The IASB is proposing new regulations for the impairment of financial assets. This is a current issue that is examinable in Paper P2, Corporate Reporting.
Current regulation on the impairment of financial assets – the incurred loss approach
IAS 39, Financial Instruments: Recognition and Measurement (IAS 39), does not require financial assets classified at fair value through profit or loss (FVTP&L) and fair value through other comprehensive income (FVTOCI) to be subject to impairment reviews. Therefore impairment reviews are only required in respect of financial assets that are classified as amortised cost – for example, loans, debt securities and trade receivables. Please see 'Related links' for the articles that I have previously written explaining these terms and the basic principles of accounting for financial instruments.
IAS 39 states that a financial asset is impaired and impairment losses are incurred only if a loss event has occurred and this loss event had a reliably measurable impact on the future cash flows. This is often called the 'incurred loss' approach.
The incurred loss approach has the advantage of being fairly objective – there has to have been a past event – for example, an actual default or a breach of a debt covenant. This objectivity reduces the risk of profit smoothing by companies are they are unable to estimate anticipated future losses. However, the incurred loss model has attracted criticism because it can result in the overstatement of both assets and profits. Arguably the incurred loss approach was a contributory factor in the credit crunch.
Proposed regulation on the impairment of financial assets – the expected loss approach
The IASB has proposed a model where credit losses on financial assets are no longer recognised when incurred but rather, are recognised on the basis of expected credit losses. This is often called the 'expected loss' approach.
The expected loss approach 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. Arguably this method will be more prudent as both assets and profits will be reduced. It is however open to the criticism that allowing the judgment of what future losses might be incurred it will allow some companies to engage in profit smoothing.
Expected credit losses are defined as the expected shortfall in contractual cash flows. The estimation of expected credit losses should consider past events, current conditions and reasonable and supportable forecasts.
Example of the expected loss approach
The Bale company has a portfolio of $50,000 financial assets (debt instruments) that have two years to maturity and are correctly accounted for at amortised cost. Each asset has a coupon rate of 10% as well as an effective rate of 10%. No previous impairment loss has been recognised. At the year-end information has emerged that the sector in which the borrowers operate is experiencing tough economic conditions. It is now felt that a proportion of loans will default over the remaining loan period. After considering a range of possible outcomes, the overall rate of return from the portfolio is expected to be approximately 6% per annum for each of the next two years.
Calculate the expected credit losses on a life time basis.
The lender was expecting an annual return of $5,000 a year ($50,000 × 10%) but is now only expecting an annual return of $3,000 a year ($50,000 × 6%). There is therefore a shortfall – ie an expected credit loss shortfall of $2,000 per year. An allowance should be calculated at the present value of the shortfalls over the remaining life of the asset.
The discount rate used should be between the risk-free rate and the effective rate of the asset. In the absence of further information, the effective rate of 10% has been used in the calculations below: