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The IASB held an education session on (1) cancellable leases (2) lessor accounting for rental income arising from investment property that is outside the scope of the lessor receivable and residual approach (3) disclosure requirements for lessors that have leases of investment property that are excluded from the scope of the receivable and residual approach.
As part of its continuing deliberations surrounding the exposure draft Leases (Leases ED), the IASB held an education session to discuss several topics including:
the accounting for cancellable leases
lessor accounting for rental income arising from investment property that is outside the scope of the lessor receivable and residual approach
disclosure requirements for lessors that have leases of investment property that are excluded from the scope of the receivable and residual approach.
No decisions were taken during this education session, as the session served to allow IASB members the opportunity to ask questions or provide feedback to the staff in advance of discussing the topics again during the joint IASB and FASB meeting on Wednesday, 14 December 2011.
Note: As no unique concerns or questions were expressed as part of the education session independent of those expressed during the joint IASB and FASB meeting on Wednesday, 14 December, please consider the Wednesday, 14 December meeting notes for a comprehensive summary of feedback received on the above discussion topics.
The IASB discussed a shortened comment period for the exposure draft 'Transition Guidance (Proposed Amendments to IFRS 10)'.
The IASB discussed a shortened comment period for the exposure draft Transition Guidance (Proposed Amendments to IFRS 10). The Board tentatively agreed that a comment period of 90 days was considered acceptable and in compliance with the Due Process Handbook for the IASB, because the exposure draft is relatively short, the matter is urgent, the amendments to the guidance are limited to the transitional provisions in the standard and are essentially clarifications of the Board’s intention when IFRS 10 was issued and there is likely to be broad consensus on the topic. These proposed amendments should alleviate concerns that some have that the transitional requirements are more burdensome than had been intended. The shortened comment period would allow for:
the proposed amendments' effective date to be aligned with that of IFRS 10 (1 January 2013);
the proposed amendments to be provided as early as possible, in order to benefit preparers as they plan for transitioning to IFRS 10; and
to provide sufficient time for the endorsement process in jurisdictions that have one.
The Board continued its discussions on development of a macro hedge accounting model.
The Board continued its discussions on development of a macro hedge accounting model. At the November 2011 Board meeting, the staff introduced the following steps in considering the valuation of the risk position in a macro hedge accounting model:
Step 1: Full fair value measurement
Step 2: Fair value attributable to interest rate risk
Step 3: Net interest margin as risk management objective
Step 4: Portfolio as unit of account
Step 5: Open portfolios to be included
Step 6: Applying repricing risk for periods rather than days
Step 7: Multi-dimensional risk objectives
Step 8: Valuation of floating rate instruments
Step 9: Counterparty risk of hedging instruments
Step 10: Internal derivatives
Step 11: Risk limits.
The agenda papers prepared by the staff and presented to the Boards during this meeting focused on steps one to three using the example of hedging interest rate risk. The staff summarised the approaches for each of the three steps being discussed.
For step 1 (eg, full fair value measurement), the staff believes it provides transparency in respect of the ‘fictitious’ sales price of the hedged item and the offsetting hedging effect. The mismatch recognised in profit or loss represents the unhedged portion of the ‘fictitious’ sales price. Additional disclosures would be needed on the measurement of those fair values.
For step 2 (eg, fair value measurement attributable to the hedged risk), the staff believes it provides transparency in respect of the ‘fictitious’ sales prices but limited to the interest rate risk element. The mismatch recognised in profit or loss represents the unhedged portion of this risk. Additional disclosures would be needed to explain the selection of the benchmark interest rate and how the value is determined.
For step 3 (eg, measurement addressing the margin hedge objective), the staff believes it provides transparency in respect of the margin risk associationed with a fixed rate instrument (eg, a negative valuation indicates a negative impact on the future net interest margin when not compensated or hedged). The mismatch recognised in profit or loss represents to what extent the margin risks are hedged. Addtional disclosures would be needed to explain the selection of the benchmark interest rate and the determination of the margin.
The Board’s discussion was dominated by four Board members with a couple of other Board members acknowledging they needed to better understand the issues involved.
A few Board members criticised the staff’s use of the term ‘fictitious’ sales price in the papers as they felt it implies that fair value information is irrelevant. The Board members emphasised that both cash flow and fair value information was relevant in the scenarios described in the agenda papers. The Board members also requested more analysis of user perspectives as they felt the papers were written from a preparer point of view. They also questioned the relevance of the examples as being ‘perfect scenarios’ and not addressing open portfolios or prepayment considerations.
The Board made no decisions during this session. The staff indicated it would continue bringing additional steps to the Board at future meetings. One Board member questioned whether July 2012 was a realistic time frame for an exposure draft and warned against trying to rush through the process.
During the November 2011 IASB meeting, the Board decided to reopen IFRS 9 to further consider 1) certain specific issues identified as entities have implemented IFRS 9, 2) the interaction of decisions made in the insurance project with the classification and measurement of assets managed to meet insurance liabilities and 3) whether further convergence could be achieved with the FASB and their financial instrument classification and measurement project.
During the November 2011 IASB meeting, the Board decided to reopen IFRS 9 to further consider 1) certain specific issues identified as entities have implemented IFRS 9, 2) the interaction of decisions made in the insurance project with the classification and measurement of assets managed to meet insurance liabilities and 3) whether further convergence could be achieved with the FASB and their financial instrument classification and measurement project.
During this meeting, the staff presented to the Board their recommendations on issues to be considered as part of the IASB’s reconsideration of classification and measurement. The staff recommended the Board include the following topics in the scope of the items to be considered when examining IFRS 9:
contractual cash flow characteristics test
bifurcation of financial assets
a third business model remeasured through OCI.
The staff raised two other issues for consideration but did not recommend the Board re-open those discussions. Those two issues both related to equity instruments, the first being the fair value through other comprehensive income election and the other being not providing a cost-based exception for non-quoted equity investments.
