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About the IASB’s credit deterioration model

Sageworks
May 28, 2013
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On March 7, 2013, the International Accounting Standards Board (IASB) released a new exposure draft, Financial Instruments—Expected Credit Losses, wherein they proposed that entities should recognize and measure a credit loss allowance or provision based on either a 12-month expected credit loss or, if the credit risk has increased significantly since initial recognition, the credit losses would be measured as the lifetime expected credit losses.

The IASB’s model, commonly referred to as the credit deterioration model, builds upon the three-bucket expected credit loss model originally drafted and agreed upon by the boards jointly, only simplified to reflect feedback received. The Financial Accounting Standards Board (FASB) released their exposure draft in December 2012, commonly referred to as the Current Expected Credit Losses (CECL) model, which has a single measurement objective due to concerns raised by its constituents.

“Our proposals are a simplified version of the expected credit loss approach that we originally jointly developed with the FASB,” stated IASB Chairman Hans Hoogervorst. “We believe the model leads to a more timely recognition of credit losses. At the same time, it avoids excessive front-loading of losses, which we think would not properly reflect economic reality.”

All entities holding financial assets and commitments to extend credit would be affected by this proposal, with the model applying to loans, debt securities and trade receivables, as well as lease receivables, irrevocable loan commitments and financial guarantee contracts. 

Essentially, the IASB’s credit deterioration model identifies three different stages (or “buckets”), which reflect the general pattern of the deterioration of a financial instrument that ultimately defaults.  The differences in accounting for each stage relate to the recognition of expected credit losses and, for financial assets, the calculation and presentation of interest revenue.  The three stages are described below:

Stage 1: Financial instruments that have not deteriorated significantly in credit quality since initial recognition or that have low credit risk at the reporting date. For these items, 12-month expected credit losses are recognized and interest revenue is calculated on the gross carrying amount of the asset (i.e., without reduction for expected credit losses).

Stage 2: Financial instruments that have deteriorated significantly in credit quality since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of a credit loss event. For these items, lifetime expected credit losses are recognized, but interest revenue is still calculated on the gross carrying amount of the asset.

Stage 3: Financial assets that have objective evidence of impairment at the reporting date. For these items, lifetime expected credit losses are recognized and interest revenue is calculated on the net carrying amount (i.e., reduced for expected credit losses).

The IASB is accepting comments on the proposal until July 5, 2013.

About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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