Financial instruments – Impairment
The Board discussed what discount rate that should be used when discounting expected losses in the general “three–bucket” impairment model. In providing background on the issues, the IASB staff stated that although the discount rate has to be kept constant over the life of the assets, they understand that in practice today, many entities do not calculate the original effective interest rate (“EIR”). This is because in an open portfolio, entities have operational difficulty in maintaining historical EIR information.
Instead, these entities make approximations. They often use the contractual interest rate to recognise interest revenue. For impairment, some entities estimate what the original EIR would have been, knowing that any difference is likely to be immaterial. This approach results in a similar effect to using the original EIR.
As a result of the operational challenges, the IASB staff recommended permitting an entity to choose a discount rate between, and including, the risk-free rate and the effective interest rate (as calculated in IAS 39).
The Board agreed with the staff recommendation but added that the proposals should be clarified to indicate that (1) if an entity uses a discount rate that is between the risk-free rate and the EIR that the rate must be based on some type of benchmark or index and (2) an entity must consistently apply the discount rate after the entity initially elects what rate should be used.
Modified financial assets
The Board discussed how modifications on financial assets should be treated in the “three-bucket” impairment model. The scope of the discussion addressed financial assets recorded at amortised cost that are renegotiated or otherwise modified, but that do not result in a derecognition of the financial asset (i.e., a modification that results in the derecognition of the original financial asset would result in the recognition of a new financial asset that would be initially classified in Bucket 1).
Specifically, the Board discussed the following issues:
- Symmetry of the model — whether modified financial assets should be considered for transfer in the same way as other assets;
- Evaluation the transfer notion — how the transfer notion should be evaluated for originated and purchased non-credit-impaired financial assets that have been modified (i.e., which credit quality and cash flows should be considered); and
- Presentation — whether the requirements should be explicit about the presentation of a modification (i.e., whether the carrying value of the instrument should be reduced or the impairment allowance increased).
Issue 1 – Symmetry of the model
The IASB staff recommended that modified assets should be considered for transfer in the same way as other assets. Meaning (a) originated and purchased non-credit-impaired financial assets that have been modified should move up to Bucket 1 if the transfer notion is no longer met and (b) purchased credit-impaired assets that are modified should remain outside Bucket 1 throughout their lives. The Board discussed that financial assets that are modified but not derecognised are not new financial assets from an accounting perspective. Consequently, the Board agreed with the staff recommendation.
Issue 2 – Evaluation of the transfer notion
The discussion focused on how an entity determines whether the downward transfer notion is no longer met after a financial asset has been modified. In other words, for the purpose of determining the extent of deterioration in credit quality if the asset (i.e., the first part of the transfer notion), the question is whether an entity compares current credit quality of the asset to (1) the asset’s credit quality at the date of modification, or (2) to the asset’s original credit quality.
The IASB staff recommended that when evaluating if the transfer notion is no longer met, an entity should: (a) evaluate the current credit quality against the original credit quality in determining whether there has been more than an insignificant deterioration in credit quality, and (b) consider the cash flows of the modified instrument when evaluating whether the likelihood of default is such that it is at least reasonably possible that some or all of the contractual cash flows may not be recoverable.
The IASB agreed with the staff recommendation but instructed the staff to clarify that original credit quality should mean the credit quality that existed at the date of origination or acquisition as opposed to the credit quality at the date of the modification.
Issue 3 – Presentation
The discussion on presentation focused on whether the effect of a modification should be reflected as a reduction to the carrying value of the instrument or as an increase to the impairment allowance. The IASB staff recommended that impairment loss for modifications should be recognised against the gross carrying value of the asset, with the new carrying value representing the present value of the future cash flows discounted at the original effective interest rate.
The Board agreed with the staff recommendation.