The Board discussion started with a Board member asking the staff if they had an idea of what to do to address the insurance mismatch and where the FASB was going on classification and measurement to attempt further convergence. The staff responded they had some initial thoughts on the insurance issue including the possibility of introducing a third business model utilising OCI. With respect to where the FASB was on classification and measurement, the staff responded that the FASB was nearing finalisation of their redeliberations on classification and measurements so while an exposure document may not be issued they were aware of the FASB’s position on most of the important issues.
A few Board members expressed their support for reconsidering an exception to permit a cost based measurement for unquoted equity investments. They noted this was a particularly relevant issue for those in emerging and developing markets. They also suggested that the existing guidance in IFRS 9 where cost may be an estimate of fair value was difficult to understand and apply in practice. Other Board members raised concerns that introducing a cost based measurement would also require introducing separate impairment considerations. However, another Board member retorted that the financial crisis of the last few years was driven by debt instruments and not equity investments. One Board member introduced the idea that some of the challenges that preparers are facing with respect to measuring fair value of unquoted equity investments could potentially be addressed in the educational materials being prepared for IFRS 13.
One Board member raised concerns with the possibility of introducing two measurement models using OCI, one for debt instruments that would recycle to profit or loss upon derecognition and one for equity investments that would never recycle to profit or loss. Certain Board members expressed differing views with respect to the importance of convergence. Some Board members stated that convergence would be good but is not the primary purpose of the reconsiderations and that the language should perhaps be tempered by using ‘try to reduce differences’ rather than full convergence. However, other Board members felt that convergence was critical citing the pressure of the G20 and noting that this represented an opportunity to further align but acknowledged that would also require the FASB to reconsider some of the decision they have made in their redeliberations.
Ultimately the Board agreed in a narrow vote [with 8 votes] to include the contractual cash flow characteristics test, the bifurcation of financial assets and introduction of a third business model remeasured through OCI to the list of topics to be addressed in the reconsideration of IFRS 9 and to attempt to address some of the concerns around unquoted equity investments through educational materials for IFRS 13.
In its joint meeting, the Boards made a number of tentative decisions, including the following:
Leases in which both the lessee and lessor each have a right to cancel the lease at any point in the future without termination penalties which effectively trigger a minimum lease term of more than 12 months would meet the definition of short-term leases when the notice period / cancellation penalty, together with any initial non-cancellable period, is 12 months or less.
Lessors of investment property would recognise rental income on a straight-line basis, or another systematic basis if that basis is more representative of the time pattern in which rentals are earned from the investment property (IFRSs only). Lessors of investment property that are not investment property entities or investment companies would recognise rental income on a straight-line basis, or another systematic basis if that basis is more representative of the time pattern in which rentals are earned from the investment property (US GAAP only).
A lessor of investment property would recognise only the underlying investment property (as well as any accrued or prepaid rental income) instead of recognising a lease receivable and corresponding lease liability.
Certain disclosures (outlined below) would be required for lessors with leases excluded from the scope of the receivable and residual approach.
The Boards discussed the accounting for a lease in which both the lessee and the lessor each have a right to cancel the lease at any point in the future without any termination penalty, subject to a short notice period (such as one month) (referred to as a 'cancellable lease').
Considering previous decisions taken by the Boards regarding the definition of 'lease term' and short-term leases', the staff presented its interpretation of the accounting for cancellable leases. The staff noted that the lease term for a lease would be limited to the non-cancellable period together with any termination or notice period. Entities would be able to apply short-term lease accounting to these leases if the non-cancellable period, together with the termination or notice period, is less than 12 months. In contrast, if option periods are not enforceable (e.g., the lessee does not have the unilateral right to extend the lease term beyond any non-cancellable period), entities would apply previous Board decisions (e.g., the lessee would not have the right to use the underlying asset beyond the non-cancellable period and would not include such options in the lease term).
Many Board members were supportive of the staff's interpretation. However, other Board members expressed concern with:
uncertainty as to whether leases which include “penalties” for failing to renew or terminating a lease qualify as 'cancellable leases' for purposes of the above interpretation. Two specific concerns were raised:
One Board member questioned whether the existence of a 'termination penalty' in a lease should inherently scope the lessee or lessor out of the cancellable lease interpretation. His concern was that a 'termination penalty' may be insignificant to the short-term lease assessment. For example, in a month-to-month lease with no notice period, where a 1-month termination penalty exists in exiting the lease, the staff's proposal was seen to scope out this lease from the cancellable lease interpretation. Therefore, the lessee and lessor would assess the lease term applying the significant economic incentive criteria. This Board member noted that a 'termination penalty' which would not 'economically' disqualify lessees or lessors from applying the short-term lease exception should be subject to the cancellable lease provision.
Another Board member questioned whether termination penalties were limited to cash consideration on termination or failure to renew a lease. He noted a lack of distinction between a lease which requires cash consideration at termination of a lease and a lease in which the lessor charges off-market terms on initiation of the lease but reimburses the lessee if the lease is extended beyond the initial term. Therefore, he wanted cancellable leases to consider off-market terms in their scope.
the inconsistency in applying the significant economic incentive threshold in recognition of the lease term but not applying a similar methodology in the recognition of short-term leases. These Board members cited application difficulties in applying two unique definitions, as well as possible structuring opportunities that may ensue. Thus, they preferred that lessees and lessors apply the significant economic incentive threshold outlined in recognition of the lease term before deciding if a lease is short term (i.e., recognised lease term is 12 months or less).
Given these concerns, many Board members expressed a desire for the staff to bring back the issue of defining a short-term lease to a future meeting. However, other Board members felt that a tentative decision could be reached if the scope of the matter was appropriately defined. Therefore, the FASB chair proposed to amend the scope of cancellable leases, whereby cancellable leases would include a lease in which both the lessee and the lessor each have a right to cancel the lease at any point in the future without a termination penalty which would effectively trigger a minimum lease term of more than 12 months. Using this scope, both Boards tentatively agreed that cancellable leases would meet the definition of short-term leases when the notice period, together with any initial non-cancellable period, is 12 months or less.
