Convergence Project by International Accounting Standards Board and Financial Accounting Standards Board - Case Study Example

Critical analysis of Convergence Project by (IАSB) & (FАSB) Name Institution Date Introduction Reasons for the Convergence Project International convergence of accounting standards refers to the goal and means applied to achieve a single set of high-quality standards that corporations can use locally and globally in regard to financial reporting.The parties involved are Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The convergence of accounting standards is an effort to reduce the discrepancies between the International financial reporting standards (IFRS) and the US Generally accepted Accounting principles (US GAAP). The belief for convergence supporters is that having a single set of standards would improve the comparability of financial reports therefore encouraging more international trade. Smith informs that the global convergence of accounting is a step towards the realization of free flow of worldwide investment and is a direct benefit for stakeholders of capital market stakeholders. The ability of investors to compare global investments helps in lowering the risks of errors caused by wrong judgment. It has the prospective of not only plummeting some costs and facilitating reporting and accounting for corporations operating globally. Convergence of accounting standards would provide an opportunity for stakeholders in their effort to improve the model of reporting .The effort to address the needs of stakeholders is faced by the challenge of cultural, legal and political convergence in addition the difficulty of converging protocols, strategies and tactical agreements (Pricewatercoopers,2007). Three-bucket Approach The three-bucket approach developed by James Tobin suggests that investments should be divided into buckets this is done with the hope of achieving the highest return in a bucket. The roots of three-bucket can be traced back to the 2010 exposure draft(ED). The approach proposes that financial assets such as debt securities and loans should move from the first bucket to the second or third. Movement from one bucket is an evidence to support deterioration to a certain level from initial recognition. Financial assets bearing anticipated loss over the next 12 months are placed in the first bucket. The second and the third buckets hold asset payments that consider full lifetime anticipated losses. To distinguish bucket two and three an institution considers the level at which the allowance is calculated. Bucket 2 allowance is generated at a portfolio stage while bucket 3 at an individual loan level (Ernst & Young 2012, p 5). There exist two approaches to three-bucket model. Absolute approach is the scenario where all loans are placed in the bucket that corresponds to their credit quality considering the origination and at each following reporting period. Relative approach is where all loans are initially placed in the bucket 1 not considering their credit quality and then taken to bucket 2 and 3 depending on changes in credit quality relative to the origination of the credit quality. This implies that in absolute approach loans of similar credit quality are anticipated in one bucket while the latter loans of different credit quality could be in one bucket (Ernst & Young 2012 p.26). Current Anticipated Credit Loss’ Model The current Anticipated credit loss Model is an exposure draft released by IASB in 2013 proposes that anticipated credit losses should reflect all relevant information. Relevant data include supported forecasts, past loss experience and prevailing conditions. The approach requires that the approximations of projected credit losses replicate the time value of money not essentially necessitating asset reduced cash flow scrutiny. Institution using the approach will be required to consider the possibility that a credit loss will transpire inferring that almost all debt implements will be acknowledged for an allowance for credit losses. Distinct debt devices categorized as FV-OCI do not have to be acknowledged in the case where their fair value is equivalent or more paralleled to amortized cost and credit losses (Ernst & Young, 2013). Merits & Flaws of Three-buckets Approach Merits of Three-bucket Approach Entities that are willing to plan and change to three-bucket approach will realize that changes to accounting for impairment will affect their institutions significantly. To benefit from the advantages an entity needs to first gain an initial understanding of the accounting changes. Impairment allowance for bucket 1.The latest development by the boards indicates that the allowance for financial assets in the first bucket would concentrate on the impact of loss anticipated in the coming 12 months. The losses in this regard refer to deficits in all cash flows estimated to happen in the next 12 months. This is amplification from erstwhile agreement signifying that bucket 1 would be less than lifetime credit losses in addition bucket 2 and bucket 3 would stand for the full lifetime projected credit losses. Recognition of lifetime anticipated losses. The criteria in deciding transfer out of bucket 1comprise a situation showing a significant deterioration in credit quality and a no-doubt likelihood of default that is unlikely to be recoverable. As a general rule recognizing lifetime anticipated losses should be based on the likelihood of default as opposed to actual realization and the magnitude of the loss. Distinguishing aspect concerning bucket 2 and bucket 3.The board reason to retain bucket 3 is so that to avail important information in addition ‘unit of evaluation’ to be the differentiating factor while transferring from bucket 2 and bucket 