Expected loss model may return for impairment accounting

The International Accounting Standards Board's exposure draft on the impairment of financial assets, which was published on November 5, is attracting criticism for taking the treatment of impairments back to the contentious expected loss model; being overly complicated; and adopting a methodology that is out of step with equivalent Basel II regulation.

The exposure draft, which forms the second phase of the replacement of the IFRS standard on financial instruments, IAS 39, was framed against the background of the global financial crisis and signals a turnaround from the incurred loss model used under IFRS so far, to an expected loss model.

Australian Accounting Standards Board chief executive, Kevin Stevenson, said: "What the Financial Crisis Advisory Group said was that the incurred loss model did not serve us well. It recommended that the IASB consider moving to an expected loss model on financial instruments."

The IASB press release accompanying the release of the exposure draft said: "The global financial crisis has led to criticism of the incurred loss model for  presenting an initial over-optimistic assessment of  no credit losses, only to be  followed  by a large adjustment once a trigger event occurs."

Banking industry consultant Andrew Reynolds said this change would be controversial because it would make the treatment of financial instruments different from everything else under IFRS, which continues to apply an incurred loss model.

He said the system outlined in the exposure draft appeared to have been framed with large financial institutions in mind. Other institutions would have "serious problems" implementing it.

The chair of KPMG's regional financial instruments team, Patricia Stebbens, said the problem with the exposure draft was that its method for coming up with an expected loss estimate was different from the Basel II method in Pillar 3 disclosures. This was likely to prompt a strong negative reaction from the banks.

Stevenson agreed that this aspect of the exposure draft was controversial. "The banks are concerned about the practicality of this. They say they do not forecast cash flows in the way the IASB is suggesting."

Stebbens said the proposed impairment rules would have wider effect than the old rules. They would capture non-financial corporates selling goods on a deferred payment basis. They would be required to account for expected loss on such transactions.

Reynolds, who blogs at Ozrisk, said the IASB could expect to see a strong argument against returning to an expected loss model. "I see this as a possibly retrograde step. The use of an expected loss model opens up the financial statements to game playing by management, as they can directly manipulate the financial statements by changing their own ideas about the future to suit the outcome they want.

"Provided these expectations are not completely outlandish they are not really susceptible to audit. While I recognise the problems with an incurred loss model, I am not sure that abandoning it is appropriate."