Rental income recognition for investment properties
The Boards discussed how a lessor should account for rental income arising from investment property that is outside the scope of the lessor receivable and residual approach. For purposes of the discussion, it was assumed that the definition of investment property would be an asset-based definition as opposed to an entity-based definition. However, the staff acknowledged that the definition of investment property would need to be addressed in a future meeting.
In light of current requirements in IFRSs and US GAAP, the IASB was asked to consider necessary guidance for all investment properties (both investment properties measured at fair value and investment properties measured at cost) under IFRSs. The FASB was asked to consider only investment properties that are not held by investment property entities or investment properties under US GAAP as the FASB's Investment Property Entities and Investment Companies exposure drafts provide rental income recognition guidance for investment properties held by investment property entities and investment companies in which the exposure drafts propose that rental income should be recognised on a contractual basis (i.e., when lease payments are received or become receivable in accordance with the lease contract).
Citing current requirements in IFRSs and US GAAP, as well as feedback received on the Leases ED's proposals about rental income recognition for investment property and as part of the FASB's Investment Property Entities and Investment Companies projects, the staff communicated two approaches to rental income recognition for investment properties: recognise rental income on a contractual basis (Approach 1) or recognise rental income on a straight-line basis, or another systematic basis if that basis is more representative of the time pattern in which rentals are earned from the investment property (Approach 2). The staff recommended Approach 2 (for all lessors of investment property in IFRSs and lessors of investment property that are not classified as investment property entities or investment companies in US GAAP).
Noting that the staff's recommendation would result in divergence between IFRSs and US GAAP for lessors of investment property that are classified as investment property entities or investment companies in US GAAP, one FASB member requested that the FASB consider feedback from constituents on its Investment Property Entities and Investment Companies projects to determine if a converged solution could be achieved. The FASB staff noted that feedback to date suggested that constituents believed that recognising rental income on a contractual basis (for investment property entities or investment companies) was more aligned with the fair value measurement basis proposed in the Investment Property Entities and Investment Companies projects, but the staff would consider further feedback from its constituents during the proposal period. With little additional debate, the Boards tentatively agreed with the staff's recommendation.
The Boards were also asked to consider the recognition of lease assets and lease liabilities for lessors of investment property. While some constituent outreach suggested that in order to be consistent with the lessee right-of-use model, a lessor of investment property should not only continue to recognise the underlying asset, but also recognise a lease receivable and corresponding lease liability, the staff recommended that a lessor of investment property should recognise only the underlying investment property on its statement of financial position (as well as any accrued or prepaid rental income). With little debate, both Boards tentatively agreed with the staff recommendation consistent with previous decisions taken by the Boards.
Disclosures for leases excluded from the receivable and residual approach
The Boards considered disclosure requirements for lessors that have leases of investment property that are excluded from the scope of the receivable and residual approach. The staff recommended, considering current disclosure requirements in IFRSs and US GAAP, previous Board decisions regarding disclosure as part of the leases project and general feedback from outreach activities, that the following disclosures be included in the leases guidance for leases of investment property that are excluded from the scope of the receivable and residual approach:
A maturity analysis of the undiscounted future non-cancellable lease payments for a lessor's lease of investment property excluded from the scope of the receivable and residual approach. The maturity analysis should show, at a minimum, the undiscounted cash flows to be received in each of the first five years after the reporting date and a total of the amounts in the years thereafter. That maturity analysis would be separate from the maturity analysis of the payments related to the right to receive lease payments under the receivable and residual approach.
Both minimum contractual lease income and variable lease payment income within the table of lease income.
The cost and carrying amount of property on lease or held for leasing by major classes of property according to nature or function, and the amount of accumulated depreciation in total.
Information about leases that are scoped out of the receivable and residual approach consistent with paragraph 73 of the Leases ED, updated for decisions the Boards have reached to date. That information would include:
A general description of those lease arrangements
Information about the basis and terms on which variable lease payments are determined
Information about the existence and terms of options, including for renewal and termination
A qualitative description of purchase options, including information about the percentage of assets subject to such agreements
Any restrictions imposed by lease arrangements.
One Board member expressed a desire to amend a) such that the maturity analysis would include the present value of future minimum lease payments as opposed to undiscounted payments. He felt that that present value information was more useful to users of the financial statements regarding balances held in the financial statements. However, others felt that undiscounted payments provided important information regarding liquidity. Further, discounted payments were seen to pose application difficulties such as defining an appropriate rate when the implicit rate in a lease may be based on payments beyond the minimum lease payments. Another Board member requested the disclosure of fair value information which was seen as more valuable information to financial statement users. However, many expressed concerns with application of a fair value model from a practical perspective.
When put to a vote, the Boards tentatively agreed with the staff's recommended disclosures without amendment.
Future meeting topics
The staff noted that in future Board meetings, it would bring back certain additional topics for deliberation, including:
the definition of investment property as applied in the above tentative decisions.
the lessee accounting model given feedback and concerns raised by constituents over the last several months.
The IASB and FASB discussed a variety of topics in the continued development of the three bucket impairment model: (1) principle of transfer from bucket one to bucket two (2) the objective of the bucket one allowance and the measurement attribute for financial assets in the bucket (3) two pervasive issues: (a) aggregation of individual financial assets for collective credit deterioration evaluation (b) differentiation between bucket two and bucket three.
During the October 2011 Board meetings, the Boards asked the staff to develop a principle for the measurement attribute of the credit allowance balance of financial assets included in bucket one and develop a principal and indicators for when it is appropriate to transfer financial assets from bucket one to bucket two. The December meeting was spent discussing a variety of topics in the continued development of the three bucket impairment model.
