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The International Accounting Standards Board (IASB) has published a proposal for a new accounting model for impairment of financial assets. The exposure draft (ED), Financial Instruments: Expected Credit Losses, contains a revised approach regarding the impairment of financial assets.
Currently IAS 39, Financial Instruments: Recognition and Measurement, states that a financial instrument is impaired and impairment losses are incurred if a loss event occurred and this loss event had a reliably measurable impact on the future cashflows. This is often called the 'incurred loss' approach. In the ED published in March 2013, the IASB proposes a model where credit losses are no longer recognised when incurred but rather, are recognised on the basis of expected credit losses on financial assets and on commitments to extend credit which are based on current estimates of expected shortfalls in contractual cashflows as at the reporting date.
In 2009, the IASB published an ED that proposed adjusting for expected credit losses through adjusting the effective interest rate of a financial instrument. The basis for this model was that expected credit losses are usually priced into the interest rate to be charged and should be reflected in the yield on the financial asset. Changes in credit loss expectations were to be recognised as incurred as these changes would not have been priced into the asset. This works conceptually but is a little impracticable.
In 2011, the IASB and the US Financial Accounting Standards Board (FASB) issued a joint supplement which proposed removing interest adjustment from the recognition of impairments and, since then, the bodies have used this approach, which is the basis of the current ED. However, the FASB has recently published its own proposed model with the key difference with the IASB's proposals being that the FASB requires a single measurement model for all financial instruments when determining the impairment provision. This is achieved by entities recognising a charge on recognition equal to the present value of lifetime expected credit losses. The FASB model does retain many of the jointly developed core principles.
Lifetime expected losses
The IASB proposals require the recognition of expected credit losses for certain financial assets by creating an allowance/provision based on either 12-month or lifetime expected credit losses. This is likely to result in earlier recognition of credit losses, which includes not only losses that have already been incurred but also expected future losses. The ED applies to financial assets measured at amortised cost and at fair value through other comprehensive income under IFRS 9, Financial Instruments. This includes debt instruments such as loans, debt securities and trade receivables. Additionally it applies to irrevocable loan commitments and financial guarantee contracts that are not accounted for at fair value through profit or loss under IFRS 9 and also lease receivables.
Expected credit losses are defined as the expected shortfall in contractual cashflows. The estimation of expected credit losses should consider past events, current conditions and reasonable and supportable forecasts. For financial assets, entities would recognise a loss allowance whereas for commitments to extend credit, a provision would be set up to recognise expected credit losses.
The principle behind the ED is that financial statements should reflect the general pattern of deterioration or improvement in the credit quality of financial instruments within the scope of the ED. On initial recognition, an entity would create a credit loss allowance/provision equal to 12-months' expected credit losses.
In subsequent years, this amount would be replaced by lifetime expected credit losses if the credit risk increased significantly since initial recognition. If the credit quality subsequently improves and the lifetime expected credit losses criterion is no longer met, the credit loss reverts back to a 12-month expected credit loss basis. The ED suggests that financial instruments with low credit risk would not meet the lifetime expected credit losses criterion. Under the proposed model, there is a rebuttable presumption that lifetime expected losses should be provided for if contractual cashflows are 30 days overdue. An entity does not recognise lifetime expected credit losses for financial instruments that are equivalent to 'investment grade', which means that the asset has a low risk of default.
The impairment amount recognised depends on whether or not the financial instruments have significantly deteriorated since their initial recognition. The ED describes three stages:
- Stage 1: Financial instruments whose credit quality has not significantly deteriorated since their initial recognition.
- Stage 2: Financial instruments whose credit quality has significantly deteriorated since their initial recognition.
- Stage 3: Financial instruments for which there is objective evidence of an impairment as at the reporting date.
At stage 1, the impairment represents the present value of expected credit losses that will result if a default occurs in the 12 months after the reporting date. In contrast, an impairment is recognised for financial instruments classified as stage 2 or 3 at the present value of expected credit shortfalls over their remaining life. The ED requires an entity to reduce the gross carrying amount of a financial asset in the period in which the entity no longer has a reasonable expectation of recovery.
Earlier recognition of losses
It is anticipated that this model will likely result in earlier recognition of credit losses compared to the current incurred loss model because it requires the recognition not only of credit losses that have already occurred, but also losses that are expected in the future. However, the increase in credit loss allowance will vary as entities with shorter term and higher-quality financial instruments will not suffer any significant effects.
The ED proposes a simplified approach for trade receivables. Entities will have an accounting policy choice to always measure the impairment at the present value of expected cash shortfalls over the remaining life of the receivables instead of applying the two-class model. This will apply to trade receivables that do not constitute a financing transaction. For long-term trade receivables and for lease receivables under IAS 17, an entity has an accounting policy choice between the general model and the model applicable for trade receivables.
In the case of purchased or originated credit-impaired financial assets, the ED states that rather than apply the two-stage approach, changes in lifetime expected credit losses since initial recognition are recognised directly in profit or loss.
A credit loss allowance is not recognised on initial recognition, as the lifetime expected credit losses would be reflected in the credit-adjusted effective interest rate. A gain could be recognised if there are favourable changes in the lifetime expected credit losses that are incorporated in the credit-adjusted effective interest rate. Interest income is calculated using the effective interest method on the gross carrying amount of the asset and is a separate line item in the income statement. When there are credit impaired financial assets, interest is calculated on the net carrying amount after impairment.
Expected credit losses are determined using an unbiased and probability-weighted approach and should reflect the time value of money. The calculation is not a best-case or worst-case estimate. The ED sets out the specific approaches, which should be used to estimate expected credit losses, but stresses that the following factors should be taken into account:
- The entity should consider a range of possible outcomes, and the probability of credit losses, even if there is low probability.
- The entity should discount the expected credit losses to the reporting date using a discount rate that is between the risk-free rate and the effective interest rate for a financial asset, and the risk-free rate adjusted for specific risks for a loan commitment and financial guarantee contract.
- The entity should consider information that is reasonably available without undue cost and effort, including information about past events, current conditions, and reasonable and supportable forecasts of future events.
Changing from the incurred loss model to an expected credit loss model will require significantly more judgment when considering information related to the past, present and future. The entity can apply the ED on a collective basis, rather than on an individual basis, if the financial instruments share the same risk characteristics.
The proposed model relies on more forward-looking information, which means that any losses would be accounted for earlier than happens under the current rules.
However, there are still technical differences between the IASB's and the FASB's proposals. In spite of efforts by both to produce common rules, the difference in the proposals could lead to material differences in the financial statements if the current proposals are adopted. The transition costs in implementing the new model will be significant, particularly for financial institutions.
Graham Holt is an ACCA examiner, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School