Financial Instruments — Impairment
Financial Instruments — ImpairmentSPECIAL REPORTNew Product or Service of the YearContent — Content Marketing Solution
2 Financial Instruments — ImpairmentFinancial Instruments — ImpairmentFinancial instruments are prevalent across all industries and entities. Examplesof financial instruments are loans, receivables (including trade receivables)and securities. These instruments are subject to complex accounting rules onimpairment. The impairment rules help ensure that the financial instruments are notovervalued in an entity’s financial statements.For years, incurredloss models havedrawn stakeholdercriticism, frompreparers to usersof the financialstatements.Current GAAP uses incurred loss models to account for the impairment of many financial instruments.Under an incurred loss model, an entity does not record an impairment loss until the loss is probable.For years, incurred loss models have drawn stakeholder criticism, from preparers to users of thefinancial statements. Overall, critics have asserted that incurred loss models delay the recognition ofcredit losses in an entity’s financial statements.The financial crisis in 2008 reinvigorated the criticisms about incurred loss models. Stakeholdersblamed the delayed recognition of credit losses for inflating the balance sheets of financialinstitutions, especially those with distressed mortgage loans. Consequently, the FASB and the IASBcreated an advisory group, the Financial Crisis Advisory Group, to help identify areas of financialreporting that could be improved following the financial crisis. The advisory group identified incurredloss models as an area for improvement.Figure 1 — Criticisms of the Incurred Loss ModelUsers want information about expected — not incurred — creditlosses on an entity’s various financial assets, such as trade receivablesand investment portfolios. Since users do not have this informationreadily available in the financial statements, users often were left tomake their own estimates of expected credit losses. Users generallyincorporate forecasts of future conditions into these estimates.Preparers have expressed concern about the probability threshold incurrent GAAP. Under current GAAP, even if a preparer expects a loss,the preparer cannot record the loss in its financial statements until theloss is probable.In response, the FASB and the IASB began a joint project to improve the accounting and reporting forimpairment of financial instruments.The goals and objectives of the joint project were to create a single impairment model for financialassets that allows for the timely recognition of credit losses and to improve the usefulness ofinformation provided to users of the financial statements.Ultimately, the boards did not agree on how to address the feedback received on the proposal,and therefore each developed its own impairment approach. In July 2014, the IASB issued its finalguidance on impairment as part of IFRS 9, Financial Instruments. In June 2016, the FASB issuedits final guidance on impairment in Accounting Standards Update (ASU) No. 2016-13, FinancialInstruments — Credit Losses (Topic 326).This special report discusses the FASB’s new guidance on expected credit losses. It also provides ahigh-level summary of the IASB’s impairment model in IFRS 9.
Financial Instruments — Impairment Overview of the FASB’s New Guidance on Expected Credit LossesASU No. 2016-13 fundamentally eliminates the current incurred loss models and replaces them withexpected loss models. To accomplish this, the ASU: Overhauls the existing impairment guidance for financial assets measured at amortized cost andintroduces a new current expected credit loss (CECL) model Makes targeted improvements to the existing rules for available-for-sale debt securitiesThe primary objectiveof ASU No. 2016-13is to give users of thefinancial statementsmore helpfulinformation aboutthe expected creditlosses on financialinstruments.Under the new guidance, an entity must record an allowance for expected credit losses over thecontractual term of a financial instrument. An entity’s estimate of expected credit losses must bebased on not only information about current and past conditions, but also forecasts about the future.Although it is likely that the financial services industry will be the most affected, the FASB has madeit clear that no entity is exempt from this guidance.The primary objective of ASU No. 2016-13 is to give users of the financial statements more helpfulinformation about the expected credit losses on financial instruments. The FASB focused on thefollowing key areas of improvement to achieve this objective: Eliminating the probability threshold that exists in current GAAP Expanding the information considered to estimate expected credit losses Requiring the consideration of forecasts Improving the accounting for purchased financial assets with credit deterioration Enhancing disclosures Requiring credit losses on available-for-sale debt securities to be recorded through an allowanceEach of these improvements is discussed in more detail in Figure 2.3