Principle of transfer from bucket one to bucket two
When recognition of lifetime expected losses is appropriate
The IASB and FASB staffs brought the Boards three alternatives for establishing a principle of transfer with the first two alternatives having multiple variations. The first alternative focuses on the extent of deterioration in credit quality since initial recognition, the second alternative focuses on both the extent of deterioration in credit quality expected at initial recognition and the risk of not collecting the contractual cash flows, and the third alternative focuses on deterioration in credit quality such that management changes its objective in holding the financial asset.
The variations for each of the alternatives were presented as follows:
Alternative 1A – Recognise lifetime losses when there has been meaningful credit deterioration since initial recognition (but without defining meaningful)
Alternative 1B – Recognise lifetime losses when the entity no longer expects to receive substantially all of the cash flows expected at initial recognition due to deterioration in credit quality
Alternative 1C – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition
Alternative 1D – Recognise lifetime losses when the entity no longer expects the same credit risk as at initial recognition due to deterioration in credit quality
Alternative 2A – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least more likely than not that the contractual cash flows may not be fully recoverable
Alternative 2B – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least reasonably possible that the contractual cash flows may not be fully recoverable
Alternative 2C – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is remote that the contractual cash flows may not be fully recoverable.
Alternative 3 – Recognise lifetime losses based on deterioration in credit quality being such that it changes managements objective for managing the asset (e.g., when the holders credit risk management objective changes from merely monitoring and analysing regular performance updates to actively engaging in managing the credit risk exposure to try to address the issues giving rise to the problems with the asset(s) and to allow appropriate re-calibration of the legal framework of the asset(s) taking into account the borrower(s) financial situation).
The Boards discussions focused on the meanings of the phrases or how the specific terms would be interpreted in practice. Most of the members from each Board tended to favour alternative 2 (particularly 2B) although some also supported Alternative 1B. One particular reason mentioned by Board members for favouring alternative 2 over alternative 1 was concern over the trigger being solely based on credit deterioration, citing the example of a AAA asset being downgraded to A as that movement may be meaningful or more than insignificant while an A credit rating would have relative insignificant concerns over collectability.
One FASB member suggested replacing the language in Alternative 2B from ‘at least reasonably possible that the contractual cash flows may not be fully recoverable’ to ‘other than remotely possible that the contractual cash flows may not be fully recoverable’. Other Board members were generally supportive of the use of ‘other than remote’ as they felt that was a lower threshold than ‘reasonably possible’. One IASB member expressed his support for Alternative 2B because it represented a fairly quick trigger to move items in to bucket two, which he mentioned was his takeaway of the Boards’ desire when they shifted from an absolute to a relative credit risk approach. However, some Board members had concern that the use of ‘other than remote’ could be interpreted to be as low as 5% while the Board tended to prefer a range of around 10% as the trigger to bucket two. One FASB Board member suggested moving the language used in Alternative 1B to the second criteria of Alternative 2B (i.e., ‘substantially all’ instead of ‘reasonably possible’ or ‘other than remote’) as he felt the term ‘substantially all’ was generally interpreted around 10%.
The Boards tentatively decided to proceed with the language proposed in Alternative 2B (e.g., recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least reasonably possible that the contractual cash flows may not be fully recoverable). The Boards also asked the staff to develop illustrative examples to highlight that the transfer should occur when the ‘risk of default starts to substantially excellerate’.
Whether the transfer should be based on probability of default or expected loss
The staffs asked the Boards to clarify whether the deterioration in credit quality is 1) the likelihood of not receiving the expected cash flows probability of default (PD) or 2) the expected loss using PD, loss given default (LGD) and exposure at default (EAD).
The staffs recommended that loss given default (LGD) information would factor in to the measurement of lifetime losses but would not factor in to the assessment of the transfer between buckets. Instead, the transfer assessment would consider solely probability of default (PD). The staffs also clarified that collateral would not be considered in the assessment of transferring items between buckets but rather the focus is whether the contractual payments will be collected. The staffs also stated their recommendation was based in part because financial institutions are familiar with tracking PD and therefore such an approach would be more operational.
The Boards were supportive of using PDs as the basis for the trigger of transfers between buckets. However, one IASB member had significant concerns with not also including consideration of LGDs. Several Board members noted that PDs would be impacted by changes in LGDs information. However, the IASB member with the concern referenced certain scenarios where he felt PDs would not reflect increases in LGDs such as a debt restructuring. Other Board members acknowledged they felt PDs should be the primary driver but could understand the concerns being raised and didn’t want the guidance to be so strict that assessment of other information should not be considered.
The Boards tentatively decided that probability of default should be the primary driver in determining when to transfer financial assets between buckets. However the Boards asked the staff to also include language that would not ignore other information indicating the potential for loss (such as LGD information).
Indicators for when the recognition of lifetime expected losses is appropriate
The staffs presented the Boards with potential indicators of when a financial asset may have experienced deterioration in credit quality. Those indicators include changes in: 1) general economic conditions, 2) industry conditions, 3) market indicators of credit risk, 4) re-origination rates, 5) management approach, 6) company performance, 7) company prospects, 8) collateral values, 9) credit quality enhancements/support, 10) loan documentation, 11) expected performance of the borrower and 12) other changes.
One FASB member questioned the inclusion of collateral values given the previous decision that the trigger would primarily be based on PDs. The staff noted that decreases in collateral values (for example a home value less than the outstanding loan balance) could provide incentive for borrowers to walk away from the debt and that incentive is tied to PDs rather than consideration of the recovery from the collateral which would be tied to LGDs.
Both Boards tentatively decided to include the guidance around potential indicators in the impairment proposals.
Bucket one allowance
The staffs asked the Boards to determine the objective of the allowance and its measurement attribute for financial assets in bucket one of the impairment model.
