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Cloud Across Atlantic
Cloud Across Atlantic
Often the clouds across Atlantic clash with each other and cause
torrential downpour across civilisations that lie on its shore. Often it stays
cloudy for days and then suddenly the sun comes out brightly forcing the
clouds to retreat, but a prudent man would always reach for the umbrella
since one never knows. In the wonderland of accountants we see such a
cloud growing in strength arising out of the loss provisioning norms
suggested under exposure draft of IFRS 9 and consequent industry
reactions coupled with the differential view taken by FASB. This article
takes a look into the provisions and impact that can be felt at the desk of
the accountants.
1) Scope: The standard requires providing for a credit loss provision for
all financial instrument that are subject to erosion in value arising out
of credit risk The proposed approach will apply to all financial assets
carrying credit loss risk on them. Some loan commitments and financial
guarantee contracts will also be covered by the approach. Following
financial instruments are covered by the proposal:
a) Originated, purchased, reclassified or modified debt instruments
that are measured at amortised cost in accordance with IFRS 9
Financial Instruments
b) Financial assets measured at fair value through other
comprehensive income
c) Loan commitments unless measured at fair value through profit or
loss
d) Financial guarantee contracts unless measured at fair value through
profit or loss
e) Lease receivables within the scope of IAS 17 Leases.
2) Methodology: The expected credit loss estimate should reflect two
aspects:
a) Probability Adjustment: An unbiased and probability weighted
amount which would encompass a range of possible outcomes. This
can be described by a matrix comprising of extent of loss in lifetime
cash flow on default and probability of such loss arising. We will
describe this matrix in greater details later in the article.
b) Time Value Adjustment: Adjustment for time value of money
arising out of payment delayed beyond contracted schedule. This is
essentially the present value of the lifetime cash flow due and the
amount the entity now expects to receive. The relevant discounting
rate should be between the risk free rate and effective interest rate
of the financial asset, though the range may be violated on period
after initial recognition due to changes in risk free rate. In case of
undrawn loan commitments and financial guarantee contracts, the
discount rate should reflect the current market assessment of the time
value of money and risks specific to the cash flows. In cases of purchased
or originated credit impaired financial assets, credit adjusted effective
interest rate should be used to discount cash flows.
3) Recognition: Recognition of the expected credit loss is broken up in a
three-stage. In the first stage an entity will apply portfolio approach to
provide for such losses unless any individual asset demonstrates signs
of specific impairment. In such cases the individual asset will be
marked separately and move on to the second or third stage, as the
case may be. An overview of the three-stage approach is stated below:
a) First stage: We will identify all financial instruments with low credit
risk or whose credit quality has not deteriorated significantly since
initial recognition. A 12 month expected credit loss will be
recognised for these assets which is essentially a product of
probability of default over a 12 month period following the reporting
date and the total expected credit loss arising out of the default.
Interest revenue, wherever required, would be computed on the
gross value and not after adjusting the provision. Trade receivables
which do not constitute a financing transaction will follow a
simplified approach and provide for credit loss using a provision
matrix depending on days overdue. Since most of such receivables
will have a lifetime of less than 12 months, the 12-month credit
provision and lifetime credit provision will be the same. Long term
trade receivables and lease rent receivable can follow either the
three-bucket approach or the simplified approach.
b) Second stage: At this stage we will identify financial instruments
excluding those rated as investment grade as on the reporting
date, that has suffered significant loss in credit quality since initial
recognition. A lifetime expected credit loss would be recognised.
This will be computed by using the probability of default occurring
anytime over the lifetime of the instrument. Interest revenue,
wherever required, would continue be computed on the gross value.
c) Third stage: Financial instruments as this stage would manifest
demonstrate objective evidence of impairment on the reporting
date. A lifetime expected credit loss is to be recognised for all such
instruments and interest revenue, wherever applicable, will be
computed on the net carrying amount that is gross carrying amount
reduced by the lifetime allowance for credit loss. All purchased
credit impaired asset will have the same treatment.
4) Disclosure: The proposed disclosure seeks to identify and state the
impact of expected credit losses amounts on the financial statements
and the effect of deterioration and improvement in the credit risk of
relevant financial instruments.
Major difference between IASB and FASB lies in that FASB considers all
contractual cash flows that are unlikely to be collected instead of the 12
month and lifetime credit loss approach preferred by IASB and
consequently the exposure draft of FASB do not have a transition criteria.
In addition as against no recognition exception proposed by IASB, FASB
provides for recognition exception to financial assets measured at fair
value through profit and loss if the fair value exceeds amortised cost and
expected credit loss is insignificant.
Having discussed the proposed standard let us look into the three major
steps necessary for operationalising the model.
Though various models can have different designs but looking at the time
and expertise that a non-banking institution is likely to have for such
complex computation and interpretation process, my personal favourite
are the models that provides a probability of default using the multiple
variable driven model described earlier. Thus we will have a single value
ranging from 0% to 100% denoting the probability of default. The data
analysis necessary to arrive at this probability of default value will allow
us to find the expected loss, as a percentage of the exposure value, that
the entity may suffer given a default. All we now need is to identify the
discounting rate.
Consider a company have customers from two regions - Middle East and
Europe with total customers numbering 200 and 250 respectively. Past
evidence suggests that expected default rate to be 10% and 8%
respectively. Following table shows the computation procedure required
to find out the loss rate.
No. Averag Probabi Exposur PV
of Total e lity e of Expect
Clien Expos Exposu of at Los ed
Region t ure re Default Default s Loss
E=C x A
A B C=B/A D xD E F = E/B
Middle 16843 131
East 200 6 842 10% 16840 35 8%
23898 152
Europe 250 2 956 8% 19120 96 6%
No matter how the company addresses the issue, the 1st January 2015
deadline is closer than it may seem on the calendar considering the
complexity of model design. It may be sensible to start rolling out the
enablers. Even without regulatory requirement, it is a good practice to
adopt. In face of a dark cloud, an umbrella is always handy.