Re.: IASB Exposure Draft 2013/3 Financial Instruments: Expected Credit Losses

Mr Hans Hoogervorst Chairman of the International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom 19 June 2013 540 Dear Mr Hoogervorst Re.: IASB Exposure Draft 2013/3 Financial Instruments: Expected Credit Losses The IDW appreciates the opportunity to comment on the Exposure Draft Financial Instruments: Expected Credit Losses. In our view, the expected loss model is an appropriate alternative to the incurred loss model, because it uses more forward-looking information and avoids the delayed recognition of credit losses. From a conceptual point of view we believe that the model proposed in the Exposure Draft 2009/12 Financial Instruments: Amortised Cost and Impairment was convincing as it reflected the underlying economics, i.e. the pricing of instruments when lending decisions are made and the existence of economic losses arising as a result of credit deterioration. Nevertheless, this model presented so many operational challenges that the benefits would not have outweighed the costs of implementing and applying such an approach. We acknowledge that in the Exposure Draft 2013/3 Financial Instruments: Expected Credit Losses the IASB has sought to approximate the accounting outcome of the Exposure Draft 2009/12 in a more operational manner. We note that some of the current proposals lack a persuasive conceptual foundation (e.g. the 12-month expected credit loss allowance),

page 2/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses increase the complexity of the requirements compared to IAS 39 (e.g. the three different accounting treatments relating to the recognition of expected credit losses and the calculation and presentation of interest revenue), and may reduce the comparability of financial statements to a certain degree as a result of accounting policy choices (e.g. trade receivables and lease receivables) and flexibility granted when applying the proposed model (e.g. information to consider when making the assessment of a significant increase in credit risk and the discount rate used to calculate expected credit losses). However, we believe that such concessions are a justifiable price that all stakeholders have to pay for the new expected credit loss concept that provides more forward-looking information, considers operational challenges and fulfils the political demands arising from the financial crisis. On balance, the proposals in the Exposure Draft seem to be a reasonable compromise. In particular, we prefer the IASB s proposals to the FASB s approach to recognise a loss allowance from initial recognition at an amount equal to lifetime expected credit losses. Despite our general support, we would like to suggest certain modifications to specific proposals. Objective of an expected credit loss impairment model Question 1 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 lifetime 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? Do you agree that recognising a loss allowance or provision from initial recognition at an amount equal to lifetime expected credit losses, discounted using the original effective interest rate, does not faithfully represent the underlying economics of financial instruments? If not, why not?

page 3/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses The main proposals in the Exposure Draft Question 2 (c) 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? 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 SD (without the foreseeable future floor)? Do you think that recognising a loss allowance at an amount equal to the 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? Answer to questions 1 and 2: We believe that the proposed approach approximates the underlying economics while allowing certain necessary reliefs. From a theoretical standpoint, we have sympathy with Mr Cooper s dissenting opinion that recognising a loss allowance at an amount equal to 12-month expected credit losses is without cogent conceptual foundation and results in a credit loss at initial recognition even when a financial asset is priced on market terms, thereby double-counting the effect of credit risk at initial recognition. However, such a loss allowance can be justified as a proxy for the yield adjustment that was a feature of the Exposure Draft 2009/12: Recognising a portion of lifetime expected credit losses from when financial instruments are first originated or purchased reflects the fact that the yield on the instrument includes a return to cover those credit losses expected from when a financial instrument is first recognised. Moreover, a period of 12 months allows certain entities to use data already collected for regulatory purposes. Consequently, the conceptual shortcomings are tolerable. Provided preparers and users are willing to accept the increased complexity of the requirements and the reduced comparability of financial statements as men-

