accounting treatment of provisioning requirements under expected loss -cafral sep 2012

7/30/2019 Accounting Treatment of Provisioning Requirements Under Expected Loss -CAFRAL Sep 2012

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Accounting Treatment of

Provisioning Requirements

Under Expected Loss ApproachRecent Developments

P.R.Ravi Mohan

Reserve Bank of India


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Agenda

Impairment requirements of IAS 39

Objective evidence of impairment

Recognising impairment losses for different assetcategories

G 20 Recommendations

Expected loss approach Recent developments

Issues and challenges


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Impairment requirements of IAS 39

There are different impairment requirements for Loans and receivables and held to maturity instruments (asset accounted for under the

effective interest method)

Available-for-sale debt securities Available-for-sale equity securities

An asset is impaired if its recoverable amount is less than its carrying amount

An impairment loss should be recognised when, and only when, there is objective evidence

that an impairment has occurred


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Objective evidence of impairment

Evidence of impairment

Significant financial difficulty of the issuer

Default or breach of contract

Granting of a concession by the lender due to the borrowers financial position

Bankruptcy or financial reorganisation of the borrower

Disappearance of an active market for the assets concerned because of financial difficulties

Significant or prolonged decline in market price in the case of an equity security

Observable data that there is a measurable decrease in the estimated future cash flows for agroup of financial assets

Adverse changes in the payment status of borrowers in the group

National or local economic conditions that correlate with defaults on assets in the group

At each balance sheet date, the entity should assess whether there is objective

evidence of impairment for an asset or group of financial assets


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Assets carried at amortised cost

Calculate individually or on a portfolio basis for groups of similar assets

Reversals of impairment losses Reversal allowed if objective evidence that impairment loss decreased after the impairment loss

was recognised

Restated carrying amount not to exceed what it would have been without impairment

Reversal recognised in income statement

Impairment loss in P&L

=

Carrying amount present value of estimated future cash flows

(excluding future credit losses)

discounted at original effective interest rate

Impairment model for:

Loans and receivables

Held-to-maturity investments


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Assessment of objective evidence for assets measured at

amortised cost

Individually significant financial

assets

yes no

Individually

significant impaired

Asses separately

Collectively

Not included in

collective

assessment

yes no

Included in

collective

assessment

results

continue


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Collective assessment for assets

measured at amortised cost

Financial assets are grouped on the basis of similar credit risk characteristics (grading,

industry, region, etc..)

The characteristics chosen are relevant to the estimation of future cash flows for

groups and are indicative of the debtors repayment ability

Future cash flows for groups of financial assets are estimated on the basis of historicalloss experience, adjusted for current observable data at the reporting date

It is only appropriate for an impairment loss to be recognised for incurred but not

reported losses i.e. the expected loss event has occurred but it is unknown which

asset is impaired

Note that the methodology used should ensure that an impairment loss is not

recognised on the initial recognition of an asset


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Available for sale assets recognising

impairment losses Situation A: asset with gains recorded in equity Situation B: asset with losses recorded in equity

= fair value

Reversal ofpreviousupward fairvalueadjustment

Write downrecognised inP&L

Recoverable

amount

Cost

D Fair

value in

equity

D Fair

value in

equity

Periodx

Period x+1 Period x+2

Transfer fairvalue writedown to P&Lnowimpairment

Recogniseimpairment inP&L

Recoverableamount

Cost

Fair value

write down

previously

recognised

in equity

Periodx

Period x+1 Period x+2


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Impairment loss in P&L

=

Acquisition cost (net of repayments and amortisation)

Current fair value less any impairment loss previously recognised in P&L

(Such cumulative loss is removed from equity

and recognised in P&L)

AFS financial assets carried

at fair value

Impairment reversals of:

Equity instruments impairment should not be reversed through P&L (but in equity)

Debt instruments impairment reversal should be recognised in P&L


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Assets carried at fair value through the

profit or loss

Write downs and reversals No specific rules all gains and losses already taken to the profit or loss

Note also that if objective evidence that an impairment loss exists for an unquoted equityinstrument that is not carried at fair value because its fair value cannot be reliably measured,the amount of the impairment loss is measured as the difference between the carrying amountof the financial asset and the present value of estimated future cash flows discounted at thecurrent market rate of return for a similar financial asset. These impairment losses cannot bereversed (IAS 39.66)

Recoverableamount

Equity instruments:

Fair value

Debt instruments:

Present value of expected cash flowsdiscounted at current market rate

=


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The global financial crisis challenged the

conventional wisdom in the area of acounting

Fair value measurement of financial

instruments failure to deal with illiquid

markets and distressed sales

Incurred loss model -Provisioning being too

little & too late

Lack of convergence between IASB & FASB.

