The IASB and FASB have issued a supplementary document to the their original proposals on impairment of financial assets. John Althoff and Yulia Feygina, from PricewaterhouseCoopers' (PwC) Accounting Consulting Services Central Team, look at the implications.
This document, Financial instruments: Impairment, proposes a common approach to the timing of recognition of expected credit losses on financial assets managed in an open portfolio. The proposals reflect the feedback received on the boards' original impairment models; it will help the boards in developing a common approach to credit loss recognition.
The supplement proposes a dual impairment model driven fromthe credit characteristics of the financial assets. This is consistent with how banks manage credit risk and is often referred to as a good book and bad book approach.
Financial assets in the good book
Impairment will be recognized on a portfolio basis over the life of the book such that the allowance account is the higher of:
The supplement does not describe how to measure expected credit losses. However, it illustrates how to use expected loss estimates and the weighted average age and life of a portfolio to calculate the time-proportionate expected credit losses.
Financial assets in the bad book
The boards have concluded it is not appropriate to recognize impairment losses over time on a bad book. Instead, the entire amount of the lifetime-expected credit losses will be recognized immediately. Whether or not it is appropriate to recognize expected credit losses over time depends on the degree of uncertainty about the collectibility of a financial asset. When collectibility becomes so uncertain that the entity's credit risk management objective changes from receiving regular payments to recovery, it is no longer appropriate to recognize impairment losses over time, and the financial asset should be transferred into a bad book.
Financial assets, therefore, move between the good book and the bad book according to the entity's internal risk management policies.
The common proposal is the result of the joint IASB and FASB discussions on an impairment model for credit losses that addresses the primary objectives of the individual boards. However, some members of the IASB and FASB prefer the models that they were developing separately. The supplement, therefore, also seeks comments on the respective IASB and FASB approaches, in addition to the common proposal.
Under the IASB alternative approach in the supplement, an entity recognizes the time-proportionate lifetime-expected credit losses on a good book with no floor, and the full amount of lifetime-expected losses on a bad book. This reflects the IASB's view that expected credit losses are priced into the margin earned on financial assets.
Under the FASB alternative approach, an entity immediately recognizes all credit losses expected to occur in the foreseeable future, with no minimum period specified. There is also no split between good book and bad book. This reflects the FASB's objective of ensuring a sufficient impairment allowance at any point in time.
The scope of the proposals is limited to open portfolios – that is, portfolios that contain financial assets with similar credit characteristics irrespective of the time of their origination. The boards invite comments as to whether the proposed approach is suitable for closed portfolios, individual instruments and any other types of instrument.
For the IASB, the proposals exclude from the scope short-term trade receivables, pending re-deliberations of the revenue exposure draft (ED).
The boards are not re-exposing other aspects of the impairment model, such as measurement of credit losses or interest revenue recognition. They will continue re-deliberating these issues based on the feedback received from their original EDs while the supplement is open for comment.
The supplement contains an IASB-only appendix, which seeks input on:
The common proposal will mainly affect financial institutions that manage their financial assets on an open-portfolio basis.
If the proposals are extended to other types of portfolio and financial assets, they may affect any entity that holds financial assets measured at amortized cost under IFRS 9, or those not measured at fair value through net income under the FASB's tentative classification and measurement model.
The comment deadline is April 1, 2011. The IASB expects to finalize the impairment requirements by June 2011. It has not yet decided when the proposals will be mandatory. The FASB expects a final update on the credit impairment model to be issued in 2011.
Management should assess the impact of the proposals and consider commenting on the supplement to ensure its views are considered.
The FASB is continuing its work on the joint project with the IASB on financial instrument accounting. It seems to be moving away from the proposals in its May 2010 document, 'Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities', which considered fair value accounting for financial assets. In its re-deliberations, it has made significant, tentative decisions for financial assets, which would include the introduction of an amortized cost category, resulting in three categories overall:
Its latest decisions are intended to address the many concerns expressed in comment letters received in response to the May 2010 proposal. The FASB's decisions could be viewed as a step closer to the IASB's approach, but they are not fully convergent at this stage. The FASB and IASB plan to meet once their respective models have been more fully developed in order to consider how any remaining differences can be reconciled.
The IASB and FASB have issued proposals that would eliminate the single largest balance sheet difference between the two accounting frameworks today.