page 4/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses tioned above, the Exposure Draft might form the basis of the final provisions on expected credit losses in IFRS 9. We share the IASB s view that recognising a loss allowance or provision from initial recognition at an amount equal to lifetime expected credit losses, discounted using the original effective interest rate is not appropriate: Recognising lifetime expected credit losses on initial recognition results in financial assets having a carrying amount that is below their fair value or transaction price on initial recognition. Such accounting treatment disregards the economic link between the pricing of the instruments and the initial expectations of credit losses, thereby double-counting the initial expected credit losses that are already priced into the financial assets. In contrast to recognising 12-month expected credit losses under the IASB s approach, this accounting treatment cannot be justified as a practical approximation of a conceptually sound model. The IASB s approach avoids an excessive front-loading of losses, especially with regard to long-term loans and bonds, which would not properly reflect economic reality. An economic loss only arises when expected credit losses exceed initial expectations, i.e. when the lender is receiving inadequate compensation for the level of credit risk to which it then becomes exposed. A discount rate that reflects expectations about future defaults (the original effective interest rate) is only appropriate if discounting the contractual cash flows of a financial asset. That same rate should not be used if discounting expected cash flows that reflect credit loss expectations, because those expected cash flows already consider assumptions about future defaults. Instead, a discount rate that is commensurate with the risk inherent in the expected cash flows (the credit-adjusted effective interest rate) would be appropriate according to the principles of the present value technique. Whilst we believe that convergence between IFRS and US GAAP would also be desirable in this area of financial reporting, this should not be of paramount importance. Several financial instrument projects on offsetting, hedge accounting as well as classification and measurement have not resulted in converged decisions. In our view, the IASB should focus on developing the best solution under IFRS without preferring a certain jurisdiction.

page 5/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses Scope Question 3 Do you agree with the proposed scope of this Exposure Draft? If not, why not? 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? The IDW agrees with the proposed scope of this Exposure Draft. Entities should apply the proposed expected credit loss model to loan commitments and financial guarantee contracts because many entities manage credit risk exposures in the same way for all of these financial instruments using the same business model, risk management and accounting systems. In respect of financial assets that are measured at FVOCI, we refer to our comment letter of 26 March 2013. The proposal to account for expected credit losses of financial assets measured at FVOCI in a manner that is consistent with the requirements applicable to financial assets measured at amortised cost contributes to the intended reduction of complexity. 12-month expected credit losses 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? Certain prudential regulation and capital adequacy systems, such as the framework developed by the Basel Committee on Banking Supervision, already require financial institutions to calculate 12-month expected credit losses as part of their regulatory capital provisions. The IASB expects entities to be able to use these regulatory measures as a basis for the calculation of expected credit losses pursuant to IFRS 9 (paragraphs BC193 and BC194 of the Exposure Draft). We share the Board s expectation, but would like to note that paragraph BC193 wrongly argues that estimates in accordance with the framework developed by the Basel Committee only use credit loss experience based on historical events. This is not the case and should be rectified in the final standard.

page 6/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses Since the final standard will also apply to other regulated industries (e.g. insurance), we would like to highlight the need for flexibility that allows those preparers to use regulatory techniques as a basis for the calculation of expected credit losses pursuant to IFRS 9, too. Appendix A defines 12-month expected credit losses as the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date (and lifetime expected credit losses as expected credit losses that result from all possible default events over the life of the financial instrument). The term possible is not explained in der Exposure Draft. In our view, this term needs to be clarified since, in theory, default events are always possible for most financial instruments. In contrast, the Snapshot is more precise and based on prudential regulatory requirements: An entity calculates 12-month expected credit losses by multiplying the probability of a default occurring in the next 12 months by the total (lifetime) expected credit losses that would result from that default (page 6) The 12-month expected credit losses are the portion of the lifetime expected credit losses associated with the possibility of a default in the next twelve months (page 7). A similar explanation is given in paragraph 63 of the Basis for Conclusions. In our view, the Board should clarify whether it is sufficient to recognise 12-month expected credit losses initially at the first reporting date after initial recognition or whether 12-month expected credit losses must already be recognised on initial recognition. In comparison with the model set out in the Exposure Draft 2009/12 Financial Instruments: Amortised Cost and Impairment, the current proposals achieve an improved balance between the benefits of a faithful representation of expected credit losses and the operational costs and complexity.