The staffs first asked the Boards to decide on the objective of the bucket one allowance by considering either 1) the approximation of a yield adjustment or 2) capturing expected losses which have not yet materialised (or no meaningful credit deterioration has occurred). No Board members expressed support for a yield adjustment approximation approach. However, the Board had difficulty in determining how to articulate the capturing of expected losses not yet materialised. One IASB member expressed concern with use of the term ‘materialised’. He also questioned whether the expected losses referred to PD (e.g., shortfall in cash flows) or LGD (including recovery of collateral). The staff clarified that the intention was to measure the shortfall in cash flows but that would also include LGD so recovery on collateral would be part of the consideration. The Boards then engaged in a debate over whether the objective of the bucket one allowance is to capture credit deterioration not yet identified or whether it is losses that are inherent in a portfolio based on original pricing and information. However, one IASB member felt that the only way to describe the objective of the bucket one allowance is one of ‘prudence’.
Given the difficulty in deciding on an objective, the Boards decided to focus on the measurement attribute for the bucket one allowance to see if that provided any better basis for determining the objective.
The staffs presented the Boards with three alternatives for the bucket one allowance:
Shortfalls in cash flows expected to materialise in the next 12 months,
Shortfalls in cash flows expected to materialise in the next 24 months, or
Shortfalls in cash flows expected to materialise over an emergence period (the emergence period could be either 1) no established boundaries, 2) a minimum of 12 months and no upper boundary and 3) defining a range of between 12 and 24 months).
One IASB member started the discussion by acknowledging that the trigger for transfers to bucket two (and recognition of lifetime expected losses) that the Boards have established should result in an allowance balance larger than that currently under the incurred loss models in either IAS 39 or US GAAP. Therefore the allowance for bucket one is an additional provision. He noted that concerns that allowance balances in certain jurisdictions may go down as a result of the three bucket model is a result of regulatory overlays to existing impairment requirements and that the Boards cannot guess what regulators in each individual jurisdiction would want for bucket one. Another IASB member agreed that the Boards cannot consider all regulatory requirements around the world. The IASB Chair agreed that the bucket one allowance was an expedient and that it should not be too big nor too complex. A FASB member also agreed that in some jurisdictions reserves may go down simply because of the regulatory overlay aspect.
However, the FASB Chair said she did not believe that the bucket one allowance was a regulatory issue but rather an acknowledgment that there are future losses that exist in performing loans. Several IASB members showed support for use of a 12 month period for the bucket one allowance. One of those stated he could not support use of an emergence period.
One of the IASB members said that he would use the income statement amounts expected to be transferred to bucket two or three in the next twelve months and adjusted for known or other expected factors. The staff responded that their proposed approach would be 12 months of PDs multiplied by the lifetime losses and that may yield a similar approach as to that described by the Board member but this approach was seen as operational by financial institutions. The FASB Chair clarified that the PDs would need to be adjusted for changes in circumstances and for migrations to bucket two.
The Board tentatively decided to require a measurement for the bucket one allowance of shortfalls in cash flows expected to materialise in the next 12 months. The Board also decided the objective of the bucket one allowance would be to recognise 12 months of expected losses.
The Boards discussed two pervasive issues that needed to be addressed in order to continue development of the three bucket impairment model. The first issue relates to aggregation of individual financial assets for collective evaluation of credit deterioration. The second issue relates to the purpose and differentiation of bucket three as compared to bucket two.
Grouping of financial assets for impairment evaluation
Providing guidance on the appropriate level of aggregation for evaluating credit impairment is an important consideration for evaluating credit deterioration, particularly in the context of transferring entire portfolios from bucket one to bucket two.
The staffs noted that the existing guidance in US GAAP and IFRS, as well as the proposals in the supplementary document, emphasize ‘shared risk characteristics’ for determining how to aggregate individual financial instruments into groups.
The staffs recommended including the following guidance in the impairment model:
The objective of grouping is to segregate the financial assets into sub-populations of sufficient granularity to evaluate the groups for impairment (that is, to identify whether the recognition of lifetime losses is appropriate for that sub-population as of the assessment date).
An entity may not group financial assets at a more aggregated level if there are shared risk characteristics for a sub-group that would indicate whether recognition of lifetime losses is appropriate.
(a) Shared risk characteristics may include the following: asset type, credit risk ratings, past-due status, collateral type, date of origination, term to maturity, industry, geographical location of the debtor, the value of collateral relative to commitment for non-recourse assets (which may influence likelihood of debtor electing to default), and other relevant factors. Groups shall be created based on shared risk characteristics as of the assessment date (that is, the groupings may change each period).
If a financial asset cannot be included in a group because the entity does not have a group of assets that share the risk characteristics of that asset, or if a financial asset is individually significant, an entity is required to individually evaluate whether the recognition of expected lifetime losses is appropriate for the financial asset.
If a financial asset shares risk characteristics with other assets held by the entity, an entity is permitted to individually evaluate a financial asset within that group or include it in a collective evaluation of a group of financial assets with shared risk characteristics to determine whether the recognition of expected lifetime loss is required.
One of the FASB Board members asked whether the issue of grouping was related to the assessment for transferring buckets or the measurement of expected losses. The staff responded that for today’s purpose the scope was limited to grouping of financial assets for the evaluation of credit deterioration in determining bucket classification but that the staffs would need to come back to the Boards on the grouping for measurement purposes.
The Boards tentatively agreed to include the guidance as recommended by the staff above.
Differentiation between buckets two and buckets three
The Boards also discussed the issue of how bucket three should be differentiated from bucket two given that both buckets share the same measurement attribute (e.g., lifetime expected credit losses). The Boards considered three alternatives for bucket three. The first alternative would use a deterioration principle such that assets that have continued to deteriorate in credit quality beyond those assets in bucket two would then be transferred to bucket three. The point of transfer would be based on either the degree of credit deterioration since initial recognition or once deterioration has reached a particular level. The second alternative would differentiate bucket two and bucket three based on a unit of evaluation such that bucket two would include assets evaluated collectively while bucket three would include only assets evaluated individually. The third alternative would merge buckets two and buckets three since they share a similar measurement attribute.
