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Staff member Hilary Eastman discussed the risk-free rate of return. She posed the question whether companies should decide what their risk-free rate should be or if there is some other overarching principle that should be used for what the risk-free rate should be for any given company. In particular, from the IASB’s perspective, should accounting standards specify what the risk-free rate is? The general view was that the determination of the risk-free rate or its use was not the Board’s responsibility.
Members discussed whether and when it would be appropriate to use one government’s debt as opposed to another’s, for example within the eurozone where the currency is the same but sovereign risk and inflation are different across countries. Some members suggested using a ‘synthesised’ risk-free rate and noted that the rate we call ‘risk free’ is really only a proxy for a risk-free interest rate.
There was some concern about which risk-free rate multi-nationals should use when they have business operations in multiple countries.
Staff member Jeff Lark discussed the IASB’s current plans for developing a new impairment model for financial instruments measured at amortised cost using a three-bucket expected loss approach. He described how the Board’s current view is that all financial assets subject to the impairment model (‘loans’ as shorthand) would be classified into one of three buckets based on their credit quality as assessed by the entity (referred to as a ‘Credit Quality Approach’):
a) the highest credit quality loans would be classified in Bucket 1 with either 12 or 24 months of expected losses recognised;
b) loans of medium credit quality would be in Bucket 2 with recognition of lifetime expected losses; and
c) loans of the lowest credit quality would be in Bucket 3 with recognition of lifetime expected losses.
Another approach to the three-bucket model was also described (referred to as a ‘Bucket 1 Approach’) where all loans would be classified in Bucket 1 on origination or acquisition (other than those acquired at a deep discount) and would move downward into Buckets 2 and 3 as the credit quality of the loan subsequently deteriorated. Loans would also be able to transfer upward if credit quality later improved.
CMAC members were strongly opposed to any method that would recognise a day 1 loss, which is the case in either of the approaches described. Loans are recognised at fair value on acquisition or origination, so in their view any method that would recognise a day 1 loss would move away from this principle and reduce the value of information provided to users of financial statements. Members stated that in their view the driving force of this project should not be the adequacy of the allowance balance. Members stated that knowing lifetime expected losses at origination/purchase is valuable. However, they would prefer that this information be presented via note disclosure, not on the face of the financial statements.
Members want information about:
a) loss expectations, as well as what is happening with the loan before it is actually impaired, presented in the note disclosures;
b) changes in loss expectations;
c) when a loan performs worse than expected. For this reason, they think the Credit Quality Approach provides less information than the Bucket 1 Approach. This is because the Bucket 1 Approach is based on loan deterioration, so loans in Bucket 2 would be those that have deteriorated since origination, which may provide some information about actual performance compared to expected performance.