05 July 2013

Deloitte: Comment letter on the IASB ED Financial Instruments (Expected Credit Losses)

Deloitte supports the Board’s efforts to improve the accounting for recognition of credit losses on financial assets (currently subject to the requirements of IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) and to be replaced by a new chapter in IFRS 9 Financial instruments (IFRS 9)) by addressing the weaknesses in the existing incurred loss model that were observed during the global financial crisis. Deloitte agrees with the Board’s objective of recognising and measuring credit losses of financial assets within the scope of the exposure draft on the basis of an entity’s current expectations about the collectability of contractual cash flows. An impairment model that is based on expected credit losses that incorporates information about past events, current conditions, and reasonable and supportable forecasts of future events and economic conditions as at the reporting date avoids the inherent problem in an incurred loss model, under which there may be delayed recognition of credit losses because objective evidence of impairment may not be identified timely in practice. Further, Deloitte supports the Board’s decision to develop a single impairment objective for all types of financial assets within the scope of the exposure draft.

Whilst Deloitte is supportive of the Board’s objectives, Deloitte is concerned that the approaches to meet those objectives taken by the Board and by the FASB in Accounting Standards Update, Financial Instruments – Credit Losses are significantly different. Deloitte strongly encourages the boards to converge their guidance on expected credit losses because Deloitte believes that converged guidance on this topic is critical to supporting well-functioning global capital markets.

Deloitte is supportive of the basic elements of the Board’s proposed impairment model such as differentiating financial assets on the basis of credit quality and basing the impairment measurement on expected losses.

However, Deloitte has concerns about certain aspects of the model. For example, Deloitte does not agree with the Board’s proposal to require entities to use a relative credit quality assessment. A relative credit deterioration model creates accounting anomalies (e.g., a credit loss allowance for similar financial assets may be measured differently based on different starting points) and adds operational complexity by requiring entities to track movements in an asset’s credit quality relative to its initial credit standing. On the basis of Deloitte´s outreach with entities with operations globally, Deloitte believes that certain entities may not have credit risk management systems sophisticated enough to track movements in an asset’s credit quality relative to its initial credit standing on an ongoing basis.

The proposed impairment approach permits an entity, in measuring the allowance for cash flows not expected to be received, to determine as the discount rate any reasonable rate that is between (and including) the risk-free rate and the effective interest rate. Deloitte agrees with use of the effective interest rate but is concerned with the proposed approach to allow the use of a reasonable discount rate within a range. Deloitte recommends that the Board instead requires that entities use the effective interest rate if it is reasonably determinable and permit the use of the risk-free rate (or, alternatively, the benchmark interest rate) in cases when it is not feasible to make a reasonable estimate of the effective interest rate. Further, Deloitte agrees that use of practical expedients consistent with the impairment measurement principles should be permitted as discussed in B34 and B35 of the exposure draft. In addition, Deloitte believes that the Board should include, as an additional example, practical expedient methods that use developed loss statistics on the basis of the ratio of the amortised cost basis written off because of credit loss applied to the current amortised cost basis (as discussed in the FASB’s proposal).

With respect to measuring interest revenue, Deloitte disagrees with the proposal to measure interest revenue on originated credit-impaired financial assets based on the net carrying amount. Such an approach is unnecessarily complex (as it requires entities to have different interest recognition systems for originated loans depending on the credit quality of assets and is not consistent with the Board and the FASB’s decisions in the revenue project which focuses on the recognition of revenue for the amount the entity expects to be entitled and not on what it expects to receive. Any concerns on the gross effect on line items in the performance statement can be addressed through presentation.

For purchased credit-impaired assets (PCI), Deloitte recommends recognising an allowance both at initial recognition and subsequently that includes those contractual cash flows not expected to be collected (i.e., including those embedded in the purchase price at acquisition). Recognition of an allowance at initial recognition for purchased financial assets assists users in making comparisons to similar originated assets.

However, with regards to interest revenue recognition on these assets Deloitte agrees that the effective interest rate should be determined based on the purchase price and expected cash inflows. Similar to Deloitte´s point above, subsequent changes to the allowance should not affect interest revenue and any increases in revenue and the allowance due to the unwinding of discounting can be addressed through presentation.

As noted in the response from Deloitte & Touche LLP in the U.S. to the FASB’s proposals, Deloitte also has concerns about the FASB proposed impairment approach. One significant concern, as noted above, is that the FASB proposed impairment model requires recognition of full lifetime expected credit losses for all financial assets, particularly at inception of these financial assets. Deloitte believes that full lifetime expected credit losses may be appropriate for individual financial assets (or a portfolio of financial assets with similar credit quality) that have a low credit quality because there is a higher likelihood that a loss will be experienced shortly. However, for other financial assets (whether evaluated individually or as a portfolio of assets with similar credit quality) requiring recognition of full lifetime expected credit losses at inception distorts the measurement of performance and comprehensive income of the entity for a particular period with respect to that asset or portfolio of assets (i.e., financial statements would potentially not reflect decision-useful information about the timing of losses). It also requires preparers and auditors to consider forecasts about economic data and conditions for periods far into the future. Because the level of precision necessarily decreases in forecasts for distant periods, some parties are likely to encounter significant operational challenges and complexity when incorporating the forecasts into measurements reflected in the financial statements.

In light of Deloitte´s concerns with both the IASB’s and FASB’s proposed models, Deloitte proposes another approach that  retains many aspects of both boards’ proposals and remains faithful to their objectives. This recommended approach is discussed below.

Recommended approach

Deloitte's recommended approach retains some key principles of the Board’s proposed model because it (1) is based on expected credit losses, (2) distinguishes between financial assets that are of high credit quality and those that are not, and (3) limits the future period examined for expected credit losses for particular high quality loans. However, Deloitte´s recommended approach uses an absolute assessment of credit quality instead of using relative credit quality assessment as proposed by the IASB. Deloitte understands that the boards had considered, and decided against, using an absolute assessment of credit quality when discussing the approach that has evolved into the IASB’s proposal. On the basis of Deloitte's outreach with entities with operations globally, Deloitte believes that many entities monitor their credit quality at a point in time without tracking status from initial recognition. In addition, an absolute assessment of credit quality avoids accounting anomalies when similar economics of financial assets are measured differently.

Under Deloitte's recommended approach, an entity would continue to monitor the credit quality of its financial assets during the reporting period. Deloitte believes that when it becomes apparent for a financial asset or assets that, on the basis of credit indicators and other relevant factors, it is not highly probable that the entity will collect all contractual cash flows when due, the entity should immediately recognise all expected credit losses (i.e., those estimated credit losses for the remaining life of the asset or for the average remaining life for the portfolio of assets). Generally, entities would assess whether such indicators and relevant factors exist at the most granular level reasonable without undue cost and effort, which in some cases may result in their making such assessments on a portfolio basis (i.e. portfolio of similar assets).

For financial assets or portfolios of assets for which it is highly probable that all contractual cash flows will be collected when due, the entity would still recognise an allowance for credit losses expected over the next 12 months (or another appropriate specific period that the boards deem appropriate). This allowance is necessary for the entity to account for the uncertainty associated with the credit evaluation process and the relatively smaller probability that a loss will occur over the next 12 months (or other specific period). On the basis of limited outreach, 12 months appears to be a reasonable and supportable forecast period.

However, Deloitte suggests that the boards perform additional research to determine whether longer periods may be appropriate.

Full comment letter

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