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Journal entry — FASB and IASB continue discussions of impairment accounting

Published on: Sep 23, 2011

At their meeting on Wednesday, the FASB and IASB (the “boards”) continued discussions of their “three bucket” expected-loss approach to the impairment of financial assets. Specifically, the boards discussed (1) the treatment of originated and purchased financial assets with lower credit quality1 and (2) the principle behind when to transfer between the buckets.

In a previous meeting, the boards decided that originated and purchased assets with lower credit quality would be initially classified in Bucket 1 and would be transferred into Bucket 2 or 3 as a result of deterioration in credit quality (the “relative” credit risk approach). However, feedback from initial outreach efforts indicated operational challenges related to that approach (e.g., entities may be unable to monitor deterioration in the credit quality of assets because of system limitations and, in certain circumstances, may not maintain historical loss expectation data). Accordingly, instead of pursuing a relative credit risk approach, the boards decided to develop an “absolute” credit risk approach in which all assets of similar credit quality as of a point in time are included in the same bucket. Under the absolute credit risk approach, assets with lower credit quality may be originated or acquired directly in Bucket 2 or 3.

The boards have identified two situations in which applying the absolute credit risk approach may result in the recording of allowance amounts that would not have been recognized under the relative credit risk approach upon the origination or acquisition of assets. The first relates to the acquisition of loans that are initially measured at fair value and then placed into one of the buckets, at which point an allowance is calculated (i.e., assets acquired in a business combination). The second relates to markets in which the origination of assets of lower credit quality is the norm rather than an exception (e.g., subprime lending) such that initially classifying those assets directly into Bucket 2 will result in the recording of full expected lifetime losses. The boards have asked the staffs to further research potential solutions or alternatives for these situations.

While the boards made no formal decisions regarding when to transfer assets between Bucket 1 and Bucket 2, they did request the staffs to further develop a principle for transfer that would be based on deterioration of credit quality to a particular level. This principle would incorporate the concepts and definitions of rating agency classifications along with concepts of regulatory guidance and other credit risk characteristics.

 


[1] This discussion did not encompass loans acquired at a discount due to credit losses that would be recognized in the “bad book,” as previously discussed at a March 2011 joint board meeting. The effective interest rate for those loans is calculated by taking into account initial credit loss expectations; therefore, no allowance is established upon initial recognition.

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