strongly of the view that what might be known as 'rainy day' provisions are set aside.
As of now, the divergent approaches by the two main standard setters to providing for asset impairment losses is a major obstacle to the convergence process and one that will need to be resolved if overall objectives are to be acheived by 2011.
In conclusion, if the 'expected loss' model had been in operation in 2007/2008 would it have significantly increased the provision levels carried by banks and would such major events of the crisis as the collapse of Lehman Brothers, or other events closer to home, have been fully factored into the calculations? Would the scale of them and their consequences have been within the bounds of reasonable expectation?
First published in Finance Dublin online