PwC IFRS blog

Proposals on impairment of financial assets – a promise of greater consistency or the door to diversity?

The IASB and FASB’s ‘supplementary document’ on impairment of financial assets represents a major step towards convergence. The boards’ original exposure drafts could not have been further apart. The IASB started off with an income statement model that built up an expected loss reserve over time, reflecting the way loans are priced; while the FASB  exposure draft took a balance sheet approach and  proposed that the entire expected credit loss should be booked immediately.

The expected loss approach was welcomed by constituents, but there was a plea for convergence. Preparers said they couldn’t run two impairment calculations; users wanted a consistent answer. There was also a concern about the ‘operationality’ of the IASB model, especially in the context of open portfolios where loans move in and out and only forward-looking credit loss estimates are available.

So the boards needed to find a way to get to a converged, operational solution. They managed to narrow a possible 12 models down to the three proposed in the supplementary document. A compromise approach is presented as the common proposal, and the two alternatives reflect IASB and FASB preferred approaches. Needless to say, the alternatives represent enhanced variations of the respective boards’ original proposals.

The supplementary document focuses on open portfolios, as this is where the key operational issues arise; it proposes a dual model driven by credit characteristics of financial assets. On a ‘bad book’, the entire remaining lifetime expected credit loss is recognised immediately. On a ‘good book’, the proposal combines a simpler version of the time-based IASB approach with a minimum floor of the full amount of loss expected to occur in the ‘foreseeable’ future.

So what are the implications of the joint proposals? Do they mean consistency in reporting impairment of financial assets or diversity in practice?

The first question that comes to mind is the scope. The supplementary document focuses on open portfolios, scopes out short-term receivables and invites views as to whether the common proposal can be applied to closed portfolios, single instruments and off-balance sheet exposures. Does this mean we may end up with multiple impairment models depending on the type of the instrument?

Once you drill down, you next wonder about the application of the ‘good book’ and the ‘bad book’ approach. The distinction is based off the degree of uncertainty about the collectability of financial asset and internal risk management objective. Credit risk management practices differ between entities, so does it seem inconceivable that where one entity recognises a full expected loss, another continues to spread it?

Within the ‘good book’, there is a further potential for diverse application. More sophisticated entities may be able to come up with detailed forecasts for the next two to three years; less sophisticated entities may end up with a 12-month minimum foreseeable future. This will mean a different ‘floor’ for similar items across preparers.

I would be interested to hear your thoughts and opinions about the proposals. Do you favour the common proposal over the alternatives? What is the right scope? Do you feel a single impairment model should apply in all circumstances or multiple models are justified? Do you support the focus on internal risk management and the flexibility or would you rather limit the available choices? Whatever the outcome of the debate, the  boards are to be commended for their willingness to listen and their commitment to work together.

IASB and FASB issue proposals to address single largest balance sheet difference

The IASB and FASB have issued proposals that would eliminate the single largest balance sheet difference between the two accounting frameworks today.

IFRS preparers’ ability to ‘net’ or offset certain financial assets and liabilities can create trillion dollar differences on the balance sheet compared with entities reporting under US GAAP.

So, although there would be little change for entities reporting under IFRS, it would have a major impact on US GAAP preparers, particularly financial institutions. 

Under current US GAAP, an entity can elect gross or net presentation for derivatives and collateral subject to master netting agreements. The ability to elect net presentation under US GAAP is an ‘exception’ to the existing offsetting criteria. The proposals would eliminate this exception, as they require offset only when net cash flows, rather than gross, are exchanged between a financial asset and liability. This is not the case for derivatives, where cash flows actually are exchanged gross.  This is because the master netting agreement only allows net cash flows in the event of default of one of the counterparties rather than in the normal course of business.

There is no consensus among users on the usefulness of presenting gross or net information about financial assets and liabilities on the face of the balance sheet.  Whichever basis is used on the balance sheet however, most users say they would like the data on the other basis in the notes. So what do you think should be presented on the face of the balance sheet? Does it matter if the information on both bases is available?

The International Swaps and Derivatives Association (ISDA) believes the proposal to report derivatives on a gross basis rather than net on the balance sheet is ‘counterintuitive, may lead to complexity in practice and can obscure the real position of the entity’.  It goes on to say that it is likely to be ‘misleading when presenting the leverage, credit risk and liquidity risk position of an institution. Misperceptions regarding the risk exposure of derivatives users may impede the ability of corporations, government entities and financial institutions to effectively manage the business and financial risks to which they are exposed.’

The boards say that the presentation of gross amounts of assets and liabilities generally provides more relevant information than a net presentation. In particular, they believe the gross amounts of derivative assets and liabilities are more relevant to users of financial statements than net amounts for assessing the liquidity or solvency of an entity. A derivative can generally be settled or sold at any time for an amount equal to its fair value.  So the boards believe that gross amounts generally provide better information about the entity’s derivatives portfolio and its exposure to risk.

There is likely to be a fierce debate on this topic. While the boards’ arguments appear sensible for non-financial companies, the ISDA has a point that gross numbers may give a misleading picture of the amount of leverage in a financial institution. Whose view do you support? 

Regardless of views on this issue, all entities that have derivatives subject to master netting agreements will be required to provide gross and net information in the notes to meet the user request for, t both gross and net information..  So even though this ED does not propose a change for the balance sheet under IFRS, entities will still need to obtain the information to be disclosed in the notes.

I’d be interested as ever to hear your thoughts.

John