Financial instruments – Impairment

Date recorded:

The IASB and FASB discussed four topics related to the amortised cost and impairment project.

Scope - short-term trade receivables

The IASB's exposure draft proposed that trade receivables, without a stated interest rate and a near term maturity so that the effects of discounting would not be material, would be initially recognised at the invoice amount less the initial estimate of undiscounted expected credit losses. That initial estimate of expected credit losses would be recognised as a reduction in revenue rather than bad debt expense. While IAS 18 requires that revenue be measured at the fair value of the consideration to be received, common practice is to recognise revenue based on the full invoice amount and subsequently estimate credit losses based on collection efforts recognised as bad debt expense.

Most comment letter respondents disagreed with the proposal and felt that short-term trade receivables should not be subject to the same recognition model proposed in the exposure draft.

The Board tentatively decided to exclude short-term trade receivables from the scope of the pending re-exposure draft and further consider the issue of credit risk associated with trade receivables in conjunction with the redeliberations of the revenue recognition exposure draft.

Certain Board members had concerns over how to appropriately define or differentiate trade receivables that should be exempt from the pending re-exposure of amortised cost and impairment and those that are financing receivables. The IASB staff proposed the scope out would exclude short-term trade receivables without a stated interest rate and are so short-term so that the effect of discounting for the time value of money would be immaterial. However, under that set of criteria, certain trade receivables in jurisdictions with high inflation levels may remain within the scope of amortised cost and impairment proposals.

Scope - individual financial instruments

The IASB's redeliberations on the amortised cost and impairment exposure draft have focused exclusively on the application to open portfolios as a result of the operational issues identified by comment letter respondents and the Expert Advisory Panel regarding the application of the proposals in the exposure draft.

The Board has stated publicly their intention to issue a revised exposure draft in January 2011. However, the Board has not discussed application of the revised proposals to either closed portfolios or individual instruments. The IASB staff requested direction from the Board on the intended scope of the revised exposure draft and whether it should solely address application to open portfolios as issues associated with individual instruments have yet to be deliberated based on comments received on the original exposure draft (such as the requirement to use a probability weighted expected outcome approach for an individual instrument). The IASB staff was concerned about including individual instruments within the exposure draft and asking questions to constituents without initially addressing the comments received on the original exposure draft.

Several Board members had concerns with specifically excluding closed portfolios or individual instruments from consideration within the planned revised exposure draft, particularly because of the worry that a third exposure draft could later be required. One Board member suggested an approach of describing the alternative model under consideration by the IASB within the exposure draft and simply asking for views on the approach and whether it addresses the operational issues identified in the original proposal. Several Board members agreed with this approach with another Board member stating that if the revised exposure draft included some context around the information and where the Board was heading it may help to alleviate some of those constituent concerns about not considering the comments from the original exposure draft.

Allocation of expected losses

As part of its redeliberations of the proposals in the exposure draft, the IASB has tentatively decided to permit the use of a non-integrated (or decoupled) effective interest rate calculation between contractual cash flows and expected credit losses.

The IASB and FASB are currently considering three methods for recognising expected credit losses. The IASB's original method (and similar to the approach in the exposure draft) was to allocate the expected losses over the life of the portfolio. The Board is also considering an accelerated recognition of expected losses method as well as the FASB's immediate recognition approach.

The IASB staff has continued building the model for expected losses to be allocated over the lifetime as they feel the accelerated methods under consideration would simply be an overlay of this approach. The methods available for allocating expected losses over the life of the portfolio include a straight line approach (either discounted or undiscounted methods are possible) or an annuity approach in which a discounted present value is converted into an annuity stream. Both the discounted straight line approach and the annuity approach would also require the use of a discount rate; therefore, the Board would also need to consider what guidance or requirements should be included in the proposal for determining the appropriate discount rate should the discounted straight line approach or the annuity approach be required or permitted.

The IASB staff analysis of the three alternatives noted that the undiscounted straight line method is more operational and less complex than the annuity approach; however it does not capture the anticipated timing of losses or the time value of money that the annuity approach includes. The discounted straight line method represents some level of compromise between the two alternatives as it incorporates consideration of the time value of money and is less complex than the annuity approach, yet still may operationally challenging for some to implement. If a discount rate were incorporated as part of the allocation method, potential alternatives for determining the appropriate discount rate include such items as the risk free rate, the IAS 39 EIR or the EIR from the exposure draft (although the IASB staff feels that the IAS 39 EIR is too high as it incorporates the expected credit losses).

The Board discussed how to allocate the initial estimates of expected credit losses over the life of the portfolio. The Board was evenly split between those that preferred not specifying any particular methodology and permitting entities to apply any of the three methods described above and those that preferred not permitting an election and simply requiring an undiscounted straight line approach (the most operational of the three approaches.

Those Board members who preferred requiring the undiscounted straight line method had concerns over the diversity created by allowing various alternatives and felt that once you have moved off the original proposal in the exposure draft, each of these alternatives are not perfect answers anyway. Another Board member noted that the differences in the staff examples (provided in the agenda paper) only occur as a result of discounting when the losses occur later in the life of the loans, which contradicts the loan data presented during the previous joint Board meeting which found that for several asset classes losses are typically front loaded. One other Board member proposed a middle ground of requiring the undiscounted straight line approach unless the impact of discounting would be significant in which case a discounted approach would be required.

Because the Board was split on the matter, the Board tentatively agreed that the revised exposure draft will not specify which method could be applied and to ask a question on the matter of whether a specific approach should be required.

Good book/bad book consideration

The final topic of the meeting was on the incurred loss model being overlaid on top of the expected loss model (often referred to as the good book/bad book approach). Under this approach, the expected losses are allocated over the life of the portfolio unless a loss event has been identified in which case the loan is transferred from the good book (the expected loss model) to the bad book (the incurred loss model) where the expected losses are immediately recognised in their entirety.

The Board considered whether to require a specific definition for loans that should be transferred to the bad book such as 90 days past due (consistent with the current definition of default established by the Basel Committee) or to develop a bad book that follows how an entity manages their non-performing loans (rather than requiring arbitrary definitions). It was noted that a certain period of time past due may be appropriate for certain asset classes but not for other asset classes and therefore a one size fits all model may not be appropriate.

All of the Board members agreed not to mandate a brightline definition for items that should be included in the bad book (e.g., 90 days past due). However, several Board members had concern with simply providing management with full discretion as to how and when to transfer items between the good book and bad book. Those Board members wanted more discipline around the criteria for the bad book.

The staff agreed to address those Board member concerns through drafting and would bring revised criteria for the transfer criteria back to the Board at a future meeting.

This concluded the special meeting on impairment.


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