Comment on the exposure draft by ICGN:
The International Corporate Governance Network (ICGN) is a not for profit body founded in 1995 which has evolved into a global membership organisation of 480 leaders in corporate governance in 45 countries, with institutional investors representing assets under management of around US$9.5 trillion. http://www.icgn.org/
ICGN has given the following comment on the above subject on 2nd July 2010
Dear Sir David,
We are writing on behalf of the International Corporate Governance Network (ICGN). The ICGN is a global membership organisation of institutional and private investors, corporations and advisors from 45 countries. Our investor members are responsible for global assets of U.S. $9.5 trillion.
The ICGN’s mission is to raise standards of corporate governance worldwide. In doing so, the ICGN encourages cross-border dialogue at conferences and influences corporate governance public policy through ICGN Committees. We promote best practice guidance, encourage leadership development and keep our members informed on emerging issues in corporate governance through publications and the ICGN website. Information about the ICGN, its members, and its activities is available on our website: www.icgn.org.
The purpose of the Accounting and Auditing Practices Committee (A&A Practices Committee) is to address and comment on accounting and auditing practices from an international investor and shareowner perspective. The Committee through collective comment and engagement strives to ensure the quality and integrity of financial reporting around the world. http://www.icgn.org/policy_committees/accounting-and-auditing-practices-committee/
Thank you for the opportunity to comment on The International Accounting Standards Board’s (IASB, Board) Exposure Draft (ED)/2009/12 regarding Financial Instruments: Amortised Cost and Impairment. This exposure draft proposes requirements for how to include credit loss expectations in the amortised cost measurement of financial assets. We understand that the proposed requirements would use more forward-looking information than the incurred loss model.
We support that the proposed requirements would result in earlier recognition of credit losses .The global financial and banking crisis has highlighted the dangers arising out of banks holding assets at levels that no longer reflect their recoverable amount. This is not consistent with the accounts providing a true and fair view. The published Basis of Conclusions of the Exposure Draft fairly lays out the balance of arguments. Accordingly, we support the Board’s view that the current ‘incurred loss’ model for recognition of impairment to financial instruments held at amortised cost should be replaced by an ‘expected loss’ model.
The Board is correct to propose an accounting treatment that reflects the requirements of investors for a true and fair view of the financial position and performance of preparers’ accounts. The IASB should reject arguments from some quarters that regulatory objectives, including a desire for accounts to have a counter-cyclical impact, should require the impact of expected losses to be smoothed.
We also agree that provisions made for expected losses should reflect forward-looking expectations of management and not be a form of mechanistic release of provisions based on previous cyclical experience. However, it is important that management should be accountable to investors for their decisions and transparency as to assumptions at the outset and the impact of changes in those assumptions during the reporting period. We believe that the Management Commentary is the appropriate means for explanation. We are not in favor as shareholders or other parties with economic stakes in companies, of requiring forms of accounting for which the costs will exceed the benefits, but strongly believe that an immediate “catch up “ adjustment on reassessment of expected credit losses may be necessary. More generally, accounting estimates are based on assumptions that by definition cannot at that time be precisely validated and this applies to expected loss provisioning. In practice it may be reasonable, for example, to allow estimates at a portfolio level to be used, certainly in the case of ‘good loan book’ assets. We would urge the IASB to be receptive to suggestions for practical solutions and we hope that the Expert Advisory Panel will be of assistance in this regard. Where the correct application of principles may remain a matter of some contention, a workable solution needs to be found.
Inevitably the estimates of expected losses are likely to prove, in retrospect, to some extent either too cautious or too optimistic. The most contentious aspects of debate relate to the manner in which subsequent truing-up of these assumptions should be accounted for. Some argue that the IASB is wrong to require changes in estimates of expected losses to be reflected in the accounts in full in the reporting period during which those assumptions have changed but instead should be smoothed over the remaining life of the loan. We do not find that argument compelling. If changed estimates represents genuine expectations of future loss, then viewed from a balance sheet perspective a loss provision must surely be made immediately and in full in order to avoid imprudence. It also reflects the reality that entities taking different decisions to make or refrain from making loan advances at the appropriate prevailing interest rates will be in a different position as expectations as to creditworthiness of borrowers changes. The Board may need to put some constraints around the size of additional provisions to be recognised or previous amounts provided for to be written back. For example, we do not consider that the total income recognised should be higher than the originally implied interest earned at the full contractual rate.
In conclusion, we support in principle the Board’s proposed approach of introducing accounting that builds up provisions for expected losses and consider this the essence of amortised cost. The key problem with the incurred loss approach in respect of assets in the nature of bank loans is the tendency towards a back-ending of impairment. However economic decisions relating to the making of loans must incorporate the implications of such expectations. We believe that the IASB is, accordingly, correct in its conceptual focus on the valuation of the asset in terms of the expected rather than contractual interest earned on a loan over its life.
We agree with the IASB’s proposal that these expected losses should therefore be matched at the outset against income. [It would not be correct to recognise a day one loss for this unless one were also to recognise the creation of a day one asset in the form of a right to the receipt of (and an expectation of collection in respect of) interest at the contractual rate which by definition exceeds the company’s required rate of return as per the effective rate.]
However, there may also be a good conceptual case to argue that total recognised impairment should not exceed the aggregate of originally expected loss plus actual incurred loss. Accounting arranged in this way would in practice avoid any risk of undue changes in management perception of the future creating pro-cyclical volatility. However, we would not accept the notion that increased expected losses should only be recognised to the extent that incurred losses already exceed the time pro-rated share of expected losses as this ignores the inherent backendedness of incurred losses.
If you would like to discuss any of these points, please do not hesitate to contact Carl Rosen, our Executive Director, at +44 207 612 7098 or carl.rosen@icgn.org . Thank you for your attention and we look forward to your response on the points above.
Yours sincerely,
Elizabeth Murrall
Co-Chair, ICGN Accounting and
Auditing Practices Committee
Christy Wood
Chairman of the ICGN Board of
Governors
Lou Moret
Co-Chair, ICGN Accounting and
Auditing Practices Committee
