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:
Thus, the expected credit loss is $3,471. This is recognised as the impairment loss thus creating an expense to be charged to profit or loss and offset against the carrying value of the financial asset on the statement of financial position.
Background to the proposals
In 2009, the IASB published an exposure draft (ED) that proposed adjusting for expected impairment 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 proposed removing interest adjustment from the recognition of impairment losses and adopting expected credit losses and this is the basis of the current ED issued in March 2013.
The ED applies to financial assets measured at amortised cost and at fair value through other comprehensive income. 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. This is a wider scope than at present.
The principle behind the ED is that financial statements should reflect the general pattern of deterioration or improvement in the credit quality of financial assets within the scope of the ED. The IASB new 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. 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.
On initial recognition, an entity would create a credit loss allowance/provision equal to 12-months' expected credit losses. In subsequent years, if the credit risk increased significantly since initial recognition, this amount would be replaced by an estimate of the lifetime expected credit losses. Financial assets with a low credit risk would not meet the lifetime expected credit losses criterion. An entity does not recognise lifetime expected credit losses for financial assets that are equivalent to 'investment grade', which means that the asset has a low risk of default. Under the proposed model, there is a rebuttable presumption that lifetime expected losses should be provided for if contractual cash flows are 30 days overdue. 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 entity can apply the ED on a collective basis, rather than on an individual basis, if the financial instruments share the same risk characteristics.
Two stage approach
On initial recognition
On the initial recognition of a financial asset an entity would recognise an impairment loss based on the 12-months' expected credit losses.
On subsequent review
Financial assets whose credit quality has not significantly deteriorated since their initial recognition; then the impairment loss is based on 12 months of expected credit losses.
Financial assets whose credit quality has significantly deteriorated since their initial recognition, then the impairment loss is based on a lifetime of expected credit losses.
Financial assets for which there is objective evidence of an impairment as at the reporting date, then the impairment loss is based on a lifetime of expected credit losses.
For trade receivables there is a simplified procedure in that no credit loss allowance is recognised on initial recognition. Any impairment loss will be the present value of the expected cash flow shortfalls over the remaining life of the receivables.
The proposed change from the incurred loss model to an expected credit loss model will require more judgment as the carrying value of financial assets will be dependent on considering more forward-looking information which means that any losses would be accounted for earlier than happens under the current rules.
Tom Clendon, FTMS