IASB/FASB convergence suffers its own impairment loss

27 September 2012

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.



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Yesterday, the IASB staff reported very similar concerns about the "3 bucket approach" to the ones the FASB staff reported over the summer. It isn't clear how the IASB will now respond to the feedback. They still seem opposed to an approach that would recognize an estimate of losses in a pool of loans based on historical experience (the day 1 issue, which really means the first reporting period after origination). It seems more important to the IASB to have a matching of interest income and estimated bad debt expense on loans that are currently performing. This can lead to partial recognition of loss estimates, so the allowance does not reflect the net realizable value of the assets. Does this provide an incentive for riskier lending, because until you hit a trigger, only part of the estimated loss is recognized? That puts an awful lot of weight on the trigger for when the complete estimate should be recognized. Whereas, the FASB seems more concerned about overstating the assets in any period (that is, the current estimate of expected losses should be recorded, not part of it), which can be punitive to earnings in periods of loan growth, if significant losses are expected. (It should not be significant in stable pools of assets, where loans are being originated and maturing at about the same rate, unless the quality of the loans change.)

It is really important that the accounting in this area be converged. But it is also important that the converged answer be credible, workable and unbiased. By the way, both proposals have to be exposed for comment, so it's not over yet.

It is really disappointing that after putting lot of effort to the process, FASB has decided to back off from achieving converged solution. It may be good to pursue individually as lot of time a compromise has been made for the sake of convergence, which is not good for standard in long run. ICAEW recently urged the Board to pursue quality as of paramount objective rather then convergence. Nevertheless, I believe variant to current incurred loss model may be provided as quick fix and more time should be allotted to come up with model which is easy to understand and not operationally difficult to implement. I remember Sir David (Ex-chairman of IASB) used to say I want Standard that is easy to explain to granny. I know criticism lies with incurred loss model, however, as many Board members already highlighted the issue was in its implementation then any thing else. So I believe the immediate workable model is to see if something could be work with existing model and wait to overhaul in light of more outreach and take more time to provide more robust solution then one proposing which is hard to implement and understand. Sophistication should not be criteria for implementing the Standard rather Simplicity is the mantra for developing Standard.

In reponse to EAW's comment on 29 September, I think it is clear that bucket 1 is intended as a practical expedient for a method that would build up the loss reserve to full lifetime expected loss over the life of the loan, which would be closest to the economics of lending. This was the basis of the IASB's first model which most commentators regarded as too complex . Efforts to simplify it were not pursued as the convergence effort with the FASB took the Board in a different direction. The trigger to move out of bucket 1 is indeed critical to to the IASB model and more work is needed to see if a workable definition can be drafted. I agree its not over yet.

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