pwc.com/ifrs Practical guide to IFRS Exposure draft on impairment of financial assets Contents: At a glance Background 2 The proposed IASB model 3 Next steps 12 Appendix Comparison between the IASB s and the FASB s proposals 14 In March 2013, the IASB issued an exposure draft (ED), Financial instruments: Expected credit losses. This is a result of several years of discussions and follows two previously published impairment proposals. The ED outlines an expected loss model that will replace the current incurred loss model of IAS 39, Financial instruments: Recognition and measurement. It seeks to address the criticisms of the incurred loss model and, in particular, that it caused impairment losses to be recognised too little and too late. It is expected that impairment losses will not only be larger but will also be recognised earlier. This practical guide summarises the key proposals and their implications, including a comparison with the FASB impairment proposals and IAS 39. At a glance weighted approach and they take into account the time value of money. The calculation is not a best-case or worstcase estimate. Rather, it should incorporate at least the probability that a credit loss occurs and the probability that no credit loss occurs. As an exception to the general model, an entity does not recognise lifetime expected credit losses for financial instruments that are equivalent to investment grade. Interest income is calculated using the effective interest method on the gross carrying amount of the asset. But, once there is objective evidence of impairment (that is, the asset is impaired under the current rules of IAS 39), interest is calculated on the net carrying amount (that is, after recognising any loss allowance). Under the proposed model, an entity should recognise a loss allowance on a financial instrument equal to a 12- month expected credit loss; or, if the credit risk on the financial instrument has increased significantly since initial recognition, an entity should recognise a lifetime expected credit loss. 12-month expected credit losses are all cash flows not expected to be received over the life of the financial instrument ( cash shortfalls ) that result from default events that are possible within 12 months after the reporting date. Lifetime expected credit losses are cash shortfalls that result from all possible default events over the life of the financial instrument. Expected credit losses are determined using an unbiased and probability- The proposal includes a simplified approach for trade and lease receivables. An entity should measure the loss allowance at an amount equal to the lifetime expected credit losses for short-term trade receivables. The same measurement basis is available as an alternative to the general model (accounting policy choice) for longterm trade receivables and lease receivables. A different model is required for purchased or originated creditimpaired assets. The comment deadline is 5 July 2013. The IASB expects to finalise the impairment requirements by the end of 2013.
Background During the financial crisis, the G20 tasked global accounting standard setters to work intensively towards the objective of creating a single high-quality global standard. As a response to this request, the IASB and the FASB began to work together on the development of new financial instruments standards. The IASB decided to accelerate its project to replace IAS 39, and sub-divided it into three main phases: classification and measurement; impairment; and hedging. Macro hedging is being considered as a separate project. The IASB completed the first phase of this project (classification and measurement) for financial assets in November 2009 and for financial liabilities in November 2010. In late 2011, the IASB decided to consider limited amendments to the classification and measurement model in IFRS 9, and published the ED on these limited amendments at the end of November 2012 (see straight away 101, IASB proposes limited modifications to IFRS 9 ). As part of this project, the IASB issued its first impairment ED in 2009. At that time, the IASB proposed that an entity should measure amortised cost at the expected cash flows discounted at the original credit-adjusted effective interest rate. As a result, interest revenue would be recorded net of the initial expected credit losses. Although constituents supported the concept, they raised serious concerns about its operationality. The FASB published its proposed Accounting Standard Update in 2010, with the objective of ensuring that the loss allowance balance reflected all estimated credit losses for the remaining lifetime of the asset. Feedback received by the IASB and FASB urged a converged model for impairment. As a result, the boards jointly issued a supplementary document to their individual ED in 2011. This document suggested that an entity should divide its financial assets into two subgroups: a good book and a bad book. The loss allowance for the good book would be calculated at the greater of: a time-proportionate loss allowance; and expected credit losses for the foreseeable future. The loss allowance for the bad book would be determined based on full lifetime expected credit losses. Respondents did not support the model set out in the supplementary document. They did not see the conceptual merit in requiring two different impairment calculations for the good book and they found it operationally complex. After receiving these responses, the boards continued to work together on the development of a new model (the threebucket model) that reflects the general pattern of deterioration in credit quality of a financial instrument. During the summer of 2012, the FASB decided to develop a different model to the three-bucket model. This decision was taken as a result of feedback received by the FASB that raised concerns about the lack of clarity around the key terms of the three-bucket model. The FASB has now developed a single measurement model that recognises a loss allowance for all expected credit losses on financial instruments. The FASB issued its ED on the Current Expected Credit Loss (CECL) model in December 2012. Comments on this ED are due by 31 May 2013. The IASB also performed outreach while developing the three-bucket model and the feedback supported a model that differentiates between financial instruments that have suffered a significant deterioration in credit quality since initial recognition and financial instruments that have not. But participants emphasised that benefits of the information provided should outweigh the cost of determining which financial instruments have deteriorated in credit quality. Based on the feedback received, the IASB modified the three-bucket model proposals, in particular, the requirements as to when a financial instrument s loss allowance should be measured at an amount equal to lifetime expected credit losses. The IASB issued its ED in early March 2013. Comments on the ED are due to the IASB by 5 July 2013. The IASB aims to finalise the impairment standard by the end of 2013. 2
