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IAS 39 Project Part 2: Can we really expect the unexpected? - Neil Maurice
"An investment in knowledge always pays the best interest" (Benjamin Franklin)
One of the key lessons from the global financial crisis was that expectations and the statistical models relating to them could not account for the sheer speed at which trust and security in financial institutions were eroded.
On 5 November 2009, the IASB issued ED/2009/12 entitled Financial Instruments: Amortised Cost & Impairment as stage 2 of the IAS 39 revamp. Its overriding aim was to move from the current incurred loss impairment methodology to one based on expected losses. Following the receipt of comments in June 2010 and subsequent board meetings, the IFRS is not expected to be finalised until early 2011 with an effective date still to be confirmed.
Under the incurred loss model, impairments on assets held at amortised cost occur when there is objective evidence (known as a ‘trigger event’) of impairment. Expected losses are not permitted and when a trigger event occurs the impairment is recorded in the profit or loss resulting in a marked adjustment. More often than not, this could occur even if the loss had always been expected. The criticisms of the incurred loss model include its over optimistic nature allowing the front loading of interest revenue followed by large adjustments later on together with the inconsistent treatment of similar financial assets based on the various analyses of trigger events.
The move to an expected loss model would require companies to determine expected credit losses when an asset is first originated and recognise contractual interest revenue less expected credit losses over the life of the financial asset. This would be re-assessed at each reporting date with changes taken to the profit or loss. The theoretical result is that it reflects the economic expectations of the lender/owner and avoids the abrupt adjustments to the profit or loss upon incurring a trigger event.
Putting aside the potentially significant implementation difficulties, has the global financial crisis not taught us that expectations and the models creating them are often wrong? Here are just a few of the issues we can think of with the impending move to the expected loss approach:
- Operational challenges: The sheer scale of the requirement to constantly assess portfolios of assets for expected credit losses is unfathomable. While larger institutions may be able to create new and adapt existing departments, how will the small and medium sized entities integrate finance, risk management, investor reporting and third party data providers?
- Availability of data: The Expert Advisory Panel (EAP) formed by the IASB has suggested that smaller banks pool their loan and credit loss data as inputs for more simplistic models. Even if the challenge of sharing data can be overcome, how are smaller lending institutions going to build robust models to forecast expected losses and is the data actually available in the first place?
- Self fulfilling prophecy: The accounting for and disclosure of expected credit losses in the public domain has the potential to create a vicious circle. As banks forecast changes in expected losses and include significant disclosures, does it not have the potential to create a spiral effect on the confidence in asset quality in the market as a whole?
- Inconsistency: If the incurred loss model resulted in an inconsistent treatment as different companies assessed the same trigger events differently, then surely the expected loss approach will have exactly the same effect as companies will forecast the same macro and micro economic factors differently?
- Smoothing earnings: The expected loss methodology enables companies to use complex models to ascertain the expected cash flows at each reporting date. Will this not provide an opportunity for companies to smooth earnings through the cycle?
The incurred loss model was definitely not perfect and the jury is out on whether the expected loss model will actually result in an improvement for the users of financial statements.
Whether we look in the past, present or future, Warren Buffett was right when he said that “In the business world, the rearview mirror is always clearer than the windshield”.
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