page 7/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses Assessing when an entity shall recognise lifetime expected credit losses Question 5 (c) (d) (e) 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? Do the proposals provide sufficient guidance on when to recognise lifetime expected credit losses? If not, what additional guidance would you suggest? 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? Do you agree with the proposed operational simplifications, and do they contribute to an appropriate balance between faithful representation and the cost of implementation? 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? In general, we support the proposed guidance on assessing when to recognise lifetime expected credit losses. Paragraph B20 of the Exposure Draft contains several pieces of information that an entity may consider when determining whether the recognition of lifetime expected credit losses is required. Whilst we concede that such flexibility affects comparability of financial statements, we believe that a precise definition of credit quality deterioration would not be appropriate because entities manage credit risk in different ways, with different levels of sophistication and using different information (paragraph BC74). In paragraph B20, the IASB uses the term significant(ly) not in all cases (e.g. paragraph B20(e)), despite the fact that an entity is generally required to assess whether the credit risk has increased significantly. We suggest the Board clarify its intent.

page 8/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses The IDW supports the operational simplification according to paragraph 6 of the Exposure Draft, i.e. the criterion in paragraph 5 (significant increase in credit risk since initial recognition) is not met if the credit risk on a financial instrument is low at the reporting date, and a financial asset that has an internal credit risk rating equivalent to the external credit rating of investment grade would be considered to have a low credit risk. Consequently, instruments that have an external credit rating of investment grade or an equivalent internal credit risk rating can be considered to have low credit risk. Finally, we agree with the proposal that the model shall allow the re-establishment 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. Interest revenue Question 6 (c) 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? Do you agree with the proposal to change how interest revenue is calculated 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 change? 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 gross carrying amount)? Why or why not? If not, what approach would you prefer? The IDW agrees with many of the proposals on interest revenue. Nevertheless, in order to reduce the complexity of the three-stage model, the Board should reconsider an approach that would require the presentation of nil interest revenue for financial assets that have objective evidence of impairment at the reporting date. In such cases, the credit risk management objective has often

page 9/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses changed from receipt of regular payments from the debtor to recovery of all or a portion of the financial asset. Given the fact that calculating interest revenue differently in stage two and stage three of the proposed model has no sufficient/sound conceptual basis anyway, it might be preferable to apply a simpler and more operational approach in stage three. Consequently, we believe that interest income recognition could cease when a financial asset reaches stage three. We agree that in order to ease operational challenges some flexibility is necessary in determining the discount rate. Nevertheless, the degree of flexibility as proposed in paragraph B29 seems excessive and impairs comparability between entities. Rather than allowing any reasonable rate between the risk free rate and the effective interest rate, the IASB should consider requiring entities to select either the risk free rate/reference interest rate (like EURIBOR or LIBOR) or the effective interest rate/credit-adjusted effective interest rate. Disclosure Question 7 (c) Do you agree with the proposed disclosure requirements? Why or why not? If not, what changes do you recommend and why? Do you foresee any specific operational challenges when implementing the proposed disclosure requirements? If so, please explain. What other disclosures do you believe would provide useful information (whether in addition to, or instead of, the proposed disclosures) and why? Since the proposed expected loss model allows substantial flexibility and significant judgement in implementation and application, many of the disclosure requirements of the Exposure Draft are necessary to provide sufficient information to enable users to understand how that very flexibility and judgement have been exercised. This includes, for instance, information about inputs, assumptions and estimation techniques used in determining expected credit losses. At the same time, such disclosures address concerns about the subjectivity of the expected loss model. On the other hand, the proposed disclosure requirements in total seem unduly burdensome. In our view, at least the following proposals should not be part of the final standard:

