Discussion at the June 2009 IASB Meeting - Impairment and Provisioning
Wednesday 17 June 2009 – Education Session by Bank of Spain (BdE) Representatives: the BdE Provisioning Model
Two representatives from the Bank of Spain (regulator of Spanish banks) presented the statistical provisioning approach which the BdE requires from entities regulated by them. The representatives explained that, in their opinion, the model incorporates losses incurred due to under-pricing of credit in times of boom in the lending cycle due to market over-optimism. The lending cycle per the model is closely correlated with the economic cycle as a whole.
The model is based on a statistical formula which incorporates an element of collective impairment relating to the point in the lending cycle ('alpha') and incurred losses relating to individual assets ('beta'). The alpha component is a collective assessment and applied to the change in the portfolio of assets at each date of assessment. Thus in times of boom in the lending cycle, the alpha component is high relative to the beta component, whereas this trend is reversed in times of slump as incurred losses relating to the general cycle are in effect transferred to individual assets; the alpha element can be negative, reflecting over-conservative pricing of credit. The representatives explained that they believe the advantage of the model is the early detection of credit losses.
The Bank has around 6 asset classes which it views as homogeneous, for each of which an alpha (effect on asset class of stage of the lending cycle) and beta (historical incurred losses relating to individual assets) are kept. In order to assess the lending cycle, the BdE holds data from the Spanish national credit register dating back to 1988 for each of the asset classes, which equates roughly to 2 full lending cycles. The representatives stressed that this is an incurred loss model as the inputs to the model are derived only from historic experience.
Board members asked questions around various aspects of the model. One member asked what approach the BdE takes for new products where there is little historic data. The representatives replied that this was not an issue that had caused much difficulty in Spanish banking given the relative absence of new products – for example, credit cards represented only around 1% of total lending in Spain. Another member pointed out that, for loans given out during periods of boom, the model effectively results in a large 'day 1'-type loss for lenders. The representatives replied that this was a necessary reflection of credit pricing in these times.
Another member asked whether BdE was aware of how much credit data other central banks held, and thus how practicable a system such as this would be for banks from other countries. The representatives replied that they were aware of some central banks holding extensive credit data; however it was unlikely that many would hold data in sufficient detail going back as far as 1988. Another board member asked whether, if an expected loss model were incorporated within IFRS, the bank would continue to use its model. The representatives replied that, in their opinion, it was possible to use the model to estimate expected losses, however it would be a relatively simple approach. The representatives agreed with board members' views that, were this model adopted more widely, more active involvement would be required from banking supervisors in assessing provisioning than is currently the case given the complex nature of the model and underlying data. The representatives put forward the view that, in times of economic difficulty such as the present time, banks would be less likely to voice the view that an approach such as their model would lead to competitive disadvantage. This had been their experience in Spain.
The chairman thanked the representatives for their presentation.
Friday 19 June 1009 – Description of Possible Alternative Features to the Exposure Draft Model
The Board discussed a proposal put forward by a Board member describing some additional features (variants) of the classification model developed by the Board. Under this variant:
- (a) Financial assets with basic loan features that are managed on a contractual yield basis would be measured at fair value in the balance sheet, unless they meet the definition of loans and receivables in IAS 39.
- (b) Such financial assets would:
- (i) be measured on an amortised cost basis in profit or loss (including recognition of impairment using the incurred loss provision requirements in IAS 39); with
- (ii) any difference between that amortised costs measure and the fair value change being recognised in other comprehensive income. There would be no recycling between OCI and profit and loss.
The effect of this proposal was that potentially more financial instruments would be measured at fair value on the balance sheet, but the value change would be allocated between profit and loss and other comprehensive income in the statement of comprehensive income.
Board members discussed this variant for a while, suggesting other possible variations. At least one member thought the variant as 'dead on arrival' and would not support it. Another Board member thought that it was unhelpful to mix the measurement of financial instruments between the statement of financial position and the statement of comprehensive income. If an item was reported on the statement of financial position at fair value, changes in that measure should be reported in profit and loss. A mixed allocation method, such as proposed with the amortised cost component being reported in profit and loss and the 'plug' between that amount and the value change being reported in other comprehensive income was likely to lead to problems and the Board developed other aspects of the revised financial instruments package.
