Expected-loss-based Accounting for Impairment of Financial Instruments: The FASB and IASB Proposals 2009–2016

Abstract

The financial and banking crisis of the late 2000s prompted claims that the incurred-loss method for the recognition of credit losses had caused undesirable delay in the recognition of credit-loss impairment. In the wake of the crisis, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) worked towards the development of expected-loss-based methods of accounting for credit-loss impairment. Their work included an ultimately unsuccessful attempt to develop a converged FASB/IASB standard on credit-loss impairment. The FASB and IASB eventually developed their own separate expected-loss models to be included, respectively, in a 2016 FASB standard and in the IASB’s 2014 final version of IFRS 9 Financial Instruments. The failure to achieve convergence on an issue of such high profile and materiality has generated some controversy, and it is claimed that it will impose significant costs on the preparers and users of the financial statements of banks. This paper examines the various sets of expected-loss-based proposals issued separately or jointly since 2009 by the FASB and the IASB. It describes and compares key features of the different approaches eventually developed by the two standard setters, referring to issues that arose in arriving at practically workable solutions and to issues that may have impeded FASB/IASB convergence. It also provides information indicative of the possible effect of differences between the two approaches.

Keywords:

• financial instruments
• impairment
• expected-loss
• loan losses
• IFRS 9

Acknowledgements

This paper is adapted from the following study that was conducted at the request of the European Parliament’s Committee on Economic and Monetary Affairs: O’Hanlon, Hashim and Li, ‘Expected-Loss-Based Accounting for the Impairment of Financial Instruments: the FASB and IASB IFRS 9 Approaches’, European Parliament, 2015, http://www.europarl.europa.eu/RegData/etudes/STUD/2015/563463/IPOL_STU(2015)563463_EN.pdf. Copyright for that study remains with the European Parliament at all times. The study by O’Hanlon, Hashim and Li was requested as part of the European Parliament’s involvement in the European Union’s endorsement process for IFRS 9 Financial Instruments. The paper has benefited from the comments of an anonymous reviewer and the editor.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

1 The requirement to use an incurred-loss model is described as follows in current US GAAP: The following provides an overview of generally accepted accounting principles (GAAPs) for loan impairment: (a) […] the concept in GAAP is that impairment of receivables shall be recognized when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements. (b) Losses shall not be recognized before it is probable that they have been incurred, even though it may be probable based on past experience that losses will be incurred in the future. It is inappropriate to consider possible or expected future trends that may lead to additional losses (FASB Codification 310-10-35-4). It is described as follows under International Financial Reporting Standards (IFRS) in IAS 39 (IASC, 1998 and subsequently amended, paragraph 59):

A financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated. […] Losses expected as a result of future events, no matter how likely, are not recognised.

2 See Camfferman (2015) for an account of the development of the incurred-loss-based impairment model within IFRS.

3 See Gebhardt and Novotny-Farkas (2011) for evidence that the adoption in the European Union of the incurred-loss model required by IAS 39 (IASC, 1998 and subsequently amended) coincided with a reduction in the timeliness of recognition of loan losses relative to previous loan-loss-accounting regimes.

4 For the Norwalk Agreement, see http://www.fasb.org/news/memorandum.pdf.

5 See also André, Cazavan-Jeny, Dick, Richard, and Walton (2009) for an indication that standard setters were under political pressure to act quickly on financial instruments in the wake of the crisis. This may have contributed to their addressing the issue of credit-loss impairment separately in the first instance.

6 See European Parliament hearing of 1 December 2015 at http://www.europarl.europa.eu/ep-live/en/committees/video?event=20151201-1500-COMMITTEE-ECON. See also O’Hanlon, Hashim, and Li (2015), which was commissioned by the European Parliament as part of its involvement in the European Union’s process for endorsement of IFRS 9, in order to document the differences between FASB and IASB expected-loss impairment proposals and their potential implications. See also Bischof and Daske (2016), Gebhardt (2016) and Novotny-Farkas (2016), which are published in this issue and are also related to papers commissioned by the European Parliament in connection with the endorsement of IFRS 9. See also Nobes (2015) and Walton (2015) for discussion of aspects of the European Union’s endorsement process.

7 See paragraphs 9 and 63 of IAS 39.

8 The numerical example in Table 1 and Figure 2 is drawn from various sources. These include the text of IASB (2009), including paragraphs B22 and B23 which relate to the allowance account, the IASB numerical example referred to in a note to Table 1, and an IASB diagram referred to in a note to Figure 2.

9 This latter decomposition is based on the authors’ assessment of how the impairment would have been dealt with under IASB (2009). As far as we are aware, this level of detail is not provided in the IASB’s own descriptions of accounting for impairment under IASB (2009).

10 See the later reference to the dissenting opinion reported in FASB (2016).

11 References to comments are based in part on the summary of comment letters on the exposure draft produced by the standard setter and in part on the authors’ review of comment letters themselves. The standard setter’s summary can be accessed at http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Impairment/Meeting-Summaries/Documents/FI0710b09Aobs.pdf; the comment letters can be accessed at http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Impairment/ED/Comment-Letters/Pages/Comment-letters.aspx.

