Financial instruments: expected credit losses

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Financial instruments: expected credit losses Exposure draft issued by the International Accounting Standards Board (IASB) Comments from ACCA to IASB July 2013 ACCA (the Association of Chartered

1 Financial instruments: expected credit losses Exposure draft issued by the International Accounting Standards Board (IASB) Comments from ACCA to IASB July 2013 ACCA (the Association of Chartered Certified Accountants) is the global body for professional accountants. We aim to offer business-relevant, first-choice qualifications to people of application, ability and ambition around the world who seek a rewarding career in accountancy, finance and management. We support our 162,000 members and 426,000 students in 173 countries, helping them to develop successful careers in accounting and business, with the skills needed by employers. We work through a network of 89 offices and centres and more than 8,500 Approved Employers worldwide, who provide high standards of employee learning and development. Further information about ACCA s comments on the matters discussed here can be sent to: Richard Martin Head of Corporate Reporting, ACCA Richard.Martin@accaglobal.com 1

2 ACCA welcomes the opportunity to comment on the exposure draft (ED) issued by IASB. The ED has been considered by ACCA s Corporate Reporting Global Forum and the answers reflect the views of this group of members from across the world. KEY MATTERS This standard is written for banks and other financial companies, but will be applied by much larger numbers of commercial and industrial companies mainly to their trade receivables. This makes it much more complex to understand and the disclosures proposed are excessive for the majority of companies. This should be remedied by either rewriting with the primary focus on the majority of companies, or by a separate standard for trade receivables. The model for impairment proposed in this ED lacks a clear principle and this means that the application is likely to be inconsistent and subjective. Given that a proper expected loss model seems to be very difficult to implement in practice, ACCA would prefer to retain the current incurred loss model which is less subjective and does contain a clear principle that can be applied across the piece. An incurred loss model in the new IFRS9 however should be modified from the present IAS39 version, by making it clear that losses that have been incurred but have not yet been reported as defaults should be recognised and that losses can occur before debtors actually default on repayments. SPECIFIC COMMENTS Question 1 (a) Do you agree that an approach that recognises a loss allowance or provision at an amount equal to a portion of expected credit losses initially, and full expected credit losses only after significant deterioration in credit quality, will reflect: (i) the economic link between the pricing of financial instruments and the credit quality at initial recognition; and (ii) the effects of changes in the credit quality subsequent to initial recognition? If not, why not and how do you believe the proposed model should be revised? 2

3 We do not agree with the proposed model as indicated above. We agree with the alternative view that the proposal lacks any clear principle underlying it. Our reservations about the proposals are the recognition of the 12 month expected losses as the portion is an arbitrary boundary lacking a clear principle leads to the exemptions proposed for trade receivables, investment-grade assets and credit-impaired assets and an option for lease receivables the distinction between twelve month loss provision (TML) and the lifetime expected loss provision (LEL) will lead to volatility which is not always reflective of the economic substance the TML/LEL boundary will be a subjective judgemental area which will give rise to inconsistent application in practice TML losses will give some counter-intuitive results. In the example of listed debt instruments at fair value through other comprehensive income (FVOCI) there may be Day 1 impairments in the profit and loss account which are not reflected in market values and so then reversed by a gain in OCI. In response to the 2009 exposure draft we accepted the move from incurred to expected loss model on balance, in part because it better reflected the economics of the borrowing rate and expectation of losses. We note that conceptually this remains the IASB s preferred treatment. This pure expected loss model has turned out to be not capable of practical application. In that case our preference would be to return to the incurred loss model which has a clear principle underlying it and has we believe a lesser degree of judgement involved in it than any expected loss model. The potential for earnings management by banks and others will be less. Any incurred loss model in IFRS9 should however remedy the shortcomings in IAS39 that have been exposed by the financial crisis. It should therefore clearly require that losses should include the incurred but not reported (IBNR) element and that there will often be objective evidence of loss before any default in repayments occurs. The incurred loss model does quite clearly signal a change in the value of the receivables in the period in which they occur. (b) Do you agree that recognising a loss allowance or provision at an amount equal to all expected credit losses from initial recognition, discounted using the original effective interest rate, does not faithfully represent the underlying economics of financial instruments? If not, why not? The proposals for the full lifetime expected loss from FASB do represent a clear principle, but we consider it is the wrong one. While the position of the balance 3