In particular, some Board members were concerned about the consequences of this variant on hedge accounting, especially that the mixed allocation might add rather than reduce complexity in some situations. If hedging is designed to manage what is recognised in profit and loss, allocating some of the exposure being hedged to other comprehensive income would create challenges in hedge accounting, in particular assessing effectiveness.
While not commenting on its merits, the Board agreed that the variant should be discussed in the forthcoming exposure draft's Basis for Conclusions (as will all the alternatives considered in detail by the Board) and that comments should be invited on it.
Discussion at the September 2009 IASB Meeting
The Board was joined by FASB staff and FASB Board members via video link. The Board discussed the responses to the Request for Information published in July and next steps.
The main message from respondents to the Request for Information was that the expected loss approach would pose significant operational challenges (especially in the area of cash flow estimates and complexity of required calculations) and would entail substantial costs and lead time to implement. Views of constituents on other issues were generally mixed. Constituents requested some additional guidance and clarification on specific issues, but on the other hand requested more prescriptive requirements on portfolio assessment of impairment. Moreover, in their view, further simplification of the approach would be desirable in order to make the principles operational.
The FASB members noted that the FASB did not discuss the impairment issue yet, but the range of interpretation of what was meant by expected loss model was wide. Some constituents understand expected loss in Basel II sense or, alternatively, as a possibility to include losses due to worsening of the economic conditions. This difference in opinion and expectations could pose a challenge in the deliberation process.
Several Board members raised the issue of application of the model to trade receivables of non-financial entities. There was a high degree of consensus that these instruments should not be excluded from the model, but additional application guidance for trade receivables should be included to alleviate the concerns raised by the industry.
Some Board members expressed their concerns over timing of the project. Given estimated lead time (2-4 year after publication of the final standard in order to adjust the systems), some Board members preferred a more thorough discussion, perhaps in the form of issuance of DP rather than ED. Other Board members were concerned that the model is not sufficiently developed for issuance of the ED. They were particularly concerned that additional guidance would be developed only after the ED has been published. Nonetheless, other members pointed to the political environment and the clear need for new guidance that was already pledged by the Board. Moreover, they pointed that alternative views were already explored by the Board in June and July and expected loss model was identified as the way forward.
The Board decided to provide a clear objective and emphasise principles that would be reinforced by clear and concise application guidance. It was felt that providing a comprehensive guidance was impossible as it could not provide guidance for all the issues. Some members of the Board expressed their concerns that if insufficient guidance was provided regulators would step in and impose additional requirements.
The Board decided to establish an Expert Advisory Group on Impairment that would assess the need for development of further guidance. FASB will participate in such discussion. The Board also considered the need for further outreach to constituents perhaps in a way of roundtables as part of deliberations on the ED.
The Board reaffirmed its decision to require one single impairment model to all financial instruments measured at amortised cost. Therefore, it did not support any exception for trade receivables, instruments trade in active markets, or individually significant assets.
The Board then considered possible simplifications of calculations required. The Board did not approve the proposed usage of the straight-line method for measurement of expected losses on initial recognition, as opposed to the effective interest rate method. It was felt that the issue was too technical in nature and should be first assessed by the Expert Advisory Group.
The Board also noted that additional discussion on application of the principles on portfolio level should be included in the ED. Some Board members noted that the application guidance should include also guidance on how portfolios should be identified.
Discussion at the Special 22 September 2009 IASB Meeting
Possible issues to be addressed in the exposure draft by application guidance or clarification
The staff explained that the purpose of this discussion was to follow up on issues that came out from responses to the Board's Request for Information on their Expected Cash Flow approach (ECF). The staff's agenda paper sets out recommendations on what issues should be addressed by application guidance and clarification in the ED and also what issues should be explored by the Expert Advisory Panel (EAP) set up to deal with application issues of the ECF.
