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Financial instruments – Impairment

Date recorded:

Interest revenue recognition and definition of amortised cost (IASB and FASB)

Current IFRS and US GAAP define amortised cost in fundamentally different ways. US GAAP currently contains three separate definitions of amortised cost within various literature (FAS 114, FSP FAS 115-2 and SOP 03-3). The FASB's proposed ASU includes a single definition of amortised cost of:

"A cost based measure of a financial asset or financial liability that adjusts the initial cash inflow or outflow (or the noncash equivalent) for factors such as amortization or other allocations. Amortized cost is calculated as the initial cash outflow or cash inflow (or the noncash equivalent) of a financial asset or financial liability adjusted over time as follows:
  1. Decreased by principal repayments
  2. Increased or decreased by the cumulative accretion or amortization of any original issue discount or premium and cumulative amortization of any transaction fees or costs not recognized in net income in the period of acquisition or incurrence
  3. Increased or decreased by foreign exchange adjustments
  4. Decreased by write-offs of the principal amount."
IAS 39 currently defines amortised cost as "the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility."

The primary difference between these two approaches is that the approach under IFRS subtracts an allowance for credit losses in calculating amortised cost while US GAAP does not. The feedback both Boards have received is that financial statement users wanted an interest income recognition model that allows them to analyse net interest margin and credit losses separately. As a result, both Boards unanimously agreed that a reduction for a credit impairment allowance would not be included in the calculation of amortised cost for a financial asset.

Discounted vs. undiscounted expected losses

The joint Supplementary Document proposed that entities would be permitted to use either discounted or undiscounted expected losses in calculating the allowance amount under the time-proportional approach. However, the FASB did not participate in the discussions in developing the time-proportional approach so the Boards had not jointly discussed the issue of whether expected losses should be discounted or undiscounted. The staffs noted that the feedback received from comment letter respondents was that the Boards should either permit the use of undiscounted cash flows of expected credit losses due to operational concerns; or if consistency is desired then to require the use of undiscounted cash flows. The staffs also clarified that this discussion related to expected loss estimates of items in both the good book' and the bad book', expect for those items purchased directly into the bad book' which had been discussed separately at the previous joint meeting.

The Boards' discussions focused around the consideration of two alternatives. The first alternative would measure expected losses as principal only on an undiscounted basis which would require developing guidance for when to place loans on non-accrual' status. The second alternative would measure expected losses as all cash flow shortfalls (both principal and interest) on a discounted basis which would require determination of how to present the unwinding of the discount on the impairment allowance.

The Boards were fairly split on the issue. IASB members generally agreed conceptually that amortised cost is a discounted cash flow measure. FASB members generally had concerns over the operationality of discounting expected credit losses. Additionally, one FASB member representing financial statement users felt it was important that loans in the bad book be placed on a non-accrual status as doing otherwise would distort the interest margin. The IASB members felt it was important that a principle be established based on the use of discounted cash flows and that methods to address operational concerns could be built in. The FASB members expressed concern with developing a requirement in the standard that people would have difficulty in applying in practice. The financial statement user representatives from both Boards agreed that not all financial statement users would have consistent views on the issue.

The Boards finally found some amount of common ground by tentatively deciding the objective of estimating expected credit losses would be a present value calculation; however, the Boards acknowledged that several statistical approaches may approximate that amount. One IASB member gave an example of utilising a loss rate that incorporates a present value component (using the example of a 5% expected loss rate to occur 5 years from today, an entity may use a loss rate of 3.5% or 4% which reflects the present value of those future cash flows that will not be received).

After deciding that the objective of estimating expected credit losses is a present value calculation approach, the Boards then began discussions on how to unwind (accrete) the associated discount. Under current IAS 39, because amortised cost is reduced for the allowance of incurred losses and interest revenue is calculated as the EIR times amortised cost, the discount is unwound through interest income. However, because the IASB has decided to decouple' the presentation of impairment losses from interest revenue and because the Boards decided earlier in this meeting that amortised cost would not be reduced for the allowance for credit losses, the Boards have to determine whether to present the unwinding of the discount through either interest revenue (either in separate line items or on a net basis) or through impairment losses.

The Boards considered three alternatives for unwinding the discount. The first alternative would present the unwinding in the impairment losses line item. The second alternative would present the unwinding as a separate line item below interest revenue to result in a net interest revenue amount. The third alternative would present the unwinding within interest revenue and disclose the components in the notes to the financial statements.

Similar to the discussion on discounting, the Boards generally had different views on the presentation. The FASB members all supported presented the unwinding in the impairment losses line item. The IASB members generally supported presenting the unwinding as a separate line item below interest revenue to result in a net interest revenue amount.

One FASB member expressed significant concerns over the operationality of either the second or third alternatives believing it would require creating closed portfolios for each year of originated loans. The FASB Chair also expressed concern that this decision was inconsistent with the decision just made on discounting as it would require performing a present value calculation rather than using another statistical method such as a loss rate. The IASB finally found enough support (9 votes) to agree with the FASB on presenting the unwinding in the impairment losses line item and providing some level of disclosure around unwinding.

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