12 References to comments are based in part on the summary of comment letters on the exposure draft produced by the standard setter and in part on the authors’ review of comment letters themselves. The standard setter’s summary can be accessed at http://www.fasb.org/cs/ContentServer?site=FASB&c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176158096249; the comment letters can be accessed at http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=1810-100.

13 Hodder and Hopkins (2014) also noted this.

14 The IASB document also included an IASB-only Appendix on Presentation and Disclosure.

15 References to comments are based in part on the summary of comment letters on the Supplementary Document produced by the standard setters and in part on the authors’ review of comment letters themselves. The standard setters’ summary can be accessed at http://www.fasb.org/cs/ContentServer?site=FASB&c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176158457166; the comment letters can be accessed at http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=2011-150.

16 See paragraph 35 of the summary of comment letters on the Supplementary Document referred to previously.

17 See the letter from Barclays dated 1 April 2011.

18 References to comments are based in part on the summary of comment letters on the exposure draft produced by the standard setter and in part on the authors’ review of comment letters themselves. The standard setter’s summary can be accessed at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176162917634; the comment letters can be accessed at http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=2012-260.

19 See the FASB’s comment-letter summary (paragraph 9a), available at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176162917634.

20 See the letter from Standard and Poor’s Ratings Services dated 28 June 2013.

21 For example, it ‘may lead some to believe that an entity must identify the exact amount and timing of uncollectible cash flows in each year of the asset’s life for use in a discounted cash flow technique to estimate expected credit losses’ (FASB, 2016, paragraph BC46).

22 This is different from current GAAP which requires a write down upon occurrence of an other-than-temporary impairment, with subsequent improvements being recognized in interest income over the remaining life. See the tentative Board decisions on modifications to impairment guidance in Topic 320 reached on 13 August 2014 at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176164310031.

23 A distinction is drawn between the general requirement for inclusion of expected credit losses in the effective-interest-rate calculation under IASB (2009) and the requirements under IASB (2013a) in respect of purchased or originated credit-impaired financial assets:

A financial instrument shall not be considered to be a purchased or originated credit-impaired financial asset solely because of its credit risk on initial recognition. For a financial instrument to be a purchased or originated credit-impaired financial asset, there must be objective evidence of impairment at initial recognition. (IASB, 2013a, paragraph B9)

24 References to comments are based in part on the summary of comment letters on the exposure draft produced by the standard setter and in part on the authors’ review of comment letters themselves. The standard setter’s summary can be accessed at http://www.ifrs.org/Meetings/MeetingDocs/IASB/2013/July/05C-Impairment.pdf; the comment letters can be accessed at http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Impairment/Exposure-Draft-March-2013/Comment-letters/Pages/Comment-letters.aspx.

25 See the letter from Barclays dated 9 July 2013.

26 Although the current effective interest rate on variable-rate loans is normally determined by reference to the reporting-date level of the interest rate against which the asset’s interest rate is indexed, there has been some debate as to whether yield-curve-based rates might be applied to expected cash shortfalls in some cases. See an IASB Staff Paper from 11 December 2015: http://www.ifrs.org/Meetings/MeetingDocs/Other%20Meeting/2015/December/ITG/AP7-Meaning-of-current-effective-interest-rate.pdf.

27 Since the loss is already stated in present-value terms, the time value of money is not referred to here.

28 The available-for-sale category of financial assets that exists in IAS 39 is not present in IFRS 9. In explaining its rationale for this, the IASB states that it believes that the FV-OCI measurement category in IFRS 9 is fundamentally different to the available-for-sale category in IAS 39 because it is based on the criteria of assets’ contractual cash flow characteristics and the business model in which they are held rather than being a residual category into which entities could classify assets using significant discretion (IFRS 9, paragraph BC4.161).

29 The relevant section of IAS 39 (paragraph AG 5) is as follows: ‘In some cases, financial assets are acquired at a deep discount that reflects incurred credit losses. Entities include such incurred credit losses in the estimated cash flows when computing the effective interest rate’.

30 Here, it should be noted that PCI assets are typically a relatively small part of banks’ assets, and that systems and accounting practice for this class of assets are well established.

31 For reasoning behind the IASB’s position on this, see IFRS 9, paragraphs BC5.219–BC5.220.

32 It should be noted that a change from one impairment model to another may alter the timing of the recognition of losses on assets and the average magnitude of balance-sheet loss allowances, but will not (other things equal) change the total amount of losses recognised over the life of the assets.

33 The lack of direct mapping between the IFRS 9 12-month-expected-loss/lifetime-expected-loss categorisation and the performing/non-performing categorisation is indicated in a PWC paper that refers to (i) the 12-month-expected-loss category (Stage 1) as ‘performing loans’, (ii) assets for which credit risk has increased significantly and the resulting credit quality is not considered to be low credit risk but are not considered to be credit-impaired (Stage 2) as ‘under-performing loans’, and (iii) assets that are considered to be credit-impaired (Stage 3) as ‘non-performing loans’ (PWC, 2014).