Board members asked about the role of the EAP and whether their remit would be restricted to the items set out in the agenda paper. The staff explained that the issues to be considered by the EAP had not yet been finalised and the list in the agenda paper was not an exhaustive list. The FASB who were in attendance by video link and other Board members questioned whether and when the output from the EAP would be incorporated in the final standard on impairment.
The staff explained that the EAP will be working alongside the issuance of the ED and their role will be to advise the Board on the type, nature, and extent of application guidance to be included in the final standard. The EAP would also help facilitate field testing of the proposals.
The Board agreed with each of the following staff recommendations:
- To provide principles based guidance in the ED that focuses on two aspects of portfolios based versus individual estimates: (a) using the approach that provides the best estimate and (b) ensuring that if entities switch between approaches, that does not result in double counting.
- Regarding estimation of cash flows, that the ED provide concise application guidance on how to source and adjust historical data drawing on existing guidance in IAS 39.AG89 and charging the EAP with analysing the remaining issues related to cash flow estimates that respondents to the RFI raised.
- To provide application guidance for trade receivables in the ED without illustrative examples.
- Rather than provide further application guidance in the ED, the EAP should be charged with addressing process driven implementation issues related to the ECF approach.
- To include in the ED clarifications regarding point-in-time versus through the cycle estimates, expected value versus most probable value and the use of entity specific versus market date and addressing the differences of fair value (to amortised cost based on ECF) in the basis for conclusions.
Transition
In this session the staff presented their paper considering three potential approaches to transition for new impairment rules based on ECF. These three include:
- Option 1: Retrospective application to all financial instruments
- Option 2: Prospective application to only new financial instruments with initial recognition on or after adoption of the ECF approach and grandfathering the old rules for existing financial instruments.
- Option 3: A customised transition approach that combines prospective application for new financial instruments where initial recognition is on or after adoption of the ECF approach with either (a) retrospective application or (b) a change in measurement (involving discounting revised expected cash flows by the original EIR, and recognising the adjustment to opening reserves) for financial instruments recognised before adoption of the new standard.
Board members discussed these options and generally agreed that Options 1 and 2 were not appropriate. Instead Option 3 seemed the most appropriate, however, there were concerns about the retention of the existing EIR for certain financial instruments initially recognised before adoption of the new standard for which full retrospective application was not elected. The concern was that this has the effect of reducing reserves and increasing interest income over the remaining life of the instrument as the original EIR under the existing incurred loss model would be higher than the EIR derived under the ECF approach.
Alternative EIRs that better represented the EIR under the ECF approach were suggested to solve the issue. However, it was acknowledged that such an EIR could be negative unless it was bound by a corridor (eg limit to between the risk free rate and the contractual rate). It was agreed that these alternatives would be considered by the staff as part of developing the customised transition approach further.
Discussion at the Special 29 September 2009 IASB Meeting
Transition and Effective Date
The staff presented two approaches to transition that are in addition to the approaches discussed at the 22 September 2009 Board Meeting:
- Effective interest rate (EIR) collar approach, which would involve determining on transition a new effective interest rate on the basis of the expected cash flows over the remaining life of the financial instrument that would be subject to a floor (the risk free interest rate) and a ceiling/cap (the contractual interest rate).
- EIR margin adjustment approach, whose objective was to determine an adjustment to the EIR under IAS 39 that resulted in an adjusted EIR that approximated the EIR that would have been determined under the expected cash flow approach.
The Board agreed that EIR collar approach would be too complex and challenging to implement. The Board was split between the customised transition approach discussed during the last meeting (that would lead to a reduction of reserves and increasing interest income over the remaining life of the instrument) and EIR margin adjustment approach (that would be more challenging to implement). The Board decided to include both approaches in the invitation to comment in the forthcoming ED.
The Board discussed the proposed effective date of the new standard (1 January 2014). The Board tentatively agreed to propose this date in the ED. The Board decided to propose that full comparative information should be provided. Some Board members noted that such a decision might delay the effective date even further. The Board decided that early application was to be allowed. Nonetheless, some Board members were concerned about comparability of the data across reporting entities given the long lead time until adoption.
