Defining Issues September 2013, No

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proposed standards on financial instruments impairment and classification and measurement.

1 Defining Issues September 2013, No Redeliberations Begin on Impairment, Classification and Measurement of Financial Instruments At their September 2013 joint meeting, the FASB and IASB (the Boards) discussed their respective proposed standards on financial instruments impairment and classification and measurement. 1 For the proposed Accounting Standards Update on impairment (proposed impairment ASU), the FASB reached tentative decisions on: Measurement of expected credit losses; Time value of money; and Application guidance when assessing the future to develop forecasts. For the proposed Accounting Standards Update on classification and measurement (proposed classification and measurement ASU), the Boards tentatively made these decisions for purposes of the solely principal and interest (SPPI) condition: Contents Impairment Measurement of Expected Credit Losses 2 Time Value of Money 3 Meaning of principal; Meaning of interest; and Prepayment and other contingent features. We previously provided detailed information about the proposed impairment ASU and proposed classification and measurement ASU in Issues In-Depth Nos and 13-2, respectively. 2 Application Guidance When Assessing the Future to Develop Forecasts 4 Next Steps 4 Classification and Measurement Meaning of Principal 4 Meaning of Interest 5 Prepayment and Other Contingent Features 5 Next Steps 7 1 FASB Proposed Accounting Standards Update, Financial Instruments Credit Losses, December 20, 2012, and FASB Proposed Accounting Standards Update, Recognition and Measurement of Financial Assets and Liabilities, February 14, 2013, both available at IASB ED/2013/3 Financial Instruments: Expected Credit Losses, and IASB ED/2012/4, Classification and Measurement: Limited Amendments to IFRS 9 (2010), both available at 2 Issues In-Depth No. 13-1, Applying the FASB Proposed Model on Financial Asset Credit Losses, and Issues In-Depth No. 13-2, Applying the FASB Proposed Model for Classification and Measurement of Financial Instruments, both available at

Impairment Measurement of Expected Credit Losses When measuring expected credit losses, the FASB tentatively decided that: For periods beyond those reasonably and supportably forecasted, an entity

2 Impairment Measurement of Expected Credit Losses When measuring expected credit losses, the FASB tentatively decided that: For periods beyond those reasonably and supportably forecasted, an entity would revert to unadjusted historical average loss experience. The estimate of all contractual cash flows refers to the cash flows over the entire contractual term of the financial asset (i.e., the life of the asset). Expected prepayments would be considered. Extensions, renewals, and modifications would not be considered when estimating all contractual cash flows unless the entity reasonably expects that it will execute a troubled debt restructuring (TDR). An entity would not recognize an impairment allowance on a financial asset in which the risk of non-payment is greater than zero but the amount of loss would be zero. Background and Observations. The proposed impairment model would require that an estimate of expected credit losses be based on all relevant internal and external information, including information about past events, current conditions, and reasonable and supportable forecasts. It was unclear whether an entity would be required to forecast economic conditions over the entire life of a financial asset (e.g., forecasting economic conditions over 25 years for a newly originated 25-year loan). Concerns arose over the operationality of forecasting over the remaining life of an asset. Based on the tentative decision, an entity would update historical loss experience for current conditions and reasonable and supportable forecasts. Beyond this period, an entity would revert to unadjusted historical average loss experience. This differs from the answer provided by the FASB staff in its frequently asked questions (FAQ) document. 3 Additionally, an entity would disclose how it reverts to unadjusted historical average loss experience. 3 FASB Staff s Frequently Asked Questions, Proposed Accounting Standards Update, Financial Instruments Credit Losses, March 25, 2013, available at 2 / Defining Issues / September 2013 / No