The ability to net or offset certain financial assets and financial liabilities can create trillion dollar differences between the balance sheet of a financial institution reporting under IFRS and one reporting under US GAAP.
These proposals would result in little change for entities reporting under IFRS but a big change for US GAAP preparers, particularly financial institutions.
The proposals require an entity to offset a recognized financial asset and financial liability only if it has an unconditional right of set-off and intends either to settle the financial asset and financial liability on a net basis or to realize the asset and settle the liability simultaneously.
An unconditional right of set-off is a right that exists in the normal course of business and is enforceable in all circumstances.
Master netting agreements where the legal right of offset is only enforceable on the occurrence of some future event (such as default of the counterparty), would not meet the offsetting requirements.
The proposals will expand disclosure requirements under IFRS and US GAAP. The disclosures focus on quantitative information about rights of set-off, including conditional rights of set-off, and related collateral arrangements.
Transition and effective date
The boards propose that the requirements should be applied retrospectively. The ED does not propose an effective date, as these are being addressed in a separate discussion paper. However, we expect the final standard to have an effective date no earlier than January 1, 2013.
Am I affected?
The comment letter period ends on April 28, 2011; a final standard is expected mid-2011. Management should consider commenting on the ED to ensure their views on the proposals are considered.
The comment period for the ED, Revenue from contracts with customers, ended in October 2010. Andrea Allocco, in PwC's Accounting Consulting Services Central Team, looks at the key themes emerging from the responses received by the IASB and FASB.
The IASB and FASB got a record-breaking number of comment letters (over 980) in response to the ED Revenue from contracts with customers. The proposed standard could significantly change the way revenue is recognized in many industries; the focus would change from completion of an earnings process and industry-specific guidance to a single, contract-based model that reflects changes in contract assets and liabilities.
The boards hope to issue the final standard in June 2011 — more on this below.
One would have expected over 980 comment letters to present a diversity of views, and this was certainly the case. But responses did show a number of common themes. Many of these highlight the delicate balance required between preserving a single, principles-based model and providing adequate guidance to ensure consistent application.
Summary of observations
|Separating a contract. The boards proposed a two-tier approach. The contract is first segmented for goods or services that are independently priced, and then evaluated for separate performance obligations, which provide a distinct good or service.||Respondents consistently suggested that the first step in the guidance is not required as long as the principle for identifying performance obligations is clarified. Many objected to the subjectivity in the proposed concept of distinct performance obligations and expressed specific concerns over the use of distinct profit margin as an indicator.|
|Recognition. Revenue would be recognized when control of a good or service transfers (when a performance obligation is satisfied).||Most respondents agreed with the principle but requested additional clarification for assessing when control transfers continuously, especially in service contracts.|
|Measurement. The amount of revenue recognized should include the probability-weighted estimate of any variable consideration and should reflect the time value of money if material.||Most respondents argued that a probability-weighted approach is not always practical or appropriate and proposed that a best estimate model be permitted. Respondents agreed with the principle of time value of money but suggested that the application challenges outweigh the benefits unless there is a clear financing component.|
|Warranties. The boards proposed two types: a latent defect warranty, which may indicate that the sale has not occurred; and a warranty for post-sale defects, which is a separate performance obligation for which revenue is allocated.||Respondents generally disagreed with the proposal because it is difficult to distinguish between the different types of warranties. Some also suggested that the current warranty models should be retained, as they are understood in practice, and reflect the substance of warranty obligations.|
|Onerous contract provisions. The ED requires a provision for each performance obligation in which the present value of the probability-weighted direct costs exceeds the allocated transaction price.||Respondents thought that a contract-level assessment may be more appropriate. Some also thought that onerous provision accounting would be better addressed in the relevant liability or contingency standards.|
Respondents also commented on several other matters, including the accounting for credit risk, the extent of disclosures and the impact of retrospective application.
The ED attracted comment from a number of industries. Some key concerns are highlighted below.
The boards have begun re-deliberation with the two fundamental issues raised by the comment letter process:separating a contract and performance obligations, and determining when control over goods or services is transferred. The preliminary discussions focused on the development of separate recognition criteria for goods and services, establishment of a less complex approach to segregating contracts and the concept of 'distinct' goods and services.
The timetable could be affected by the extent of re-deliberations required to address respondents' concerns; the interaction of the ED with the leasing project; and the request for views on effective dates and transition methods of other new standards expected in 2011.
