Accounting Treatment of Provisioning Requirements Under Expected Loss -CAFRAL Sep 2012
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Transcript of 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
G 20 Recommendations
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G 20 Recommendations
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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G 20 Recommendations
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
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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
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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:
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Variation of Impairment supplement
Category or bucket 1
A possible cyclical
bucket
Category or bucket 2
A portfolio loan bucket
Category or bucket 3-
Individual loan bucket
Low Credit deterioration High Credit deterioration
Category or bucket 1
- 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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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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
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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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
Boards Tentative Decisions-Summary
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Boards Tentative Decisions-Summary
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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Boards Tentative Decisions-Summary
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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Interaction with Basel II (contd)
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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Interaction with Basel II (contd)
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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Interaction with Basel II (contd)
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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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?