Corporate disclosures are about to get even longer if the International Accounting Standards Board gets its way.
The IASB has just published an exposure draft on its proposals to rejig the way impairments are accounted for. This is a big deal, since one of the prime criticisms of accounting standards in the financial crisis was that loan impairments were accounted for too little and too late. (Another criticism — that there were too many different types of impairment models — is also being dealt with via the IASB’s fair value revisions to IAS 39).
Here’s the basic idea, from the IASB:
Both International Financial Reporting Standards (IFRSs) and US generally accepted accounting principles (GAAP) currently use an incurred loss model for the impairment of financial assets. An incurred loss model assumes that all loans will be repaid until evidence to the contrary (known as a loss or trigger event) is identified. Only at that point is the impaired loan (or portfolio of loans) written down to a lower value.
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 . . .
Under the proposals expected losses are recognised throughout the life of the loan (or other financial asset measured at amortised cost), and not just after a loss event has been identified. This would avoid the front-loading of interest revenue that occurs today before a loss event is identified, and would better reflect the lending decision. Therefore, under the proposals, a provision against credit losses would be built up over the life of the financial asset. Extensive disclosure requirements would provide investors with an understanding of the loss estimates that an entity judges necessary
In graphic form, the effect looks like the below – smoother and less volatile results (and we thought the IASB was against smoothing):
Savvy readers will have spotted that this is heavily reliant on the banks’ abilities to forecast and manage loan losses. Interestingly enough, IASB members say there are quite a few banks who don’t already do this – in particular, US banks. Those that do, cynical readers might say, aren’t necessarily any good at it.
Even more cynical readers might also question the ability of the banks to game such an expected loan loss system. To that, the IASB says the proposed new system is not any more prone to gaming than the current one – where banks might ignore loss events so that they don’t have to make a loss provision. Plus, those “extensive disclosure requirements”, which will also include greater detail on credit quality, should help reveal any bank trickery.
In other words – financial reports are about to get much, much, much longer. But, hopefully, with a clear purpose.
Full details of the proposals available here.
Related links:
Beware bankers spinning story of smooth results – Bloomberg
International accounting standards board: figuring it out – Times Online
Great Depression-esque bad debt at US banks – FT Alphaville