The final standard is likely to have an effective date no earlier than 2014; we expect the proposals in the ED to change before implementation. However, management should begin to consider the impact of the proposals on existing contracts with customers and broader implications on processes and controls.
For more information on the comment letter responses, see PwC's Practical guide — Revenue from contracts with customers.
The IASB and FASB have received over 770 comment letters in response to the proposed leasing standard (a record beaten only by the responses to the revenue ED (see article above)). These, combined with the consultation they have undertaken, including a number of round-table discussions, have given the boards some food for thought. A director in PwC's Accounting Consulting Services in the UK, Marian Lovelace, looks at some of the themes.
January's public round-table discussions on the leasing project provided an early indication that the boards are willing to address some of the issues raised by constituents; however, these discussions were only educational sessions, and no formal decisions have been made. There were several themes in the comment letters and round-table discussions, even across industries. There was broad support for the need for the project in general, especially, as it aims to bring all leases onto lessees' balance sheets; however, most respondents expressed concerns about many aspects of the proposals. They are encouraging the boards to take the necessary time to produce a standard that is both high quality and operational.
The boards have outlined five key areas where re-deliberation is necessary, namely:
Decisions made during the re-deliberation of these key areas could significantly change the direction of the project. The boards are still targeting to issue the final standard in the second quarter of 2011; so there is substantial work left to do.
The table below summarizes the key comment letter themes by topic. For more information on the comment letters responses, see PwC's Practical guide — Leasing proposals: the results are in.
Summary of comments
|Definition of a lease||There was a high level of concern raised regarding the fundamental question of whether an arrangement contains a lease, both in relation to the current accounting model and the proposed model. Some respondents indicated that many transactions legally identified as a lease may not be a lease for accounting purposes under the proposed definition. Others have indicated that certain other contracts, although called something else, may be fundamentally a lease, such as some power purchase contracts. Still others have raised significant concerns that there may be many more multiple-element contracts than originally expected that contain an embedded lease, which would substantially increase the complexity of applying the proposed standard.|
|Lessee accounting||Many respondents supported the right-of-use model for lessees, at least, with respect to the balance sheet implications for simple leases. However, many disagreed with the measurement provisions for more complex leases. In addition, many expressed concern about the "deemed financing" premise and resulting accelerated expense recognition pattern.|
|Lessor accounting||Views on lessor accounting are more diverse. The ED proposes a hybrid model, under which certain leases are accounted for under a performance obligation approach, while others are required to use a de-recognition approach. Many believe that the proposed hybrid model for lessor accounting has not yet been demonstrated to be a significant enough improvement from the current model to warrant a change. Some believe that a hybrid model is necessary to deal with different business models (for example, financing versus contracts to use). Others believe a hybrid model is not consistent with concepts in the revenue recognition ED and that only a de-recognition approach is appropriate.|
|Extension options||Almost all respondents disagreed with the definition of lease term as the longest possible term "more likely than not" to occur. They believe this may result in recognition of amounts for extension periods that do not meet the definition of a liability. They also believe this approach would be highly subjective in application, result in significant volatility and could be subject to manipulation in practice. While most respondents believe that some extension options should be included, there were differing views regarding the threshold at which respondents believe they should be recognized.|
|Contingent payments||The ED proposes that contingent payments generally be included in the amounts recorded using a probability-weighted approach. Most respondents were critical of a probability-weighted approach and believe a best estimate approach is more appropriate. Some respondents also believe that certain types of contingencies (usage, performance or index-based) should be treated differently, although there were differing views as to which types should be included and why.|
|Profit and loss recognition pattern||The ED includes an inherent financing element in the right-of-use model. This model results in a recognition pattern for the lessee that changes the expense recognition pattern of operating leases from rental expense to a combination of amortization and interest expense. It will also typically result in the acceleration of expenses compared to today's operating lease accounting and the timing of cash payments. Many respondents questioned the usefulness of this information.|
|Reassessment||The ED provides for reassessment of significant assumptions if facts and circumstances indicate there would be a significant change in the amounts from a previous reporting period. Many respondents raised concerns about the operationality and cost/benefit of this approach. Some respondents indicated that an annual reassessment may be appropriate; others suggested a trigger-based reassessment.|
|Transition||The ED provides for a simplified retrospective approach and does not allow for early adoption. Many respondents supported this approach for cost/benefit reasons, but others observed that it creates an artificial and non-recurring expense pattern. Many respondents also asked for more guidance on transition issues in general (for example, use of hindsight) and for specific issues (for example, sale leasebacks and build-to-suit leases).|
|Disclosure||Most respondents supported the overall disclosure objectives, but believe that preparers should be allowed to exercise judgment in determining the volume of disclosures and financial statement presentation.|
This is the second article in a series regarding issues affecting countries that are moving to IFRS. This month, ACS partner in Korea , Kyungho Lee, looks at the scope of the consolidation requirements, the measurement of post-employment benefits and classification of financial liabilities and equity instruments.
