In November, the IASB issued a new exposure draft proposing changes to the existing standard on classification and measurement. Although these amendments are labelled ‘limited’, they could have significant implications for an entity’s financial reporting. On impairment, the IASB and FASB remain on divergent paths and will be exposing different models.
Andrew Vials,KPMG’s global IFRS Financial Instruments leaderKPMG International Standards Group
The future of IFRS financial instruments accounting
This edition of IFRS Newsletter: Financial Instruments highlights the discussions and tentative decisions of the IASB in November
2012 on the financial instruments (IAS 39 replacement) project.
Highlights
Classification and measurement
l The IASB has issued an exposure draft that proposes limited amendments to IFRS 9 (2010) Financial Instruments on the classification and measurement of financial assets and
financial liabilities.
Impairment
l The IASB tentatively decided to clarify and simplify its three-bucket model. Recognition of lifetime expected losses would be required when a financial asset’s credit quality has
deteriorated significantly since initial recognition. For a higher-quality asset, this would be when it deteriorates below investment grade.
l The FASB outlined the fundamentals of its current expected credit loss (CECL) model in an education session.
Offsetting
l The FASB has proposed limiting the scope of the offsetting disclosure requirements developed jointly with the IASB, which are effective from 1 January 2013. This means that offsetting disclosures prepared
in accordance with IFRS and US GAAP may be less comparable.
IASB TO PROCEED WITH THREE-BUCKET MODEL, BUT WITH SOME CLARIFICATIONS
The story so far ...Since November 2008, the IASB has been working to replace its financial instruments standard (IAS 39 Financial Instruments: Recognition and Measurement) with an improved and simplified standard. The IASB structured its project in three phases:
Phase 1: Classification and measurement of financial assets and financial liabilities
Phase 2: Impairment methodology
Phase 3: Hedge accounting.
In December 2008, the FASB added a similar project to its agenda; however, the FASB has not followed the same phased approach as the IASB.
The IASB issued IFRS 9 Financial Instruments (2009) and IFRS 9 (2010), which contain the requirements for the classification and measurement of financial assets and financial liabilities. Those standards have an effective date of 1 January 2015.
The Boards were working jointly on a model for the impairment of financial assets based on expected credit losses, which would replace the current incurred loss model in IAS 39. The Boards previously published their own differing proposals in November 2009 (the IASB) and in May 2010 (the FASB), and published a joint supplementary document on recognising impairment in open portfolios in January 2011. However, at the July 2012 joint meeting the FASB expressed concern about the direction of the joint project and began developing its own impairment model. The prospects for convergence in this area no longer look promising.
The IASB has split the hedge accounting phase into two parts: general hedging and macro hedging. It issued a review draft of a general hedging standard in September 2012, and is working towards issuing a discussion paper on macro hedging in the first half of 2013.
What happened in November?In November 2012, the IASB issued an exposure draft on limited amendments to the classification and measurement requirements of IFRS 9.
In the impairment project, the FASB presented details of its CECL model and informed the IASB that it plans to issue an exposure draft later this year. The IASB tentatively decided to proceed with its three-bucket impairment model and, in response to constituent feedback, tentatively clarified the criteria for recognising lifetime expected losses. It also discussed types of information that might be used to determine expected losses and to assess when they should be recognised. In addition, the IASB redefined the disclosures that would be applicable for entities applying the simplified approach for trade and lease receivables. The IASB reported that it has finalised its technical redeliberations and that it will discuss its next due process steps in December. An IASB exposure draft is expected in the first quarter of 2013.
In the offsetting project, the FASB updated the IASB on its tentative decision on disclosure requirements.
The IASB has issued an exposure draft that proposes limited amendments to IFRS 9 (2010).
What happened in November?On 28 November 2012, the IASB issued an exposure draft proposing limited amendments to IFRS 9 (2010) on the classification and measurement of financial assets and financial liabilities. The exposure draft introduces:
• a new fair value through other comprehensive income (FVOCI) measurement category for financial assets;
• a new business model, along with new application guidance on applying the business model concept;
• a ‘modified economic relationship’ test for assets where the economic relationship between principal and interest is subject to change; and
• permission to early apply only the own credit requirements for financial liabilities measured under the fair value option, without having to early apply IFRS 9 in its entirety.
