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Financial instruments – Impairment - education session

Date recorded:

Estimating expected credit losses (education session)

The IASB and FASB staffs held an education session with the IASB in preparation for the Boards' discussion on estimating expected credit losses next week. The Supplement proposes that entities would consider all available, reasonable and supportable information, including consideration of future events, in developing estimates of expected credit losses, but have not yet discussed how to estimate expected credit losses.

The IASB's ED 2009/12 originally proposed that "estimates of cash flow inputs are expected values...estimates of the amounts and timing of cash flows are the probability-weighted possible outcomes." The FASB's proposed ASU did not refer to expected losses but instead focused on cash flows not expected to be collected. Comment letter responses have concerns with the description of expected value as they felt it required consideration of all possible outcomes. Additionally, they felt the use of probability-weighted possible outcomes was not relevant for a single asset as the calculated expected loss would likely be an amount that was not a possible alternative.

The FASB did not provide any specific guidance on the calculation of credit impairment losses but for individual financial assets provided that an entity could not automatically conclude no credit impairment exists and instead must asset the asset together with other financial assets that have similar characteristics (a pool overlay') and apply the historical loss rate for the group. Comment letter respondents did not specifically respond to this issue based on the FASB not proving specific guidance on measurement.

The staffs plan to provide the Boards with two alternatives on how to address estimates of expected credit losses.

  • Alternative A - Establish an objective that would require estimating expected losses based on the expected value (mean) of possible outcomes for both portfolios and single instruments. The standard would clarify that one way to estimate an expected value would be to identify the possible outcomes, estimate the likelihood of each and calculate their probability-weighted average. However, other appropriate methods could be used as a proxy to a pure expected value calculation, such as use of loss rate methods, probability of defaults (PDs), loss given defaults (LGDs), or exposure at defaults (EADs)
  • Alternative B - Estimate expected losses using all available and supportable information to estimate cash flows that are expected to be uncollectible at the date of estimation (i.e., not specify an approach for estimating expected losses) but for single instruments a pool overlay' would also be required.

Based on the discussions during the education session, it was apparent that the IASB staff supported Alternative A while the FASB staff supported Alternative B. The FASB staff fielded several questions from the IASB. The FASB concerns with Alternative A seemed to focus on their view that a burden of proof would be created by requiring probability weighted possible outcomes approach. As a result, entities may need to prove that use of the proxy approaches were also representative of a probability-weighted possible outcomes approach. The IASB Chairman acknowledged that the staffs seemed to be generally wanting the same thing but simply talking past each other. The IASB and FASB will discuss the topic jointly during next week's meetings in Norwalk.

Accounting for purchased debt instruments (education session)

The IASB and FASB staff also held an education session with the IASB to discuss the accounting for purchased debt instruments in preparation for next week's joint Board meetings.

IAS 39 currently differentiates loans acquired at a deep discount that reflect incurred credit losses from other acquired loans. Similarly, US GAAP currently has a separate accounting model for loans acquired at a discount due to credit deterioration.

Presentation of purchased loans

IFRS 3(R) and ASC 805-10 require loans acquired in a business combination to be initially recognised at fair value. As a result, loans are recognised on a net' basis and do not carryover any valuation allowance related to credit quality. Financial statement users have often complained over losing information on the valuation allowance associated with these assets and the lack of comparability to originated loans.

The staffs have developed three possible alternatives for the presentation of purchased loans.

  • Alternative 1 - Present the loan balance gross' by separately presenting the principal amount, portion of the discount attributable to the allowance as determined by the impairment model in the Supplement, and a separate premium/discount representing the remaining difference between the acquisition price and the original principal amount
  • Alternative 2 - Present the loan balance gross with separate presentation of the portion of the purchase discount attributable to the allowance as determined by the impairment model in the Supplement
  • Alternative 3 - Present the loan balance at fair value less the allowance as determined by the impairment model in the Supplement.

The FASB staff tend to support alternative 1 or alternative 2 as they feel such an approach would alleviate some of the presentation concerns by aligning originated and purchased loans and feel that expected losses are part of the transaction price and therefore the transaction price should be grossed up' to reflect the expected losses as well as the remaining discount. The IASB staff tend to support alternative 3 as they feel such an approach is consistent with the application of the Supplement to originated loans and do not view loss expectations differently for originated and purchased loans. They would prefer that financial statement users are provided comparability information through disclosures rather than presentation.

Effective interest rate and accretion of discount on purchased loans

As part of the discussion on accounting for acquired loans, the Boards will need to consider whether the effective interest rate should equate the acquisition price of the loan to contractual or expected cash flows. The staffs have developed four approaches for the Boards to consider.

  • Alternative 1 - Require all purchased loans to accrete a discount based on the contractual cash flows
  • Alternative 2 - Require all purchased loans except for those acquired at a deep discount to accrete a discount based on the contractual cash flows. Loans acquired at a deep discount would accrete a discount based on cash flows expected to be collected
  • Alternative 3 - Require all purchased loans to accrete a discount based on cash flows expected to be collected
  • Alternative 4 - Permit entities to make an accounting policy election in respect to Alternative 1 or 2.

The IASB staff support Alternative 2 as they feel for performing loans' the time proportional approach counters a higher effective interest rate based on contractual estimated cash flows, but it is appropriate to differentiate problem loans' to prevent inflated EIRs being calculated. The FASB staff support Alternative 3 as it eliminates the differentiation of credit impaired and non-credit impaired purchased loans.

The IASB expressed surprise at the FASB staff's support for Alternative 3 as they analogised it to the integrated effective interest rate approach in ED 2009/12 and referenced the operational challenges that most comment letter respondents had with the proposals.

Changes in collectability subsequent to purchase

The Boards must also consider how subsequent changes in expectations of collectability should be recognised, as either an adjustment to the effective interest rate, an allowance for credit losses or a combined approach.

The staffs have developed two alternatives, but each having a sub-option.

  • Alternative 1 - Recognise certain changes in expectations as an adjustment of yield and certain changes as an impairment and adjustment of the allowance for credit losses
    • Alternative 1A - All increases in the amount of cash flows expected to be collected, beyond the reversal of existing impairment reserves, since acquisition or the prior period would be recognised through an increased yield. Decreases in the amount of cash flows expected to be collected would be recognised as an impairment expense.
    • Alternative 1B - All increases in the amount of cash flows expected to be collected, beyond the reversal of existing impairment reserves, would increase yield, while decreases in the amount of cash flows expected to be collected would decrease the yield to the initial effective rate, with further decreases recognised as an impairment expense
  • Alternative 2 - Recognise no changes in expectations as an adjustment of yield. All changes in expectations would be recognised as adjustments of the allowance for credit losses. Under this alternative, the initial effective interest rate is "locked in" to accrete to the amount of cash flows expected to be collected upon acquisition
    • Alternative 2A - All changes in expectations are recognised through an allowance for credit losses (or carrying value adjustment) regardless of whether it is established at acquisition or subsequent to acquisition. Increases in cash flows expected to be collected may be recognised as gains even if there has not been previously recognised impairment charges by the acquiring entity
    • Alternative 2B - Changes in expectations related to increases in cash flows expected to be collected may be recognised by reversing the allowance for credit losses until it reaches a zero balance, but not beyond that point. After that point, an entity would not recognise increases in cash flows expected to be collected as gains prior to recognising an impairment expense subsequent to acquisition.

The staffs did not discuss this portion of the proposals in detail.

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