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U.S. comment letter on proposed ASU "Financial Instruments — Credit Losses"

Published on: Jun 03, 2013

An excerpt from the comment letter is shown below:

We support the Board’s efforts to improve the guidance in U.S. GAAP on the impairment of financial assets measured at amortized cost or fair value with changes in fair value recognized in other comprehensive income (financial assets) by (1) addressing the weaknesses in the existing incurred loss model that were observed during the global financial crisis and (2) simplifying such guidance by reducing the number of impairment models. We agree with the Board’s objective of recognizing and measuring credit impairment of financial assets on the basis of an entity’s current expectations about the collectability of contractual cash flows. An impairment model that is based on expected credit losses that incorporates information about past events, current conditions, and expectations about future economic events and conditions avoids the practical difficulties of an incurred loss model, under which there may be delayed recognition of credit losses because of the complexities in identifying when a loss event has occurred. Further, we support the Board’s decision to develop an impairment approach that would equally apply to all forms of financial assets.

While we support the project’s objectives, we have significant concerns about the proposed ASU’s approach. One significant concern is that it differs in important aspects from the approach proposed by the IASB in ED/2013/3, Financial Instruments: Expected Credit Losses. We strongly encourage the boards to converge their guidance on expected credit losses because we believe that converged guidance on this topic is critical to supporting well-functioning global capital markets.

In addition, we have concerns about the requirement in the FASB’s proposed model to recognize full lifetime expected losses for all financial assets, particularly at inception of these financial assets. Full lifetime expected losses may be appropriate for individual financial assets (or a portfolio of financial assets with similar credit quality) that have a low credit quality because there is a higher likelihood that a loss will be experienced shortly. However, for other financial assets (whether evaluated individually or as a portfolio of assets with similar credit quality) requiring recognition of full lifetime expected losses at inception distorts the measurement of performance and comprehensive income of the entity for a particular period with respect to that asset or assets (i.e., financial statements would potentially not reflect decision-useful information about the timing of losses). It also requires entities, auditors, and regulators to consider forecasts about economic data and conditions for periods far into the future. Because the level of precision necessarily decreases in forecasts for distant periods, some parties are likely to encounter significant operational challenges and complexity when incorporating the forecasts into measurements reflected in the financial statements. These concerns would potentially be addressed by shortening the time horizon an entity would be required to consider as part of the measurement of the credit loss allowance for high-credit-quality assets.

The IASB’s proposed financial asset impairment model differentiates financial assets on the basis of credit quality and limits the forecast period for particular financial assets; however, we have some concerns with this model. In particular, we do not agree with its use of a relative credit quality assessment instead of an absolute evaluation of an asset’s credit quality. A relative credit deterioration model (1) creates accounting anomalies because a credit loss allowance for similar assets may be measured differently and (2) adds operational complexity by requiring entities to track movements in an asset’s credit quality relative to its initial credit standing. We will submit a comprehensive response to the IASB’s proposed model in a separate letter.

In light of our significant concerns with the FASB’s and IASB’s proposed models, we propose an alternative approach that we believe retains many aspects of both boards’ proposals and remains faithful to their objectives. This recommended approach is discussed below.

Recommended Approach

Our recommended approach (1) is based on expected credit losses, (2) distinguishes between financial assets that are of high credit quality and those that are not, and (3) uses an absolute assessment of credit quality (i.e., it is not an assessment of the current credit standing relative to that at the time of origination or purchase like the IASB’s proposed credit loss model). We understand that the boards had considered, and decided against, using an absolute assessment of credit quality when discussing the approach that has evolved into the IASB’s proposal. We believe, however, that an absolute assessment is more operational and avoids accounting anomalies when similar economics of financial assets are measured differently.

Under our alternative approach, an entity would continue to monitor the credit quality of its financial assets during the reporting period. We believe that when it becomes apparent for a financial asset or assets that, on the basis of credit indicators and other relevant factors, it is not highly probable that the entity will collect all contractual cash flows when due, the entity should recognize all expected credit losses estimated over the remaining life of the asset or over the average remaining life for the portfolio of assets.1 Generally, entities would assess at the most granular level reasonable and without undue cost and effort whether such indicators and relevant factors exist, which in some cases may result in their making such assessments on a portfolio basis (i.e., portfolio of similar assets). In addition to a measurement based on the present value of expected cash flows using the asset’s effective interest rate, the model would permit the allowance for credit losses on these assets to be calculated as the lifetime probability of default multiplied by the loss given default multiplied by the exposure at default with the objective of measuring expected value. Other estimation techniques that meet the objective would be permitted. For financial assets or portfolios of assets for which it is highly probable that all contractual cash flows will be collected when due, the entity would still recognize an allowance for 12 months of expected credit losses (or another appropriate specific period that the boards deem appropriate). This allowance is necessary for the entity to account for the uncertainty associated with the credit evaluation process and the relatively smaller probability that a loss will occur over the next 12 months (or other specific period). Measurement of the allowance may be based on the present value of expected cash flows for those financial assets for which a credit event is expected in the next 12 months (or other specific period). Alternatively, an entity would be permitted to estimate the allowance on the basis of the 12-month (or other specific period) probability of default multiplied by the loss given default multiplied by the exposure at default, with the objective of measuring expected value. Other estimation techniques that meet the objective would be permitted.

On the basis of our outreach, 12 months appears to be a reasonable and supportable forecast period. We suggest that the boards perform additional research to determine whether longer periods may be appropriate. However, such forecast period should remain the same throughout financial reporting periods (i.e., it should not change because of changing economic circumstances).

Full text of the comment letter is available below.


1 Given that the asset or portfolio of assets is not of high credit quality, it would not be appropriate to use any period less than the full remaining expected term (i.e., lifetime losses), though it is likely that this period is relatively short and that more precise information is available for use in estimating expected credit losses.


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