For more information on the exposure draft, see our publication In the Headlines: Proposed amendments to IFRS 9 – Classification and measurement (November 2012).
The IASB will proceed with the three-bucket model, but with some clarifications.
What happened in November?At the November 2012 meeting, the IASB continued its redeliberations, discussing:
• criteria for recognition of lifetime expected losses;
• methods and information used to assess criteria for recognition of lifetime expected losses; and
• disclosures for assets under the simplified approach.
The FASB provided an overview of its CECL impairment model in an education session.
Lifetime expected losses would be recognised if there has been significant deterioration in credit quality since initial recognition.
Simplified criteria for recognition of lifetime expected losses
What’s the issue?
The proposed IASB three-bucket impairment model uses a dual-measurement approach. Under that approach, an entity would recognise:
• 12 months’ expected losses if an asset has not met the criteria for recognition of lifetime expected losses; and
• lifetime expected losses if the asset has met those criteria.
The IASB had tentatively decided that an entity would recognise lifetime expected losses if the probability of not collecting all contractual cash flows:
• has increased more than insignificantly since initial recognition; and
• is at least reasonably possible.
These are described as the ‘transfer criteria’.
Following recent outreach activities, the IASB staff (the staff) reported that constituents generally supported the model’s objective of distinguishing assets that have deteriorated from those that have not. However, they said that constituents were unclear about:
• how much of a change in credit risk is ‘more than insignificant’;
• what ‘reasonably possible’ means; and
• the relevance of the term structure of credit risk – in particular, that long-term lending might be disadvantaged if the criteria did not acknowledge that the lifetime probability of default (PD) is higher for longer-duration assets than for shorter-duration assets of similar credit quality.
What did the IASB discuss?
The IASB discussed possible clarifications to the transfer criteria. The staff believed that the following alternative combinations of criteria for recognising lifetime expected losses marked the boundaries for achieving an appropriate balance between:
• the benefit of information; and
• the cost and operational complexity involved in obtaining it.
These combinations would be consistent with the objective of the dual-measurement approach.
Combination A – Larger deterioration/higher credit quality
Combination B – Smaller deterioration/lower credit quality
Deterioration criterion
The probability of not collecting all contractual cash flows has increased more than insignificantly since initial recognition.
There has been a deterioration in credit quality since initial recognition that is significant (when considering the term of the asset and the original credit quality).
There has been any deterioration in credit quality since initial recognition.
Credit quality criterion
The probability of not collecting all contractual cash flows is at least reasonably possible.
The credit quality of the asset is below ‘investment grade’.
The credit quality of the asset is below a ‘CCC’ rating.
The staff did not believe that other possible combinations of criteria would satisfy the objectives of the dual-measurement approach.
l Large deterioration/low credit quality: this would be close to an incurred loss model, and would not be sufficiently forward-looking.
l Small deterioration/high credit quality: this could lead to very early recognition of lifetime expected losses, and the benefits of distinguishing deteriorated assets would not outweigh the costs.
The staff argued that, under the three-bucket model, part of the cost and complexity arises from tracking assets to assess the deterioration condition. The credit quality criterion reduces this cost, because if the credit quality of the asset is above the specified threshold, then the degree of deterioration is not relevant.
Clarifying the deterioration criterion
The term ‘significant deterioration’ is not defined. The staff explained that providing specific quantitative thresholds for the degree of deterioration would add to the costs of assessment, and it may be difficult to obtain the necessary data. It believed that the original credit risk of an asset was relevant to assessing the amount of deterioration required and, if a quantitative approach were taken, this might require multiple deterioration thresholds. The staff argued that the assessment of credit risk and measurement of expected losses are inherently subjective, and that specifying further what is ‘significant’ would be arbitrary; this in turn may inadvertently prevent entities from being able to make a sensible assessment based on the information available and their own risk knowledge.
