The document discusses the reserve for bad debts, also known as the allowance for loan and lease losses (ALLL). It is a valuation reserve established by banks to estimate amounts from loans and leases that may be uncollectible. The higher the provision for loan losses, the lower the bank's net operating income. The document also discusses proposed changes by the IASB and FASB to move from an incurred loss model for recognizing loan losses to an expected loss model.
2. Definition
Reserve for Bad Debts
Valuation reserve established and
maintained by charges against a
bank’s operating income
Estimate of uncollectible amounts
used to reduce the book value of
loans and leases to the amount
that a bank expects to collect.
3. Income 5% 10% 20%
Loan Income 50,000$ 50,000$ 50,000$
Other Income 3,500$ 3,500$ 3,500$
Total Income 53,500$ 53,500$ 53,500$
Operating Expenses
Loan Servicing 500$ 500$ 500$
Provision for Loss 2,500$ 5,000$ 10,000$
Total Expenses 3,000$ 5,500$ 10,500$
Net Operating Income 50,500$ 48,000$ 43,000$
Non-Operating Expenses
Interest Paid to Depositors 500$ 500$ 500$
(Gain) Loss on Sale of Investment -$ -$ -$
Total Non-Operating Expenses 500$ 500$ 500$
Net Income 50,000$ 47,500$ 42,500$
6. Made at the request of theG20
WillChange IFRS 9: Financial Instruments
Will Replace IFRS 39: Recognition
Comment Deadline: 5 July 2013
7. The existing model
delays recognition
of credit losses until
there is evidence of
a credit loss event
8. Expected credit
losses would be
updated at each
reporting date to
reflect changes in
credit quality
9. All entities that hold
financial assets or
commitments to
extend credit that
are not accounted
for at fair value
10. Stage I
12 Month
ExpectedCredit
Loss
Effective Interest
on Gross Carrying
Amount
Stage II
Lifetime
ExpectedCredit
Losses
Effective Interest
on Gross Carrying
Amount
Stage III
Lifetime
ExpectedCredit
Losses
Effective Interest
on Amortized
Cost Carrying
Amount
11. GAAP and IFRS use Incurred Loss Model
Both want Expected Loss Model
FASB Proposed Different Model
An entity would not measure loss allowance for any
financial instrument using 12 Month Expected Credit
Loss provisions in IASB proposal
12. • This is a great idea!
IFRS/FASB
• Are you kidding me?
Industry
My discussion tonight is about a joint proposal by IFRS and FASB that would dramatically revise the way companies, specifically banks, account for doubtful accounts.At issue is the central question: when do you reserve for a loss, and how much do you reserve?My discussion will focus on the banking industry. As a result, I may use industry terms that differ slightly from classic accounting terminology.
The Allowance for Loan Loss. Reserve for Bad Debts. Provision for Loss.This is an expense banks and credit unions accrue when they believe someone may default on a loan. It is an estimate by banks of how much they would charge off of their books in the event the loan moves into default.The current standard is to recognize the loss before it happens but as close to the default as they can predict.Banks do it this way because it affects Net Income.
In this balance sheet, we have three columns. Provisioning at 5-percent, 10-percent, and 20-percent of Loan Income.As you can see, by reserving for bad loans, it reduces net income.Historically, however, the percentage of loans that actually default is much smaller than what banks reserve.
This graph shows net charge-offs over the past decade. These numbers come from the Credit Union industry. The 2013 number is an estimate.In the United States since 2004, credit unions charged off an average of 0.83% of total loans.Charge-offs peaked in 2009, following the mortgage implosion in 2008. Despite this fact, charge-offs were just 1 ¼ percent.
Here are the four major types of loans—again from the Credit Union industry.Credit Card defaults clearly are the major problem, and this holds true for banks. The mortgage crisis was an outlier historically.Second mortgage charge-offs were higher among banks.
The G20 nations asked IASB and FASB to reconsider how the financial industry makes a provision for defaults.The current IFRS proposal will change parts of the guidance on Financial Instruments.It will replace the section on recognition.Get your comments in by July 5th.
The new proposal would be more timely in its recognition of a loss.
While the proposal is a response to the mortgage lending, the proposal would affect any entity that holds a financial asset that is not accounted for at fair value.Auto lending, HELOCs, and personal guarantees come to mind.
Stage I: As soon as a financial instrument is purchased, recognize 12 month expected loss. Book the S/T loss before you lose.Stage II: As instrument deteriorates below investment grade, recognize lifetime expected loss. Book the L/T loss before you lose.Stage III: At impairment, adjust the gross carrying amount for the loan loss12 Month Expected Credit Loss: The possibility of a default. Not expected cash shortfalls. No credit losses forecasted to default.Lifetime Expected Credit Loss: Expected present value credit losses.