4 sheet under that model is clear the resulting measure of performance is not appropriate by tending to understate income in the earlier years of a loan and make any significant deterioration in the value of the loans less evident. As noted above we prefer an incurred loss (including IBNR) model. Question 2 (a) Do you agree that recognising a loss allowance (or provision) at an amount equal to 12-month expected credit losses and at an amount equal to lifetime expected credit losses after significant deterioration in credit quality achieves an appropriate balance between the faithful representation of the underlying economics and the costs of implementation? If not, why not? What alternative would you prefer and why? (b) Do you agree that the approach for accounting for expected credit losses proposed in this Exposure Draft achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than the approaches in the 2009 ED and the Supplementary Document (without the foreseeable future floor)? (c) Do you think that recognising a loss allowance at an amount equal to the full lifetime expected credit losses from initial recognition, discounted using the original effective interest rate, achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than this Exposure Draft? As noted above we prefer an incurred loss (including IBNR) model. However if the proposed partial expected loss model is proceeded with then one of the advantages is that the move from TML to LEL will provide a clear signal of a significant change in the values of the receivables. We would prefer that to the full LEL model. Question 3 (a) Do you agree with the proposed scope of this Exposure Draft? If not, why not? (b) Do you agree that, for financial assets that are mandatorily measured at FVOCI in accordance with the Classification and Measurement ED, the accounting for expected credit losses should be as proposed in this Exposure Draft? Why or why not? We agree with the proposed scope. We agree that financial guarantee contracts though they are potential liabilities not assets should be within the scope of 4

5 impairment in IFRS9 as the value of the liability should be measured by the impairment of the guaranteed asset. We also agree that FVOCI assets should be within scope, despite some potentially confusing results of the interaction of changes in fair value and impairments. Having one model of impairment for both items at amortised cost and FVOCI would be a significant improvement. Question 4 Is measuring the loss allowance (or a provision) at an amount equal to 12- month expected credit losses operational? If not, why not and how do you believe the portion recognised from initial recognition should be determined? We note that the TML model is similar albeit not identical to the loan loss provision requirements of some regulators in the banking and insurance industries. This should help to make it operational. Question 5 (a) Do you agree with the proposed requirement to recognise a loss allowance (or a provision) at an amount equal to lifetime expected credit losses on the basis of a significant increase in credit risk since initial recognition? If not, why not and what alternative would you prefer? (b) Do the proposals provide sufficient guidance on when to recognise lifetime expected credit losses? If not, what additional guidance would you suggest? (c) Do you agree that the assessment of when to recognise lifetime expected credit losses should consider only changes in the probability of a default occurring, rather than changes in expected credit losses (or credit loss given default ( LGD ))? If not, why not, and what would you prefer? (d) Do you agree with the proposed operational simplifications, and do they contribute to an appropriate balance between faithful representation and the cost of implementation? (e) Do you agree with the proposal that the model shall allow the reestablishment of a loss allowance (or a provision) at an amount equal to 12- month expected credit losses if the criteria for the recognition of lifetime expected credit losses are no longer met? If not, why not, and what would you prefer? 5

6 As noted above we prefer an incurred loss (including IBNR) model. However if the proposed partial expected loss model is proceeded with we have views on the matters raised as follows. (a) As noted above, moving to full LEL when there is a significant deterioration in credit quality will communicate to users that a loss is likely to take place or has already done so. Clearly the effect could be very material for some types of assets and so consistent application of the crossing of this bright line will be both important but likely to be difficult. We expect that the 30 day rebuttable presumption is not going to be very appropriate in some jurisdictions. (b) There seems sufficient guidance in B20 on pages 38 and 39 which we would generally agree with. We are not sure that on its own B20 (a)(iii) is a very helpful indicator. We think there should be more guidance on how the fair value changes should be dealt with vis-à-vis the profit and loss for the year and OCI. It is not very clear how much the Examples 3 to 8 on pages 66 to 74 are realistic and helpful. (c) We agree it should be the changes in the probability of default which should determine the move from Stage 1 to Stage 2. Changes in the extent of the loss given default should be reflected in the measure of TML or LEL. (d) As noted above though these seem operationally useful simplifications, the exception for changes in credit risk on investment grade assets simply points up that there is no proper principle involved here. (e) Yes. It seems reasonable to allow assessments of significant changes in credit quality to move in either direction. Question 6 (a) Do you agree that there are circumstances when interest revenue calculated on a net carrying amount (amortised cost) rather than on a gross carrying amount can provide more useful information? If not, why not, and what would you prefer? (b) Do you agree with the proposal to change how interest revenue is calculated and presented for assets that have objective evidence of impairment subsequent to initial recognition? Why or why not? If not, for what population of assets should the interest revenue calculation and presentation change? (c) Do you agree with the proposal that the interest revenue approach shall be symmetrical (i.e. that the calculation can revert back to a calculation on the 6