Term structure of credit risk
To ensure that the assessment considers:
• the relationship between time and credit risk; and
• how both affect the lifetime PD,
the staff argued that an entity should consider the duration of an asset when assessing both the credit quality and the deterioration criteria.
Reflecting the term structure in the credit quality criterion improves the comparability of credit risk for assets with different maturities by comparing them against a credit risk curve.
Reflecting the term structure in the deterioration criterion recognises that a different amount of change is significant for different terms.
What did the staff recommend?
The staff recommended Combination A to describe the criteria for lifetime expected loss recognition. Combination A implies that an investment-grade loan would have to deteriorate below investment grade if lifetime expected losses were to be recognised. Assets below investment grade would be assessed using the significant deterioration criterion alone.
The staff did not recommend a more detailed prescription of when the significant deterioration criterion is satisfied.
What did the IASB decide?
The IASB tentatively decided to simplify the requirements to contain a single criterion – that an entity would recognise lifetime expected losses if there has been a significant deterioration in credit quality since initial recognition (taking into consideration the term of the asset and the original credit quality). The IASB added that an example of significant deterioration would be if an existing financial asset would be priced differently because of the increase in its credit risk since initial recognition.
Although not retaining a separate credit quality criterion, the IASB did tentatively decide that lifetime expected losses for a higher credit quality asset should be recognised when the asset deteriorates below ‘investment grade’. This would alleviate the cost and complexity of performing assessments of credit risk deterioration for higher-quality assets.
The IASB agreed to provide guidance on how to assess the significant deterioration criterion, including the types of information that should be considered.
Methods and information to assess criteria
What’s the issue?
The IASB and the FASB had previously decided that an entity would use the best information that is available without undue cost or effort to apply the expected loss model. An entity would not ignore information that is available, or invent information that is not available.
Many constituents expressed concerns about applying a model based on credit deterioration to retail loans, because detailed information about credit quality is not typically available after origination. Banks also expressed significant concerns that the credit quality of assets would have to be assessed using the lifetime PD of an asset. They explained that this would add cost and complexity for all assets with a 12-month expected loss measure, because entities would need to measure both:
• the lifetime PD, to determine whether recognition of lifetime expected losses is required; and
• the 12-month PD – i.e. the probability of default in the next 12 months – to calculate the 12-month expected loss.
By contrast, many banks have geared their credit risk management systems towards a 12-month PD.
What did the IASB discuss?
The IASB’s discussion aimed to provide guidance on how to assess the criterion for recognition of lifetime losses, including the types of information that should be considered.
The staff believed that the following methods might be used.
PD is a statistic that can be estimated or derived from multiple sources of data, including:
• an entity’s own default studies and statistical models;
• external default studies conducted by rating agencies; and
• models that compute a PD from market data such as yield spreads, credit default swap prices and macro-economic inputs.
The staff thought that an entity should ideally project a credit risk curve for an asset (or a class of assets with similar credit characteristics), to assess whether to recognise lifetime expected losses. However, the staff believed that an entity could achieve a reasonable approximation by using a 12-month PD rather than lifetime PD to assess whether it needs to recognise lifetime expected losses. They argued that a shift in the 12-month PD will usually result in a shift in the entire risk curve, and that this would generally be a reasonable assumption to make if there is no evidence that the risk curve is abnormal.
Prices for credit Using pricing information poses practical problems in determining whether a change in price implies a change in the PD or in another component of the price – e.g. liquidity risk.
Therefore, changes in prices should not generally be looked at in isolation, but together with other information – e.g.:
• macro-economic changes;
• specific news items about an entity; and
• other changes in an entity’s business risk.
Credit ratings Entities use a wide range of rating systems: external and internal; absolute and relative.
External ratings are a useful tool, but they are only available for some assets.
Internal ratings are influenced by an entity’s business practices, and this makes corroborative information more important. Therefore, internal ratings should be either:
• mapped to external ratings; or
• supported by default studies that show that the ratings are appropriate for use in credit risk assessment.
