«Dear Sir or Madame, Comments on the Exposure Draft “Financial Instruments: Amortised Cost and Impairment” We appreciate the efforts of the ...»
June 30, 2010
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
Dear Sir or Madame,
Comments on the Exposure Draft
“Financial Instruments: Amortised Cost and Impairment”
We appreciate the efforts of the International Accounting Standards Board (IASB) on the
financial instruments project and welcome the opportunity to comment on the Exposure Draft
“Financial Instruments: Amortised Cost and Impairment” (hereinafter referred to as the “ED”).
The views described below are those of the Financial Instruments Technical Committee within the Accounting Standards Board of Japan.
General Comments We support the objective of the ”Amortised Cost and Impairment” phase of the IASB’s Financial Instruments project that aims at improved measurement of amortised cost to provide more decision-useful information to users, particularly in transparency of provisions for losses on loans and the credit quality of financial assets.
We acknowledge the weakness of the current impairment model that recognition of credit losses might be belated.
In our view, the ED’s proposal to reflect initially estimated credit losses in an effective interest rate is conceptually acceptable. However, we have concern about the proposal to require immediate recognition of the effect of changes in subsequently estimated credit losses in profit or loss through revising the estimate every reporting period.
Our primary concern is that measuring amortised cost as the present value of expected cash flows at all times would be inconsistent with the concept of adopting the measurement attribute distinct from fair value in the “Classification and Measurement” phase. We are also concerned about unresolved issues relating to the feasibility of the expected loss model proposed in the ED.
We suggest that the IASB consider an approach of recognising subsequent changes in credit losses based on the clarified indicators or triggering events, together with the treatment of reflecting initially estimated credit losses in an effective interest rate, to make recognition of credit losses earlier.
We hope that global convergence in this project, including issues we point out in this comment letter, will be sought as early as possible, since it is one of the items in the MoU with the US Financial Accounting Standards Board (FASB).
Comments on Questions Our comments on the questions set out in the ED are provided below.
Objective of amortised cost measurement (paragraphs 3–5 of the ED) Question 1 Is the description of the objective of amortised cost measurement in the exposure draft clear? If not, how would you describe the objective and why?
Question 2 Do you believe that the objective of amortised cost set out in the exposure draft is appropriate for that measurement category? If not, why? What objective would you propose and why?
1. The description of the objective of amortised cost measurement in the ED is clear.
2. For financial assets held for earning interest, the objective of amortised cost set out in the ED is appropriate. However, our concern is that the objective of amortised cost measurement set out in the ED may not be appropriate for certain other financial assets. For example, the notion of effective return is less relevant for financial assets held for the purpose other than earning interest, such as trade receivables.
3. For financial assets such as trade receivables as mentioned above, we consider it necessary to include the description about their measurement objective, presentation and disclosure, corresponding to the practical expedients (shown in Questions 11 and 12) proposed in the ED.
Measurement principles (paragraphs 6–10 of the ED)Question 3
-2Do you agree with the way that the exposure draft is drafted, which emphasizes measurement principles accompanied by application guidance but which does not include implementation guidance or illustrative examples? If not, why?
How would you prefer the standard to be drafted instead, and why?
Question 4 (a) Do you agree with the measurement principles set out in the exposure draft? If not, which of the measurement principles do you disagree with and why?
(b) Are there any other measurement principles that should be added? If so, what are they and why should they be added?
4. We suppose that the way the ED is drafted is a reflection of a criticism to existing IAS 39 that detail guidances on identification of loss events in the incurred loss model, including examples of loss events (paragraphs 59 and 60) and related application guidance (paragraphs AG89 and AG90), have caused diversity in interpretation and lack of comparability among different companies.
5. However, we consider the proposed impairment model needs minimum application guidance and examples to ensure that objective and comparable financial information is prepared. Our concern is that the application of the proposed impairment model, without further guidance, would be no less arbitrary and diverse than the current practice, given that it would involve significant management judgment to estimate expected cash flows.
6. In addition, further guidance or examples would be necessary for certain financial assets such as revolving loans and instruments with a combination of variable and fixed interest rates (e.g. a loan with an interest rate cap), because their treatment is not made sufficiently clear by the proposed measurement principles and application guidance.
7. In our view, the proposed approach that initially estimated credit losses should be reflected in determining an effective interest rate is conceptually acceptable (see paragraph 9). However, we have concern about another aspect of the proposed approach that the effect of changes in subsequently estimated credit losses should be immediately recognised in profit or loss through revising the estimate every reporting period (see paragraphs 10-13).
(Two elements of the credit losses under the proposed model)
(The first element – allocation of initial estimate of credit losses)
9. We are of the view that the proposed treatment of the first element is conceptually acceptable, because the effective interest rate would include the initial estimate of credit loss and reflect the manner an entity determines the contract interest rate. Allocation of the initially estimated credit losses over the entire life of the instruments would provide more useful information about the effective rate. This approach is consistent with the entity’s purpose of holding the instrument, that is, to collect its contractual cash flows rather than to sell it.
(The second element – subsequent recognition of the estimate in credit losses)
10. We suppose that the proposed treatment of the second element is an attempt to address the weakness of the current impairment model that recognition of credit losses may be belated.