The proposal does not specify its effective date, but is seeking comments on the appropriate mandatory effective date for all phases of IFRS 9. observation: Currently we do not have a converged model with each board exposing different models. The FASB s ED was issued in December 2012, with a recently extended comment period to 31 May 2013, and the IASB's ED was published in March 2013 with a comment period to 5 July 2013. These timing differences could present challenges for those who plan on responding to both proposals. As a result, constituents that are expected to be significantly affected by the proposed changes should start evaluating them now. Convergence is one of the principal objectives of a wide range of interested parties and, as a result, both boards have been urged to work together to develop a converged impairment model. Our expectation is that the boards will jointly discuss the comments received on their respective proposals after the comment periods end. The proposed IASB model Scope The proposed model should be applied to: financial assets measured at amortised cost under IFRS 9; financial assets measured at fair value through other comprehensive income under the ED Classification and measurement: Limited amendments to IFRS 9 ; loan commitments when there is a present legal obligation to extend credit, except for loan commitments accounted for at fair value through profit or loss under IFRS 9, financial guarantee contracts within the scope of IFRS 9 and that are not accounted for at fair value through profit or loss; and lease receivables within the scope of IAS 17, Leases. observation: The proposed impairment model is applicable not only for financial assets (currently accounted for under IAS 39) but also for certain loan commitments and financial guarantees that are currently accounted for under IAS 37, Provisions, contingent liabilities and contingent assets. The board included these in the scope of the ED because entities manage credit risk for all these financial instruments in the same way. General model Under the ED, an entity should measure the expected credit losses for a financial instrument at an amount equal to 12- month expected credit losses if the credit risk of the financial instrument has not increased significantly since initial recognition. However, lifetime expected credit losses are required to be provided for if, at the reporting date, the credit risk of the financial instrument has increased significantly since initial recognition. Twelve-month expected credit losses do not represent the cash shortfalls only expected to occur in the 12-month period after the reporting date. Rather, they equate to the present value of all cash shortfalls expected to occur over the remaining life of the instrument resulting from default events on the financial instrument that are possible within the 12-month period after the reporting date. observation: The IASB has not defined the term default event. This is a critical term for the measurement of expected credit losses. Although illustrative examples are provided in the ED, judgement will be required when applying the model. This measure of 12-month expected credit losses in the ED is not identical to 12-month expected credit losses as defined in regulatory (such as Basel) calculations. Both the probability of a default and the loss given default are calculated differently. Entities might want to use the systems they have developed for regulatory purposes and make appropriate adjustments to arrive at the IFRS figure. See further discussion later. 3
In contrast, the lifetime expected credit loss represents the present value of all cash shortfalls expected to occur over the remaining life of the asset, regardless of when the default event is expected to occur. Cash shortfalls (the credit loss), referred to in the previous two paragraphs, are defined as the present value of the difference between all contractual cash flows that are due to an entity and cash flows that the entity expects to receive. observation: The ED proposes a model that reflects the general pattern of deterioration in credit quality of a financial instrument. As a result, the recognition of full lifetime expected credit losses does not occur on initial recognition. The loss allowance is recorded at the 12-month expected credit loss at initial recognition and continues to be measured on this basis until a trigger is met (that is, a significant increase in credit risk). Once the trigger is met, the loss allowance is measured based on lifetime expected credit losses. A different model is applied to purchased or originated credit-impaired assets (see further discussion below). The most significant difference between the IASB s proposed model and the FASB s CECL model relates to the timing of when an entity recognises a lifetime expected credit loss. The CECL model requires an entity to provide for the full lifetime expected credit losses on initial recognition of a financial instrument. This measurement basis does not change throughout the life of the instrument. The IASB s model is a dual measurement model and the FASB s model is a single measurement model. observation: Both the IASB s model and the FASB s CECL model represent a significant change from current practice. Both boards have moved away from an incurred loss model and adopted an expected loss model. Both the FASB and IASB models require the recognition of a day one impairment loss in the profit or loss account. This loss will be lower under the IASB s model (12- month expected credit losses) than the FASB s model (full lifetime expected credit losses). Some might argue that the recognition of any day one loss does not reflect the economics of