page 10/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses disclosure of the gross carrying amount of modified financial assets at each reporting date throughout the remaining life (according to paragraph 38), disclosure of the gross carrying amount of financial assets that have an expected credit loss of zero because of the collateral (paragraph 40). Application of the model to assets that have been modified but not derecognised Question 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 with the proposed treatment of assets that have been modified. In this context, we propose that the IASB address the absence of guidance in IFRS on when a modification of a financial asset results in its derecognition. At present, entities often develop an analogy to the notion of a substantial change of the terms of a financial liability. Application of the model to loan commitments and financial guarantee contracts Question 9 Do you agree with the proposals on the application of the general model to loan commitments and financial guarantee contracts? Why or why not? If not, what approach would you prefer? Do you foresee any significant operational challenges that may arise from the proposal to present expected credit losses on financial guarantee contracts or loan commitments as a provision in the statement of financial position? If yes, please explain. The IDW supports the application of the general model to loan commitments and financial guarantee contracts to the greatest possible extent. Hence, consistent with our answer to question 6 and bearing in mind that the effective interest rate is not applicable in these cases, we suggest to the IASB amend the proposed paragraph B29 to require the use of a risk free rate/reference interest rate (such as EURIBOR or LIBOR) as the discount rate.

page 11/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses Exceptions to the general model - Simplified approach for trade receivables and lease receivables Question 10 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? 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? We agree with the simplified approach for trade receivables and lease receivables. Exceptions to the general model - Financial assets that are creditimpaired on initial recognition 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? The IDW supports the proposals for financial assets that are credit-impaired on initial recognition. Effective date and transition Question 12 (c) 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. Do you agree with the proposed transition requirements? Why or why not? If not, what changes do you recommend and why? Do you agree with the proposed relief from restating comparative information on transition? If not, why? In our view, a mandatory effective date of about three years after the date of issue of the IFRS would generally give sufficient lead-time for implementing the proposed requirements.

page 12/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses A mandatory effective date of about three years after the date the IFRS is issued would bring the effective date close to the effective date of the upcoming standard for insurance contracts. Generally, users prefer extensive changes to be implemented at the same effective date in order to avoid successive major changes. With a view to preparers accounting systems it would also be preferable not to have two distinct effective dates for IFRS 9 and the new IFRS 4 (unless the insurance contracts project will be delayed significantly). In order to allow entities to implement the new Standard without interruptions and modifications, the IASB should now determine an appropriate mandatory effective date for IFRS 9 and should refrain from changing it again as a result of further redeliberations. Paragraph C2 of the Exposure Draft provides an exception to retrospective application if, at the date of initial application, determining the credit risk (probability of default) as at the initial recognition of a financial instrument would require undue cost or effort. In this case, the loss allowance or provision shall be determined only on the basis of whether the credit risk is low at each reporting date. In our view, the IASB could consider, as an alternative, allowing the use of the credit risk (probability of default) of the earliest period for which it is available if determining the credit risk (probability of default) as at the initial recognition of a financial instrument would require undue cost or effort (similar to IAS 8). According to paragraph C4 of the Exposure Draft, on the date of initial application an entity is required to disclose information that would permit the reconciliation of the ending impairment allowances under IAS 39 or the provisions under IAS 37 to the opening loss allowances or provisions determined in accordance with IFRS 9. For financial assets, this disclosure shall be provided by the related financial assets measurement categories in accordance with IAS 39 and IFRS 9, and shall show separately the effect of the changes in the measurement category on the loss allowance at that date. In our view, such a complex reconciliation will not provide useful information, given the fact that both classification and impairment methodology change on the date of initial application.

page 13/13 IDW CL to Mr Hoogervorst on IASB ED/2013/3 Financial Instruments: Expected Credit Losses Effects analysis Question 13 Do you agree with the IASB s assessment of the effects of the proposals? Why or why not? The IDW generally agrees with the IASB s assessment of the effects of the proposals. In particular, we concur with paragraph BC201 of the Exposure Draft, explaining that the implementation of the expected credit loss approach will require substantial system changes, time and resources resulting in significant costs for most entities including financial institutions that are already calculating expected credit losses for regulatory purposes. This is the main reason why we believe that a lead-time of three years is necessary for implementing the proposals. We would be pleased to answer any questions that you may have or discuss any aspect of this letter. Yours sincerely Norbert Breker Technical Director Accounting and Auditing Uwe Fieseler Director International Accounting