According to the view of IASB staff1, one rationale for “catch-up approach” is that it would ensure that the amortised cost measured based on the proposed model would be always equal to the present value of expected cash flows discounted at the initial expected yield, including at initial recognition. We have the following concern about this, although some of our members supported the above rationale by the IASB staff.
11. First, a favorable change in estimated credit losses in earlier times might produce a counter-intuitive result that the amount of the gain to be immediately recognised exceeds the accumulated credit losses previously recognised. Such a consequence results from the inconsistency of the treatments of the second element with that of the first element, which would allocate the initially estimated credit losses over the remaining life of the financial assets.
12. Second, under the proposed treatment, there would be no strong reason for keeping the initial effective interest rate fixed as the discount rate, other than achieving cost-based measurement, because profit or loss for each reporting period would be determined as changes in cash flows and its present value during the period.
13. Lastly, the measurement principle of amortised cost proposed by the ED would result in creating an additional measurement attribute similar to fair value, in that the carrying amount IASB’s Webcast Recording and Q&As on the project “Replacement of IAS 39”
-4would be determined based on the future cash flows estimated at each measurement date, except that a discount rate is fixed. Creation of such a measurement attribute was not at all discussed in the “Classification and Measurement” phase and it would undermine the basic concept consisted of two measurement categories (amortised cost and fair value). In addition, we are of the view that to reflect the recoverable amount in the carrying amount on an ongoing basis would fail to attain the objective of amortised cost proposed in the ED.
14. To address such concern, we considered two alternative approaches as below:
(Alternative 1: Allocation of estimated additional loss to entire period or remaining period)
15. One possible alternative approach, which addresses concern raised in paragraphs 11 and 12, would be to allocate the effect of changes in estimated credit losses over the initially estimated life of the financial instrument. Under this approach, the effect of changes in estimated credit losses would be divided into the amount attributable to the past period and to the future remaining period. The former would be immediately recognised in profit or loss and the latter would be recognised in profit or loss over the future remaining period. According to this approach, there would be no case of immediately recognising a gain in excess of the accumulated credit losses previously recognised (see paragraph 11) when there is a favorable change in estimated credit losses. However, taking account of practicability, there could be an approach of reflecting entire amount of revisions to estimates prospectively in a manner similar to the adjustment to depreciation of property, plant and equipment as required in IAS 8, rather than requiring retrospective adjustments to prior periods2. Accordingly, allocation of the revisions to expected losses over the remaining life of the financial asset would be consistent with the ordinary approaches of allocation.
16. There may be a criticism to this alternative approach that it would delay recognition of losses.
Some members of us argued that this approach would delay the recognition of losses compared to the existing requirement, in cases of bad loans individually assessed for collectibility because of the triggering events under IAS 39.
(Alternative 2: Recognition of losses based on triggering events)
17. Another possible alternative approach, which addresses the concern raised in paragraph13, would be to retain the indicators or triggering events like the existing incurred loss model, together with the treatment of the first element in the ED. The ED criticizes the current For example, the effect of subsequent changes in expected losses could be allocated prospectively by resetting the effective interest rate based on re-estimated future cash flows.
-5incurred loss model for its systematic bias toward delayed recognition of losses (paragraph BC11(b) of the ED). Nevertheless, necessity of revisions to estimated credit losses on an ongoing basis would be reduced by the treatment of the first element that allocates the initially estimated credit losses to each period, because only the loss in excess of the initial estimate would be subsequently recognised. Accordingly, problems arising from retaining the triggering events would not be so significant.
18. The ED points out another criticism of the current incurred loss model that it is not necessarily clear when the loss event occurred and thus there have been significant diversity in practice.
Such a criticism could be addressed by improving the current IAS 39 to clarify what are the triggering events so as not to generate diversity. Some preparers indicated that the proposed model requiring the estimate of future cash flows to be revised each period would generate more diversity than under the current practice. It seems that the ED focuses on justification for elimination of the triggering events and has not sufficiently considered the possibility of refining the triggering events. This point should be further considered utilizing an expertise of the Expert Advisory Panel.
19. We therefore suggest considering an approach of recognising subsequent changes in credit losses based on the clarified indicators or triggering events, together with the treatment of reflecting initially estimated credit losses in an effective interest rate so as to enable earlier recognition of credit losses, like our alternative approach 23.
20. We acknowledge that the following practicability issues on the expected loss model, already pointed out in responses to “Request for Information” issued by the IASB in June 2009, are still significant concerns among preparers about the ED.
Difficulty of deriving estimates of expected cash flows over the life of the financial asset, which requires using historical data that might be difficult to obtain or not exist.
Challenges in incorporating expected credit losses in the calculation of the effective interest rate.
21. The proposed model in the ED, which requires keeping the initially determined effective interest rate fixed, generally seems to fit well to closed portfolios composed only of loans with The FASB’s proposed Accounting Standards Update (ASU) issued in May 2010 proposes to remove the “probable” threshold for recognising credit impairments in the current incurred loss model. Such an approach can also lower the thresholds required to be crossed before recognizing any impairment losses (paragraph BC11(b) of the ED) and this might mitigate the weakness of the current incurred loss model that it has a systematic bias toward delayed recognition of losses as mentioned in paragraph 17.