4 Financial Instruments — ImpairmentFigure 2 — Main ImprovementsImprovementDescriptionEliminatingthe probabilitythresholdthat exists incurrent GAAPCurrent GAAP is based on incurred losses. Stakeholders criticize theincurred loss model because it delays the recognition of a loss orimpairment until the loss is probable.The guidance in ASU No. 2016-13 is based on expected (not incurred)losses. Therefore, an entity no longer waits for a loss to be probablebefore the loss is recognized. Instead, an entity records an allowance thatreflects management’s current estimate of expected credit losses overthe life of the asset.The change from an incurred loss model to an expected loss modelgenerally will result in the earlier recognition of credit losses. In theory,the change will affect the timing (but not the total amount) of creditlosses recognized.Expanding theinformationconsideredto estimateexpectedcredit lossesUnder current GAAP, an entity estimates incurred losses using onlyinformation about past events and current conditions. In other words,under current GAAP, an entity does not consider forecasts about thefuture.ASU No. 2016-13 requires an entity to estimate expected credit lossesusing information about past events, current conditions, and reasonableand supportable forecasts.The FASB thinks that expanding the information considered to estimateexpected credit losses ultimately helps to increase the usefulness of theinformation provided to users of the financial statements. It also alignsthe preparation of the financial statements with the same principles thatissuers consider in the underwriting process.Requiring theconsiderationof forecastsUnder ASU No. 2016-13, reasonable and supportable forecasts must beconsidered to determine expected credit losses.Constituents have asserted that considering forecasts is essentialto developing an estimate of credit losses over the life of a financialinstrument. Ignoring forecasts would produce a misleading estimate ofexpected credit losses.Forecasts must be reasonable and supportable to be included in anentity’s estimate of expected credit losses.
Financial Instruments — Impairment 5ImprovementDescriptionImproving theaccountingfor purchasedfinancialassetswith creditdeteriorationASU No. 2016-13 makes the accounting for purchased financialassets with credit deterioration (PCD assets) more consistent with theaccounting for other financial instruments.Under current GAAP, no allowance is recorded on the day that a financialasset with credit deterioration is purchased. Under ASU No. 2016-13,however, an entity must record an allowance for credit losses on thepurchase date.This change better aligns the accounting for purchased assets andoriginated assets. Under ASU No. 2016-13, an entity must estimateexpected credit losses and record an allowance regardless of whether anasset is purchased or originated. Ultimately, this will make it easier forusers of financial statements to compare purchased assets and originatedassets.EnhancingdisclosuresAlthough many of the disclosure requirements in ASU No. 2016-13 aresimilar to current GAAP, the ASU does include some new or enhanceddisclosures. The disclosures are intended to provide better informationabout: The credit risk associated with the entity’s portfolio of assetsHow management monitors this riskThe entity’s estimate of expected credit lossesAny changes in the entity’s estimateOne of the most notable changes to the disclosures is a new disclosurerequired for public business entities. A public business entity mustdisclose credit quality information for assets by vintage (year oforigination). The FASB thinks that this disclosure provides users ofthe financial statements with better information about an entity’sunderwriting standards. For instance, this disclosure may provide insightinto how strictly an entity looks at credit quality before transacting withanother party and whether the entity has tightened or loosened itsunderwriting policies over time.Similar to current GAAP, the disclosures in ASU No. 2016-13 generallymust be provided by portfolio segment, class of financial assets, or majorsecurity type.Requiringcredit losseson availablefor-sale debtsecurities tobe recordedthrough anallowanceUnder current GAAP, an entity records credit losses as a write down toan available-for-sale debt security. If the issuer’s credit improves in asubsequent period, an entity is prohibited from adjusting the security forthe improvement.Under ASU No. 2016-13, credit losses on an available-for-sale debtsecurity must be recorded through an allowance. If the issuer’s creditimproves in a subsequent period, an entity must adjust the allowance toreflect the improvement.The use of an allowance permits changes in an issuer’s credit (bothimprovements and deteriorations) to be reflected in an entity’s incomestatement in the periods in which the changes occur. This gives users offinancial statements better information about changes in expected creditlosses.