the transaction if financial assets have been priced on origination at current market interest rates that appropriately reflect the risk of loss. Also, it means that financial assets are initially recorded at an amount which is lower than fair value. Assessment of change in credit risk The IASB s dual measurement model requires an entity to assess the point at which it is required to transfer a financial instrument from the 12-month expected credit loss measurement to the lifetime expected credit loss measurement. Under the ED proposals, this transfer point is met when the credit risk of a financial instrument has increased significantly since initial recognition. Where credit risk subsequently reduces to a point where there is no longer a significant increase in credit risk since initial recognition an entity should transfer from the lifetime expected credit loss measurement to the 12-month expected credit loss measurement. observation: The IASB has not defined the term significant when assessing the change in credit risk or specified the amount of change in probability of a default that would require the recognition of lifetime expected credit losses. Although illustrative examples are provided in the ED, judgement will be required when applying the model. When considering the magnitude of a change in credit risk, entities should use probabilities of a default rather than the change in expected credit losses. When performing this assessment, an entity should compare the probability of a default on the instrument as at the reporting date with the probability of a default on the instrument as at initial recognition. Generally speaking, the lifetime probability of a default (over the remaining life of the instrument) should be used. But, as a practical expedient, in order to use other information used by an entity (that is, for regulatory purposes), a 4
12-month probability of a default can be used if it would not lead to a different assessment. observation: The ED allows entities to make the assessment of change in credit risk by using a 12-month probability of a default, but this does not mean that the 12-month probability of a default used for regulatory purposes can be used without any adjustment. Twelve-month regulatory expected credit losses are normally based on through the cycle probabilities of a default and can include an adjustment for prudence. But probabilities of a default used for the ED should be point in time probabilities of a default and the IASB favours the principle of neutrality over the regulatory principle of prudence. However, regulatory probabilities of a default are a good starting point, provided they can be reconciled to IFRS probabilities of a default. Entities should be aware that a simple or absolute comparison of probabilities of a default at initial recognition and at the reporting date is not appropriate. All other things staying constant, the probability of a default of a financial instrument should reduce with the passage of time. So, an entity needs to consider the relative maturities of a financial instrument at inception and at the reporting date when comparing probabilities of a default. In other words, the probability of a default for the remaining life of the financial asset at the reporting date (for example, two years if three years have already passed on a fiveyear instrument) should be compared to the probability of a default expected at initial recognition for the last two years of its maturity (that is, for years 4 and 5). Entities might find this requirement operationally challenging. When determining whether the credit risk on an instrument has increased significantly, an entity should consider the best information available, including actual and expected changes in external market indicators, internal factors and borrower-specific information. The factors to be considered are listed in the ED s application guidance (paragraph B20) and include: changes in external market indicators (such as credit spreads); changes in current and expected external and internal credit ratings; changes in internal price indicators for credit; existing or forecast changes in business, financial or economic conditions that are expected to cause a change in a borrower s ability to meet its debt obligations; and changes in operating results of the borrower. The information used should not only reflect past events and current conditions, but should also include reasonable and supportable forecasts of future events and economic conditions. The ED expects that most entities should be able to use more forward-looking information (rather than past-due information) when determining whether there has been a significant increase in credit risk since initial recognition. But it accepts that, in certain circumstances, entities could consider past-due information. The ED includes a rebuttable presumption that a significant increase in credit risk has occurred if contractual payments are more than 30 days past due. This presumption can be rebutted if there is persuasive evidence that, regardless of the past-due status, there has been no significant increase in the credit risk. For example, an entity has a history that its borrowers pay regularly, but generally on day 45 after the due date. In such a case, an entity would be able to continue to measure impairment at 12-month expected credit losses until payments are more than 45 days past due. Another situation where an entity could rebut the presumption would be where, based on experience, it can demonstrate that its customers miss their due date at the start of their loan agreement due to delays in setting up their direct debit arrangements and such delays are not a sign of an increase in credit risk. observation: Past-due status is seen by the board as the last sign of an increase in credit risk. So it is expected that, by using more forward-looking information, entities would move earlier to lifetime expected credit losses. As an exception to the general model, if the credit risk of a financial instrument is low at the reporting date, irrespective of the 5