3.An institution that makes a collective decision to transfer an asset out of bucket 1 the asset should go to bucket 2 however if the decision was by individual basis the asset should be moved to bucket 3.decision to transfer assets from bucket 2 to bucket 3 if the entity starts to assess the assets individually. Grouping assets for impairment evaluation. ‘Shared risk’ trait should be the basis for how and when assets are grouped and whether transfer out of bucket 1 is needful. Asset grouping necessitates if an asset is individually significant an individual assessment should be performed. An asset that shares risk traits with other assets then it will be okay to choose collective or individual assessment. Use of’ anticipated value in estimating losses. The board agreed on the trouble of establishing a bright line that would be prescribed in using the credit deterioration model. This requires the entity to analyze the practicality and need of identifying practical expedients (Ernst & Young 2012 p.20). A flaw in the approach is that only community banks seem to like bright lines in aligning related accounting and credit risk functions. For the majority of other entities preference is towards the flexibility of a principles approach. The other flaw is that the consequence of the three-bucket methodology is on capitals is not definite. Another flaw is in regard to use of the three-bucket approach on debt securities. The challenges highlighted include the additional scrutiny placed in reference to the degree to which institutions rely on third-party credit ratings, the fact that not all securities have credit ratings and the prohibition by the Dodd-Frank Wall street Reform and consumer protection Act on the use of credit ratings. The 12-month anticipated loss measure is preferred because it enables entities in using information that is already available however other institutions are confused by what is to be measured. A number of entities disapprove of the concept all together making the efforts of convergence futile. Most entities prefer an absolute approach leading to some loans in bucket 2 and others in bucket 3 thereby requiring full recognition. To the debate on whether institutions would like bright lines to be a guideline in regard to different loan types suggest a thin line. Regional institutions support bright lines arguing that they too support principles-based only that they understand that regulators will establish bright lines and their own interpretations (IFRS 2011). Merits & Flaws of ‘current anticipated credit loss’ Merits of CECL Gaining a good understanding of the proposal for CECL is the only way to realize the benefits. To an entity the approach means the following; Credit-impaired assets on initial recognition-If there is an unbiased indication of impairment the exposure draft will want an institution to disregard a credit loss allowance preliminary recognition as this will be reproduced in a credit-adjusted effective interest rate (EIR). A credit loss allowance will be acknowledged reliant with upsurges in lifetime estimated credit losses. This means that a gain will be realized if favorable changes lead to lifetime anticipated credit losses being lower than the original estimate in the EIR. Interest revenue-the exposure draft requires that interest revenue be categorized as a separate line item in the income statement. An institution should generate its interest revenue using the effective interest method on the gross carrying amount. Anticipated credit losses-The exposure draft indicates that the estimates of lifetime anticipated losses would be based on the present value of cash shortfalls for the remaining life of an instrument. Even though the proposal do not prescribe the specifics of `default ‘an asset using the approach would reflect anticipated credit losses attributes. The issue of anticipated credit loss allowance calls for a heightened judgment by an entity especially in converging the past, present and future information. Additional Considerations Unit of account-The ED supposes that an institution may generate the anticipated credit losses and its criteria on collective basis. Instruments of finance that share risk characteristics are grouped together. Indicators-These refer to the information the entity would use in applying the lifetime anticipated credit losses criterion. These are both internal and external credit risk indicators such as fair value information, credit rating and credit spread indicators. The behavior, operating results and performance of the borrower also comprise the indicators (IFRS 2013). Write offs-The ED requires an institution using the approach to decrease the gross carrying amount of an asset following the period the institution has no reasonable expectation of recovery. Disclosures-In catering for the needs of an entity’s stakeholders the ED proposes that uses an extension of IFRS & Financial Instruments: Disclosures. This has enabled transparency of institutions credit risk and provisioning process. Transition-The exposure draft has a transition relief that indicates the direction if determining the initial risk translates to undue cost an institution should just apply the lifetime anticipated credit losses criterion based on whether the credit risk is low at initialization. Flaws CECL requires all relevant data concerning the anticipated credit losses, this would require the entity to obtain and document new assumptions which will add to the already subjective process of judgment by the management. The approach requirement to reflect either implicitly or explicitly the time value of money may not be impossible however adjusting existing models to fit the principles of the CECL could be complex to some entities. It is not a rare