7 gross carrying amount)? Why or why not? If not, what approach would you prefer? We agree that no useful purpose is served by recognising interest income (including the unwinding of discount rates) on loans where default is expected, only to have to increase the impairment charge as a result. We would favour the net position for these loans. Where interest has been received in cash then separate recognition should be required. We agree that the treatment of interest revenue should be capable of being reversed from the net to the gross basis if conditions change. Question 7 (a) Do you agree with the proposed disclosure requirements? Why or why not? If not, what changes do you recommend and why? (b) Do you foresee any specific operational challenges when implementing the proposed disclosure requirements? If so, please explain. (c) What other disclosures do you believe would provide useful information (whether in addition to, or instead of, the proposed disclosures) and why? As noted in our preliminary observations in matters of disclosure this ED seems to have been written for banks whereas the majority of the companies applying it will not be banks and they will have mostly short term investments and trade receivables. For banks these credit loss estimations will often be the most significant aspect of the financial statements and the effect on the bank s performance fundamental. The disclosures suggested seem reasonable in that context. For other entities who will be principally applying the standard to trade receivables and to investment grade debt instruments the disclosure requirements are excessive, in particular those in paragraphs 41 and 44. The IASB seemed to have espoused, for example at the conference in January 2013 and in the Chairman s ten point action plan, the idea that the disclosures in annual financial statements may be excessive. This proposed standard in contrast would add significantly to the checklist. Question 8 7

8 Do you agree with the proposed treatment of financial assets on which contractual cash flows are modified, and do you believe that it provides useful information? If not, why not and what alternative would you prefer? We agree. Question 9 (a) Do you agree with the proposals on the application of the general model to loan commitment and financial guarantee contracts? Why or why not? If not, what approach would you prefer? (b) Do you foresee any significant operational challenges that may arise from the proposal to present provisions arising from expected credit losses on financial guarantee contracts or loan commitments as a separate line item in the statement of financial position? If yes, please explain. The application of the 12 month model to loan commitments may not always be easy as the amount expected to be drawn may not be certain let alone the credit losses on any portion drawn. Question 10 (a) Do you agree with the proposed simplified approach for trade receivables and lease receivables? Why or why not? If not, what changes do you recommend and why? (b) Do you agree with the proposed amendments to the measurement on initial recognition of trade receivables with no significant financing component? If not why not and what would you propose instead? As explained we think there are good reasons why the proposals for trade receivables might be presented in a separate standard, or the current ED should be rewritten. The fact that the majority of companies applying this standard will be applying an exception to the general model points this up rather clearly. As noted above we prefer an incurred loss (including IBNR) model. However if the proposed partial expected loss model is proceeded with then we agree that trade receivables should not be dealt with by the three stage model starting with TML but should go straight to an LEL basis. This is a clear principle which will be able to be well understood. The issue of this being different in principle from the impairment of loan receivables might be more apparent than real given that the lifetime will most often be less than 12 months. We do not agree that there should be optional accounting treatments in regard to trade receivables where there is a financing component and to lease receivables. 8

9 Alternative accounting treatments are an inherently undesirable feature as they go against the overall purpose of accounting standards. These receivables should be dealt with under the main model. Question 11 Do you agree with the proposals for financial assets that are credit impaired on initial recognition? Why or why not? If not, what approach would you prefer? As noted above we prefer an incurred loss (including IBNR) model which would not need any special treatment for such credit impaired assets. However if the proposed partial expected loss model is proceeded with then a full LEL model and recognition of interest on the credit adjusted effective interest rate would seem most relevant. Question 12 (a) What lead time would you require to implement the proposed requirements? Please explain the assumptions that you have used in making this assessment. As a consequence, what do you believe is an appropriate mandatory effective date for IFRS 9? Please explain. (b) Do you agree with the proposed transition requirements? Why or why not? If not, what changes do you recommend and why? (c) Do you agree with the proposed relief from restating comparative information on transition? If not, why? We agree with the restatement proposals. We would like to see co-ordination of the whole of IFRS9 and IFRS4 replacement in respect of the mandatory date of application. Significant changes to systems may be required in many cases. So an application date at least two years after publication seems reasonable. There should be early application allowed. Question 13 Do you agree with the IASB s assessment of the effects of the proposals? Why or why not? While clearly this is not a normal cost/benefit analysis, we agree with the assessment of effects on the basis adopted. 9

Response to the IASB Exposure Draft Financial Instruments: Expected Credit Losses

Response to the IASB Exposure Draft Financial Instruments: Expected Credit Losses 14 June 2013 CA House 21 Haymarket Yards Edinburgh EH12 5BH enquiries@icas.org.uk +44 (0)131 347 0100 icas.org.uk Direct: