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Abstract
As a result of the recent financial crisis, several key institutions urged the IASB and the FASB to re-evaluate their models for loan loss accounting and use more forward-looking information. The paper examines the principal features of the new expected loss approach, taking into account the tensions between accounting and prudential objectives with respect to credit losses. We discuss the rationales for the change introduced by IFRS 9 and explore the differences between the IASB and the FASB models. Based on the notions of accounting conservatism and earnings management, we discuss the potential consequences of the new models. While both the FASB and the IASB model are more conservative than the incurred loss approach, each portrays a different type of conservatism, whose ability to provide information will depend on the bank’s business model. We also argue that the differences in business models that prevail in different jurisdictions might help to explain the existence of two expected loss models. Besides, we identify new avenues for further research within the financial sector.
Disclosure statement
No potential conflict of interest was reported by the authors.
Notes
1. According to Papa and Peters (Citation2014), the mean (median) carrying value of bank loans worldwide was 48% (52%) of total assets during the period 2004 to 2013.
2. Despite regulators and supervisors perform different roles, making the rules and ensuring their application respectively, they share the same interests regarding accounting information on loan risks. Hence, in this paper, we refer to both of them as prudential institutions or prudential bodies.
3. The FCAG was established in 2008 by the IASB and the FASB to advise the two Boards about standard-setting implications of the global financial crisis and potential changes to the global regulatory environment.
4. It is common in the literature to use some accounting and prudential terms such as provisions and allowances as synonymous, although they are not. Here, we employ the terms based on those used in the present accounting standards and prudential rules. ‘Impairment’ is defined as the loss recognized in the income statement in the reporting period; ‘allowance’ is the accumulated impairment that appears in the balance sheet at the end of the reporting period. The term ‘provision’ is used in the prudential bank regulation, and refers to the portion of the loan which may not be recovered according to the prudential regulation parameters. From a contemporary accounting perspective, the term ‘provision’ refers to a type of liability, although this has not been always the case. Furthermore, in accounting parlance it is still common to use ‘loan loss provision’ to refer to ‘loan loss allowance’.
5. Thus, for example, IAS 36 requires recording an impairment when the carrying amount of an asset is higher than its fair value and value in use, which implies estimating the present value of expected future cash flows. The recoverable amount is the largest of both figures.
6. The literature confirms income smoothing using loan losses during the 1980s and 1990s in the US (Wahlen Citation1994, Collins et al. Citation1995, Lobo and Yang Citation2001, Beatty et al. Citation2002, Gunther and Moore Citation2003, Kanagaretnam et al. Citation2003, Citation2004). Shrieves and Dahl (Citation2003) show how Japanese banks used loan loss allowances to smooth reported income. Hassan and Wall (Citation2003) and Bikker and Metzemakers (Citation2005) also find such behavior in cross-country comparisons; the latter finds that entities create larger allowances in good times when earnings are large, suggesting income smoothing. This countercyclical behavior is in line with the prudential view that we discuss in the next subsection.
7. In 1998, SunTrust Banks made a cumulative reduction of about $100 million of the loan loss allowance corresponding to the years 1994 through 1996 following an inquiry by the US SEC. As Wall and Koch (Citation2000) argue, this incident illustrates the conflict between bank regulators and the US SEC at that time.
8. A good illustration of this debate can be seen in Dugan (Citation2009), a prudential supervisor who argued for larger provisions charged in the income statement during good times. He complained about managers and auditors for not doing so due to the accounting standards in place at that time (the incurred loss model).
9. When the expected probability of default is low in the first years but increases substantially over time (which appears highly probable), the loan or portfolio would appear very profitable in the early years while reflecting large losses in later periods. Considering that when pricing loans, managers take into account the expected losses, the contractual interest rate of low-quality loans could be even higher than the normal or expected rate, leading to the counter intuitive result that ‘lower quality loans’ would lead to higher earnings in the first years. Although it could be argued that the effect is nonmaterial if the portfolio is stable over time, this might not always be the case, as for example in periods of growth.
10. The Basis for Conclusions of the Conceptual Framework (IASB Citation2018b: para BC1 23 to para BC1-26) summarize the conflicting views about whether or not to include financial stability as an additional objective, as well as the final decision not to do so. ‘The Board also noted that providing financial information that is relevant and faithfully represents what it purports to represent can improve users’ confidence in the information, and thus contribute to promoting financial stability’ (para BC1-26).
11. We recognize that some stakeholders would prefer that accounting standards were closer to the type of objectives embodied in prudential regulation. In this line of argument, Maystadt (Citation2013, p. 9) suggested that the EC should add a new criterion to decide on the endorsement of IFRS, ‘the accounting standards adopted should not endanger financial stability’.
12. For an exhaustive analysis of the whole process leading to the new standards, see Hashim et al. (Citation2016).
13. Under this approach the allowance is gradually formed from the difference between the adjusted interest rate and the contractual interest rate.
14. Although at this stage the draft excluded forecasts of losses based on future conditions, they were included afterwards.
15. The comment letters of the Basel Committee to the subsequent documents issued by the two standard setters – PASU (FASB Citation2012) and ED 2013/3 (IASB Citation2013) – are very useful to understand the regulators’ view:
As supervisors, we attach the utmost importance to the adequacy of the balance sheet allowance for credit losses … Impairment recognition and measurement should be based on sound methodologies that reflect expected credit losses over the remaining life of a bank’s existing portfolios at the reporting date; The new standard should require earlier provisioning than under the incurred loss approach.
16. Mr Schroeder, FASB Vice-Chairman, and Board member Mr Smith voted against the final US standard due to the day-1 loss requirement. They employed similar arguments to those used by Mr Cooper, IASB member, who voted against the earlier ED/2013/3 (IASB Citation2013), as explained in footnote 22.
17. The expression ‘12-month expected credit losses’ is defined in IFRS 9 Appendix A (IASB Citation2014) as a portion of life time expected losses that result from default events that are possible within 12 months, weighted by the probability of that default occurring. It is exemplified within the Implementation Guidance of IFRS 9.
18. The ‘significant deterioration’ requirement does not necessarily mean ‘objective evidence of impairment’ as required in IAS 39. ‘If reasonable and supportable forward-looking information is available without undue cost or effort, an entity cannot rely solely on past due information when determining whether credit risk has increased significantly since initial recognition’ (IASB Citation2014: 5.5.11). In other words, IFRS 9 eliminates the threshold, this is the ‘triggering event’, included in IAS 39.
19. To calculate the interest, a distinction is made between those loans with significant deterioration (stage 2) and those clearly impaired (stage 3); for the first type, the gross value is used, while for the second one, the net value is used. Consequently, this model is also known as the ‘3-bucket approach’.
20. The Staff Paper prepared for the IASB meeting where the comment letters to ED/2013/3 were analyzed provides the following comments about lifetime expected credit losses (ECL):
Most respondents consider a lifetime ECL model to totally disregard the economic link between the pricing of a financial instrument and its credit quality, thereby diminishing the relevance of financial reporting. The majority of users of financial statements stated that it is important to maintain the economic link between pricing and credit quality at initial recognition. They are concerned that the FASB model distorts this economic link by exacerbating the double-counting of expected credit losses incorporated in the pricing of financial instruments compared to the IASB model (IFRS Foundation Citation2013, para 20).
21. The standard does not impose using a discounted cash flow method to estimate expected credit losses (FASB Citation2016: 326–20–30–3). Therefore, if time value of money is not considered, or if the contractual interest is used, the longer the asset life, the larger the undervaluation will be.
22. In his alternative view expressed in ED/2013/3, IASB member, Mr Cooper – who was in favour of the economic approach in ED/2009/12 (IASB Citation2009) – states the following:
The problem with a lifetime expected loss being equal to the present value of contractual cash flows that are not expected to be collected is that the calculation is incomplete … the expected credit losses must be offset at the date of origination or purchase by the expected additional interest revenue (through part of the credit spread) (IASB Citation2013: AV10, 144).
23. Details on securitization accounting can be seen in Deloitte (Citation2014).
24. According to the European Central Bank (Citation2008), this loan market remained smaller in Europe than in the US, and was relatively more focused on collateralized debt obligations (CDO). Before the crisis, the total issuance volume in the US was five times higher than in Europe; in particular, 50% of US mortgages were funded via securitization in 2007 compared with 13% in Europe.
25. The 2016 working document of the Committee on Economic and Monetary Affairs of the European Parliament (Rapporteur: Paul Tang) provides an analysis of the securitization in the EU compared with the US. It states that in 2014 the volume of securitization in the EU was 74% lower than in 2008, in which it had a maximum € 819 billion; in contrast, the US market that in 2008 was at its minimum level of € 916 billion, in 2014 was five times larger than the EU market (Tang Citation2016).
26. Although credit rating agencies could have contributed to solve the asymmetry problem, they did not. Thus, instead of controlling these practices, US credit rating agencies gave triple-A ratings; ratings in Europe did not turn out to be quite as wrong as in the US (Tang Citation2016).
27. The reintroduction of prudence is justified in the Basis for Conclusions of ED/2015/3 as a mechanism to ‘help preparers, auditors and regulators to counter a natural bias that management may have towards optimism’ (IASB Citation2015: BC2.9), which we consider implies admitting that it is a means to address the problem of moral hazard in the preparation of the financial statements. However, in the opinion of Barker and McGeachin (Citation2015) something else is missing in the framework that helps to link it with the multiple examples of conservatism in the standards.
28. However, as the reviewer has pointed out, if the definition of news were expanded to include information (expectations) on future performance, the value of the assets would be lower, and from this angle a broader notion of conditional conservatism could be established.
29. However, in the discussion on Beck and Narayanamoorthy (Citation2013), Ryan and Keeley (Citation2013) argue that other factors influenced the results, such as the favorable economic conditions in the post-SAB 102/pre-financial crisis period.
30. Thus, the Basis for Conclusions of ED/2013/3 state
The IASB is aware that some interested parties favour a lifetime expected credit loss approach, … Under such an approach, the recognition of initial lifetime expected credit losses is triggered by the initial recognition of a financial asset rather than by the deterioration in credit quality since initial recognition. The IASB does not believe that this is appropriate because it would result in financial assets being recognized at a carrying amount significantly below fair value on initial recognition and would therefore be inconsistent with the economics of the asset. (IASB Citation2013: BC172, 133)