Financial Instruments: Impairments
The IASB held an IASB only session to discuss the presentation of interest revenue, the application of the proposed expected loss model to assets reclassified from FVTPL, disclosures specific to IFRSs and transition.
In previous deliberations, the Boards tentatively decided that interest income for financial assets measured at amortised cost should be determined based on the carrying amount of the asset excluding the amount of the impairment allowance. However, as part of those previous deliberations, the Boards decided to reconsider whether to require disclosure of the effect of the unwinding on the impairment allowance at a later date.
Thus, at this meeting, the IASB considered how the proposed impairment model would apply to financial assets that are reclassified from FVTPL to amortised cost under IFRS 9 and FVTOCI under the proposed classification and measurement project.
Under the proposed impairment model, an entity would move from an impairment allowance of 12 months expected loss to an allowance of lifetime expected losses for financial assets that have deteriorated in credit quality more than insignificantly since initial recognition. Because of the decoupled approach to measuring expected losses, an entity would be permitted to discount expected losses using a rate between the effective interest rate as determined under IAS 39 Financial Instruments: Recognition and Measurement, and the risk free rate. However, to determine the unwind of the discount rate, an entity would be required to identify and track the impairment allowance for each asset, including determining the effect of transfers between the 12 month expected loss and lifetime expected loss.
During staff outreach performed, concerns have been raised by constituents regarding the difficulty of determining the effect of unwinding the discount. Outreach suggested that since the measurement of the impairment allowance is decoupled from the amortised cost measurement, entities would not be able to track the individual impairment allowance related to the financial assets that move into and out of a portfolio, or between buckets (i.e., the measurement would be a point in time measure).
As a result of concerns that users would not be able to piece together information to determine the economic yield of impaired financial assets and that interest revenue will not faithfully represent the economic yield of the impaired financial asset, the staff recommended that the Board reconsider its tentative decision on the presentation of interest revenue.
The Boards tentatively agreed with the staff recommendation to reconsider the presentation of interest revenue.
Thus, the staff outlined an analysis of the objective for interest revenue. They noted that there are some financial assets that have deteriorated in credit quality to such an extent that presenting interest revenue on the basis of the gross carrying amount reflecting the contractual yield would no longer faithfully represent the economic yield. The level of credit quality that would give rise to such a concern, in the staff’s view, would be a lower credit quality than the credit quality that requires recognition of a lifetime expected loss allowance.
This concern ultimately resulted in the Boards’ previous tentative decision that, for purchased credit-impaired financial assets, an entity should adjust the effective interest rate for the expected cash flows estimated at initial recognition (subsequently the impairment allowance balance represents the changes in lifetime expected losses from initial recognition). For other assets, the effective interest rate is calculated ignoring expected losses. For these assets, the model reflects deterioration in credit quality by measuring expected losses based on current information and by moving from an allowance of 12 months expected loss to an allowance of lifetime expected losses for financial assets that satisfy the criteria for recognition of a lifetime expected loss allowance. Based on the tentative decisions to date for these assets, interest revenue is always calculated on an effective interest rate that is not adjusted for initial credit loss expectations and is always computed on the carrying amount without deduction of the impairment allowance. Thus, the presentation of interest revenue does not reflect the deterioration in credit quality and the question arises of how the model should treat interest revenue for originated credit-impaired financial assets and deteriorated credit-impaired financial assets.
Considering originated credit impaired financial assets, deteriorated credit-impaired financial assets and the definition of credit-impaired more broadly, the IASB staff recommended that the accounting treatment of purchased credit-impaired financial assets should be extended to all financial assets subject to impairment accounting that are credit-impaired on initial recognition. For other financial assets subject to the general deterioration impairment model, an entity should present interest revenue calculated on the carrying amount net of the impairment allowance if the asset is credit-impaired as at the reporting date. This evaluation should be made at each reporting date and will be applicable for the following reporting period. Finally, the staff recommended that financial assets should be considered to be credit-impaired if there is objective evidence of the criteria in paragraphs 59(a)-(e) of IAS 39.
Much of the IASB deliberations related to interest revenue presentation for deteriorated credit-impaired financial assets. The staff had proposed two alternatives for calculating the interest revenue to be presented for deteriorated credit-impaired financial assets: a net interest approach which requires revenue to be calculated on the basis of the net carrying amount, or a nil interest approach which reduces the interest revenue presented to nil. Under this approach, an entity would be required to offset interest revenue on the subset of assets with an equal amount of impairment loss.
Many Board members noted that the net interest approach is consistent with current requirements in IAS 39. These same Board members noted that calculating interest revenue on the net carrying amount more faithfully represents the economic yield of the expected cash flows because the contractual effective interest rate is reduced by the unwind of the impairment allowance. Other changes to the estimate of the impairment allowance would be presented separated in the credit loss line item.
However, other Board members noted that the net interest approach is unduly complex. An entity would be required to identify a subset of financial assets and their related impairment allowances and apply the effective interest rate to the net amount; something which is not required under the nil interest approach.
One Board member, outlining the simplicity of the nil interest approach, noted that banks are currently applying the nil interest approach as a proxy to the net interest approach. He noted that banks often stop accruing interest instead of adjusting the effective interest rate.
Many Board members noted that banks which have found the proxy of the nil interest approach to be materially accurate would likely apply a similar approach after the new proposals come into effect. These Board members were concerned with prescribing a nil interest approach, however, as they believed the approach comingled the unwind of the present value of expected cash flows with other impairment losses. They expressed concern that the nil interest approach would understate interest revenue.
When put to a vote, the IASB tentatively agreed with the recommendations set forth by the staff.
Application of the impairment model to assets reclassified from FVTPL
The IASB considered how the proposed impairment model would apply to financial assets that are reclassified from FVTPL to amortised cost under IFRS 9 and FVTOCI under the proposed classification and measurement project.