6 Financial Instruments — ImpairmentCompared to currentGAAP, ASU No.2016-13 generally willrequire an entity toapply a larger degreeof judgment as partof its impairmentassessment. The ASUalso is expected toresult in recognizingcredit losses earlier inan entity’s financialstatements.ASU No. 2016-13 adds a new topic to the Codification — Topic 326, Financial Instruments — CreditLosses. Topic 326 is further broken down into subtopics that provide separate guidance for financialassets measured at amortized cost and available-for-sale debt securities. Topic 326 also addressesthe accounting for purchased financial assets with credit deterioration (PCD assets). The guidance inTopic 326 is intended to be measurement guidance, not recognition guidance. Specifically, Topic 326discusses how to measure expected credit losses on financial instruments.In addition, ASU No. 2016-13 makes various revisions to other topics of the Codification. The revisionsprimarily conform the language in the other topics with the new impairment rules in Topic 326. Therevisions, however, also make notable changes to the guidance on beneficial interests in Subtopic325-40, Investments — Other — Beneficial Interests in Securitized Financial Assets.Compared to current GAAP, ASU No. 2016-13 generally will require an entity to apply a larger degreeof judgment as part of its impairment assessment. The ASU also is expected to result in recognizingcredit losses earlier in an entity’s financial statements.ASU No. 2016-13 is a significant new standard and is expected to require considerable cost andeffort to implement. The FASB expects to receive a number of implementation questions about thestandard and has created a transition resource group to help field questions as they arise.Scope of the FASB’s New Guidance for Reporting Expected Credit LossesASU No. 2016-13 applies to all entities. While financial institutions may be affected the most by thenew standard, all entities with financial instruments (including net investments in leases and tradereceivables) are expected to be affected to some degree.Observation: The degree to which an entity is affected by ASU No. 2016-13 will dependon various factors, such as: The size of an entity’s portfolio of assets The composition of the portfolio The level of credit risk associated with the portfolio The availability of data for estimating expected credit losses The company’s existing capabilities and expertise around modeling and estimatesASU No. 2016-13 applies to a wide range of instruments, including: Financial assets measured at amortized cost, such as:–– Loans–– Held-to-maturity debt securities–– Trade receivables from revenue transactions with customers–– Reinsurance recoverables–– Receivables related to repurchase agreements or securities lending agreements Lease receivables (specifically, net investments in leases) Loan commitments, standby letters of credit and other similar off-balance-sheet creditexposures that are not accounted for as insurance Available-for-sale debt securities
Financial Instruments — Impairment 7Observation: ASU No. 2016-13 does not apply to equity securities. In January 2016, aspart of the FASB’s overall project to improve the accounting for financial instruments,the FASB issued ASU No. 2016-01, Financial Instruments — Overall (Subtopic 825-10):Recognition and Measurement of Financial Assets and Financial Liabilities.Equity securities are within the scope of ASU No. 2016-01, which generally requiresthese instruments to be reported at fair value with changes in fair value recorded innet income.Financial Assets Measured at Amortized CostASU No. 2016-13 introduces a new impairment model for financial assets measured at amortizedcost, such as held-to-maturity debt securities, loans and receivables. The new impairment model forthese assets is referred to as the current expected credit loss (CECL) model.The CECL model is discussed in detail in Subtopic 326-20, Financial Instruments — Credit Losses —Measured at Amortized Cost.The CECL model is based on expected losses. An entity must establish an allowance that reflectsmanagement’s estimate of expected credit losses over the life of the asset.Observation: The concept of an allowance is new for certain instruments subject to theCECL model. For example, under current GAAP, an entity does not record an allowancefor held-to-maturity debt securities. Instead, current GAAP requires an entity to record adirect write down to the amortized cost basis of a held-to-maturity debt security that isother-than-temporarily impaired. The removal of the concept of “other-than-temporaryimpairment” is one of the most significant changes by ASU No. 2016-13.Under ASU No. 2016-13, an entity has the flexibility to determine which method it will use todetermine the allowance. An entity might use methods that consider discounted cash flows, lossrates, roll rates, probability of default, aging analyses or other factors.Observation: An entity is not required to use a complex estimation method. Publicentities, however, typically will be held to a higher standard than nonpublic entities. Inother words, public entities generally will be expected to have more sophisticated andprecise estimation methods than nonpublic entities because public entities tend to haveaccess to more resources and expertise. Therefore, it is likely that many public entitieswill use a discounted cash flow method to project their expected future cash flows andin turn, derive current expected credit losses.An entity must estimate expected credit losses on a collective (pool) basis for assets that have similarrisk characteristics. An entity must estimate expected credit losses on an individual basis for an assetthat has unique risk characteristics.Observation: The concept of assessing impairment for a pool of assets is new for certaininstruments subject to the CECL model. For example, under current GAAP, an entityevaluates individual held-to-maturity securities separately for impairment.Observation: An entity must establish an allowance for an asset on either an individualbasis or a collective basis. An entity must be careful not to double count an asset byboth evaluating it individually and including it in a pool of assets.
