Revised proposals on accounting for leases and insurance contracts
Read our July 2013 financial reporting brief for commentary on accounting and regulatory developments during the second quarter of 2013
A new impairment model - Does it measure up?
An overview on a new impairment model for IFRS 9
Significant comment by European supervisors on financial reporting. Proposed new standard issued by FRC on accounting for Insurance Contracts, with additional guidance for companies reporting on debt and cash flows. The Central Bank publish consultation papers on client assets and on corporate governance. This Brief comments on accounting and regulatory developments during the third quarter of 2013.
Back in 2008 when the IASB commenced its project to replace IAS 39, many stakeholders, including those preparing financial statements and investors/analysts, were anticipating a simple solution to the impairment loss model in IAS 39. A picture soon emerged of a move from an 'incurred loss' model, currently used by IAS 39 to an 'expected loss' model. The IASB has now put forward its proposals in an exposure draft (ED) of the sections to be included in IFRS 9.
The ED is the product of a lengthy development process which has considered a number of approaches to determining an 'expected loss' model. These included both a 'good book & bad book' approach proposed in November 2009 and a 'three bucket' approach put forward in early 2011.
Although both of these ideas were based on more forward looking information, the buy-in from different stakeholders was limited because of the complexity involved. The IASB ED proposes a simpler approach than the original proposals and more closely follows the operational and risk management systems of financial institutions.
How are impairment losses measured?
Unlike IAS 39 where impairment rules vary depending on the categories of financial assets, the exposure draft proposes a single impairment model for all types of financial assets subject to impairment. The proposals also provide guidance on impairment of loan commitments and financial guarantee contracts which are currently covered under the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
A single impairment model, apart from being simple, is expected to bring efficiencies as the preparers of the financial statements should no longer have to develop different models for each category of financial asset.
Under the proposed rules, expected credit losses would be recognised from the point at which the financial instruments are originated or purchased. It would no longer be necessary for a credit event to have occurred before credit losses are recognised.
At the time of origination or purchase of a financial asset, 12-month expected credit losses would be recognised in profit and loss and an allowance for expected credit losses would be established. For these financial assets, interest revenue would be calculated based on the gross carrying amount i.e. without adjustment for the loss allowance. When credit risk increases or credit quality deteriorates after initial recognition, the full lifetime expected credit losses would be recognised.
The exposure draft proposes that the credit risk is considered low when a financial asset has an internal credit rating equivalent to the external credit rating of 'below investment grade'. When the credit quality of a financial asset deteriorates to the point that credit losses are incurred or the asset is credit impaired, a reporting entity would recognise lifetime expected credit losses. However, interest revenue would now be calculated on the net amortised carrying amount i.e. gross amount adjusted for the loss allowance. Lifetime expected credit losses are an expected present value measure of credit losses that arise if a borrower defaults on their obligation throughout the life of a financial instrument.
Purchased or originated credit-impaired financial assets are those financial assets that have objective evidence of impairment on initial recognition. Objective evidence of impairment is in turn defined as one or more events that have occurred and have an impact on the expected future cash flows of the financial instruments. It includes observable data that has come to the attention of the holder of the financial instrument about the following events:
- Significant financial difficulty of the issuer or borrower
- A breach of contract (such as a default or delinquency in interest or principal payments) for economic or contractual reasons relating to the borrowers financial difficulty, the lenders granted the borrower a concession that would not otherwise be considered
- It becoming probable that the borrower will enter bankruptcy or other financial reorganisation
- The disappearance of an active market for the financial asset because of financial difficulties
- The purchase of a financial asset at a deep discount that reflects incurred credit losses
Simplified approach for trade receivables and lease receivables
The exposure draft proposes a simplified approach for trade receivables that do not constitute a financing transaction under IAS 18 Revenue. Under the approach, a reporting entity would always measure the loss allowance at an amount equal to lifetime expected credit losses. In respect of trade receivables that constitute a financing transaction and, similarly, lease receivables, a reporting entity can make an accounting policy election to measure the losses at an amount equal to lifetime expected credit losses.
The ED requires extensive disclosures to help readers understand the amounts in the financial statements that arise from expected credit losses as well as the effect of deterioration and/or improvement in the credit quality of financial assets. The disclosures would normally be made in the financial statements but the directors may prefer to provide such disclosures in their report. Where the directors prefer to do so, a cross reference from the appropriate note in the financial statements to the directors' report is required.
Disclosures required include:
- Reconciliation of impairment allowance
- Accounting policy for write offs
- Explanation of inputs, assumptions and estimation techniques used in estimating 12 month and lifetime expected credit losses
- In respect of collateral, the description and amount
- Explanation of changes in credit risk
The proposed 'expected loss' model for impairment is more forward looking and considers a broader range of information than the existing 'incurred loss' model. Adoption of the proposed rules would be a challenge for many entities that will impact not only finance, but also would require involvement of and integration between risk management, corporate reporting and investor relations.
The proposals would have the greatest impact on those entities that have their financial assets or commitments to extend credit accounted for other than at fair value through profit or loss. There will be a significant impact on banks and other financial institutions. Entities may need to upgrade their information technology capabilities to ensure that robust sources of data are available to support their estimates of credit losses as well as providing information for the required disclosures.
An effective date has not been proposed pending completion of redeliberations. The effective date of IFRS 9 into which the proposals in the exposure draft will be incorporated is annual periods beginning on or after 1 January 2015, subject to EU endorsement. While still some time away, entities that will be affected need to start planning now and ensuring that the requisite reporting processes, systems and controls are in place.