change in credit risk, the entity should not transfer from 12-month expected credit losses to full lifetime expected credit losses. We understand that the IASB s intention here was to capture instruments with a credit risk equivalent to investment grade. observation: The ED refers to investment grade as an example. But this should not prevent entities from defining financial assets which do not have an external credit rating as low credit risk (such as assets in retail portfolios), provided they conclude that the financial asset has low credit risk at the reporting date. Credit risk is considered to be low if a default is not imminent and any adverse economic conditions or changing circumstances could lead to, at most, weakened capacity of the borrower to meet its contractual cash flow obligations on the financial instrument. This exception to the general model was introduced to make the model more cost effective. This eliminates the need for tracking the change in credit quality for an instrument with low credit risk. observation: With the exception of financial instruments with low credit risk at the reporting date, an entity needs to track credit quality at inception and compare it to the credit quality at the reporting date. This is likely to require changes to existing systems, but entities might be able to use their current risk management practices. Measurement of impairment Expected credit losses should be determined using an unbiased, probability-weighted approach and take into account the time value of money. An entity should use the best available information. The calculation is not a best-case or worst-case estimate. The IASB has made it clear that relatively simple modelling might satisfy the requirement and it is not always necessary to develop a large number of detailed scenarios. But the calculation should incorporate at least both the probability that a credit loss occurs and the probability that no credit loss occurs. observation: The FASB s proposal includes the same principles for measuring expected credit losses. In other words, all financial instruments will have some (albeit, in some circumstances, very small) probability of a default and this will drive the amount of credit loss to be recognised. For example, consider a CU1,000 loan which was originated by an entity where there has been no significant increase in the credit risk since initial recognition and there is a 1% probability of default in the next 12 months with an assumption that, if the default occurs, the loss will be 20% of the gross carrying amount. For this loan, the loss allowance recognised for the 12- month expected loss recognised should be CU1,000*0.2*0.01=CU2. However, for highly collaterised financial instruments, the loss given default might be zero and so, notwithstanding the fact that the instrument has a probability of a default, the amount to be recognised as loss allowance in such a case will be nil. observation: As previously mentioned, an entity should use unbiased assumptions when calculating expected credit losses. This might require adjustments to regulatory data that is already used by the entity (such as for Basel). Unit of account An entity should generally assess, on an individual instrument basis, whether a loss allowance equal to an amount of 12- month or lifetime expected credit losses should be recognised. But an entity can perform this assessment on a collective basis (for example, on a group or portfolio basis) if the financial instruments have shared risk characteristics. Examples of risk characteristics can be type of instrument, credit risk rating, type of collateral, date or origination, remaining term to maturity, industry, geographical location of borrower, and relative value of collateral. Financial instruments should not be grouped and assessed on a collective basis if the measurement of lifetime 6
expected credit losses is appropriate for only some of the financial instruments in the group. An entity should re-assess its aggregation whenever new information becomes available. In addition, an entity should measure the loss allowance by estimating expected credit losses on an individual basis, or on a collective basis if the financial instruments have shared risk characteristics. observation: The IASB s ED is applicable to individual instruments, but it allows the impairment assessment and measurement to be made on a portfolio basis (if the instruments have shared risk characteristics). Entities will need to ensure that such a collective assessment would not lead to a different result from an individual assessment. The ED explicitly requires that aggregation should be re-assessed whenever new information becomes available, which can increase operational complexities. observation: The FASB s proposal does not address explicitly the unit of account. However, we understand that the FASB intends that the CECL model could be applied to either portfolios of assets or individual assets. Some aspects of the model require consideration at an individual asset level. For example, when evaluating whether an asset carried at fair value through other comprehensive income (FV-OCI) is eligible for a practical expedient available in the FASB s proposal (that is, not to recognise credit losses when specified conditions are met), the evaluation of whether significant credit losses exist is carried out at the individual asset level. Discount rate When calculating the expected credit loss (regardless of whether it is the 12-month or the lifetime expected credit loss), the time value of money must be considered. The ED requires an entity to determine the appropriate discount rate, which could be any discount rate between the risk-free rate and the effective interest rate. This rate can be a current rate (for example, the prevailing risk-free rate at each reporting period). But, once there is objective evidence of impairment (that is, the asset is impaired under the current rules of IAS 39) at reporting date, an entity shall measure the expected credit losses as the difference between the asset s amortised cost and the present value of estimated future cash flows discounted at the financial asset s original effective interest rate. One of the exceptions to the rule is for undrawn loan commitments and financial guarantees. For loan commitments and financial guarantees, the discount rate should reflect the current market assessment of the time value of money and the risks that are specific to the cash flows. Another exception is for purchased or originated credit-impaired assets, where expected credit losses should be discounted using their specific creditadjusted effective interest rate. observation: Under the FASB