Accountants’ Quarrel: How Many Buckets for Credit Impairment

The Financial Accounting Standards Board and the International Accounting Standards Board, from their headquarters in Norwalk, CT and from London, respectively, are trying to converge on a single set of principles for the treatment of certain volatile assets.  The issue in its various forms has been with both outfits, and with accountants for a variety of institutions, for several years now. In October 2008, the FASB and IASB set up a joint Financial Crisis Advisory Group, and it recommended looking into alternatives to the incurred-loss model for treating credit losses. This is one issue (not the only one) as to which the expected convergence, as the Journal of Accountancy said on March 7, is diverging. The Journal of Accountancy’s observations arose from the IASB’s release of an exposure draft, Financial Instruments: Expected Credit Losses, which continues the IASB’s work on what is known as the “three buckets” model, work the IASB and the FASB had begun in tandem. The FASB has since gone off in a different direction. Fooling Mr. Market The underlying question, simply put, is this: if a business is holding a note receivable from counterparty, then under what circumstances and with what timing should it write down the value of that note as an asset?  It now appears that the FASB is likely to tell accountants that the value ought to be written down a bit earlier than the IASB’s likely instructions will entail, although both favor accelerating recognition relative to the status quo. There are related questions that may well interest the seekers of alpha. If two banks or other financial services firms in the same real economic circumstances account for the same impairment in different ways, is the difference likely to fool Mr. Market?  Will the different treatment within the limits of GAAP lead for example to different stock valuations for these two hypothetical firms despite their identity of underlying economic reality? If so, then, this looks like a source of market inefficiency, which somebody ought to be able to ‘play’ for profits. At present, GAAP rules require recognition of losses either when a loss is incurred or where there is “objective evidence of impairment.” This is generally considered inadequate, closing the barn door only after the horses are far away if you will. The IASB’s new rules would eliminate the “recognition threshold” and require regular update for changes in credit loss expectations, using for example “historical credit loss events for similar financial instruments” as a basis for those expectations. Source: IFRS Foundation: Exposure Draft, ED/2013/3 The table above provides a straightforward example of how this might be done for an institution that has two segmented borrower groups, X and Y, defined by their risk characteristics. This looks specifically at the entire contractual term of loans that defaulted in the first year after origination, then discounts to present value of observed loss. This, as the IASB notes, a simple example assuming away such matters as transaction costs of prepayment options. The underlying idea though is clear, an entity is to calculate 12-month expected credit losses by multiplying the likelihood of a default over the next 12months (in column D above) by the expected credit losses that would result (in column B). Three, Two, One The threatened divergence arises because the IASB distinguishes between assets with a 12-month allowance balance and those with a lifetime expected loss balance. This is a “two bucket” model, according to an update recently presented to the G-20. But for historical reasons, (that is, with reference to an earlier stage in deliberations when the system was going to be a bit grainier), it is sometimes still called the “three-bucket model.” Separately, the FASB published an Exposure Draft of its own in December 2012. The FASB is pursuing what it calls a Current Expected Credit Loss (CECL) model, which entails only one bucket, so to speak.  An income statement should reflect the effects of credit deterioration or improvement, the FASB says, and the balance sheet should reflect the current state of expected credit losses at the reporting date. Both sides are keeping a stiff upper lip about this set-back to the cause of global convergence in accounting standards, and stressing the similarities in their approaches.  But in weeks and months to come, we’ll surely hear a good deal about what the IASB calls the “day 1 issue,” that is the possibility that the FASB model recognizes losses too early and excessively because it demands a guesstimation of  lifetime loss recognitions all at one fell swoop.