Impairment — Education session (IASB/FASB)
During the third quarter of 2012, the FASB began development of an alternative to the IASB’s proposed impairment model after receiving feedback from FASB constituents suggesting that the IASB’s model is difficult to understand, audit and operationalise. The alternative model — referred to as the Current Expected Credit Loss (CECL) model — is intended to address constituents’ concerns by establishing a single measurement approach, rather than the dual-measurement model under the IASB’s three-bucket approach, for impairment of an entity’s financial assets. The CECL model’s measurement approach would be expected credit losses (i.e., an entity’s current estimate of contractual cash flows not expected to be collected). At each reporting date, an entity would recognise a credit impairment allowance equal to its current estimate of expected credit losses. Further details of the FASB’s model are available on the FASB website.
At this meeting, FASB members presented to the IASB an overview of its alternative impairment model. The IASB was not asked to make any tentative decisions. Instead, this meeting served to allow the IASB to ask questions relating to the CECL model.
Multiple IASB members expressed support for aspects of the FASB’s model. For example, one IASB member liked: the lack of a transfer line (i.e., the CECL model does not have different measurement objectives or a transfer notion); the fact that the model reflected a measure of current likelihood of loss for the remaining life of assets (i.e., it was neither a ‘worst case’ nor a ‘base case’ measurement scenario); the fact that the model is fully responsive to changes in credit quality (i.e., every reporting period, expected credit losses would be re-estimated with favourable and unfavourable changes would be reported in earnings); and the proposed disclosures. Overall, he saw the CECL model as simpler than the three-bucket model from an operational perspective.
However, caveating this support, the IASB member, echoing the comments of many in the room, expressed concern with the conceptual basis of the FASB’s CECL model. He questioned the conceptual merits of recognising impairment losses when an entity originates or purchases a financial asset at fair value, as he believed a day 1 loss did not reflect the economics of a market-based transaction. Specifically, he saw the impairment losses recognised on day 1 as duplicative to those priced into the interest rate on debt instruments. Not unlike his previous stance in development of an impairment standard, he believed that for conceptual purity, any expected loss model required adjustment of the (contractual) discount rate to reflect changes in credit quality.
IASB members also expressed concern with the ‘cliff effect’ on transition to the FASB’s CECL model; noting that a sizeable adjustment will be required on transition which does not reflect the economics of the transaction.
In response, FASB members noted:
- the extent of day 1 ‘cliff effect’ depends on the changes in the volume of loans originated, maturing (i.e., the stability of loans) and the extent of deterioration or recovery. Assuming a steady state of loans of comparable credit quality, they believed the day 1 ‘cliff effect’ would be relatively small. However, IASB members disagreed with the assumption of a steady state of loans. They noted volatility in lending across boom and bust cycles/jurisdictions. Likewise, they noted that entities with higher loan growth would be penalised with lower profitability as a result of the FASB’s proposed model; thus inhibiting lending and reducing comparability across entities unless users/investors adjust financial statements for both allowance levels and loan growth activity.
- the IASB’s three-bucket model can create a ‘double counting’ effect of losses as well. In response, many IASB members acknowledged the IASB’s three-bucket model was not conceptually pure either. However, in their view, the IASB model accepts that credit risk is priced into the interest rate on debt instruments, and therefore, recognises the income to cover expected losses over the life of the loans.
- the impact on earnings is strictly a timing difference. The FASB model recognises the ‘cliff effect’ on day 1, while the IASB model recognises a ‘cliff effect’ in moving from Bucket 1 to Buckets 2 or 3 (i.e., 12-month losses to lifetime losses). IASB members did not see the three-bucket model as providing for a ‘cliff effect’. Instead, they saw their model as responsive to changes in credit quality. Further, they saw their model as more economically pure in the timing of allowance recognition.
Following a lively debate, the FASB Chair noted that the FASB intends to issue an exposure draft on its CECL model later this quarter, with a comment period ending the later of 30 April 2013 or 120-days. The FASB also asked to be kept abreast of the IASB’s deliberations on the three-bucket model, as the FASB intends to consider the results of the IASB’s deliberations when redeliberating its CECL model next year.