Expected vs. Incurred Loss Models

On November 5, the International Accounting Standards Board issued an exposure draft on the amortized cost measurement and impairment of financial instruments. The exposure draft proposes an expected loss model for recognizing impairments on financial assets recorded at amortized cost.

As noted in the IASB press release, currently, both U.S. GAAP and IFRS use an incurred loss model for recording impairments on financial assets. Under an incurred loss model, impairments are recognized only after a loss or trigger event is identified. An expected loss model would recognize loss estimates throughout the life of a loan (or portfolios of loans) and other financial assets recorded at amortized cost.

A column in the Financial Times, Beware the ripple effect of accounting losses, warned that the expected loss model would accelerate losses at the beginning of a down cycle and, consequently, still have a pro-cyclical effect. However, the Financial Crisis Advisory Group (FCAG), a group of senior leaders with broad experience in international financial markets, supports exploring alternatives to the incurred loss model, including the expected loss model and a fair value model. The Basel Committee on Banking Supervision released a statement earlier this year calling for accounting changes, including the need for earlier recognition of loan losses to ensure robust provisions.

The FCAG in their July report to the FASB and IASB expressed concern about the risk of earnings management and said the Boards should take care to develop an approach that would not foster earnings management, which would decrease transparency.

Do you believe that a move to an expected loss model and the proposals introduced in the exposure draft would be a move in the right direction? Let us know what you think.

- Paul Parks | www.IFRS.com

Comments

[Joe Jefferis]

If a few bankers were held to the personal accountabilty standards of existing Sarbanes-Oxley laws, then more global elite bankers would act quicker to behave in a responsible manner.

Ken Lewis and the Bank of America board of directors failed to disclose extensively larger losses when they sought shareholder approval to purchase Merril Lynch.

While the Supreme Court is scheduled to rule on the Constitutionality of Sarbanes-Oxley laws, the man caused disaster we refer to as the financial crisis of 2008 did not extinguish the purpose or existence of USA's Sarbanes-Oxley laws.

"Up to 20 years in prison for providing false and misleading statements." No caveat for exceptionally misleading statements during a financial crisis was contemplated, just the opposite.

Intergrity is more important than ever in a time of crisis. We will have to wait and watch to see how the Judicial Branch of the government reconcilies the facts and the laws.

[Rich Jones]

Although I am uncomfortable with all the projections of values that seem to be intruding on true and fair finncial statement reporting, I am equally concerned about the unwillingness of banks and other financial institutions to recognize losses on their existing financial assets. Of course, one could argue that existing accounting rules requires recognition of those losses based on historical estimates of portfolio performance and current economic conditions. Yet, they resist. Maybe the proposed guidance, with detailed disclosure, will highlight, for investors, those companies that continue to resist recognizing losses on their underwater financial assets.

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True, we can come up with historic trends. We can come up with estimates as to what percent of receivables are going to go bad at some future date. But when that future date comes, we know that the actual percent will more probably be either more or less than this projected rate.

[Ca Homes]

"Allowing mark-to-market accounting in financial statements was a contributing factor in the financial crisis of 2008."

I do Agree with this.

[John Wall]

I feel that the question of whether GAAP or IFRS should use an incurred loss model for recording impairments on financial assets versus an expected loss model turns on what the understood purpose of financial statements prepared using IFRS rules is. Are IFRS statements intended to present the current financial condition of the entity being reported on, or are they intended to project what the financial condition will be in some future period.

If an audit testing of a financial asset reveals that the debtors behind these assets are in arrears on their payments, or that the collateral underlying the asset is grossly insufficient, these are historic considerations which must be taken into account in evaluating the true current value of these assets. However, if the payments are current and the underlying asset are sufficient then there is reason to accept the historic value of the asset at face value. True, we can come up with historic trends. We can come up with estimates as to what percent of receivables are going to go bad at some future date. But when that future date comes, we know that the actual percent will more probably be either more or less than this projected rate. Why not leave the risk of future default lye where it belongs – in the investor’s lap. If IFRS can make it perfectly clear what the current condition of the entity and its components is, the investor will be in a good position to estimate the level of risk on his own and invest accordingly.

Recently Robert Herz has commented that “the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario” by the stress tests conducted on major U.S. bank holding companies was “related to loans and other receivables carried on a historical cost basis . . . and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting . . . has done a better job of indicating the true financial condition of those assets than the cost basis.” Clearly this reveals a bias towards projecting what the value of assets will be under some future unknown circumstances than towards reporting what they are worth today under current conditions. If the fair value of an asset under today’s market conditions needs little or no adjustment to reflect values under a future, fictitiously adverse scenario, then aren’t we failing in our obligation to report the current, unbiased value? And if an investor starts with values on a financial statement that already reflect future adverse scenarios, isn’t he going to come up with totally fallacious values once he puts his own risk adjustments to it. Won’t he end up applying risk excessively?

It may sound demeaning to relegate IFRS statements to an admitted historic role, but isn’t this where the true value of IFRS statements and of the CPA’s who report on them resides? I grew up with a great pride that CPA’s should be chosen to tally up the votes for the Academy Awards, etc., but aren’t they chosen because of their integrity in unbiased reporting of the “historic” votes as they were given by the academy members rather than their ability to put their own spin on the results?

Let’s end the chase to see who can report future adverse financial results the earliest. Leave this to the investor. It is not the purpose of IFRS to protect the investor from his own responsibility to forsee future events.

[Joe Jefferis]

Expected loss sounds like a bad idea or concept for a system build on real profits and free enterprise capitalism.

Much like an "expected profit" business model (mark-to-market bubblemaking) playing tricks with expected losses is smoke and mirrors financial reporting.

Allowing mark-to-market accounting in financial statements was a contributing factor in the financial crisis of 2008.

IFRS is a bad idea for free enterprise capitalism.