Financial instruments – Impairment

Date recorded:

The Boards concluded that the staffs should develop (1) an impairment model using a relative credit risk approach, (2) potential triggers, indicators, or thresholds used to transfer assets out of Bucket 1 into Bucket 2, and (3) disclosures to provide transparency around an entity's credit risk management and application of the impairment model. The staffs plan on presenting these items to the Boards at their joint meeting in December.


The objective of the proposed impairment model is to reflect the general pattern of deterioration of the credit quality of debt instruments. To do this, financial assets subject to impairment accounting (such as loans or debt securities measured at amortised cost or fair value through other comprehensive income) would be split into three main buckets. These buckets would determine the amount and timing of credit losses to be recognised on debt instruments reflecting different phases of credit deterioration.

The boards have been debating whether to apply a "relative" or an "absolute" credit risk approach in "bucketing" debt instruments. Under a relative credit risk approach, originated and purchased assets would be initially classified in Bucket 1 even if they are of lower credit quality (e.g., subprime loans) and would be subsequently transferred into Bucket 2 or 3 if a deterioration in credit quality occurs; for loans acquired at a discount due to credit losses, the effective interest rate is calculated taking into account initial credit loss expectations and no allowance is established upon initial recognition. However, feedback from initial outreach efforts indicated operational challenges related to that approach (e.g., entities may be unable to monitor and track deterioration in the credit quality of assets over time because of system limitations and, in certain circumstances, may not maintain historical loss expectation data). Instead of pursuing a relative credit risk approach, therefore, the boards reversed course and tentatively decided at their September 2011 meeting to pursue 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 into Buckets 2 or 3.

Relative Credit Risk Approach

The Boards began their discussion on the impairment of financial assets by providing feedback obtained in a meeting with banking regulators and the Institute of International Finance. Preparers were concerned about a model, such as an absolute credit risk approach i The absolute and relative credit risk approaches were discussed at the September 21, 2011 joint board meeting - that would result in day 1 losses, particularly for entities who participate in higher risk lending. The Boards responded to these preparers that they had decided to change course (as noted above) and pursue an absolute credit risk approach rather than a relative credit risk approach because of concerns expressed by preparers about the operationality of a relative credit risk approach.

Because of (1) the inconsistencies in the feedback received on the absolute and relative credit risk approaches (through previous outreach studies and by way of this meeting) and (2) the Boards' views that the relative credit risk approach was conceptually better than the absolute credit risk approach and that the perceived operational concerns with a relative credit risk approach were not as insurmountable as previously assumed, the Boards directed the staff to develop an impairment principle using a relative credit risk approach. This approach would most closely align with the overall objective of the "three bucket" expected loss model, which is to reflect the general pattern of deterioration of the credit quality of assets. Under this approach, assets would start in Bucket 1 and would be transferred to Bucket 2 and Bucket 3 as credit loss expectations deteriorate (reflecting the uncertainty in the collectibility of cash flows). In addition, the Boards recommended that the principle apply not only to loans but also to debt securities.

The Boards also discussed the principle supporting the Bucket 1 allowance of 12 to 24 months. While some board members believed that the allowance amount represented an incurred-but-not-reported (IBNR) loss amount, others viewed the allowance as an amount that properly adjusted an asset's effective yield. Because of this debate, the Boards highlighted the need to clearly articulate this principle when drafting the Basis for Conclusions for the new impairment standard.

Transferring Out of Bucket 1

The Boards acknowledged that the a new impairment model would address the "too little, too late" criticism raised in the recent financial crisis about the current impairment model in U.S. GAAP and IFRS only if the principle on when to transfer assets out of Bucket 1 was clearly articulated and grounded by a threshold lower than "probable", indicating a deterioration in an asset's credit quality to a particular level. Based on previous Board discussions, this principle would incorporate the concepts and definitions of rating agency classifications along with concepts of regulatory guidance. Further, certain Board members indicated that the principle should also incorporate a notion that an entity should not ignore current market conditions that may indicate that some or all of the contractual cash flows will not be collected.


The Boards acknowledged that a relative credit risk approach to impairment may lead to comparability concerns across financial institutions because the manner in which entities manage credit risk and view assets' credit quality may differ. Accordingly, the Boards instructed the staffs to develop disclosures to provide transparency around an entity's credit risk management. The Boards also recommended that the staffs leverage existing standards when developing such disclosures.

Next Steps

Some Board members expressed a concern that the staffs could not develop an impairment principle based on a relative credit risk approach and related disclosures in time for the next joint meeting in November. Because of this, the Boards agreed to discuss the staffs' proposals at their joint meeting in December.

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