Discussion at the Special IASB Meeting 6 October 2009
Guidance for variable interest rates
The Board decided to provide application guidance on variable rate instruments that requires a catch-up adjustment (a mechanism that is used to ensure that the carrying amount of a variable rate instrument unwinds to the remaining expected cash flows by an adjustment to profit or loss, which changes the carrying amount of the instrument).
Presentation and disclosures
The Board discussed in detail the requirements for presentation and disclosure resulting from the change to the expected losses model of impairment. Some Board members expressed their concerns that the proposed disclosures were overly burdensome and would be too complex and costly to implement. On the other hand, the majority of Board members thought that the disclosures were necessary for the decision-usefulness of the financial statements.
The Board decided to require the following disclosures:
- interest revenue based on contractual cash flows, adjustment for allocation of initial expected losses and changes in expectations of expected losses on the face of statement of comprehensive income
- reconciliation of the provision account for credit losses by class of financial instruments
- vintage information of financial assets held at amortised cost
- loss triangle in table format and qualitative information in case of significant changes in loss estimates
- disaggregation of the change in expectations of expected losses
- management's assumptions and methodology in determining expected losses
- high level 'sensitivity analysis' on key assumptions and effect of using reasonably possible alternatives
- stress testing information if management performed stress testing for the internal risk management purposes
- reconciliation of non-performing financial assets held at amortised cost
- additional disclosures on transition from incurred loss model to expected loss model
The most significant discussion of disclosures focussed on the requirement to provide information on stress testing (#8 above). Some Board members felt that such disclosures are not appropriate as they would reduce comparability (not all entities would perform stress testing) and would not provide useful information (boilerplate disclosures). Other Board members disagreed. They argued that merely disclosing that the entity performed stress testing was potentially useful. Moreover, most of financial intermediaries may be required to perform stress-testing by the regulators.
Some discussion was directed also to the vintage and loss triangle disclosures (#3 and #4 above). Some Board members felt that those disclosures were not cost beneficial, and on an aggregate level as proposed would not provide the intended information. They pointed out that practices in risk management might differ among entities, and thus the quality of the portfolio was very much influenced not only by the date when the financial instruments were originated but also by the type and quality of an entity's risk management practices. Most Board members disagreed. They noted that these data should be available to any institution as they are based on contractual cash flows and are necessary to assess the risk profile of any portfolio for internal risk management purposes.
Interaction with other IFRSs (IAS 28 and IFRS 4)
The Board considered the consequential amendments to IAS 28 and IFRS 4 resulting from the change of the impairment model.
The Board decided to use the impairment indicators in IAS 36 to determine whether additional impairment testing was required for an investment in associate. The Board considered this approach appropriate, as the amount of impairment loss is measured in accordance with IAS 36 under current IAS 28 requirements.
The Board also agreed to retain the existing requirement for reinsurance assets in IFRS 4 as it felt that eliminating the loss event guidance in IAS 39 would not result in a change in accounting policies for entities applying IFRS 4 to reinsurance assets.
Comment period
The Board briefly discussed the expected comment period. The staff re-affirmed the intention to publish the Impairment ED in October. The staff proposed an extended 180-day comment period for the ED so the Expert Advisory Panel would have a sufficient time to finalise its application guidance for re-deliberations. Some Board members proposed an even longer comment period (9 months). The Board agreed that an extended comment period is desirable given the complex nature of the proposal but deferred a final decision on the comment period to a future Board meeting.
Discussion at the Special IASB Meeting 15 October 2009
Drafting of the exposure draft and comment period
The staff introduced the session by summarising tentative decisions made by the Board. The Board authorised the staff to proceed with drafting the exposure draft (ED). On formal vote, one Board member indicated he would dissent from publishing of the ED as he did not agree with the proposed approach.
