Accounting for NPAs when economy is down

BL : Mohan  R Lavi : Aug 30,2012

The jury is still out on who would be more disappointed if Kingfisher Airlines goes belly-up — the airline or State Bank of India (SBI). SBI leads the consortium of unpaid banks and financial institutions that have forked out funds to the airline.

Most of these lenders have already considered their exposure as a non-performing asset (NPA) in accordance with the guidelines of the Reserve Bank of India (RBI).

The SBI chief has called for a re-look at the NPA norms to prescribe standards that are in sync with reality.

In the past, whenever the economic environment has turned bleak, the Government has got going with a slew of measures — the stimulus package a couple of years back, relaxation in FDI norms in certain industries and deviation from accounting standards to permit capitalisation of exchange gains and losses being some examples.

During these times, the RBI has focused on managing interest rates and largely remained silent on tweaking NPA norms. All the glare and attention seems to have been focused on Kingfisher — a bit unfairly one could say — though there are other borrowers who are in a worse shape than the airline, and some who have even defaulted wilfully.

PRUDENTIAL NORMS

As per present the RBI guidelines, NPA norms come into effect when an account is not funded for a period of 90 days. 

Assets are classified depending on how long they stay in the NPA category.

In the present economic environment, 90 days is 

considered too early to trigger NPA status. 

Even though other conditions such as collateral security and restructuring proposals would affect the NPA status of an account, there is a view that the RBI can be a bit more liberal in this regard.

Accounting standards are also keeping pace with the times. A change is recommended from the ‘incurred loss model’ to the ‘expected loss model’, to recognise impairment conditions existing in financial assets.

The International Accounting Standards Board has issued an exposure draft on the amortised cost measurement and impairment of financial instruments. The exposure draft proposes an expected loss model for recognising impairments on financial assets recorded at amortised cost.

Currently, both US GAAP and IFRS use an incurred loss model for recording impairments on financial assets. Under an incurred loss model, impairments are recognised only after a loss or trigger event is identified. An expected loss model would recognise loss estimates throughout the life of a loan (or portfolios of loans) and other financial assets recorded at amortised cost.

The Basel Committee on Banking Supervision’s international accounting standards should be changed to improve how assets are valued when markets are illiquid or malfunctioning.

The International Accounting Standards Board should set standards to gauge “fair value” when the measures are unclear, and banks should record losses expected over the life of a loan portfolio earlier.

India is one of the countries that supports the expected loss model in the global move towards IFRS. Some experts have warned that the expected loss model would accelerate losses at the beginning of a downturn and, consequently, still have a pro-cyclical effect.

The Financial Crisis Advisory Group (FCAG) supports exploring alternatives to the incurred loss model, including the expected loss model and a fair value model.

The financial world sees a lot of merit in banks and financial institutions adopting Spain’s system of forcing banks to hoard capital in good times to draw upon in bad. The European Union (EU) is following suit with draft rules.

IFRS IN INDIA

After maintaining a stoic silence over an extended period of time, the Government has now stated that it would soon move over to IFRS. 

Whenever that occurs, the RBI should be prepared with Prudential Norms for Income Recognition and Asset Classification.

Most banks and financial institutions in India are listed and, hence, they would certainly be in the first set of entities that move over to IFRS.

The task for the RBI is certainly cut out, as it has to balance a dark economic environment with aggressive accounting standards. 

Having done so in the past (for Indian accounting standards), this should not be a too Herculean a task for the RBI