Financial instruments — Impairment
The IASB and FASB continued their discussions on the development of the three bucket impairment model. As part of the development of the Supplementary Document (‘SD’) issued in January 2011, the Boards had tentatively decided in March and April 2011 that purchased financial assets where there was no explicit expectation of credit losses would be assessed for impairment under the SD approach (similar for originated financial assets) while purchased financial asset with an explicit expectation of loss (e.g. those purchased at a deep discount due to credit deterioration) would recognise interest income based on expected cash flows rather than contractual cash flows. However, given the significant differences in the impairment model under the three bucket approach and the good book/bad book approach in the SD, the staffs wanted the Boards to revisit their previous decisions on purchased financial assets.
Application of the general impairment model to financial assets with an explicit expectation of losses at acquisition
The Boards considered whether, for purchased financial assets that have been designated for income recognition using expected cash flows, changes in initial expectations should be based on a bucket one measurement (e.g., changes in the next 12 months) or on a bucket two/three measurement (e.g., changes in lifetime expected losses). The result of this decision would determine whether these purchased assets would initially be classified in bucket one or in bucket two or three for future impairment considerations. While initially classifying these loans in buckets two or three could be viewed as inconsistent with the overall three bucket impairment model (which would begin all assets in bucket one with transfers based on deterioration of credit quality), such an approach still follows a deterioration notion as no impairment expense is recognised upon acquisition, rather impairment is only recognised upon changes in initial expectations. Based on this rational, the IASB and FASB tentatively decided that purchased financial assets with an explicit expectation of losses should be initially classified in buckets two or three and recognise an impairment allowance based on the changes in lifetime expected cash flows since acquisition.
The Boards then discussed the scope for which purchased financial assets it is appropriate to recognise interest income based on an initial expectation of cash flows at the time of acquisition and what level of aggregation should be used in that assessment.
Both existing IFRS and US GAAP include similar concepts for purchased financial assets that have experienced credit deterioration since origination. IAS 39 describes the scope of such instruments as those ‘acquired at a deep discount that reflects incurred credit losses’. US GAAP’s ASC 310-30 applies to financial assets with ‘evidence of deterioration of credit quality since origination acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable’. During the March and April 2011 discussions on purchased financial assets the Boards had used the phrase ‘purchased financial assets where an explicit expectation of losses exists [when analysed at the individual asset level]’.
The discussion began with the IASB Chair asking the staffs if there was a possibility of marrying the two existing scope criteria. The IASB staff noted that the existing scopes in IFRS and US GAAP are based on an incurred loss model and use in an expected loss impairment model may not be as easily transferable as thought.
The IASB Board members, with minor exceptions, were broadly in favour of keeping the scope fairly narrow by using language similar to ‘explicit expectation of losses’ as they believed this would be interpreted similar to the ‘acquired at a deep discount’. They noted the operational concerns of the original IASB ED which required an expected cash flow interest income recognition model and therefore wanted to ensure the population was not too broad to reintroduce those operational concerns. One IASB member did note a preference for ‘fine-tuning’ the existing scope definitions raising a concern over introduction of the term ‘explicit expectation of losses’ and its ultimate interpretation. Another IASB member preferred to make the division at purchased financial assets expressing concern over how to appropriately differentiate ‘deep discounts’ and other discounts. One IASB member mentioned the importance of appropriately defining unit of account and raised concerns over the possibility of creating arbitrage opportunities such that grouping a problem purchased loan with other performing purchased loans in order to bypass the scope.
However, certain FASB members preferred to use similar terminology as to the model for transferring originated assets to bucket two or three. They suggested that purchased assets would recognise interest income based on expected cash flows when there is a more than insignificant deterioration in credit quality since origination and the likelihood of default is such that it is at least reasonably possible that the contractual cash flows may not be recoverable. However, the IASB cautioned that such an approach could lead to scope much broader than intended and subject more financial assets to this income recognition model, reintroducing the operational concerns with the original IASB exposure draft. The FASB Chair noted that she would prefer to get the scope right and then address the accounting separately to see if modifications could address those operational concerns. However the IASB was highly sceptical of such an approach noting they’ve been working for several years in attempting to address those operational challenges and the time proportional approach in the SD was their best effort at addressing those concerns which was rejected by constituents.
The Boards made no decision on scope of purchased assets subject to an income recognition model based on expected cash flows.
Changes in expectations subsequent to acquisition
Under the model for purchased financial assets with credit deterioration, where interest income is recognised on expected cash flows and impairment is based on credit deterioration subsequent to acquisition, the issue of improvements in credit quality must be considered. The Boards considered whether the original effective interest rate (‘EIR’) based on expected cash flows should be ‘unlocked’ and adjusted for improved expectations or whether reversals of impairment charges or gains should be recognised immediately in profit or loss. Under current US GAAP, the EIR is adjusted for favourable changes in expectations while under IFRS, for fixed rate assets the EIR is locked and any changes are recognised as changes in the impairment allowance.
The Boards were generally supportive of an approach where the initial EIR is locked and any favourable changes in expected cash flows is recognised as a ‘gain’ in profit or loss. One of the FASB members raised issue with classifying the favourable changes in a separate line item from the impairment loss. Rather, he requested both favourable and unfavourable changes in expected cash flows should be recognised in the same line item (i.e., impairment loss). The FASB members agreed with this modification; the IASB members were originally not supportive preferring recognition as a gain rather than distorting the impairment loss amount. However, for convergence the IASB also tentatively decided that increases in cash flows expected to be collected are recognised immediately in profit and loss as a reduction of the impairment loss.
Presentation of purchased financial assets with an explicit expectation of losses
Under IFRS 3(R) and FAS 141(R), purchased financial assets are recognised at their acquired fair value without any carryover of allowance for uncollectibility. FASB constituents in particular have raised the issue of the differing balance sheet presentation methods for originated and acquired financial assets and the issues raised in financial statement analysis (as originated loans have an associated allowance while purchased loans are recognised at fair value with no associated allowance balance).
One IASB member stated his preference for net presentation (e.g., no associated allowance for purchased loans) as in his view it was not relevant to disclose losses incurred by someone else. However, he did note that appropriate disclosure was needed for comparability between originated and purchased assets. Another IASB member emphasised what a difficult issue this was as recognising purchased loans at fair value without a corresponding allowance balance does impact analysis for financial institutions. However, she also mentioned that presenting purchased assets on a gross basis would also impact other analysis so there wasn’t a clear and simple solution. Other IASB members raised the issue of other asset classes that are acquired under business combination accounting and that there are similar implications for property, plant and equipment and other assets that are recognised at fair value without carryover of accumulated depreciation. The IASB unanimously supported requiring net presentation for purchased financial assets. The FASB had slightly different views with several of their Board members stating initial preferences for gross presentation. However, they noted that for convergence they could also support a net presentation if sufficient information were disclosed about the gross amounts. The Boards tentatively decided to require net presentation for purchased financial assets but would develop disclosures as part of the impairment disclosure package to provide transparency on the gross amounts of purchased financial assets.