The FASB members were generally supportive of alternative two while the IASB members were generally split between alternatives two and three although a couple of IASB member expressed support for alternative one. Certain FASB members felt there was important information provided by stratifying assets between buckets two and three while certain IASB members questioned whether any benefit was gained from stratification other than for disclosure purposes. This led to a debate over whether bucket three was a measurement issue or simply a disclosure issue. Certain FASB members felt, in addition to information for disclosure purposes, there could be measurement implications as individual assets are transferred out of bucket two and in to bucket three could result in measurement difference in the PDs and LGDs of those remaining assets in bucket two.
The Boards tentatively decided that bucket three would be differentiated from bucket two in that bucket three would relate to assets evaluated for credit deterioration individually rather than collectively.
The Boards' discussions around development of the three bucket approach have to date focused around commercial loans. However, constituents had raised concerns in the supplementary document and during outreach activities over the application to individual debt securities. The Boards took this opportunity to discuss specific application issues associated with debt securities, commercial loans, and consumer loans.
Application of the three bucket model to debt securities
The Boards first discussed whether the guidance around grouping of financial assets was appropriate for debt securities. The Boards felt the guidance would work for debt securities and should not change existing practice of evaluating debt securities on an instrument-by-instrument basis.
The Boards then considered whether the list of indicators decided upon during the previous day were sufficient for both loans and debt securities or whether debt securities, given they often had fair values quoted in active markets, required some rebuttable presumption indicating recognition of lifetime expected losses was appropriate when the fair value was less than the cost basis for a predefined term (either percentage decrease or percentage decrease for a period of time).
The staffs noted that when the fair value of the debt security exceeded the cost basis that in most cases an entity could conclude that recognition of lifetime losses was not required. One IASB member questioned when the fair value exceeding the cost basis could result in recognition of lifetime expected losses. The staff responded that, while remote, there could be a possibility of an instrument with a high coupon in a low interest rate environment where the issuer was experiencing credit deterioration such that the instrument would trade at a premium as a result of the yield above market rates even after taking in to account the credit deterioration of the issuer.
One IASB member raised an issue with the 'change in market indicators of credit risk' indicator decided upon the previous day noting the guidance for securities discusses 'the length of time and the extent to which the fair value of the debt security has been less than the amortised cost'. His concern focused on the trigger established by the Boards for movements to bucket two did not include a time based concept and he feared establishments of brightlines in application. The staffs acknowledged his concern and said they would consider how to clarify the indicator so as not to establish brightlines.
One IASB member then asked the staffs whether debt securities in buckets two or three would be eligible to return to bucket one. The staffs responded that their intention was to keep the impairment model the same for loans and debt securities and that since loans could return to bucket one after being moved to bucket two they felt that debt securities should do the same. This raised the issue with other Board members on whether the impairment model should be symmetrical or not. The FASB Chair raised the issue of a restructured debt and how that would be treated when considering whether to move back from bucket three in to bucket one. Several Board members said the Boards should examine how the indicator approaches when applied to improving credit conditions.
The Boards agreed with the staff that the indicators were sufficient to apply to both loans and debt securities and that no rebuttable presumption (e.g. brightline) should be applied for evaluating debt securities for credit deterioration when fair value is less than the cost basis.
The Boards then discussed the application of an expected value approach in estimating expected losses for debt securities. The Boards had previously decided that expected losses should be estimated with the objective of an 'expected value' approach. However, constituents have raised concerns over application of an 'expected value' approach to assets assessed for impairment on an individual basis as it results in an expected loss that is not one of the possible alternatives and does not consider the fair value of the collateral for secured lending arrangements.
During the March 2011 Board meeting, the Boards had agreed that the final standard would clarify that:
"in practice, a concrete estimate of an expected value would not require the use of every single possible outcome. Rather, in the case where there are many possible outcomes, a representative sample of the complete distribution can be used for determining the expected value of the credit loss. In identifying that sample, the entity would need to take into account only the information that is available about the outcomes. It would not have to (and should not) make up anything else."
The staffs asked the Boards whether additional application guidance should be provided for individually evaluated financial assets. The FASB Chair recommended that the existing guidance in US GAAP with respect to consideration of collateral values be carried forward in to the impairment model. She acknowledged this was not an expected value but would simplify the approach in certain instances. One IASB member expressed concern with inserting US guidance in to IFRS but acknowledged that application guidance should be provided and it should be clarified that a most likely outcome approach is not consistent with an expected value. The FASB Chair asked the IASB member if a loss rate approach were utilised which dropped the high and low end possibilities from consideration if that was viewed as an expected value approach. The IASB member said he would view it as a good proxy for an expected value approach. A FASB member said he agreed with the IASB member but thought the Boards should include some practical expedients are proxy approaches to expected values.
The staffs said they would work on developing further guidance around methods that could reasonably be used to achieve the objective of an expected value approach. The Boards suggested the staff look to the decisions made in the revenue recognition and insurance projects regarding expected value approaches.
Application of the three bucket model to loans
As noted above, the Boards' discussions around development of the three bucket approach have to date focused around commercial loans. The Boards took this opportunity to consider the impairment model under development to both commercial and consumer loans. Based on the analysis provided by the staffs, the Boards felt that the model under development should work for both consumer and commercial loans.
The Boards also decided that the impairment model should not include a presumption (e.g., brightline) that meaningful credit deterioration has occurred based on predetermined factors such as number of days delinquent or reaching a particular credit risk rating.
The staffs also raised the issue of whether concentration risk of loans should be captured within an expected value measurement. Concentration risk of loans is a similar concept to a blockage factor for equity securities in that holding a significant amount of loans in a concentrated area, should the underlying collateral need to be seized and sold, the marketing of all properties in the same area would put downward pressure on the sales price. The Boards were of the view that similar to the blockage factor in a fair value measurement, the concentration risk would not impact the measurement of expected losses but is something that could warrant consideration for disclosure purposes.