3 The FASB reached a tentative decision to clarify that expected prepayments on an asset s expected life would be considered when determining the estimate of expected credit losses. To illustrate, assume an entity originates a 15-year mortgage loan that is expected to be prepaid in two years. Based on historical loss experience, the entity notes that the majority of losses for similar loans occurred in the fifth and sixth years. Current conditions and reasonable and supportable forecasts were considered but did not change the entity s estimate of when credit losses would occur. If the expected prepayment assumption of two years is considered, the entity s estimate of expected credit losses would be lower than if prepayment had not been considered. However, if the loan was expected to be prepaid in year ten, the estimate of expected credit losses would be higher given the entity s experience that the majority of losses occurs in years five and six. Prepayments would be considered because they are terms of the existing contractual arrangement. Extensions, renewals, and modifications that are not related to TDRs would not be considered because they are not terms of the existing contractual arrangement. In contrast, extensions or modifications related to TDRs would be considered because the FASB believes they are economic concessions granted in an effort by the entity to maximize its recovery on an existing credit. Questions arose about the FASB s intention that an estimate of expected credit losses always reflects both the possibility that a credit loss results and the possibility that no credit loss results. Based on the tentative decision, the estimate of expected credit losses should always reflect the risk of loss, even when the risk is remote. However an entity would not recognize an impairment allowance on a financial asset when the risk of non-payment is greater than zero but the amount of loss would be zero. To illustrate, assume an entity acquires a fully collateralized loan and believes there is a 20 percent risk of non-payment. However, the amount of loss if non-payment occurs is zero because the loan is fully collateralized. In this situation, no impairment allowance would be recognized. Time Value of Money The reference to explicitly or implicitly reflect the time value of money would be removed. A discounted cash flow (DCF) technique or other loss estimation methods would be acceptable for estimating expected credit losses. Background and Observations. The proposed impairment model would have required that an estimate of expected credit losses reflect the time value of money either explicitly or implicitly. Some constituents have a different view about what it means to implicitly reflect the time value of money and do not agree with the FASB that certain methods implicitly reflect the time value of money. The FASB tentatively decided that the DCF model, loss-rate method, probability-of-default method, and provision matrix using loss factors are acceptable methods to estimate expected credit losses. 3 / Defining Issues / September 2013 / No

4 Application Guidance When Assessing the Future to Develop Forecasts Application guidance on factors that management should consider when assessing current conditions and developing forecasts about the future would be included in the standard. Background and Observations. An estimate of expected credit losses would be based on all relevant internal and external information, including information about past events, current conditions, and reasonable and supportable forecasts. The guidance to be included in the ASU would largely leverage current banking regulatory guidance on qualitatively adjusting historical loss rates but would not be all inclusive. Next Steps The issues presented to the FASB were only for FASB decision making. The joint Board meeting gave each Board the opportunity to consider how the other would enhance its proposed model to address feedback. It is not clear whether convergence will be achieved. At a future meeting, the FASB will discuss the recognition of credit losses (i.e., recognizing losses at the date of origination or purchase, over the emergence period, or when there is significant credit deterioration). Classification and Measurement Meaning of Principal Principal would mean the amount that the current holder transferred to obtain the asset. Background and Observations. The proposed classification and measurement model requires an entity to determine whether the cash flows of a financial asset are SPPI to conclude if the asset should be measured at amortized cost or fair value through other comprehensive income (FV-OCI), rather than fair value through net income (FV-NI). Constituents asked the Boards to clarify the meaning of principal for the purpose of the SPPI condition as divergent views could result in different classification outcomes for particular instruments. For example, if principal were to be viewed literally as the contractually defined principal, a non-prepayable zero coupon bond would not meet the SPPI condition because it does not have a contractually stated principal amount upon which interest is computed. The Boards indicated that an investor would assess the SPPI condition by comparing the contractual cash flows to the amount that it actually invested. Thus, non-prepayable financial assets with off-market contractual interest rates and zero coupon bonds would be consistent with the SPPI condition, if they do not contain other payments that are not SPPI. This also would affect prepayable financial assets purchased at a deep discount or premium because the cash flows received upon prepayment (usually par or near par) would comprise something other than the amount transferred and interest at initial recognition. 4 / Defining Issues / September 2013 / No

