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Journal entry — Financial instruments — IASB clarifies several aspects of its impairment model

Published on: Nov 07, 2013

At its meeting on October 31, the IASB continued to redeliberate its March exposure draft and made a number of tentative decisions related to the topics below in response to feedback received from constituents. The Board will continue to deliberate the exposure draft at the November 2013 meeting and will decide at a future meeting whether to proceed with finalizing it.

Assessing When to Recognize Lifetime Expected Credit Losses

The IASB tentatively decided to confirm that an entity should recognize lifetime expected credit losses for financial instruments when there has been a significant increase in credit risk since initial recognition. Further, the Board decided to clarify that:

  • Entities could establish the maximum credit risk for a portfolio at initial recognition (e.g., product type or region) and compare that risk to the credit risk of financial instruments in that portfolio as of the reporting date1 to determine whether there has been a significant increase in credit risk.
  • Entities could determine whether there has been a significant increase in credit risk by assessing a counterparty as long as such assessment achieves the objectives of the proposed model.2
  • In assessing whether there has been a significant increase in credit risk, entities should only consider changes in the risk that a default will occur rather than changes in the amount of the expected credit losses (or the loss given default).
  • Entities would be allowed to assess whether there has been a significant increase in risk on the basis of the change in the risk that a default will occur in the next 12 months unless circumstances indicate that an assessment over the lifetime of an asset would be necessary.3 The guidance would include an example of when a 12-month assessment would not be appropriate.4
  • A loss allowance measured at an amount equal to 12-month expected credit losses should be reestablished for financial instruments for which the criteria for the recognition of lifetime expected credit losses are no longer met.

Operational Simplifications

Rebuttable Presumption for Payments More Than 30 Days Past Due

The Board tentatively confirmed the proposed rebuttable presumption that there is a significant increase in credit risk when contractual payments are more than 30 days past due. Further, the Board decided to clarify that:

  • The rebuttable presumption is intended to serve as a backstop in the identification of instruments whose credit risk has significantly increased.
  • The presumption would help entities identify lifetime expected credit losses before there is objective evidence of impairment.
  • Entities can rebut the presumption if they have reasonable and supportable information that more than 30 days past due is not the point at which there is a significant increase in credit risk.

Low Credit Risk

The IASB tentatively decided that an entity can assume that a financial instrument’s credit risk has not significantly increased if the risk is low as of the reporting date. The Board also tentatively decided to:

  • Modify the proposed description of low credit risk to reflect investments (1) whose risk of default is low, (2) for which in the near term the borrower has a strong capacity to meet its obligations, and (3) for which, in the longer term, the borrower’s capacity may be reduced, but not necessarily as a result of adverse business and economic conditions.
  • Clarify that entities would not be required to get external ratings for financial instruments to qualify as low credit risk, and that “low credit risk” corresponds to a global credit-rating definition of “investment grade.”
  • Clarify that when the credit risk of an instrument is no longer low, the entity should assess whether the risk has significantly increased.

Measurement of Expected Credit Losses

The IASB tentatively decided to require that expected credit losses should be discounted at the effective interest rate (EIR) or at an approximation of the EIR.

Further, the IASB tentatively confirmed that the measurement of expected credit losses:

  • Should incorporate the best information that is reasonably available, including information about past events, current conditions, and reasonable and supportable forecasts of future events and economic conditions as of the reporting date. For periods beyond those that can be reasonably forecasted, an entity should consider how best to reflect its expectations by taking into account information, as of the reporting date, about the current conditions as well as forecasts of future events and economic conditions.
  • May be based on regulatory expected credit loss models but should be adjusted, if needed, to meet the objectives of the proposed impairment model.

In addition, the IASB tentatively decided to clarify that 12-month expected credit losses represent a portion of lifetime expected credit losses.

Editor’s Note: In response to feedback from constituents, the Board decided to clarify the application guidance that is currently in paragraph BC63 of the exposure draft to specify that 12-month expected credit losses do not represent either of the following:

  1. Lifetime expected credit losses that an entity will incur on financial instruments that it predicts will default in the next 12 months.
  2. Cash shortfalls that are predicted over the next 12 months.

Modifications

The Board tentatively agreed to confirm the following proposed guidance:

  • The modification requirements apply to all modifications or renegotiations of contractual cash flows, regardless of the reason for the modification.
  • If the criteria for recognizing lifetime expected credit losses are no longer met for a modified financial instrument, entities can reestablish a loss allowance measured at an amount equal to 12-month expected credit losses (in a manner similar to other financial instruments).
  • The modification gain or loss should be recognized in profit or loss.

____________________

1 This objective of the clarification is to address constituents’ concerns about the operational complexity of the proposal to require entities to track changes in an asset’s credit quality relative to its initial credit standing. As a result of the Board’s decision to simplify the application of the requirement, entities would not be required to track changes in credit risk since initial recognition at an individual instrument level.

2 As noted in the IASB staff’s Agenda Paper 5A, “[u]sing this approach an entity would recognise lifetime ECL on all financial instruments it holds with the same borrower if the credit risk of the borrower has reached a specified level at the reporting date (including on newly originated or purchased financial instruments at market terms). This approach is really more akin to an absolute approach, in that once the credit risk of a borrower reaches a particular level (or exceeds it) lifetime ECL would be recognised on all exposures to that borrower.”

3 Agenda paper 5A indicates that “the 12-month probability of a default occurring is generally a reasonable approximation of the lifetime probability [and thus] the assessment should generally be possible using the 12-month probability. The intention of the IASB was not to require entities to do both a 12-month and a lifetime assessment and to prove that the outcome would not differ.”

4 For example, for loans whose payment obligations beyond the next 12 months are significant (such as bullet loans or financial instruments that are nonamortizing in the first few years).

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