The first step in the transition to IFRS is defining a reporting group. A reporting group includes a parent and all subsidiaries that the parent controls. Control is defined in IAS 27, Consolidated and Separate Financial Statements, and is not subject to local regulations. The definition of what is and is not a group entity will change the whole picture of the IFRS financial statements.
The scope of subsidiaries under Korean GAAP has been regulated by local law. For example, when an entity owns over 50% of the shares of another entity, or owns over 30% of the shares and is the number one shareholder, the entity is deemed to control that entity. However, the entity is not a subsidiary and is not consolidated if the total assets of entity are less than KRW 10 billion (a small-sized company). This is considered to be one of the major differences between Korean GAAP and IFRS. Many Korean companies are facing consolidation judgments on transition. Some examples are outlined below.
Does control reside with the major shareholder if it holds more than 30% but less than 50% interest?
There is a potential complication about to be added to the debate on de facto control decisions. The IASB is expected to issue a new standard, Consolidated Financial Statements, in March 2011. More guidance on de facto control will be included in this standard and the impact on the current discussions is unclear until the new standard is available.
If the new standard is not available for adoption until after 2011 and results in changes in consolidation scope, it would cause significant distress among Korean companies adopting IFRS in 2011. This will be one of the most controversial issues when the new standard comes out.
Consolidation of small-sized subsidiaries
The local regulation exempting consolidation of small-sized subsidiaries will no longer be effective on transition to IFRS. All entities will therefore have to be consolidated by their controlling investor regardless of size.
Adopting IFRS is not just a change in accounting standards. It involves a transformation in a companies' operations, and a wide range of areas need to be considered. One of the most significant issues in Korea relating to this change of framework is pension accounting.
orporate pension schemes were only recently introduced in Korea. Basic compensation schemes for completion of service by employees has been the severance payment, in which a lump sum amount is paid based on the length of service and the average salary in last three months. Under Korean GAAP, the company's liability for a severance payment was measured at the liquidation value; the full amount to be paid by the company to all employees for a severance payment was recognized at the reporting date.
The actuarial technique for estimating the amount of benefit is a daunting issue –not only for preparers but also for auditors. There has been no practice of involving third party actuaries or valuation specialists to measure a company's liability to employees. Management has had to set-up a whole new process and internal controls to cope with the new requirements. Additional audit procedures should also be performed to verify the competence and objectiveness of third party actuaries or pension fund providers, and to review the plan valuation and disclosure items provided by them.
In tandem with the fair valuation of financial instruments and other non-current assets, the requirement for actuarial valuation is changing the way Korean companies manage financial reporting as we move toward IFRS.
Under Korean GAAP, equity and derivatives to be settled in the issuer's own equity instruments have been classified as equity regardless of their substance, based on the terms and conditions. All preference shares and derivatives that oblige the company to deliver cash to another entity and that cannot meet the "fixed for fixed" requirement under IFRS are classified as equity.
Many companies in Korea have issued redeemable preference shares, which are redeemable at the holder's option. These companies are required to recognize more liabilities and less equity on transition to IFRS. The reclassification from equity to liability will increase the debt-equity ratio.
In Korea, conversion rights in convertible preference shares often contain terms that violate the fixed for fixed requirements, typically, through adjustments to the conversion ratios based on pricing of future share issuances. Where debt and equity reclassification includes derivatives, the knock-on effect on the issuers is more pervasive. Since derivative liabilities are required to be measured at fair value at every reporting date, issuers often rely on third party valuation specialists to provide the fair values. Application of such new valuation strategies will require the implementation of more control processes and result in the increased cost of financial reporting. In addition, continuous re-measurement increases volatility in profit and loss and key financial ratios.
As the deadline for IFRS adoption gets closer, we are working with companies to iron out some of these complexities and move towards a smooth transition.