The staff recommended that the application of the proposed impairment model to financial assets as at the date of reclassification should follow the application of the proposed impairment model to financial assets on initial recognition. They noted that such an approach would be consistent with paragraph 5.6.1 of IFRS 9 that an entity apply the reclassification prospectively from the reclassification date and not restate any previously recognised gains, losses or interest. The financial asset is recognised at fair value and an effective interest rate determined as at the reclassification date as for a newly recognised asset.
Thus, at the date of reclassification from FVTPL, an entity would be required to determine an impairment allowance of 12 month expected losses unless the financial asset meets the definition of credit-impaired on initial recognition. If the financial asset meets the definition of credit-impaired on initial recognition, then the entity would be required to subsequently measure the financial asset using a credit-adjusted effective interest rate.
With no debate, the Board tentatively agreed with the staff recommendation that the application of the proposed impairment model to a financial asset on the date of reclassification from FVTPL should be the same as a financial asset at initial recognition.
The Board discussed the transition to the proposed expected loss impairment model for IFRSs.
The Board was first asked to consider application of the new model when initial credit quality information does not exist.
The staff noted that the impairment model contains a transfer notion that determines when financial assets are transferred to or from Bucket 1. That is, financial assets would move out of Bucket 1 when there is both:
- a more than insignificant deterioration in credit quality since initial recognition, and
- the likelihood of default is such that it is at least reasonably possible that the contractual cash flows may not be recoverable.
To determine whether the allowance balance for financial assets on transition should reflect lifetime expected losses in accordance with this criteria, an entity needs information about the initial credit quality of an asset. Therefore, ideally on transition, entities would use information about the credit quality of financial assets as at initial recognition, either through historical data that is available despite not having been required for accounting or risk reporting or by another means with comparable integrity.
As IAS 8 would not require information about initial credit quality to be used for existing assets if it is impracticable to do so, a question was raised as to how the expected loss model should be applied on transition without information about the initial credit quality. The staff identified three possible approaches: (a) resetting or deeming the ‘initial credit quality’ to be the credit quality at the date the new model is initially applied; (b) categorising these financial assets in Buckets 2 or 3 until derecognition; or (c) modifying the transfer notion so that the transition provisions require these assets to be evaluated only on the basis of the second criterion in the transfer notion. That is, the assets would be classified in Buckets 2 or 3 on transition to the new impairment model when the likelihood of default at that time is such that it is at least reasonably possible that the contractual cash flows may not be recoverable. This would mean that some financial assets subject to this transition relief would be initially categorised in Bucket 1 even though they have deteriorated in credit quality.
The staff recommended approach (c). The staff recommendation also asked the Board whether entities should be permitted to not use initial credit quality information. For example, should preparers be provided an option to not use initial credit quality information, or should it be based on either an impracticability assessment or undue cost or effort assessment?
One Board member expressed concern that the approaches described by the staff may result in significant variability in operating results between those entities which have access to initial credit quality and those which do not; especially if entities are provided an option to elect to apply initial credit quality information. He noted that an option may result in entities not being incentivised to obtain initial credit quality information in order to record significant gains in profit or loss subsequent to the transition date.
However, through general discussions amongst Board members, most expressed a desire to provide some relief in the form of an undue cost or effort assessment. Some preferred that use of this relief be met with additional disclosure as to those assets to which the relief was provided, while others believed that additional disclosure was not necessary.
When put to a vote, the IASB tentatively decided that an entity should be required to use the credit quality at initial recognition for existing financial assets when initially applying the new impairment model unless obtaining such credit quality information requires undue cost or effort. If the credit quality at initial recognition is not used at the date of initial application, the transition provisions would require these financial assets to be evaluated only on the basis of the second criterion in the transfer notion: the likelihood that contractual cash flows may not be collected is at least reasonably possible.
Other staff recommendations related to transition included:
- Restatement of comparative periods is permitted, but not required, if the information is available without the use of hindsight.
- In considering paragraph 28(f) of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, which requires disclosure of, for the current period and each prior period presented, to the extent practicable, the amount of the adjustment for each financial statement line item affected and, the impact on basic and diluted earnings per share (if IAS 33 Earnings per Share applies):
- these disclosures should be permitted, but not required, for prior periods if the information is available without the use of hindsight.
- these disclosures should be required for the current period.
With little debate, the Board tentatively agreed with these recommendations as set forth by the staff.
Following from deliberations on disclosures earlier in the week, the IASB discussed IASB only disclosures as part of the impairment project.
The IASB staff provided a comprehensive overview of disclosures related to IASB only decisions. Those disclosures cover write-offs, discount rate, modifications, financial assets 90 days past due and interest revenue. As a result of this analysis, the staff recommended that an entity disclose the following as part of the impairment project (absent those disclosures previously discussed at joint Board sessions with the FASB):
- qualitative information related to the discount rate elected.
- information regarding financial assets for which an impairment allowance of lifetime expected losses is required that have been modified at any time in their life.
- the gross carrying amount and related allowance of financial assets measured under the impairment model if a default has occurred.
- the balance of financial assets 90 days past due with an impairment allowance measured at 12 months' expected losses.
- the amount of interest revenue and details of how it is calculated (i.e., gross, net, credit-adjusted effective interest rate).
With no debate, the IASB tentatively agreed with the recommendations as set forth by the staff. However, the IASB noted that if any of the above disclosures, including those tentatively agreed in joint sessions with the FASB, are satisfied by disclosures required by other applicable regulations, an entity would be permitted to cross-refer to those disclosures.
The IASB is expected to discuss due process considerations and the comment period at a future meeting and intends to publish an exposure draft in the fourth quarter of 2012.