Board Meeting Handout

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1 Board Meeting Handout Accounting for Financial Instruments Credit Losses on Financial Assets Recognized in the Fair Value-Other Comprehensive Income Category October 21, 2009 INTRODUCTION 1. The Board decided on July 15, 2009, to measure all financial instruments at fair value with changes in the fair value recognized in net income (FV-NI) or other comprehensive income (FV-OCI). For the financial assets that are categorized in the FV-NI category, an impairment model is not necessary. However, for financial assets in the FV-OCI category, the Board decided to recognize credit impairments separately on the face of the balance sheet and income statement. For the purposes of this handout, the term credit loss is used interchangeably with credit impairment. As a result, the need for a credit impairment calculation is limited to identifying an amount that is embedded in the overall change in fair value that would be attributed to the credit impairment and reported in the income statement. 2. The objective of today s meeting is to discuss the following credit impairment models that would identify a credit loss amount to be recognized in the income statement. See Table A for a summary of the following approaches: i. Approach A: Incurred Loss Model Based on the Approach Used in Subtopic , Troubled Debt Restructuring by Creditors, and Subtopic , Receivables Overall (formerly FASB Statement No. 114, Accounting by Creditors for Impairment of Loans an amendment of FASB Statements No. 5 and 15) ii. Approach B: Modified Incurred Loss Model iii. Approach C: Expected Loss Model (1) Approach C1: Through-the-Life Expected Loss Model with Variable Discount Rate The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations

2 (2) Approach C2: Through-the-Life Expected Loss Model with a Constant Discount Rate (IASB) (3) Approach C3: Near-Term Expected Loss Model iv. Approach D: Hybrid Incurred Loss/Expected Loss Model EXPECTED FUTURE CASH FLOWS AND IMPAIRMENT MEASUREMENT OBJECTIVE 3. It is important to differentiate between expected future cash flows and the impairment measurement objective for which those cash flows are used to calculate impairment. When people think of expected future cash flows, they generally think of fair value. When used in a credit impairment context, expected loss models generally come to mind. For impairment purposes, expected future cash flows are not used to determine the measurement impairment objective but instead are used to calculate the amount of impairment based on the objective of the impairment measurement. 4. A significant difference between how expected future cash flows are used in fair value models versus incurred or expected impairment loss models is that in fair value models the cash flows are based on current market expectations whereas in incurred or expected loss models the cash flows are generally based on management s expectations. 5. Under an incurred loss model, the entity s estimate of the expected future cash flows would be based on the entity s loss estimates resulting from the occurrence of an event or the probability of an event occurring and the probability that a loss has occurred as a result of the occurrence of an event or the probability of an event occurring. 6. Under an expected loss model, the entity s estimate of the expected future cash flows would be based on the entity s loss estimates resulting from a loss that has occurred as a result of the occurrence of an event or the probability of an event occurring as well as losses expected to occur over a future time horizon. 2

3 7. Under a fair value model, which would encompass more than just credit losses, the estimate of the expected future cash flows would be based on market expectations of the cash flows. APPROACHES 8. To facilitate the discussions on the six credit impairment models presented below, assume that Bank A has a portfolio of 100 loans at $1,000 each for $100,000 on January 1, X1. The contractual interest rate on the loans is 12 percent and the term is 10 years. Bank A expects to lose about 2 percent on the loans over the 10-year period, and earn a net yield of 10 percent on the portfolio of loans. Assume there are no discounts, premiums, costs or fees and that the loans are not prepayable. Approach A: Incurred Loss Model Based on the Approach Used in Subtopic Subtopic requires an entity to recognize an impairment loss on loans and debt securities if it is probable that a creditor will not be able to collect all amounts due according to the contractual terms of the loan agreement. The contractual cash flows refer to interest and principal cash flows in the contract. 10. Approach A requires a creditor to measure the impairment loss using the present value of the expected future cash flows discounted at the loan s effective interest rate (NPV). As a practical matter, the use of an observable market price of the loan or the fair value of collateral on the loan is permitted to be used as surrogates for the NPV. If the NPV (or practical expedient) is below the recorded investment in the loan, Approach A requires an impairment loss to be recorded by adjusting the valuation allowance and bad debt expense. 11. The expected future cash flows that are used in the incurred loss model under Approach A are the creditor s best estimate of cash flows using reasonable and supportable assumptions. 12. Approach A requires that the expected future cash flows be discounted using the loan s effective interest rate (EIR), which is the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan (that is, 12 percent in the scenario above). 3