5 Meaning of Interest The notion of interest was intended to capture financial assets with a basic lending-type return and would be comprised of compensation for the time value of money and credit risk, and also may consider liquidity risk, profit margin, and costs associated with holding the financial asset over time (e.g., servicing costs). The Boards also tentatively decided that: The objective of time value is to provide consideration for only the passage of time; The tenor of the interest rate and the currency of denomination are relevant factors in assessing time value; The time value assessment could be qualitative or quantitative; A fair value option in lieu of assessing time value would be prohibited; and Regulated interest rates would be acceptable as interest if not inconsistent with a basic lending-type return. Other features that could only have a de minimis effect on cash flows would not be inconsistent with the SPPI condition and thus would be ignored. The de minimis threshold relates to the magnitude of the impact that a feature could potentially have on the cash flows of a financial asset. This is different from the remote threshold related to contingent payments (see the section below), which relates to the probability of an event occurring. Background and Observations. Constituents have raised concerns about the meaning of interest in the context of the SPPI condition. The Boards believe that for amortized cost or FV-OCI to be an appropriate measurement basis, a financial asset s cash flow characteristics must reflect a basic lending-type return. This term is meant to capture originated and acquired financial assets where the lender or investor demands compensation for the passage of time and credit and liquidity risk. That return also could include a profit margin and costs associated with holding the financial asset over time. Despite agreeing to the individual items mentioned above, the FASB stated that it would need to consider these items conceptually in aggregate, and also specifically the time value of money to assess its operational feasibility. For example, the FASB questioned whether an entity would be able to: Determine that an interest rate tenor mismatch is consistent with the concept of solely in the SPPI condition; and Distinguish interest rate leverage features from profit margin and costs associated with holding the financial asset over time. Prepayment and Other Contingent Features An entity would analyze a financial asset containing prepayment or other contingent features by determining whether the cash flows resulting from the contingent event are SPPI, regardless of the nature of the triggering event. 5 / Defining Issues / September 2013 / No

For prepayment and other contingent features that would result in cash flows that are not SPPI, the FASB tentatively decided the non-sppi cash flows would be ignored if the likelihood of the related

6 For prepayment and other contingent features that would result in cash flows that are not SPPI, the FASB tentatively decided the non-sppi cash flows would be ignored if the likelihood of the related triggering event occurring is remote. Financial assets with contingent non-sppi cash flows that are classified as amortized cost or FV-OCI would be reclassified to FV-NI upon the contingent event becoming more likely than remote. Transfers out of the FV-NI would be prohibited. The IASB tentatively decided on different thresholds. Background and Observations. Constituents have expressed concerns that prepayment and other contingent features commonly contained in financial assets could be considered inconsistent with the SPPI condition. For example, constituents asked about a fixed-rate loan that resets only upon a change in control. This contingent reset feature would be consistent with the SPPI condition if the new rate reflects a basic lending-type return. Likewise, an interest rate on a financial asset that increases upon the credit deterioration of the issuer could be consistent with the SPPI condition even if the increase is considered punitive if the increase is consistent with market practice related to lending transactions. The Boards clarified that prepayment and term extension features should not be considered differently from other contingent features in the context of the SPPI condition. The FASB tentatively concluded that any contingent feature that resulted in non-sppi cash flows could be ignored only if the likelihood of the contingency is remote. Thus, an investor in a convertible bond would have to consider the fact that the bond is convertible into equity shares, unless it determined that the likelihood of conversion is remote. 6 / Defining Issues / September 2013 / No

7 Next Steps In contrast with the impairment discussion, the Boards redeliberated the same classification and measurement issues and reaffirmed their earlier tentative decisions, except where noted. However, the FASB will consider each of the individual tentative decisions in the aggregate to determine if this is a path that it would like to continue pursuing. In particular, the FASB staff will further analyze the operational issues in the U.S. capital markets related to the meaning of interest. It is not clear what interest and other features would be evaluated under the de minimis or remote tests such as an equity return on a debt instrument. We expect the Boards to clarify this at future meetings. Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Enrique M. Tejerina Michael A. Gaiso Danielle Imperiale Earlier editions are available at: The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standards or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity.

Defining Issues September 2012, No

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