The IASB and FASB discussed: (1) policyholder participation (2) measurement of options and guarantees embedded in insurance contracts (3) cash flows that existing contracts require to be paid to future policyholders (4) discounting of insurance liabilities for incurred claims.
With the exception of Marc Siegel for FASB and Ian Macintosh for the IASB all members of the Boards attended the session on insurance contracts where four individual issues were deliberated.
The first paper did not ask for a decision but reported on the FASB meeting of 30 November. At that meeting FASB agreed a simplified method for the measurement of certain cash flows of insurance contracts with non-discretionary and performance–linked participating features. These cash flows are determined by reference to assets and liabilities that are the underlying of the non-discretionary performance –linked participating feature. These cash flows will be measured at the insurer’s current obligation adjusted to eliminate accounting mismatches that reflect timing differences between the current obligation and the USGAAP/IFRS value of the underlying items the cash flows are linked to. These differences should reverse within the time horizon set by the boundary of the insurance contract
This wording is subtly different to the May 2011 IASB decision to measure the relevant component of the insurance participating contract liability at the IFRS value of the relevant underlying assets and liabilities.
It was noted that although the wording of the FASB decision differs from the previous IASB decision the effect of this FASB decision is that FASB have now converged so as to be equivalent with the IASB decision taken in May 2011. Under both Boards’ proposals the participating contract insurance liability would be adjusted to mirror the measurement and presentation of the underlying items to the performance of which it is linked. The Staff and Boards will further consider whether they can agree on an identical wording that can be used to set out both decisions.
It was reported that FASB also agreed to converge with the earlier IASB decision that any changes in the relevant component of the insurance contract liability should be presented in the same way within the SoCI (i.e. consistently within net income or OCI) as the relevant underlying assets and liabilities.
Measurement of options and guarantees embedded in insurance contracts
The Staff paper noted that although (as noted above) a mirroring approach has been agreed for certain non-discretionary performance-linked participating features, it is necessary to consider separately any embedded options and guarantees.
The paper noted that embedded options and guarantees could be valued either by including guaranteed cash flows in the scenarios where the guarantee takes effect or directly determining a market-consistent value for the option and guarantee. In other words in those scenarios where the embedded derivative has effect the cash flows of the derivative and not of the underlying item should be considered in measurement of the insurance liability. Staff recommended that for all insurance contracts (including participating contracts):
"all options and guarantees embedded in insurance contracts that are not separately accounted under the financial instrument standard as a derivative instrument should be measured using a current, market-consistent expected value approach"
After some discussion as to whether further clarification was needed on the selection of the discount rate, the Board members present unanimously supported this Staff recommendation.
Cash flows that existing contracts require to be paid to future policyholders
The paper relates to participating contracts where the insurer is required to declare a distribution of the assets within participating funds the insurer holds to its policyholders when the insurer and where undistributed amounts to policyholders who have lapsed, surrendered or matured their policies are carried forward for future distributions and cannot be attributed to the insurer’s own equity. When policies expire they forfeit the policyholders’ benefits not yet distributed and these benefits are spread between the remaining and any new policyholders that would purchase a new contract issued from the same participating fund. In rare cases where there are few policyholders remaining and the undistributed surplus is quite large the entity maybe able to apply to the insurance regulators to affect a payout to someone other than policyholders but this requires a change of the contractual terms.
The Staff paper concluded that there is a present obligation arising from a current contract and that it represents a liability even though the identity of future policyholders is not known. The contract boundary is not breached as the liabilities relate to a current contract not a future contract. . Staff recommended that:
"...when measuring an obligation created by a contract that depends partly on the performance of assets and liabilities of the insurer, an insurer should include in the measurement of the insurance contract liability all such payments that result from that contract, whether payable to current or future policyholders."
It was noted by various Board members that in some circumstances insurers may obtain judicial and/or regulatory approval to vary the contract terms so that part of the contract obligation may be payable to shareholders but the consensus was that any such potential variation of contract terms could be dealt with by specific disclosure should it arise. With one abstention the Board members present otherwise unanimously supported this Staff recommendation.
Discounting of insurance liabilities for incurred claims (board paper 7H/77H)
Before the discussion on this paper Hans Hoogervorst noted that IASB had received a memo from the Hub Global Insurance Group which requested the Boards to withdraw this paper – citing there had not been proper due process. Mr Hoogervorst confirmed that the Boards would not withdraw to the paper and would respond to the Hub Global Insurance Group noting that the Boards disagreed with many of the points raised in the memo.
The Boards discussed the first part of this paper in which the Staff asked the Boards to:
"reconfirm their earlier decision to require the discounting of the liability for incurred claims when the effect would be material."
The paper noted the views of those respondents to the ED that are opposed to discounting. Board members noted their support for a general principle that requires discounting where its effect would be material. It was noted that the time value of money is an essential component of an insurer’s business and pricing models and that as the time value of money is implicit in asset valuation, measuring liabilities on an undiscounted basis would introduce accounting mismatch.
The Staff paper also included the results of the Staff model which looked at the impact of discounting the incurred insurance claim liability on the net income and total surplus based on US non-life insurance regulatory filings for the period 2005-2010. The results showed a significant effect due to discounting which varied over the period.
It was noted that all undiscounted liability information currently included in the financial statements would continue to be available within the financial statements including the 10 year development table on an undiscounted basis.
The final accounting standard will require the disclosure of the yield curve used to determine the effect of discounting and a maturities table showing the expected settlement pattern.
The Board members present unanimously supported this Staff recommendation.
Two members noted that consideration should be given to an exception from the discounting requirement for certain very material one-off exposures. Such exposures often have considerable uncertainty over the timing of settlement, limited relevant prior experience of such exposures and the absence of a group of such exposures, resulting in considerable difficulty in determining an appropriate settlement pattern for such one-off exposures against which to apply discounting. Consideration of this question was deferred until Friday.