s CECL model, an estimate of expected credit losses should reflect the time value of money, either explicitly or implicitly. If an entity chooses to use a discounted cash flow approach, which would explicitly consider the time value of money, cash flows should be discounted at the effective interest rate. observation: The IASB s ED provides entities with a choice of discount rate to be applied. This contrasts with IAS 39, which requires the use of the original effective interest rate. Entities need to ensure that expected credit losses are discounted to the reporting date and not to the default date (which is used by some credit management systems). Interest revenue Interest revenue is calculated using the effective interest method on an asset s gross carrying amount. Similar to today, it should be presented as a separate line item in the statement of profit or loss and other comprehensive income. But, once there is objective evidence of impairment (that is, the asset is impaired under the 7
current rules of IAS 39), interest is calculated on the carrying amount, net of the expected credit loss allowance. The IASB believes that the basis for interest calculation needs to be changed at this point to avoid increasing the gross carrying amount above the amount that will be collected by the entity. observation: The requirement to differentiate between assets which have a lifetime expected loss measure (and no objective evidence of impairment) and those for which there is objective evidence of impairment will place an additional burden on entities. The IASB argues that a similar interest calculation is currently required for impaired assets under IAS 39. observation: The FASB s interest recognition proposal is different. The CECL model requires entities to recognise contractual interest income unless it is not probable that the entity will collect all contractual cash flows. An entity will cease its accrual of interest income when it is not probable that the entity will receive substantially all of the principal or substantially all of the interest. observation: Both the IASB and the FASB require a different treatment for interest recognition for financial assets. Whilst the IASB still expects the recognition of interest (calculated based on the net amount) for assets where there is objective evidence of impairment, the FASB requires entities to cease the accrual of interest (where it is not probable that an entity will receive substantially all of the principal or substantially all of the interest). The IASB s proposal is in line with current accounting under IFRS. The FASB intended its proposal to reflect current industry practice. Loan commitments and financial guarantees For loan commitments and financial guarantees that are in scope, the expected drawdown for provisioning purposes should be determined over the period that an entity has a contractual obligation to extend credit. This means that, if an undrawn facility is immediately revocable, no provision for expected credit losses will be recognised, even if an entity expects that the facility will not be revoked in time to prevent a credit loss. As mentioned previously, when calculating the expected credit losses, an entity does not have the same choice over selecting the discount rate. The discount rate for assessing the expected credit losses on loan commitments and financial guarantees should reflect the current market assessment of the time value of money and the risks that are specific to the cash flows. observation: Loan commitments are in the scope of the FASB s proposed model. Financial guarantees are currently outside its scope. observation: The IASB s proposed model for loan commitments is different from current practice under IFRS. Currently, entities assess impairment for credit risk management purposes based on the behavioural expectations of an entity (which can extend beyond the contractual period). So, the IASB ED s requirements for measurement to reflect the contractual obligation could require entities to change their current assessment, which might result in a decrease in the level of provisions (as compared to current practice). Purchased or originated creditimpaired assets The general impairment model does not apply for purchased or originated creditimpaired assets. An asset is considered credit-impaired on purchase or origination if there is objective evidence of impairment (as set out in IAS 39) at the point of initial recognition of the asset (for instance, if it is acquired at a deep discount). For such assets, impairment is determined based on full lifetime expected credit losses on initial recognition. But the lifetime expected credit losses are included in the 8
estimated cash flows when calculating the effective interest rate on initial recognition. The effective interest rate for interest recognition throughout the life of the asset is a credit-adjusted effective interest rate. As a result, no loss allowance is recognised on initial recognition. Any subsequent changes in lifetime expected credit losses, both positive and negative, will be recognised immediately in profit or loss. observation: Under IAS 39, the effective interest rate used for assets acquired at a deep discount is a credit adjusted discount rate which is the same under the ED. observation: The FASB s ED also includes specific guidance on purchased credit-impaired (PCI) assets. PCI assets are defined as acquired individual financial assets (or acquired groups of financial assets with shared risk characteristics at the date of acquisition) that have experienced a significant deterioration in credit quality since origination, based on the assessment of the acquirer. For PCI assets, the FASB s proposal requires buyers to assess the discount embedded in the purchase price that is attributable to expected credit losses at the date of acquisition. This amount is not recognised as interest income. On acquisition the entity will be required to record an allowance to represent the amount of contractual cash flows not expected to be collected. Each component of the original purchase price will be grossed up to reflect the day one allowance. On day two, the allowance for expected credit losses for PCI assets will follow the same approach as other debt instruments in the scope of the FASB s model. In other words, changes in the allowance for expected credit losses will be recognised