The Bruce Column — At a loss to explain

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31 Jan 2011

The difference between incurred losses and expected losses might seem to the outside world to be a relatively arcane piece of accounting.

Within the accounting world, as the publication of the joint IASB/FASB supplement to the exposure draft on amortised cost and impairment shows, it is important. But no one, in the run-up to the supplement's publication, expected to find the ideas being bounced around at a hearing of the UK House of Lord's Economic Affairs Committee a few days before.

Their Lordships were focussing on the effectiveness of IFRS during the economic crisis and were asking the Government ministers in front of them at the hearing if they expected significant changes. And suddenly Richard Carter, Director, Business Environment, at the Department for Business, Innovation and Skills, decided to talk about what was about to be produced on losses, whether incurred or expected.

'What I think we are likely to see emerge is a standard which people can understand, a standard which people can apply, and a standard which people have confidence in and which will avoid, as far as any standard can, the sort of issues we've had over the last couple of years', he said.

Those, as anyone involved in the world of standard-setting will realise, are bold words. But the hope is that the new supplement will achieve some of those hopes. What the joint IASB/FASB publication does show is that they have achieved their goal of recognising losses earlier, which was after all where the pressure was coming from. And this part of the overall project was the hardest hurdle the Boards had to overcome. They must hope that, with this now out for comment, the rest will prove easier.

And it takes the lead from banks, which have tended to make a distinction between the 'good book', loans which are expected to hold up, and the 'bad book', which is the dodgy stuff. Now this concept will be extended to all entities. And that will bring all manner of change. But not all of it will be expensive system changes. It will force organisations to bring together their efforts in risk management, corporate reporting and investor relations.

There is logic to this. Most people would see it as common sense. At present no one provides for anything before a loan goes definitively bad. This is the incurred loss. This is a dead parrot, as the Monty Python comedy team would have once said. What needed to happen was the acceptance that you know that some loans, despite looking good at the outset, will turn out to be bad. These are the expected losses. And, under the new proposals these can be provided for.

As Richard Carter went on to explain in the House of Lords: 'Historically we have been in a situation where the banks' accounting would only take account of those losses which they already knew had been incurred. But there is the suggestion, which I think is probably quite a good one which is going forward that they should take account of those losses which they expect are going to be incurred because of something which is going to happen in the future. That', he said, 'is quite a significant change. At one level it sounds technical. In practical terms I think that it could be very important'.

This is important to politicians because there is a view that had losses been recognised and provisions made earlier some of the economic carnage in recent years might have been avoided. But, as Carter went on to say of the new proposals: 'Would it actually have produced a significant difference three or four years ago? I don't know'.

And there is another reason why politicians will be welcoming the proposals. Governments would love to see that if financial services companies start making provisions for losses from Day One then it might change some of the attitudes which led to unsuitable loans being handed out like free gifts, free from responsibilities, and free from what the politicians call moral hazard. It was always going to be a temptation for banks, if they didn't have to deal with losses until loans actually went bad, to provide large and cheap mortgages to anyone who wanted them.

That is why this new supplement from the joint Boards has another political dimension. Having come through the awful period of the crash and hopefully having picked up a few lessons along the way people now feel uncomfortable about the concept of incurred losses and only booking them after the event. Although we are probably no better placed at predicting future losses on loans than we were before the financial crisis it now feels irresponsible not to give the new model a go.

Robert Bruce
January 2011

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