A further point raised and deferred for consideration to Friday is whether the materiality of discounting is considered at contract inception or on an ongoing basis as claims are incurred and settled.
The remainder of paper 7H/77H concerning application guidance on materiality for discounting and a possible practical expedient to exclude certain contracts from the discounting requirement will be considered on Friday.
Discounting of insurance liabilities for incurred claims (board paper 7H/77H) (continued)
The meeting considered the second and third proposals in the Discounting paper – proposal one having been considered the previous day.
The second proposal in the Staff paper was
"... that no specific guidance was required on determining when the effect of discounting of the liability for incurred claims would be immaterial"
It was noted that there is a general principle in IFRS and US GAAP that the requirements of accounting standards are not applied to immaterial items. The members of both Boards present agreed unanimously to the Staff proposal.
The third Staff proposal was
".. that for contracts to which the insurer applies the premium allocation approach, not to require discounting of incurred claims that are expected to be paid within 12 months of the claim occurrence date"
After noting that this determination would be made on the basis of a portfolio of contracts, Staff confirmed their intention to have application guidance that would require discounting of all cash flows within those portfolios that were expected to be paid after 12 months, unless the effect was immaterial.
The recommendation would require an insurer to determine at each reporting date whether the 12 months expedient is applicable. For those liabilities with a settlement period beyond 12 months from the claim occurrence date discounting would always be applied, unless immaterial.
Staff noted that the shortcut on immaterial discounting for claims settled over a short period only applies only to portfolios of contracts to which the insurer applies the premium allocation approach. This practical expedient is not proposed for contracts where the building blocks approach is applied where only the general materiality principle applies. This recommendation is so designed because the main beneficiaries of the practical expedient will be insurers applying the premium allocation approach who may find that all of their business falls within the characteristics described for the application of the practical expedient.
The members of both Boards agreed unanimously with the Staff proposal.
Unit of account (board papers 7A/77A, 7B /77B, 7C/77C and 7/I/77I)
Paper 7I/77I was made available to observers just before the meeting and diagrammatically illustrates the Staff proposal to group contracts in a portfolio if they share similar risks, have similar expectations of profitability and are managed together.
The risk margin is the component of the measurement model that is calculated based on this unit of account.
The most important news to highlight from this set of papers is that the Staff of the two Boards decided to recommend a departure from the proposals contained in the ED and suggested that the risk adjustment liability is reduced for any diversification across portfolios that exist within the same reporting entity (covered in paper 7C/77C). The ED had introduced the concept of pooling of risks but limited it to the portfolio as defined with an explicit prohibition to allow cross-portfolio diversification to be taken into account in the setting of the insurance liabilities.
The Staff proposed that the diversification within the same entity once computed is allocated to each individual portfolio and the residual margin is then increased accordingly to prevent the recognition of accounting profit. Staff recommended that an insurer determines components within a portfolio to classify different elements of the overall residual margin liability of that portfolio and applies to each of these components the appropriate earning model that would release the residual margin component to profit. These components would also be used for the unlocking of the residual margin.
Contracts are grouped together in these components or sub-portfolios if they have similar inception dates, a similar contract boundary (economic duration) and similar expected patterns of release of the residual or single margin.
Staff noted that the definition of residual margin sub-portfolios is important because it determines the extent to which day 1 losses are offset against positive residual margins rather than expensed on day 1.
Many members from both Boards commented that they were uncomfortable with the "similar profitability" criterion in the portfolio definition as it may require many separate portfolios due to varying levels of profitability. Others noted that the profitability criterion would prevent profitable and unprofitable contracts being offset within a portfolio. Staff responded that their intention was that the criterion would only require separating portfolios where profitability was significantly different.
Several members commented that the proposals were over-engineered and that there should only be one concept of portfolio and insurers should develop appropriate entity–specific methods to earn residual margin over the life of their contracts.
After considerable discussion it was agreed that the Staff would be asked to delete the sub-portfolio proposal and revise the portfolio definition so that it focussed on the criteria of similar risks, similar duration and pattern of release of margin. For the premium allocation approach the second criteria would be a similar pattern of release from risk or a similar pattern for the provision of services.
Based on this tentative decision contracts would not require to be managed together or have similar estimated profitability in order to be grouped into a portfolio.
When the Boards were taken through paper 7C/77C the Staff explained that the calculation of the risk adjustment although allocated to each portfolio would take into account the benefit of diversification across portfolios up to the level of the reporting entity.
In order to achieve this aim Staff proposed:
"... not to prescribe the unit of account for determining the risk adjustment but instead to specify the principle that the risk adjustment should measure the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfils the insurance contracts"
After much discussion as to whether prescribing a unit of account greater than the portfolio may lead to possible double counting of the effect of diversification and Staff noting that there will be guidance to explain that entity-wide diversification should be taken into account in determining the risk adjustment the Staff recommendation was agreed unanimously by the IASB. FASB is not supportive of a risk adjustment liability and did not vote on this paper.
Onerous contracts (board paper 7D/77D)
An onerous contract test is required under the building blocks approach and premium allocation approach during the pre-coverage period (as insurance contracts are only to be recognised in the financial statements when coverage starts) and additionally for the premium allocation approach during the coverage period given that the premium is allocated and not remeasured.
The Staff made three recommendations covering
What is an onerous contract?
When should an onerous contract test be carried out initially and subsequently?
Should the basis of measuring an onerous contract be consistent with the measurement of the liability for incurred claims?
During the discussion it became clear that Staff and the members of both Boards had not had chance to consider these proposals in the light of the earlier agreement that for the premium allocation approach discounting would not be required where a claim was expected to be settled within 12 months of the occurrence. It was therefore agreed that this paper would be considered at a later date.
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