Plans for reforming the way loan losses are accounted for are too convoluted and costly. And they contribute to accounting split

Nothing is ever simple with accounting changes, and this issue is no exception. The principle pitches the interests of regulators against those of investors and in detail the expected-loss approach worries accountants who fear it could aid managements seeking to manipulate earnings figures. And the IASB’s proposals on loan impairment differ from those of its US counterpart, the Financial Accounting Standards Board (FASB), thereby contributing to the split between the two standard-setters that’s threatening the Group of Twenty goal of achieving a single set of global accounting rules.

There’s a need for a single impairment model that reduces complexity and mitigates pro-cyclical effects – the tendency to reinforce the ups and downs of the economic cycle – and moving to a model based on expected loss rather than incurred losses is a step in the right direction, the Swedish Bankers’ Association said in comments on the IASB proposal.

But “we do not believe that the highly complex measurement model based on expected cash flows proposed by the IASB is the right way forward. We urge the IASB to find a less complex model that allows for both an open and a closed portfolio approach and that keeps the current definition of the effective interest rate intact,” the Swedish association said.

Two dozen comments

The association’s comments were among some two dozen so far received on the IASB’s proposals from banking and accounting organisations, regulators and firms. June 30 is the deadline for comment on the IASB’s November 2009 exposure draft, or consultation document, on the amortised cost measurement and impairment of financial instruments. The comments so far also echo many of those made in response to the IASB’s request last year for views on the feasibility of the expected-loss concept.

The impairment document is part of the second stage of the IASB’s three-phase replacement of the international IAS 39 rule on accounting for financial instruments, the bonds, loans, investments and derivatives that feature heavily on bank balance sheets. Spurred on by the G20, the IASB has already rolled out phase 1 covering the classification and measurement of the instruments and expects soon to issue an exposure draft on accounting for derivatives.

FASB meanwhile issued its single-package on financial instruments at the end of May for comment until September 30. On loan impairment, FASB proposes to accelerate loss recognition by removing the existing “probable” threshold for recognising impairments and recognising credit problems immediately a bank doesn’t expect to collect all amounts due on loan. This differs from the IASB’s “through-the-cycle” expected loss model and the two boards have set up an expert advisory panel to help them develop a common approach.

Kenneth Sharp, global leader, assurance services with accountants Grant Thornton International commented that the IASB’s expected loss approach has theoretical advantages. By incorporating expectations of default into measurement and income recognition throughout the life of a loan it better reflects the economics of lending.

“We are however concerned that the operational challenges of implementing the proposed approach may result in cost and complexity that exceeds its benefits. Moreover, we believe that these challenges could be disproportionately burdensome for many non-financial institutions,” Sharp said.

The Hong Kong Association of Banks believes that the expected cash flow model will result in increased subjectivity.

“As a result, the expected losses which will be recognised in the profit and loss account may be more volatile and procyclical than under the current incurred loss model,” the Hong Kong association said.

“In addition the readers of financial statements may find it very difficult to understand and interpret the numbers given the high degree of subjectivity and the combining of credit losses with interest. From a practical perspective, the proposed model is extremely complex and hence will be very difficult and costly to implement.”

The Madrid-based Instituto Iberoamericano de Mercados de Valores (IIMV), the umbrella organisation for Spanish and Latin American securities regulators, is worried that there won’t be an opportunity to comment on any outcomes emerging from the work of the expert advisory panel.

Comment letters are accessible on the IASB’s website: www.iasb.org.