4 13. For variable rate loans for which the contractual interest rate is based on an index such as the London Interbank Borrowing Rate (LIBOR) or U.S. Treasury Bill Rate (T-bill), Approach A permits the creditor to use either a variable EIR as the index changes or a fixed EIR determined as of the date the loan became impaired. 14. The income statement under Approach A would show separately the interest income at 12 percent of the recorded investment and the credit impairment expense at each reporting period. The balance sheet under Approach A shows the recorded investment (less any direct charge-offs) separately from the allowance for loan losses at each reporting period to arrive at the NPV. Approach B: Modified Incurred Loss Model 15. Approach B embodies the same principles as Approach A above except that this approach would recognize all incurred losses regardless of any threshold. In other words, all credit losses, including remote, reasonably possible and probable, would be recognized under Approach B but only probable credit losses would be recognized under Approach A. 16. Impairment would be measured as the present value of management s current estimate of cash flows not expected to be collected (that is, decrease in NPV at each reporting date). The estimate of the expected future cash flows would be based on all available information relating to past events and existing conditions that are relevant to the collectability of the financial asset(s), such as the remaining payment terms, the financial condition of the issuer, expected defaults, and collateral values, as well as existing environmental factors, such as industry, geographical, economic and political data, that indicate that some contractual cash flows are not expected to be collected. The entity would not consider possible future scenarios. 17. The discount rate under Approach B is the same as discussed under Approach A above (the effective interest rate that is 12 percent in the scenario above). 18. Approach B would also recognize interest income at the 12 percent contractual effective interest rate on the recorded investment in the loans and present that interest income separately from any credit losses on the face of the income statement. The amount and timing of interest income recognition under Approach B is identical to that in Approach A, as described above. 4

5 19. Under this approach, all losses would be recognized separately on the face of the income statement. It is interesting to note that the amount of credit losses that would be recognized could be lumpier in Approach B than any of the other approaches, other things being equal. 20. The balance sheet under Approach B would show identical information to that in Approach A above except that the allowance for loan losses in Approach B would be higher (including remote and reasonably possible losses) than in Approach A. Approach C: Expected Loss Model 21. Theoretically, an expected loss model is based on the way in which a lender would price a loan or portfolio of loans. If an entity wanted to achieve a certain return on a portfolio of loans, it would estimate the amount of expected losses and price the loans at an amount that would enable it to hopefully achieve that return. Such an approach would require the entity to look out over the life of the loans and develop loss forecasts based on changing credit factors, macroeconomic factors, and other factors. Expected losses would be reforecasted on a regular basis with expected yields on the portfolio changing as loss expectations change. Approach C1: Through-the-Life Expected Loss Model with Variable Discount Rate 22. Under this expected loss model, the entity estimates the expected future cash flows over the entire life of the portfolio of loans. Like all the other expected loss models, the expected future cash flows under Approach C1 reflect both current and future credit loss expectations without the use of any threshold or particular loss event(s). 23. The discount rate used in Approach C1 is the revised net effective interest rate after deducting future credit loss expectations at each reporting period. One reason for using the net EIR rather than the gross EIR is because the expected future cash flows already reflect the expected credit losses. 24. Under this approach, the amount of interest income reflected in the income statement each period would represent the rate of return the lender expects to receive over the life of the loans. This can be further clarified through the following example. The interest income separately recognized on the income statement under approach C1 5

6 reflects the gross contractual interest rate of 12 percent on the carrying value of the portfolio of loans (that is, recorded investment less cumulative allowance for loan losses). The amount of interest income recognized under Approach C1 would vary from year to year and would be lower compared to those in Approaches A and B because the carrying value tends to be lower than the recorded investment. 25. The change in NPV from one period to the other is the credit losses separately presented on the face of the income statement under Approach C1. The balance sheet under Approach C1 reflects the loan amount less cumulative credit losses to arrive at the NPV at each reporting period. Approach C2: Through-the-Life Expected Loss Model with a Constant Discount Rate (IASB Model) 26. The expected future cash flows under Approach C2 are based on the same principles as outlined under Approach C1. One difference between expected future cash flows under Approaches C1 and C2 lies in the extent of the credit loss recognized and its effect on the carrying value and thus interest income cash flows. 27. Unlike Approach C1 in which the discount rate would start at the net EIR and be revised at each reporting period, Approach C2 would keep the EIR constant (that is, 10 percent in the above scenario) in discounting future cash flows. 28. Consistent with Approach C1, interest income under Approach C2 is computed at the carrying value of the portfolio of loans and recognized separately on the face of the income statement. This differs from Approach C1 as a result of the differences in the carrying values on which the interest income is computed or based. 29. The balance sheet under Approach C2 is also similar to that in Approach C1 in that the loan amount is recognized separately along with the cumulative credit losses to arrive at the NPV. The key differences between Approaches C1 and C2 result from the differences in the discount rates and amount of credit loss recognized in each period. 30. This expected loss approach also reflects a through-the-life notion similar to Approach C1 except that (a) the discount rate under this approach would remain constant at the net interest rate at each reporting period for fixed-rate instruments and would not be revised to a new EIR and (b) interest income return would remain 6

