Financial instruments – Impairment

Date recorded:

Estimating expected credit losses

The Boards discussed the measure that entities should use when estimating expected credit losses. The two alternatives discussed by the Boards were:

  • Alternative A - Expected losses for both single instruments and portfolios should be estimated using expected value as an objective with clarity being provided related to the calculation of the expected value. For example, one way to estimate a pure expected value would be to identify the possible outcomes (or a representative sample of the possible outcomes), estimate the likelihood of each and calculate their probability-weighted average. The final standard should acknowledge that other appropriate methods could be used as a proxy to a pure expected value calculation (e.g., loss rate methods and use of probabilities of default, loss-given default, and exposure at default data)
  • Alternative B - Expected losses should be estimated using all available and supportable information to estimate cash flows that are expected to be uncollectible at the date of estimation. Losses are estimated on single instruments and then a pool overlay would also be required.

Certain Board members (primarily IASB Board members) supported Alternative A as they believe that the most important reason for using an expected value is that an expected value estimate is an inherent part of an expected loss model. When considering expected losses based on all the available evidence (including forward-looking information), an entity will inherently consider multiple scenarios and possible outcomes. Some also believe that an objective that is not based on expected value would be inconsistent with the view that the pricing of financial assets includes considerations of expected losses.

Other Board members supported Alternative B as they believe that the objective for measuring credit impairment losses and the allowance for credit losses does not necessarily need to be expressed in the context of a particular statistical methodology. These Board members would rather not be overly prescriptive in how an entity estimates cash flows, rather they prefer that the objective be that an entity would be required to estimate the amount of cash flows that an entity does not expect to collect (also referred to as losses) using the best available and supportable information at the date of estimation (historical, current, and forecasted). Further, they were concerned with the approach in Alternative A that may result in entities having to prove that the use of the proxy approaches described in Alternative A were also representative of probability-weighted approaches.

After a lengthy discussion about the merits of either alternative, the IASB voted 15 to 0 in favour of Alternative A while the FASB voted 4 to 3 in favour of Alternative B. At least one FASB board member indicated that he could support Alternative A depending on the final language in Alternative A. Specifically, if Alternative A was written in such a way that did not overly burden an entity to prove that its use of a proxy approach, as described in Alternative A, is representative of a probability-weighted approach.

Accounting for purchased debt instruments

The Boards discussed the accounting for acquired loans, specifically whether the effective interest rate should equate the acquisition price of the loan to contractual or expected cash flows. In general, it appeared as though the IASB board members favoured the accretion of a discount based on contractual cash flows while the majority of the FASB Board members supported the accretion of the discount based on expected cash flows.

Those Board members who supported the accretion of the discount based on contractual cash flows believe that separate models should not exist for originated and purchased loans. Further, they believed that it was conceptually purer to have a single model for all loans, whether originated or purchased, that achieves an effective interest rate aligned with the credit quality of the asset.

The Board members who supported accretion based on expected cash flows believe that it would be inappropriate to accrete to an amount that an entity does not expect to collect. Further, they believed that permitting the accretion of the discount in these situations to contractual cash flows would artificially inflate yields where an impairment model would not counter this effect.

In summary, the Boards asked the staffs to prepare illustrations of the accretion the discount to contractual and expected cash flows to be discussed at next week's joint Board meeting.

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