Financial Crisis


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G 20 formulated the following recommendations:

Accounting standard setters to reduce complexity

of accounting standards for financial instruments &

enhance presentation standards

IASB to enhance efforts to facilitate global

convergence towards a single set of high quality

accounting standards



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Accounting standard setters should strengthen

accounting recognition of loan loss provisions

by considering alternative approaches for

recognising and measuring loan losses thatincorporate a broader range of available credit

information.


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Accounting Standard setters and Prudential

Regulators should work together to identify

solutions that are consistent with the

complementary objectives of:

Promoting the stability of financial sector and

Providing transparency of economic results in

financial reports


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ImpairmentLatest Developments

ED on Financial Instruments- Amortised Cost

& Impairment published by IASB in November

2009 which was open for comments till 30

June 2010

A supplement to this ED was issued in January

2011 with a comment period up to 1 April

2011

This was a joint document with FASB


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Impairment -Proposals in original EDs

16

Component IASB Expected cashflow (ECF)

FASB

immediaterecognition

Initial loss

expectations

Allocate over life

(integrated effective

interest rate)

Immediate

Subsequent

changes in

estimates

Immediate Immediate

Information set Forward-looking Hold constant

The BIG question.

How to converge and create a more operational model,

especially for open portfolios?


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Overview of impairment proposal January 2011

CreditRiskManagement

Objective

Receive

Regular

Payments

Good Book

Recovery Bad book

Good book

Highest of:

Time proportional amount oflosses for the remaining life;

Expected losses in the

foreseeable future (12 months)

Loan Loss Allowance

+Bad book

All expected losses

Feedback on model

Mostly negative feedback from banks and

investors


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Impairment methodology- revised proposalCredit Quality Approach

(a) An expected deterioration in

financial performance of the

borrower that results in a change

in credit risk from low/medium to

medium/high, together with

(b) an increase in uncertainty

about the ability to fully recover

cash flows.

Bucket 1 Bucket 2 Bucket 3

Low to Medium Medium to High High to Very High

(a) A deterioration in

financial performance of theborrower that results in a

change in credit risk from

medium/high to high/very

high, together with

(b) expected non-

recoverability of cash flows.

Credit

Risk

Internal credit categories need to be mapped to buckets

As loans are purchased or originated, they are classified in accordance with level of credit risk (eg credit

rating)

Loans migrate downward or upward depending on the change in credit quality/rating

Newly originated higher credit risk loans could be in Bucket 2 or 3.

Transferbetween

Buckets1-3

18


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Impairment -Allowance balance

* Can use loss rate basis for calculation

The boards have not yet decided on the measurement of Bucket 1 allowance.

Bucket 1 Bucket 2

Possible approaches:

12 months worth of expected losses*

24 months worth of expected losses*

Emergence Period

Full remaining lifetime expected losses

Bucket 3

Allowance balance equal to:

19


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Variation of Impairment supplement

Category or bucket 1

A possible cyclical

bucket


A portfolio loan bucket

Category or bucket 3-

Individual loan bucket

Low Credit deterioration High Credit deterioration


- No events with

possible direct

relationship to

possible defaults

Category 1

No expected lossindicators

Minimum 12 months worth

of expected losses

Expected loss

indicators would suggest a direct relationship with possible futureDefaults

Life time expected losses

Default trigger eliminated

Expected credit losses not

individually

Identifiable

Expected credit losses are

individually

Identifiable


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Users Perspective

Integrated Effective Interest rate in Original ED

not found feasible

Good Book Bad Book Separation in SD was

also not acceptable to stakeholders

Will the three bucket approach be

conceptually sound and operationally

feasible?


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Boards Tentative Decisions-Summary

Summary of IASBs tentative decisions regarding

measurement of impairment allowance are as follows:

Scope:

Financial assets measured at amortised cost

Financial assets measured at Fair Value through OCI

Trade Receivables within scope of IFRS on revenue

Lease receivables within scope of IAS 17


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Measurement:

At each reporting date an entity shall measurethe impairment allowance at:

Lifetime expected losses for a financial asset thatsatisfies certain conditions

The change in lifetime expected losses sinceinitial recognition for a financial asset acquired ata deep discount that reflects incurred creditlosses

12 month expected losses for all remainingfinancial assets


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Measurement of Lifetime Expected Credit Losses -Conditions

An impairment allowance shall be measured at lifetimeexpected credit losses if as at the reporting date:

There has been a more than insignificant deteriorationin credit quality since initial recognition

The likelihood that some or all of the contractual cashflows may not be fully collected is at least reasonablypossible

For trade/lease receivables either policy election or theabove conditions

24

24


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An entity shall measure lifetime expected

losses at the present value of all cash

shortfalls expected over the life of the

financial asset

Cash shortfalls are the difference between all

cash flows due to the entity under the

contract and all cash flows expected to bereceived by the entity


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An entity shall measure 12 month expectedlosses at the present value of all cashshortfalls expected over the life of the

financial asset associated with the probabilityof a loss event in the 12 months after thereporting date