7 constant at the net interest rate each period unless an incremental current loss event occurs to reduce the rate of return. 31. For variable-rate instruments for which the discount rate could vary from one period to the other, a cumulative effect adjustment (NPV using old discount rate less new NPV using new discount rate) would be reflected in the income statement in the period of the change in the discount rate. The new discount rate would then be used prospectively to determine the NPV under this model. Approach C3: Near-Term Expected Loss Model 32. Approach C3 recognizes the practical difficulty of estimating expected losses and expected future cash flows over the life of the loan portfolio and instead uses a shorter forecast period such as 12 to 24 months. The principles of the expected loss approach hold true for Approach C3 except for the shortened loss projection time period resulting in entities assuming zero expected losses beyond the forecast period. Like Approach C1, the discount rate is revised at each reporting period to reflect the effective interest rate implicit in the loan given expected future cash flows and loss estimates. 33. The interest income under Approach C3 is computed at the gross interest rate of the carrying value of the loans at the beginning of the reporting period. Interest income would be recognized separately on the income statement similar to Approaches C1 and C2. The credit losses would be computed at the change in NPV from one period to another and separately recognized in the income statement. 34. The balance sheet presentation is similar to Approaches C1 and C2 in that an entity would present the gross loan amount separately with the appropriate allowance for credit losses and the NPV on the face of the balance sheet. Approach D Hybrid Incurred Loss/Expected Loss Model 35. The hybrid incurred/expected loss model (a) recognizes interest income at the contractual rate times the recorded investment (less any charge-offs), similar to the incurred loss approaches, (b) uses the near-term expected loss notion of Approach C3 by forecasting expected losses over the foreseeable future (12 to 24 months), and (c) 7

8 uses a constant discount rate equal to the contractual effective interest rate (that is, 12 percent in the scenario above). Impairment Model Q. Which model should be used for calculating the amount of credit impairment to recognize in the income statement for financial assets classified in the FV-OCI category? 8

9 Table A Summary of Alternative Credit Impairment Models Credit Impairment Objective Current Incurred Loss model (Approach A) Present Value (PV) of current estimate of cash flows below recorded investment Modified Incurred Loss Model (Approach B) PV of current estimate of cash flows not expected to be collected Through the Life Expected Loss Model (Approaches C1 and C2) Near Term Expected Loss Model (Approaches C3 and D) Expected credit losses Expected credit losses Level of Aggregation Portfolio or loan by loan Portfolio or loan by loan Portfolio Portfolio or loan by loan Threshold Probable None None None When Is Credit Loss Recorded? (Trigger) When PV or fair value is below recorded investment Discount Rate Fixed Effective Interest Rate (EIR) at impaired date, or Variable EIR over time At each reporting period as factors indicate that cash flows may have changed At each reporting period At each reporting period Same as SFAS 114 discount rate Approach C2 Fixed rate instruments: Constant EIR determined at inception (net of credit losses) Variable rate instruments: Updated EIR Approach C1: Current EIR as determined at each reporting period (net of credit losses) Approach C3 Current EIR as determined at each reporting period (net of credit losses) Approach D Same as SFAS 114 discount rate 9

10 Recoveries Allowed but cannot exceed recorded investment Change in estimate through Bad Debt Expense but cannot exceed Recorded Investment Inherent in the calculation Inherent in the calculation Expected Future Cash Flows Included Credit Losses Included in the Calculation Entity specific best estimate of cash flows based on past events that result in a loss being probable of occurring Only probable credit losses are included Entity specific best estimate of cash flows based on all available information relating to past events Entity specific best estimate of cash flows over the life of the financial asset(s) All credit losses All credit losses expected over the life of the portfolio Time Horizon Current period only Current period only Through the life of the instrument Entity specific best estimate of cash flows based on all available information relating to past events and events expected to occur in the near term All credit losses expected over a near term time horizon (12 to 24 months) Near term (12 to 24 months) Day 1 Gain/Loss No No No No 10