34 Note that the effect on equity of a difference in the loan-loss allowance is determined to some extent by the tax treatment of recognized loan losses.

35 This possibility was also referred to at the meeting of the European Parliament’s Committee on Economic and Monetary Affairs (1 December 2015) in connection with the Parliament’s involvement in the European Union’s endorsement process for IFRS 9.

36 In a meeting between FASB representatives and representatives of US Community Banks on 4 February 2016, community bankers expressed concern at the difficulty of forecasting losses beyond short horizons.

37 For example, in adjusting its 2014 balance-sheet Shareholders Equity of USD 190,447 millions in order to arrive at its Tier 1 Capital of USD 152,739 millions, HSBC Holdings plc deducted USD 5813 million in respect of ‘negative amounts resulting from the calculation of expected loss amounts’. See the Annual Report and Accounts 2014 of HSBC Holdings plc, p. 246, at http://www.hsbc.com/investor-relations/financial-and-regulatory-reports. For details of the calculation of regulatory capital calculations for US Bank Holding Companies, see schedule HC-R of the FR Y-9C form published by the Board of Governors of the Federal Reserve System: http://www.federalreserve.gov/reportforms/forms/FR_Y-9C20150630_f.pdf.

38 See Barth and Landsman (2010) for discussion relevant to this issue.

39 The effect documented by Bushman and Williams (2015) contrasts with the more direct effect documented by Beatty and Liao (2011). They report that, relative to banks with less timely expected-loss recognition, banks with more timely recognition reduce their lending less during recessions, and that this effect arises in part through a regulatory-capital-related constraint.

40 See, for example, the IASB’s, 2015 exposure draft ED/2015/3 Conceptual Framework for Financial Reporting (IASB, 2015)

41 Title 12, Chapter 16, US Code § 1831n (a)(2)(A) states that ‘the accounting principles applicable to reports or statements required to be filed with Federal banking agencies by all insured depository institutions shall be uniform and consistent with generally accepted accounting principles’. The following paragraph (§ 1831n (a)(2)(B)) then requires that if the Federal banking agency or corporation determines that the application of GAAP is inconsistent with the objectives of (i) accurate measurement of capital, (ii) facilitation of effective supervision and (iii) facilitation of corrective action, an accounting principle may be applied ‘which is no less stringent than generally accepted accounting principles’. Also, the March 2016 version of the Instructions for Preparation of Consolidated Reports of Condition and Income (FFIEC 031 and 041) states that ‘For recognition and measurement purposes, the regulatory reporting requirements applicable to the Call Report shall conform to U.S. generally accepted accounting principles’. See https://www.ffiec.gov/pdf/FFIEC_forms/FFIEC031_FFIEC041_201506_i.pdf.

42 This statement is available at http://www.federalreserve.gov/boarddocs/srletters/2006/SR0617a1.pdf, and referred to in http://www.federalreserve.gov/boarddocs/srletters/2006/SR0617.htm. It is stated that:

This policy statement applies to all depository institutions (institutions), except U.S. branches and agencies of foreign banks, supervised by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision (the ‘banking agencies’) and to institutions insured and supervised by the National Credit Union Administration (NCUA) (collectively, the ‘agencies’).

43 In verbal comment to the European Parliament’s Committee on Economic and Monetary Affairs (1 December 2015) in connection with the Parliament’s involvement in the European Union’s endorsement process for IFRS 9, Mr Michael Ashley said ‘… the whole history of U.S. GAAP accounting for loan losses is steeped in what the prudential regulators in the U.S. have required …’.

44 The dissenting opinion reported within FASB (2016) included the following:

For example, respondents to the proposed Update expressed the belief that the incremental loss that would be recognized under the Update is not based on the economics of the transaction but rather on a prudential desire to have a higher level of loan loss reserves reflected in financial reports to investors. Messrs. Kroeker and Smith believe that requiring an initial loss at an amount equal to expected credit losses contradicts the concept of neutrality that is fundamental to the FASB’s own Conceptual Framework. They are unaware of any other area of financial reporting for which a loss and a related valuation allowance are immediately established to reduce the value of a recognized asset that is purchased or originated on market terms … This conceptual shortcoming in the Update may lead some readers to conclude that the Board had a specific prudential policy objective when it approved it. Messrs. Kroeker and Smith do not believe that it is appropriate for the Board to ignore the concept of neutrality in its standards. (FASB, 2016)

45 The summary can be accessed at http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176162917634; the comment letters can be accessed at http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=2012-260.

46 See the references to the view of Standard and Poor’s Ratings Services (in Section 3.1.1) and Barclays (in Section 3.2.2). See also the quotes from the FASB summary of commentators’ feedback (in Section 6).