In otherwords 12 month expected losses arenot only the cash shortfalls expected over thenext 12 months


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The estimate of expected losses shall reflect:

All reasonable and supportable informationconsidered relevant in making the forward

looking estimate A range of possible outcomes that considers

the likelihood and reasonableness of those

outcomes ( ie It is not merely an estimate ofthe most likely outcome

The time value of money


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An entity shall consider information that is

reasonably available without undue cost and

effort

As a consequence, the estimate of expected

losses does not require a detailed estimate for

periods far in future


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Derecognition:

An entity shall write off a financial asset or

portion of financial asset and associated

impairment allowance when it has no

reasonable expectation of recovery of that

financial asset or portion of that financial asset


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Application Guidance:

If a financial asset shares risk characteristicswith other assets held by an entity the entity

is permitted to individually evaluate thefinancial asset or to include it in a collectiveevaluation of the group of financial assetswith shared risk characteristics to determinewhether the measurement of lifetimeexpected losses is required



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Risk Characteristics may include the following: Asset Type

Credit risk ratings

Collateral type Date of origination

Term to maturity

Industry

Geographical location of the debtor Value of collateral


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Indicators of credit deterioration include but not

limited to the following:

1. General Economic or market conditions

2. Borrower specific factors


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Recent Developments

FASB has not agreed to these and the

convergence regarding impairment between

two Boards has fallen apart

IASB has since decided to go ahead with an

Exposure Draft on impairment


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Issues& Challenges

Interaction with Basel II

Basel II = Probability of Default X Loss Given Default X Exposure at Default

ECF = Probability of Default X Loss Given Default X Exposure at Default

Look the same?..if only it were that simple

The Basel II IRB Approach and the expected cash flow approachcalculations both have the following inputs


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Interaction with Basel II (contd)

For Basel II only one PD is calculated and recordedin risk systems

ECF approach would require 40 sets of PDs to be

captured for a 10 year loan to facilitate quarterly

reporting

Even if data existed, systems do not have fields or

capacity to capture

Major banks have millions customers, data storagerequired would be huge


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Basel II PDs are through the cycle PDs

ECF PDs are point in time

As a result of Basel II, bank systems have moved

away from point in time PDs, hence almost allsystem PDs would require adjustment

Basel II PDs are 12 month

ECF PDs are for estimated life of assets

How would you estimate PDs for mortgage booktoday in respect of 2017?


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LGD for Basel II is an estimate of the actual loss incurred during downturnconditions, ie the highest point reached historically

Under ECF approach, it is the actual loss expected to be incurred at the time of

default

To calculate this, it is necessary to know when an asset will default and the

conditions at default. Both require significant judgement

During downturn conditions, as now, there is no material difference, however these

may not reflect the conditions at default date

ECF

Basel II


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Basel II EAD is calculated as:

the outstanding balance; plus

the committed but undrawn amount multiplied by a conversion factor.

ECF approach only applies to recognised exposures

The undrawn element is particularly material, for example, on credit card portfolios,

where substantial credit limits may be in place that are rarely fully used or balances

are paid in full each month. It is unclear how such revolving facilities would be dealt

with under ECF approach.

Again, timing of expected defaults will be key in estimating EADs, and different

EADs will be required throughout the life of an instrument.


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39

Operational challenges

Data - banks do not generally hold the long run PD and LGD data by

vintage and tenor and quality of underwriting criteria

Systems - databases will need to be constructed to hold data and

contractual/behaviouralised cashflow information

(note EIR is typically a high level portfolio

adjustment due to immateriality)

Re-estimation - ED requires the relentless re-estimation of cash flows

and the underlying PD and LGD matrices

Historical data - in many countries there is little historical PD and LGDdata


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Bank risk management systems (contd)

Considerable degree of analysis and review is being undertaken by the

banks

Complex adjustments to multiple internal risk systems would be

required, in addition to those required for Basel II

No definitive solutions or preferences have emerged so far

Issue is whether the shorter-term and/or higher level approaches can be

utilised or calibrated to a (simplified) expected loss model?


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Users Perspective

Use of Practical Expedients

Original ED had the concept of Practical

Expedients for short term trade receivables

Can be in the nature of Single loss rate,

Provision matrix

Has to be expanded

Makes it simple for jurisdictions having

standardised, Less complex banks


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Main open points & Timelines

Practical Expedients & Application Guidance

Clarity needed in guidance related to pooling

Loan commitments and financial guarantee

contracts

Restructuring

Disclosures Exposure draft in Second half of 2012?

accounting treatment of provisioning requirements under expected loss -cafral sep 2012

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