as an adjustment to the provision for credit losses in the current period. observation: The IASB s model for purchased or originated creditimpaired assets differs from the FASB s PCI model. Under the IASB s proposal, there is no concept of grossing up the basis of the loan to reflect the embedded loss allowance. The IASB does not require an expected credit loss allowance to be recorded on day one, but instead limits the accrual of interest income to the expected cash flows (including initial expected credit losses) as opposed to the contractual cash flows, which is similar to the current practice of applying AG5 in IAS 39. Trade and lease receivables The proposal includes a simplified approach for trade and lease receivables. An entity should measure the loss allowance at an amount equal to the lifetime expected credit losses for shortterm trade receivables resulting from transactions within the scope of IAS 18, Revenue. The ED also proposes to amend IFRS 9 to initially measure trade receivables that have no significant financing component at their transaction price (rather than at fair value, as currently required) when the new Revenue Standard is published. For long-term trade receivables and for lease receivables under IAS 17, an entity has an accounting policy choice between the general model and the model applicable for short-term trade receivables. observation: The simplified model for short-term trade receivables (and, if chosen, for long-term trade receivables and lease receivables) would give rise to the same measurement basis under the IASB s and the FASB s proposals. The use of a provision matrix is allowed if it is appropriately adjusted to reflect current conditions and forecasts of future conditions. observation: The simplified model for short-term trade receivables represents a change from the current practice under IAS 39 where an impairment loss is frequently recognised 9
when the trade receivable becomes past due. The IASB included the simplified model of the recognition of the lifetime expected credit loss allowance on day one to reduce the cost of implementation for short-term trade receivables. Modifications Where an entity modifies the contractual cash flows of a financial asset, and the modification does not result in its derecognition, an entity should adjust the gross carrying amount of the asset to reflect the revised contractual cash flows. The new gross carrying amount should be determined as the present value of the estimated future contractual cash flows discounted at the asset s original effective interest rate. The resulting adjustment should be charged to profit or loss as a gain or loss on modification. Modified assets should be assessed, to determine whether a significant increase in credit risk has occurred, in the same way as any other financial instrument. An entity should consider the credit risk at the reporting date under the modified contractual terms of the asset. This is compared to the credit risk at initial recognition under the original unmodified contractual terms of the financial asset. If this comparison does not show a significant increase in credit risk, the loss allowance should be measured at 12-month expected credit losses. observation: The IASB s ED includes guidance on determining the gross carrying amount of a modified asset as well as assessing modified assets for changes in credit risk. But it does not provide any guidance on when modification of a financial asset would result in a derecognition. This is an area where judgement will continue to be required. observation: Under the FASB s proposal for modifications other than troubled debt restructuring (TDR), there is no change to current guidance with respect to evaluating whether the modification results in a new loan or a continuation of the old loan. For TDRs, the CECL model requires an adjustment to the cost basis of the modified asset, so that the effective interest rate on the modified asset continues to be the original effective interest rate. The basis adjustment will be calculated as the amortised cost basis before modification less the present value of the new series of cash flows (discounted at the original effective interest rate). Write-offs The ED proposes that the gross carrying amount of a financial asset should be directly reduced where there is no reasonable expectation of recovery. observation: The write-off principles are consistent between the FASB and IASB models. This is expected to help comparability. But judgement will still be needed in assessing when there is no reasonable expectation of recovery, so an entity should disclose its write-off policy (including the indicators for writeoff) and whether there are assets that have been written off which are still subject to enforcement activity. Presentation An entity should present interest revenue in the statement of profit or loss and other comprehensive income as a separate line item. Impairment losses (including reversals of impairment losses or impairment gains) should also be presented as a separate line item in profit or loss and other comprehensive income statement. An entity should recognise expected credit losses in the statement of financial position as follows: as an expected credit loss allowance if those expected credit losses relate to a financial asset measured at amortised cost or a lease receivable; and as a provision (that is, a liability) if they relate to a loan commitment or financial guarantee contract. For financial assets that are mandatorily measured at fair value through other comprehensive income in accordance with the Classification and measurement ED, the accumulated 10
