🏦Financial Services Reporting Unit 12 – Impairment and Loan Loss Provisions

What's This All About?

• Impairment and loan loss provisions are critical accounting concepts in financial services reporting
• Impairment occurs when an asset's carrying value exceeds its recoverable amount, indicating a potential loss in value
• Loan loss provisions are estimates of expected credit losses on a company's loan portfolio
• These concepts help ensure that financial statements accurately reflect the true value of assets and potential losses
• Understanding impairment and loan loss provisions is essential for assessing a company's financial health and risk management practices
• Impairment testing is performed regularly to identify and quantify potential losses in asset value
• Loan loss provisions are recorded as expenses on the income statement and as allowances on the balance sheet

Key Concepts and Definitions

• Impairment: A reduction in the value of an asset when its carrying amount exceeds its recoverable amount
• Carrying amount: The value of an asset as recorded on the balance sheet, typically based on historical cost less accumulated depreciation or amortization
• Recoverable amount: The higher of an asset's fair value less costs of disposal and its value in use
  • Fair value less costs of disposal: The price that would be received to sell an asset in an orderly transaction between market participants, less the costs of disposal
  • Value in use: The present value of the future cash flows expected to be derived from an asset or cash-generating unit
• Loan loss provision: An estimate of expected credit losses on a company's loan portfolio, recorded as an expense on the income statement and as an allowance on the balance sheet
• Expected credit loss (ECL): The weighted average of credit losses with the respective risks of a default occurring as the weights
• Probability of default (PD): The likelihood that a borrower will default on their loan obligations over a specific time horizon
• Loss given default (LGD): The percentage of the loan amount that is expected to be lost if a borrower defaults

Why It Matters in Finance

• Impairment and loan loss provisions directly impact a company's financial statements, affecting reported profits, assets, and liabilities
• Accurate assessment of impairment and loan loss provisions is crucial for providing a true and fair view of a company's financial position
• Investors and analysts use this information to evaluate a company's financial health, risk profile, and future prospects
• Regulators require companies to follow specific accounting standards and guidelines when determining impairment and loan loss provisions to ensure consistency and comparability across the industry
• Inadequate or improper recognition of impairment and loan loss provisions can lead to misstatements in financial reports, which may result in penalties, reputational damage, and loss of investor confidence
• Effective management of impairment and loan loss provisions is essential for maintaining the stability and resilience of financial institutions
• Proper accounting for these concepts helps companies make informed decisions about risk management, capital allocation, and strategic planning

Types of Impairments and Provisions

• Goodwill impairment: Occurs when the carrying value of goodwill exceeds its implied fair value, indicating that the acquired business is no longer as valuable as initially anticipated (e.g., due to changes in market conditions or poor performance)
• Intangible asset impairment: Happens when the carrying value of an intangible asset (such as patents, trademarks, or customer relationships) exceeds its recoverable amount
• Property, plant, and equipment (PP&E) impairment: Arises when the carrying value of PP&E assets exceeds their recoverable amount, often due to physical damage, obsolescence, or changes in market conditions
• Investment impairment: Occurs when the fair value of an investment falls below its carrying value, and the decline is considered to be other-than-temporary (e.g., impairment of available-for-sale securities or investments in associates)
• Loan loss provisions: Estimates of expected credit losses on a company's loan portfolio, which can be further categorized into:
  • General provisions: Collective assessment of expected credit losses for groups of loans with similar risk characteristics
  • Specific provisions: Individually assessed expected credit losses for loans that have been identified as impaired or have a higher risk of default

How to Calculate Impairment Losses

• Determine the recoverable amount of the asset or cash-generating unit (CGU) by comparing its fair value less costs of disposal and its value in use
• If the recoverable amount is lower than the carrying amount, calculate the impairment loss as the difference between the two values
• Allocate the impairment loss first to reduce the carrying amount of any goodwill allocated to the CGU, and then to the other assets of the unit pro rata based on their carrying amounts
• Record the impairment loss as an expense on the income statement and reduce the carrying amount of the asset or CGU on the balance sheet
• For loan loss provisions, use the expected credit loss (ECL) model:
  • Estimate the probability of default (PD) and loss given default (LGD) for each loan or group of loans
  • Calculate the expected credit loss as: $ECL = PD × LGD × Exposure at Default (EAD)$
  • Record the loan loss provision as an expense on the income statement and as an allowance on the balance sheet

Accounting Standards and Regulations

• International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) provide guidance on accounting for impairment and loan loss provisions
• IAS 36 "Impairment of Assets" (IFRS) and ASC 360 "Property, Plant, and Equipment" (U.S. GAAP) outline the requirements for identifying, measuring, and recording impairment losses
• IFRS 9 "Financial Instruments" and ASC 326 "Financial Instruments - Credit Losses" (U.S. GAAP) introduce the expected credit loss (ECL) model for recognizing loan loss provisions
  • The ECL model requires companies to recognize expected credit losses from the point at which financial instruments are originated or purchased
  • This is a significant change from the previous "incurred loss" model, which only recognized credit losses when there was objective evidence of impairment
• Regulatory bodies, such as the Securities and Exchange Commission (SEC) in the U.S. and the European Securities and Markets Authority (ESMA), enforce these accounting standards and may impose penalties for non-compliance
• Basel III, a global regulatory framework for banks, sets guidelines for capital adequacy and risk management, which include requirements for loan loss provisioning and the treatment of impaired assets

Real-World Examples and Case Studies

• In 2020, many companies across various industries recorded significant impairment charges due to the economic impact of the COVID-19 pandemic (e.g., airlines, hotels, and retailers)
• During the 2008 financial crisis, banks and financial institutions reported substantial loan loss provisions and impairment losses on mortgage-backed securities and other financial assets
• In 2019, General Electric (GE) recorded a $22 billion impairment charge related to its power business, citing reduced demand for fossil fuel-based power generation and the company's shift towards renewable energy
• Kraft Heinz recorded a $15.4 billion impairment charge in 2019, primarily related to its Kraft and Oscar Mayer brands, due to increased competition, changing consumer preferences, and higher costs
• In 2016, Wells Fargo agreed to pay $185 million in fines for opening unauthorized customer accounts, which led to increased loan loss provisions and reputational damage

Common Pitfalls and How to Avoid Them

• Failing to regularly assess assets for impairment indicators, such as changes in market conditions, technological advancements, or declining financial performance
  • Conduct regular impairment testing and monitor market and industry trends to identify potential impairment triggers
• Using unrealistic or overly optimistic assumptions when estimating future cash flows or determining fair values
  • Base assumptions on objective, verifiable data and consider multiple scenarios to ensure a balanced and realistic assessment
• Inadequate documentation and support for impairment calculations and loan loss provision estimates
  • Maintain detailed documentation of assumptions, methodologies, and data sources used in impairment and loan loss provision calculations to ensure transparency and auditability
• Inconsistent application of accounting standards and policies across different business units or reporting periods
  • Develop and implement clear, company-wide accounting policies and procedures to ensure consistent treatment of impairment and loan loss provisions
• Delaying the recognition of impairment losses or underestimating loan loss provisions to artificially inflate reported profits
  • Prioritize accurate and timely financial reporting over short-term performance metrics, and foster a culture of transparency and integrity within the organization