Delinquencies Delinquency is a lagging indicator of deterioration in credit risk. However, in some cases delinquency seems to be the only information available without undue cost or effort. For example, credit risk information is used to make initial lending decisions for retail loans, but then it is often not updated at all or not updated on a timely basis.
Generally, other information – e.g. macro-economic data that is not specific to a borrower – should exist before delinquency information is available that indicates an increase in credit risk (although taking this information into consideration requires modelling, and identification of sub-portfolios).
Ideally, entities that use delinquency information should understand the relationship between delinquencies and expectations of default.
When delinquency information is used as a backstop, a rebuttable presumption could be included in the model that lifetime losses should be recognised if an asset is 30 days past due. An entity could rebut the presumption if there were other information (such as default studies) showing that it is not a suitable indicator. This rebuttable presumption could be applied even when delinquency information is not otherwise used by the entity; the staff believed that disclosure should be required if an entity does rebut it.
Other qualitative inputs
In some cases, available qualitative information may be sufficient for a fundamental credit analysis, and to determine that an asset has significantly deteriorated.
What did the staff recommend?
The staff recommended that the information used to determine expected losses and to assess the need to recognise lifetime expected losses should include external and internal indicators – for example:
• market pricing information – e.g. credit spreads and credit default swap (CDS) prices;
• changes in origination terms and rates;
• credit ratings;
• economic conditions;
• borrower-specific factors; and
• changes in expected payment status.
Determining which information is most relevant would depend on facts and circumstances.
The staff recommended that delinquency information be used in isolation only if:
• that information is the basis for managing the relevant assets’ credit risk; and
• more forward-looking information is not available without undue cost and effort.
The staff also recommended including a rebuttable presumption that lifetime losses should be recognised if an asset is 30 days past due, and to require disclosure if an entity has rebutted the presumption.
It also recommended that entities should be permitted to use 12-month PD, rather than the lifetime PD, to assess the transfer criteria if there is no evidence that the risk curve is abnormal.
What did the IASB decide?
The IASB agreed to provide guidance on how to assess the criterion for recognition of lifetime expected losses, including the types of information that should be considered. It also tentatively decided:
• that the borrower-specific information considered by an entity may include delinquency information;
• to include:
– a rebuttable presumption that the criterion for lifetime-loss recognition would be met if an asset is 30 days past due; and
– a requirement for disclosure if this presumption is rebutted; and
• that an entity may use a 12-month PD to assess the lifetime expected loss criterion, unless there is information indicating that a lifetime PD would result in a different outcome – e.g. if the loss curve is abnormal.
Disclosures would generally be applicable to entities using the simplified approach; some further simplifications were also made.
Disclosures for assets under the simplified approach
What did the staff discuss?
The purpose of the discussion was to identify disclosures under the three-bucket model that would be applicable to entities applying the simplified approach for trade receivables and lease receivables.
What did the staff recommend?
The staff recommended that the disclosures previously tentatively decided for general impairment accounting would generally be applicable to entities using the simplified approach if they relate to the measurement of lifetime expected losses. Disclosures relating to the effect of deterioration and improvements in credit quality of financial assets were excluded, because they are not applicable under the simplified approach.
The following adjustments were recommended for entities applying the simplified approach.
• Entities may use provision matrices as a basis for the disclosure; this would meet the requirements for the disclosure of their risk profile.
• Entities would disclose the effect of modifications only for assets that are 30 days past due.
• Lease receivables would be excluded from the requirement for a qualitative description of collateral, because they are already covered under the leases project.
What did the IASB decide?
The IASB observed that the disclosures would generally be applicable, and tentatively agreed with the staff recommendations for adjustments described above. The IASB also tentatively decided not to require disclosure of a reconciliation of the gross carrying amounts of lease receivables, because of overlap with the leases project.
The FASB provided an overview of its model; some IASB members criticised its potential impact on lending decisions.
FASB’s CECL model
What’s the issue?
