PwC IFRS blog

Impairment: what is the right answer?

Both the FASB and IASB have published their proposals on the recognition and measurement of expected credit losses for financial instruments. The good news is that they are available for comment – we all see this as a step forward. But there is bad news as well. The proposals are not only different, but arguably both depart from the underlying economics in favour of operational shortcuts.

Neither proposal revealed any surprises compared to what I expected last Autumn. I mentioned then that the FASB model might be simpler from an operational perspective, but one has to question the conceptual merits of recognising impairment losses when an entity originates or purchases a financial asset at fair value. A ‘day one’ loss does not reflect the economics of a market-based transaction. Others have also questioned whether being forced to book a full expected loss on day one will act as a further constraint on bank lending. The IASB model recognises a smaller day one loss than the FASB model and, while still not conceptually pure, at least tries to acknowledge that credit risk is priced into the interest rate on debt instruments, and that the income to cover expected losses is earned over the life of the loans.

So which proposal is best? Both models aim to address the often-articulated criticism of the current ‘incurred loss’ model: ‘too little, too late’. The FASB goes further down that road than the IASB. However, both proposals compromise on operationality and conceptuality. The question is whether to accept that a conceptually pure answer is too difficult and choose one of the compromises so we can finish the project.

Digging deeper, the next question is whether there is any correlation between the current level of a bank’s reserves/capitalisation (banks are the most impacted by the proposals) and the economy it operates in, and its preference for a model. It seems that there is. While some banks expect that, under the IASB model, their impairment loss allowance will double, others argue that they would end up releasing loss allowances. Setting aside the conceptual question of how that might happen when moving from an incurred loss model to any iteration of an expected loss model, I have to admit that the impact of the proposal is highly dependent on current reserve levels and the economic situation.

The original IASB proposals contained the concepts to do the job better. Identifying the credit risk element of interest pricing, and setting it aside as a future loss reserve, would reflect the true economics of a transaction. But the proposed model was extremely complex, and so banking industry complaints were listened to. Previously, preparers, users and regulators had considered that convergence was extremely important. The question is now whether respondents believe that the urgency of the need to move to an expected loss model outweighs the drawback of having two versions.

What will happen after the comment periods end? The boards have said that they will share their feedback and decide on the next steps. Although many institutions (including the Financial Stability Board and the Basel Committee) have expressed their disappointment on the lack of convergence, a converged model is unlikely. I don’t expect either board would move to accept the other’s proposal.

Potential compromises might include taking a period longer than 12 months, but shorter than lifetime, to measure expected credit losses on initial recognition. But, during previous discussions, the boards considered and rejected the 24-month alternative. Another possibility would be to try again with a conceptual solution (for example, consider the lifetime expected credit losses at inception but, rather than recognise immediately in the profit or loss account, spread the expense over the instrument’s life), but this would add a further significant delay.

Whether we like this or not, we have until 31 May (FASB) and 5 July (IASB) to finalise our responses. As ever, I welcome your thoughts.

Disclosures

There’s a remarkable consensus in the IFRS world that we have a problem with disclosure. There’s a problem with the problem, though, as was very evident from the IASB Disclosure Forum at the end of January: there is no consensus on what the problem is.

Preparers complain about disclosure overload pushing up the cost of financial reporting. Some regulators and users argue that there is too much irrelevant disclosure – “clutter” – such that important disclosure gets lost amongst the trivial. Others say there isn’t actually enough disclosure on critical issues. Some feel that the amount of disclosure isn’t the problem, it’s the way it’s organised and explained.

Without agreement on what the problem is, it’s no surprise that there is no obvious solution on the table. A cottage industry has developed in the last couple of years around producing discussion papers on the subject. The only common theme emerging from these is that we should all be braver in applying the materiality concept to disclosures. Even here, there are differences of view as to whether existing materiality guidance is sufficiently clear. Materiality alone doesn’t solve all the perceived problems – preparers still have to collect the data to decide whether something is material, and just reducing clutter doesn’t necessarily make what’s left any more readable or useful.

