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Financial instruments – Impairment

Date recorded:

Recognition of credit impairment losses

The IASB and FASB continued their discussions on the recognition of expected credit losses for financial instruments. At the 17 November 2010 joint meeting, the Boards narrowed their consideration from seven potential impairment models to three models.

The staff of the IASB and FASB further developed those three models including modelling these alternatives under the same data set. Variations on two of the models were also added into the analysis prepared by the staff such that in total, five models were discussed during the meeting. At a high level summary, the models discussed included (numbered based on the original seven models under consideration):

Model 2 — Immediate recognition of the amount of the credit losses expected to emerge, and are reliably estimated, over a portion of the expected life of the financial assets, or where feasible, the full expected life of the financial assets.

Model 4 — Recognition of lifetime expected credit losses using a time-proportionate approach for financial assets in a "good book" and full recognition of lifetime expected losses for financial assets transferred to a "bad book".

Model 4' — Recognition of lifetime expected credit losses using a time-proportionate approach for financial assets in a "good book" and full recognition of lifetime expected losses for financial assets transferred to a "bad book". However, the "good book" allowance would have a floor sufficient to at least cover expected losses in the upcoming year.

Model 5A — Recognition of lifetime expected credit losses using a time-proportionate approach for financial assets transferred to a "good book" and full recognition of lifetime expected losses for financial assets in a "bad book". However, the time-proportionate approach is accelerated so the recognition of expected losses using notional sub-portfolios reflects distinct loss patterns over the life of an asset.

Model 5B — Recognition of lifetime expected credit losses using a time-proportionate approach for financial assets transferred to a "good book" and full recognition of lifetime expected losses for financial assets in a "bad book". However, the time-proportionate approach is accelerated so the recognition of expected losses adjusts the expected loss allocation based on the timing of expected losses.

The meeting began with a discussion of Model 2 which is a variation on the proposal in the FASB's exposure draft to immediately recognise all lifetime expected losses (Model 1). Several IASB Board members were confused over the differentiation between Model 1 and Model 2 focusing on the "reliably estimated" component of the Model 2 definition. To attempt to address some of the confusion over the application of Model 2, the FASB staff clarified that Model 2 would forecast losses over a shorter emergence period as their outreach has said that banks can more reliably estimate credit losses over the near term rather than over the entire life of the instrument. Model 1 would likely apply a historical loss rate over the life of the instrument as specific forecasting would be difficult given the long projection period.

One IASB Board member asked how the credit losses would be recognised for a longer term asset (10 year loan) in a steady state environment with a historical loss rate of 3%. The FASB staff and a FASB Board had differing views with the Board member feeling that loss would be fully recognised immediately where the FASB staff felt that only that portion of the expected losses forecast over the near term would be recognised immediately. The FASB Board member clarified that under Model 2 they may not have used the 3% loss rate as forecasting may have resulted in a different assumption.

The IASB staff then began discussions on Models 4, 4', 5A and 5B. Model 4 is an adaption of the IASB integrated effective interest rate model proposed in the exposure draft with changes made to address operational challenges based on recommendations from the Expert Advisory Panel. Models 4', 5A and 5B each attempt to retain the notion in the IASB's exposure draft that credit losses are priced into the interest rate of a financial asset and therefore should be recognised over the life of the instrument as interest revenue is earned. However, these models also address the concerns some have raised over Model 4 that the allowance amount is insufficient when the loss pattern is front loaded for a financial asset class.

The IASB Chairman asked the IASB staff if the intention of Model 4' was to replace Models 5A and 5B. The IASB staff noted that while they were further developing Model 5, it proved operationally challenging. Model 4' attempts to provide a sufficient allowance without adding the additional complexity of Models 5A and 5B. The IASB staff noted that a twelve month expected loss forecast is already required for banks applying Basel II, therefore applying this minimum "floor" reserve should not add any additional operational burden to Model 4. The IASB staff clarified that the allowance reserve under Model 4' would be the allowance as determined under application of the "bad book" in addition to the allowance calculated under the time proportionate approach from Model 4 unless the twelve month expected losses exceeded the allowance under the time proportionate approach, in which case the twelve month expected loss would be used instead.

One IASB Board member questioned the operational complexity associated with Model 5B and supported its attributes. However, a majority of the IASB (10 Board members) expressed support for Model 4'. One IASB Board member summarised the advantages of Model 4' as a compromise between the Expert Advisory Panel recommendations (retaining the basics of the IASB exposure draft) and the Basel Committee's recommendation of wanting a minimum allowance balance. A few IASB Board members did have concerns with the arbitrary twelve month period for the "floor" preferring instead to use language such as "foreseeable future, but not less than twelve months" to permit entities to forward project near term expected losses in excess of twelve months.

The FASB Board members were split in their views on Model 4'. Two FASB Board members stated their continued preference for Models 1 or 2. However, three FASB Board members expressed interest in further exploring Model 4'. The FASB also had concern over the arbitrary twelve month period used for the minimum "floor" allowance. The FASB analogised the concept in Model 4' to the principal within Model 2 for the losses anticipated over a shorter time horizon. The acting Chair of the FASB felt that Model 4' articulated this concept in a more intuitive way and may be consistent with how management currently estimates their credit losses.

While no official votes were taken, the Boards agreed to further develop Model 4' and conduct outreach activities with the expectation to reconvene during next week's scheduled joint Board meetings.

This concluded the special meeting on impairment.

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