impairment amount is not separately presented in the statement of financial position. observation: The FASB s proposed CECL model requires similar presentation, except for requiring a separate line presentation of expected credit losses on the statement of financial position as an allowance that reduces the amortised cost of the asset. As discussed earlier, purchased credit-impaired assets are subject to different presentation requirements under both models. The IASB s proposed presentation does not represent a change from current IFRS practice. Disclosures Extensive disclosures are proposed to identify and explain the amounts in the financial statements that arise from expected credit losses and the effect of deterioration and improvement in credit risk. Sufficient information should be provided to allow users to reconcile line items that are presented in the statement of financial position. For disclosure purposes, financial instruments should be grouped into classes that facilitate the understanding for users. The ED requires reconciliations of opening to closing amounts separately for gross amounts and for the associated loss allowance for each of the following measurement categories: financial assets with a 12-month expected credit loss allowance; financial assets with a lifetime expected credit loss allowance; financial assets with objective evidence of impairment; purchased or originated creditimpaired assets; loan commitments; and financial guarantees. Inputs, assumptions and estimation techniques that are used when estimating 12-month or lifetime expected credit losses are required to be disclosed. This includes information about the discount rate that is, the discount rate selected, the actual rate (namely, its absolute figure), and significant assumptions that have been made to determine the discount rate. Disclosure will be required for modifications, including any modification gain or loss, together with the amortised cost of financial assets that have been modified while their loss allowance was measured at an amount equal to lifetime expected credit losses. In later periods, an entity should disclose the gross carrying amount of previously modified assets where the loss allowance measurement has switched from lifetime to 12-month expected credit losses and also re-default rates (if assets were modified while in default). The following detailed information should also be provided about collateral: description of the collateral; information about the quality of the collateral and explanation of any changes in its quality; how the collateral reduces the severity of expected credit losses in case of financial instruments with an objective evidence of impairment; and the gross amount of financial assets that have an expected credit loss of zero because of collateral; and details of portfolio or geographical concentrations should also be given. An entity should explain the inputs, assumptions and estimation techniques that are used when determining whether the credit risk of a financial instrument has increased significantly, as well as any change in the estimates or techniques. If an entity rebutted the presumption that financial assets more than 30 days past due have a significant increase in credit risk, the entity should disclose how it has rebutted that presumption. The gross carrying amount of financial assets, and the amount recognised as provision for loan commitments and financial guarantee contracts, should be disclosed by credit risk rating grades. observation: The FASB s proposal also requires extensive disclosures to enable users of the 11
financial statements to understand: (1) the credit risk inherent in the portfolio and how management monitors the credit quality of the portfolio; (2) management s estimate of expected credit losses; and (3) changes in the estimate of expected credit losses that have taken place during the period. Given the judgemental nature of the new impairment models, both boards require considerable additional disclosure in addition to that which is currently required by either IFRS or US GAAP to provide greater comparability of financial statements. Transition The ED is to be applied retrospectively, but restatement of comparatives is not required. But entities are permitted to restate comparatives if they can do so without the use of hindsight. If an entity does not restate comparatives, it should adjust the opening balance of its retained earnings for the effect of applying the proposals in the year of initial application. observation: The FASB s proposed transition guidance requires the recording a cumulative-effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is effective. This is similar to the IASB s proposal for those entities that do not restate comparatives but adjust the opening balance of the retained earnings. However, a reconciliation of the closing impairment loss allowances under IAS 39 and the loan commitment and financial guarantee provisions under IAS 37 to the opening loss allowances or provisions under the ED should be disclosed. If, at the date of initial application, the determination of the credit risk at initial recognition of a financial instrument would require undue cost or effort, the loss allowance should be determined by considering whether or not the credit risk is low ( investment grade ) at each reporting period until that financial instrument is derecognised. observation: The IASB s proposal does not require the restatement of comparatives because it can be very difficult to do so without the use of hindsight. On the other hand, the proposal ensures that users of the financial statements can assess the impact of the move to the new model by requiring a reconciliation from the closing impairment under IAS 39 or IAS 37 to the opening expected credit losses. The ED offers a practical expedient for entities that historically did not track credit risk data from initial recognition and are not able to obtain the data without undue cost or effort. In this case, entities are allowed to determine the loss allowance based only on absolute credit risk at the reporting date. This requirement means that loss allowance for assets that are below investment grade will be measured at an amount equal to the lifetime expected credit losses, whether or not credit risk has increased significantly since initial recognition. Entities will need to consider the cost/benefit aspects of this practical expedient. Next steps Comments are due to the IASB on the ED by 5 July 2013. All constituents are encouraged to provide feedback to the board, particularly those in the banking and insurance industries, who will be most significantly affected by the proposals. The proposal does not specify its effective date, but is seeking comments on the appropriate mandatory effective date for all phases of IFRS 9. observation: The FASB s ED was issued in December 2012, with a recently extended comment period to 31 May 2013. 12