In an education session, the FASB provided an overview of the CECL model. The FASB told the IASB that it had substantially completed its discussions and redeliberations, and that it had circulated a draft exposure document to fatal flaw reviewers and to IASB members.
The FASB explained that substantial similarities between its CECL model and the IASB’s three-bucket model exist in the following areas:
• scope – in particular, the same model applies to:
– both securities and non-security debt instruments; and
– both assets measured at amortised cost and those measured at FVOCI;
• the information used in estimating expected credit losses; and
• the fact that the measurement of expected credit losses reflects multiple possible outcomes and the time value of money.
By contrast, the FASB identified key differences in the following areas.
FASB’s CECL model IASB’s three-bucket model
Measurement objective
Single measurement objective that requires recognition of all expected credit losses at the end of each reporting period.
Dual-measurement objective (for assets that are not credit impaired on initial recognition) that requires recognition of lifetime expected losses only if the asset has deteriorated in credit quality from initial recognition; otherwise, 12 months’ expected losses are recognised.
Debt instruments measured at FVOCI
Practical expedient – no expected losses have to be recognised if:
• the fair value of the financial asset is greater than the amortised cost basis; and
• expected credit losses are insignificant.
No practical expedient.
Purchased credit-impaired assets
Similar to originated or other purchased assets.
Single measurement approach for assets that are credit-impaired on initial recognition; recognition of lifetime expected losses is required in this case.
Some IASB members were critical of the FASB model – especially its potential impact on lending decisions. They thought that the requirement to book all expected lifetime losses on day one, particularly in the current economic climate, would discourage banks from lending – especially for longer terms.
They also felt that the FASB model may not provide useful information, because it does not differentiate between loss allowances set up on initial recognition and the subsequent deterioration of assets. So, when two banks with different asset growth are compared, the allowance may be similar but the deterioration of the underlying assets may be very different.
Next steps
FASB’s next steps
The FASB plans to issue an exposure draft later this quarter, with a comment period of 30 April 2013 or 120 days. The FASB will invite comments on its own model and on differences between the CECL model and the IASB’s three-bucket model.
IASB’s next steps
The IASB tentatively decided to proceed with the three-bucket model, with the clarifications set out above.
The IASB reported that it has finalised its technical redeliberations. At its December meeting, the IASB will discuss:
• compliance with due process requirements;
• considerations for re-exposure; and
• the comment period and permission to ballot.
An IASB exposure draft is expected in the first quarter of 2013.
The FASB proposed limiting the scope of its offsetting disclosures, developed jointly with the IASB.
What’s the issue?
In December 2011, the IASB and the FASB issued common disclosure requirements for offsetting, with an effective date of 1 January 2013. Responding to stakeholder feedback, the FASB has tentatively decided to limit the scope of the offsetting disclosure requirements that it published in December 2011 to derivatives, (reverse) sale and repurchase agreements, and securities borrowing and lending arrangements. By contrast, the original 2011 requirements under both IFRS and US GAAP apply to financial assets and financial liabilities that are:
• offset in the statement of financial position; or
• subject to an enforceable master netting arrangement or similar agreement.
What did the Boards discuss?
During its meeting, the IASB was updated on the FASB’s tentative decision. In particular, FASB stakeholders were concerned about how the disclosures might be applied to:
• a wide population of contracts, including standard terms that allow either party to settle net in the event of default; and
• payables and receivables arising from unsettled regular-way security trades.
The staff reported that if the FASB’s tentative decisions are finalised, then the offsetting disclosures in IFRS and US GAAP would cover different items, and the information provided for IFRS preparers would be more comprehensive.
Following the meeting, the FASB published the proposed amendments to its requirements on 26 November 2012, with a 25-day comment period (ending on 21 December 2012) and a planned effective date of 1 January 2013.
What did the IASB decide?
The IASB made no decision. However, the staff commented that, even if the IASB were to consider changing the requirements in IFRS 7 Financial Instruments: Disclosures for consistency with the FASB’s proposals, it would have to follow the required due process steps: it would not be able to change IFRS 7 before 1 January 2013.
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