occurrence to find that some institutions do not have the data set required. The approach has limitation in that it calls for almost all instruments of debt failing to exclude the highly rated instruments (Ernst & Young 2013). Arguments for Three-bucket Approach The survey to the accounting policy executives at 14 U.S financial institutions show that many executives support the three-bucket approach and believe it represents more as a step toward the final convergence. The issue of whether to use an absolute or relative approach by an entity could be taken care taken care by a relative approach hybrid with an absolute overlay. Current anticipated credit loss model in most cases will result to early recognition of credit losses if compared with current incurred loss. This is because it requires the recognition of a 12-month lifetime occurred and anticipated losses. This therefore means that the proposals are likely to increase the credit loss allowance and this is anticipated to vary in institutions. An institution with shorter term and higher quality financial assets will be less affected Conclusion Investors have made it clear that the current reporting is under delivers. The survey by Ernst & Young of the 14 U.S financial institutions confirms our findings about the three-bucket approach. Most entities agree that it is operational while some think the approach is not much better than a 2 bucket approach or widely used incurred loss model. Concerns regard the fact that a lot of time must be allowed for testing the models since time and money will be spent in case of a decision towards transition (IFRS, 2011:Ernst &Young b). Many institutions cited concerns on deliberations by the board suggesting that an allowance would only be derived by quantitative measures. Most entities in the US financial entities have a `qualitative reserve’ in their allowance for credit losses. Converging accounting standards will require seeing how to incorporate such aspects of qualitative adjustments into the historical loss rates alternatively provide similar adjustments. The idea of merging bucket 2 and bucket 3 since they have the same measurement objective is not a farfetched idea maybe because it is in line current credit risk monitoring functions. The approach use of buckets does align with the norm of institutions credit risk monitoring. Assignment of loans rating are for example substandard or below are evaluated for impairment within the provisions of ASC 310-10.While most of the financial institutions believe that principles are better than bright lines, they also accept that diversity in practice will be achieved with time through application and the influence of auditors and regulators. The potential for inconsistency in the course of application is to be addressed by transparent disclosure requirements (IFRS, 2011). Rational Recommendations for Changes to Current (AASB 139) AASB 139 in its efforts to make a contribution towards convergence should work with institutions especially the auditing firms and help them gain an understanding of the accounting changes by designing and training and carrying out awareness sessions. The auditing firms to be trained on performing initial assessment of anticipated accounting changes; benchmarking institutions against others of the same industry; assessing means for information availability ,internal control systems and information technology capabilities. Success of the convergence project is not only for IASB and FASB but for all the parties and therefore AASB should walk faster to the last stage of converging which is to communicate the effects of convergence to stakeholders (AASB, 2011: AASB, 2007). . References AASB 139 (2007). Financial instruments: Recognition and measurement. Adopted from IAS 39Financial Instruments: Recognition and Measurement. Retrieved from http://www.cpaaustralia.com.au/cps/rde/xbcr/cpa-site/AASB-139-fact-sheet.pdf Australian Accounting Standards Board (2010). AASB 101 Presentation of financial statements, Canberra, viewed 14 July 2011, http://www.aasb.com.au Australian Accounting Board.2010 Financial Instruments: Recognition and Measurement.Australia. Retrieved from. http://www.aasb.gov.au/admin/file/content105/c9/AASB139_07-04_COMPoct10_01-11.pdf Ernst & Young (2012a).The new impairment model.US financial institutions weigh in on the new impairment model being developed by the FASB and IASB. viewed in February 2012 Ernst & Young (2013b).IASB proposes new anticipated credit loss model. IFRS developments. Issue 54. Retrieved viewed march 2013; http://www.ey.com/Publication/vwLUAssets/Devel54_FI_Impairment_March2013/$File/Devel54_FI_Impairment_March2013.pdf Ernst & Young (2013c). Anticipated loss model proposed by FASB for all financial assets. Practical matters. Viewed 24 January 2013Retrieved from: http://www.ey.com/Publication/vwLUAssets/Practical_matters_for_financial_institutions_Anticipated_loss_model_proposed_by_FASB_for_all_financial_assets/$FILE/Practical%20matters%20for%20financial%20institutions_Anticipated%20loss%20model%20proposed%20by%20FASB%20for%20all%20financial%20assets.pdf Financial Accounting standards Board (2012). Summary of board decisions. Retrieved from; http://www.fasb.org/cs/ContentServer?site=FASB&c=FASBContent_C&pagename=FASB/FASBContent_C/ActionAlertPage&cid=1176160275211. Thornton G. (2013). An Instinct for Growth. On the horizon for IFRS. (n.p) viewed on 28 January 2013.(Thornton 2013:IFRS 2011) IFRS foundation (2011).Impairment: Three bucket approach. IASB and the FASB. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org PriceWaterHouse Coopers (2007).Convergence of IFRS & US GAAP. ed Smith London. Retrieved from: http://www.pwc.com/extweb/pwcpublications.nsf/docid/a3263860a2ac0059802572220057ef35 Read More