The Board agreed to extend the comment period of the ED to 8 months to allow sufficient time for the Expert Advisory Panel (EAP) to articulate its recommendations. This timeline would not endanger the agreed timetable to publish final IFRS in December 2010. The Chairman asked if it was more appropriate to have a shorter comment period and to allow the EAP to respond to the comment letters. The staff replied that it would not recommend such alternative as in that case the comment period would coincide with high reporting season. Moreover, staff stressed that extended comment period was also designed to allow constituents who usually do not comment on the Board's proposals to have sufficient time to express their views.
November 2009: IASB proposes to amend IAS 39 on impairment
On 5 November 2009, the IASB issued an exposure draft (ED) proposing to amend IAS 39 Financial Instruments: Recognition and Measurement to modify the way impairment losses are recognised on financial assets measured at amortised cost. This is one of the phases of the IASB's comprehensive project to replace IAS 39.
The existing incurred loss model
Currently, IAS 39 recognises impairment of financial assets using an 'incurred loss model'. An incurred loss model 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 a lower value.
IASB's proposed expected loss model
The model proposed in the ED is an 'expected loss model'. Under that model, expected losses are recognised throughout the life of a loan or other financial asset measured at amortised cost, not just after a loss event has been identified. 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. Proponents of the expected loss model believe it better reflects the lending decision. Under the IASB's proposed expected loss model:
- Initial measurement. An entity determines the amortised cost carrying amount of a financial asset or portfolio of financial assets at initial recognition on the basis of the present value of future expected cash flows in considering expectations about future credit losses.
- Subsequent measurement. Subsequent to initial recognition the entity re-estimates the future expected cash flows and determines the present value. An impairment loss is therefore recognised only if there is an adverse change in expected cash flows, and a reversal of impairment losses is recognised if there is a favourable change in expected cash flows with any adjustment recognised in profit or loss. All measurements are made on the basis of present values, not market values. Extensive disclosure requirements would provide investors with an understanding of the loss estimates that an entity judges necessary.
Amortised cost is calculated based on the effective interest rate (EIR) method as present value of the expected cash flows over the remaining life of the financial instrument discounted at the EIR. Expected cash flows are estimates based on probability-weighted possible outcomes (that is, even if the most likely outcome is full repayment, the likelihood of the debtor not repaying all contractual principal and interest is also factored into the estimate). For a fixed rate financial instrument, the EIR is held constant over the life of the financial asset and does not change as market interest rates change. For a floating-rate financial instrument (such as a financial asset that pays LIBOR plus a fixed credit spread), the EIR is not a single, constant interest rate. Instead the IASB proposes that the EIR be determined by combining the spot interest rate curve for the benchmark interest rate (for example, LIBOR) and a derived initial effective spread. The IASB has published on its Website numerical examples accompanying the ED illustrating application of the mechanics of the EIR.
This expected loss approach will result in earlier loss recognition than the incurred loss model by taking into account future credit losses expected over the life of loans or other financial assets. Under this approach, an allowance for expected future losses is gradually built over the life of a financial asset by deducting a margin for future credit losses from gross interest revenue even if no losses have yet been incurred. This approach is based on the principle on which a lender would price a loan, that is, based on net yield after deducting a margin for expected credit losses.
The ED also proposes comprehensive presentation and disclosure requirements intended to enable users of the financial statements to evaluate the financial effects of interest revenues and expense and the quality of financial assets including credit risk.
Because of significant practical challenges in moving to an expected loss model, the IASB will establish an Expert Advisory Panel comprising experts in credit risk management to advise the board. Deadline for comments on the ED is 30 June 2010. Click for IASB Press Release (PDF 99k).
November 2009: Heads Up on IASB credit loss proposal
Deloitte United States has published a Heads Up Newsletter (PDF 172k) titled IASB Proposes New Approach to Accounting for Credit Losses. The newsletter discusses the IASB's recent exposure draft Financial Instruments: Amortised Cost and Impairment, which proposes a fundamentally new approach to accounting for credit losses to replace the existing 'incurred-loss' model. The proposed approach, which affects the recognition of both net interest revenue and credit impairment, is designed to result in earlier loss recognition by taking into account future credit losses expected over the life of loans or other financial assets (an 'expected-loss' approach).
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