Convergence is one of the principal objectives of a wide range of interested parties and, as a result, both boards have been urged to work together to develop a converged impairment model. Our expectation is that the boards will jointly discuss the comments received on their respective proposals after the comment periods end. observation: The IASB previously decided that the requirements of IFRS 9 would be effective from the start of 2015. But the ED contains a consequential amendment to IFRS 9 that removes the effective date of 1 January 2015. The board is seeking views on the lead time that entities would need to implement the impairment proposals. In addition, the EU has not yet endorsed IFRS 9, thereby precluding IFRS reporting entities within the EU from adopting the standard early. The EU has indicated that it will only make a decision on endorsement once the entire financial instruments guidance has been finalised, excluding macro hedging. If you have questions about the proposals in the ED or require further information, speak to your regular contact. 13
Appendix Comparison between the IASB s proposals on Financial Instruments: Expected Credit Losses and the FASB s proposals on Current Expected Credit Loss Description IASB FASB Scope Financial assets measured at amortised cost under IFRS 9. Financial assets measured at fair value through other comprehensive income under the draft Classification and Measurement: Limited Amendments to IFRS 9. Loan commitments when there is a present legal obligation to extend credit, except for loan commitments accounted for at fair value through profit or loss under IFRS 9. Financial guarantee contracts within the scope of IFRS 9 and that are not accounted for at fair value through profit or loss. Lease receivables within the scope of IAS 17, Leases. Applies to loans, debt securities, loan commitments, trade receivables, reinsurance receivables, and lease receivables that are not measured at fair value through net income. Financial guarantees are currently outside the scope of the FASB s proposals. Information considered when estimating credit losses Definition of expected credit losses Entities should consider information that is reasonably available (including information about past events, current conditions, and reasonable and supportable forecasts of future events and economic conditions). The weighted average of credit losses with the respective probabilities of default as weights. Credit loss is defined as the present value of the difference between all principal and interest cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive. Same. Same. 14
Description IASB FASB Measurement objective for the allowance for credit losses An entity recognises lifetime expected credit losses only when there has been a significant increase in credit risk since initial recognition. Otherwise, the loss allowance is measured at an amount equal to 12-month expected credit losses. An entity recognises an allowance for all expected credit losses for all debt instruments at each reporting date. Recognition of changes in the allowance for credit losses The profit or loss account reflects the changes in 12-month expected credit losses for instruments without significant deterioration in credit risk, and it reflects the changes in lifetime credit losses for all other instruments. The profit or loss account also includes: (1) the effect of a change in the credit loss measurement objective from 12-month expected credit losses to lifetime expected credit losses for instruments that have experienced significant increase in credit risk; and (2) the effect of a change in the credit loss measurement objective from lifetime expected credit losses to 12-month expected credit losses for instruments that have no longer experienced a significant increase in credit risk. Changes in the allowance for credit losses are recognised immediately in net income. Interest recognition Purchased creditimpaired financial assets Interest revenue is calculated using the effective interest method on the gross carrying amount of the asset. But, once there is objective evidence of impairment (that is, the asset is impaired under the current rules of IAS 39), interest is calculated on the net carrying amount after loss allowance. The asset is recorded at its initial fair value, and its effective interest rate includes the estimate of lifetime credit losses at initial recognition. An entity recognises contractual interest income unless it is not probable that it will collect all contractual cash flows. The basis of the asset is grossed up to reflect the embedded allowance. The remaining portion of the original purchase discount, that is not attributed to credit, is accreted in interest income over the life of the asset. 15
Description IASB FASB Originated creditimpaired financial assets Follows the purchased creditimpaired financial assets model. Follows the general CECL model. Principles for measuring expected credit losses Write-offs Discount rate The estimate of expected credit losses reflects the time value of money and, at a minimum, reflects both the possibility that a credit loss results and the possibility that no credit loss results. An entity is prohibited from estimating expected credit losses based solely on the most likely outcome. An entity will write off a financial asset in the period in which it has no reasonable expectation of recovery. The discount rate can be any rate between the risk-free rate and the effective interest rate. Same. Same. If using a discounted cash flow approach, the effective interest rate should be used. Unit of account An entity should generally assess, on an individual instrument basis, whether an expected credit loss allowance equal to an amount of 12-month or lifetime expected credit losses should be recognised. But an entity can perform this assessment on a collective basis (for example, on a group or portfolio basis) if the financial instruments have shared risk characteristics. An entity should measure the expected credit loss allowance by estimating expected credit losses on an individual basis, or on a collective basis if the financial instruments have shared risk characteristics. It does not address explicitly the unit of account. The model is intended to be able to be applied to individual assets or portfolios of assets. Loan commitments and financial guarantees Follows the general model, except for no choice over the selection of the discount rate. Loan commitments follow the CECL model. Financial guarantees are currently outside the scope of the FASB s proposals. 16