I believe the debate needs to be expanded to consider more radical ideas. There has been much talk about establishing a single principle for disclosure but, so far, there has been little research into what that principle might be. Two ideas that come to mind are:

• to disclose information that has direct predictive value for cash flows; or
• to disclose information that allows users to have an in-depth understanding of the quality of assets and claims and the expected timing of payments and the ultimate amount of liabilities.

Applying either would probably eliminate some disclosures, but equally it could highlight the need to expand other disclosures or introduce new ones. There’s no guarantee that the amount of disclosure would reduce, but at least following a principle should help to present a more coherent set of information rather than a compliance checklist of data.

Interestingly, the first option above did come up at the IASB Discussion Forum but, apart from a disagreement among participants about how much disclosure it might eliminate, it wasn’t really explored. I think it should be, although I don’t underestimate the difficulty in both agreeing a single principle and then agreeing how to apply it. But a more radical debate might well help in bringing closer together the different views on what the real problem is.

The IASB Forum concluded there are no quick fixes. This might be true, but I believe we can make short-term progress. I suggested that we establish a principle that every piece of disclosure be accompanied by an explanation of its significance to the business. This could have two benefits: first, where that significance is difficult to find, it could embolden us to leave the disclosure out as not material, thus getting rid of clutter; and, secondly, additional explanation would help the reader to navigate the financial statements – the “story” behind the financial statements would be clearer. A couple of preparers found this idea interesting – what do you think?

John

IASB/FASB convergence suffers its own impairment loss

So, like many in Europe I headed off on summer holidays thinking the Boards (IASB and FASB) have been working harmoniously on their financial instruments project and that we might yet have convergence, only to come back and find out that the FASB has decided to abandon the jointly deliberated model and pursue their own model for impairment of financial assets (see our ‘straight away’ guidance). 

The current, ‘incurred loss’ impairment model for financial assets was criticised during the global financial crisis. Indeed, one of the key messages that the Boards received from the G20 was that a converged impairment model is critical to responding to the global financial crisis. The issue with the current model is that impairment losses (and resulting write-downs in the reported value of financial assets) can only be recognised when there is evidence that they exist. Companies are not allowed to consider the effects of losses expected in future. There is a view that earlier recognition of loan losses may have reduced the cyclical moves in the recent crisis. So after spending almost two years working together on an expected loss model, it is disappointing that the FASB has decided to go in its own direction – and so soon after the Boards finished debating the key technical principles of what we thought was a converged model, the ‘three-bucket model’.

Throughout the development of the joint model, the staff of both Boards held outreach sessions with various parties. The FASB in particular heard significant negative feedback from US constituents: that further clarifications of the model were necessary; but also a broader concern about the model’s operability and whether comparability may actually be reduced as a result, as it was noted that defining the concepts would be difficult.

The FASB concluded that it should develop a simpler model based on booking a full provision for lifetime losses on loans as they are originated.

While the IASB’s outreach was more positive, how operational its model proves to be will depend on the clarity of the trigger point that moves a loan from the first bucket to one of the others.

The FASB model may be simpler from an operational perspective, but one has to question the conceptual merits of recognising impairment losses when an entity originates or purchases a financial asset at fair value, as a day 1 loss does not reflect the economics of a market-based transaction. The IASB model, while also not conceptually pure, is at least trying to acknowledge that credit risk is priced into the interest rate on debt instruments and the income to cover expected losses is earned over the life of the loans.

Bucket 1 in the current IASB model is a compromise, made with the aim of achieving convergence. Now that convergence has failed, the IASB must have been tempted to go back to a variant of its original proposal, which essentially required the credit risk element of interest pricing to be identified and set aside as a future loss reserve.

However, the industry saw the original model as too complex, and there is a pressing demand to get the new model finalised. The IASB has said it will press on with the three-bucket model.

It is a great pity that we won’t have a converged model. Like many, I saw this as one of the most important areas to achieve convergence given the intense focus on bank capital today. However, we can’t wait much longer for an expected loss model.

As ever, I welcome your thoughts on this issue.

BFN