8 Financial Instruments — ImpairmentTo estimate expected credit losses, an entity must consider all available information that is relevant tothe assessment. This includes information about past events, current conditions and reasonable andsupportable forecasts. An entity must make a reasonable effort to obtain the relevant information. Anentity, however, is not expected to use undue cost and effort.An entity must estimate expected credit losses over the life of the asset (not a shorter period, suchas 12 months). The life of the asset is the contractual term of the asset. An entity must not considerfuture extensions, renewals or modifications of a loan or receivable unless the entity reasonablyexpects to enter into a troubled debt restructuring with the debtor.An entity records an allowance for expected credit losses even if the risk of loss is remote.Observation: In very limited cases, an entity might not expect any credit losses over thelife of the asset. Thus, the entity might record an allowance equal to zero. For instance,this might be the case for a U.S. Treasury security or an instrument that is expected tobe 100-percent collateralized over the life of the instrument.Before reaching a conclusion that no credit losses are expected, an entity must consider allof the facts and circumstances. If an entity reaches this conclusion, it is important for theentity to maintain appropriate documentation to support its conclusion. The FASB expectsthese cases to be rare. In other words, an entity typically will foresee at least some creditlosses over the life of an asset.The allowance for expected credit losses is presented on the balance sheet as a reduction to theamortized cost basis of the assets, as shown in Figure 3.Figure 3 — Balance Sheet Presentation for Financial Assets Measured at Amortized CostCompany ABCBalance Sheetas of December 31, 20X1Cash. XXLoans at amortized cost. XXAllowance for expectedcredit losses.(XX)Loans, net of allowance. XXOther assets. XXTotal assets. XXFor off-balance-sheet credit exposures, an entity must present expected credit losses as a liability onthe balance sheet. This liability must be presented separately from the allowance for credit losses.Examples of off-balance-sheet credit exposures are off-balance-sheet loan commitments, standbyletters of credit and financial guarantees that are not insurance.The allowance must be remeasured each reporting period to reflect management’s current estimateof expected credit losses. If an entity establishes an allowance for a pool of assets, the entity mustcontinue to evaluate if the assets in the pool have similar risk characteristics.
Financial Instruments — Impairment 9Changes in the allowance are recorded in income. Changes in the allowance generally must berecorded as credit loss expense. An entity has a choice of how to reflect the change, however, if it usesa discounted cash flow approach to estimate expected credit losses. Figure 4 shows the two optionsavailable. This figure uses the following assumptions: An entity uses a discounted cash flow approach to estimate expected credit losses The entity has a loan receivable. The allowance for credit losses at the beginning of the periodis 5,000. The entity’s estimate of expected credit losses at the end of the period is 6,000.Therefore, the total change in the allowance is 1,000. Of the total change in the allowance, 50relates to the passage of time.Figure 4 — Two Options if an Entity Uses a Discounted Cash Flo
The impairment rules help ensure that the financial instruments are not overvalued in an entity’s financial statements. Current GAAP uses incurred loss models to account for the impairment of many financial instruments. Under an incurred loss model, an entity does not record an impairment loss until the loss is probable. .
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3 December 2014 Impairment of financial instruments under IFRS 9 What you need to know The impairment requirements in the new standard, IFRS 9 Financial Instruments, are based on an expected credit loss model and replace the IAS 39 Financial Instruments: Recognition and Measurement incurred loss model. The expected
associated with the impairment test, the impairment-only approach may be favoured by users in providing information about the success of business combinations and avoiding arbitrary amortisation expenses. However, the Board also noted that an impairment test would be required under both the impairment-only and amortisation approaches.
An impairment test must be undertaken if there are indications of impairment. Consequently, the identification of indicators of impairment becomes a crucial stage in the process. IAS 36 provides guidance in the form of a list of internal and external indicators of impairment. It stresses that this list is the
This Section explains the process for the quantitative impairment test – in other words estimating the recoverable amount of the asset or group of assets and comparing this to the carrying value. The impairment test determines if an entity needs to record an impairment loss or reverse a previous loss. This Section covers the following Steps:
impairment, with a greater weight given to objective findings. It is the responsibility of the . examination and test , results . 5. Follow the recommendations to establish a level of impairment. 6. For a non- schedule permanent disability, evaluate the impact of the impairment(s) on
Goodwill and Impairment (Agenda Paper 18) The Board met on 25 January 2018 to discuss whether it can simplify the value in use calculation without making the impairment test in IAS 36 Impairment of Assets less robust. The Board tentatively decided to consider removing the requirement for an entity to exclude from the value in use
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