Accounting for Financial Instruments’”Credit Impairment

Accounting for Financial Instruments- Credit Impairment
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Accounting for Financial Instruments- Credit Impairment
Abstract
The recent past has had us witness a chain of events that have aroused various responses. Some have been positive while others negative but the bottom line is that the matter at hand will affect most of us if not all. The effect is not a matter of choice but a facet of credit and financial accounting. Credit impairment refers to the state of an individual having low credibility for a loan application. It results in frustration, and it also leads one to further plunging into debt and ultimately crippling the company to dissolution. Credit impairment results in a loss of trust, and though it may be on a small scale on an individual level, it affects businesses on a much larger scale.
Accounting for Financial Instruments – Credit Impairment
Financial weakness does not just come in when one cannot sustain themselves but also when they cannot summon the resources that they need for sustenance. It means that they do not have the financial muscle to promise results. Alternatively, it shows a shortchanged future that may seem bright but only for a short season. As a result, the individual or business cannot negotiate for a loan with ease. It is often very difficult to get a loan that would be needed to improve their current state. The difficulty in this is due to the inability of the business to give solid proof that they are capable of paying up when the time is due.

In other words, they do not have the financial muscle to service a loan. The criteria used here is that there is a gauge of the current in the vision of the future, and the two must correspond. Records are important in making such decision because a score would be known if data has been collected and stored. In this piece, we will not go into the authenticity of the data provided. We will look at the credit impairment and how it has affected the corporate world and consequently the individuals.
When a person or a business has low credit worthiness, the offers are often high rated. The loans available for them are high rate loans. It first discourages them from taking the loan and secondly calls for a re-evaluation of the cause for which the money is needed. When a bank gives a loan to a business with a low credit worth, they expose themselves to great risk. At the moment, the business is on the lower side and has not proven worthy, that is why most banks seldom lend to low credit worth businesses. The main contributor of low credit scores is late payment of debt obligations. It means that there have been credit commitments made prior but fulfilling them has been hard. Though they may try, they may not be able to pay back in time. It shows that this has been a scenario that has occurred over some time. Some circumstances that would lead to this would be the like of losing a job, long illnesses and death on an individual level. Regarding a business, poor management, and increased competition would be some aspects that could bring it to a low credit score. It could be due to loans or financial guarantee contracts (Etheridge 2012).
When we take a credit card as an example, we will find that a jobless individual would be spending money that they do not have or cannot pay back. It is because of the current needs faced that they continue using it. When it is time to pay up, they may not be able to pay up or due to irregular job availabilities, the payments may be made at irregular intervals. Such circumstances lead individuals and business to feel pushed to the wall, and they may resultantly opt to default on bonds.
Such a state and situation can be resolved when it is temporary. There can be cases where the effect has been too intense that there is not remedy. However, when it is still temporal, it can be reverted, if not, then this could serve as a prediction of the business’s future. It could show that there will soon be a crisis if some rectifications are not done. Some remedies to this would be to reduce expenses, sell assets and using cash flow to pay the outstanding debts. It is important especially to notice that the cash that is generated is channeled outside unlike within. For example, when there is an inflow of money, that money would be used to pay the debts thereby reducing the intensity of the debts that are there at the moment. In doing this, the weight of the debts to be paid is reduced. There is a recovery of the credit score as it rises from its initial position to a more favorable one. It is evident that the business does not halt first then after it finishes with the debts continue with the operation. This process requires a keenness and prowess in leadership (American Bankers Board 2012). Balancing what is needed for the business and giving out some outside itself is something that would seem unachievable but with skill and patience, temporal credit impairment can be reversed. It requires one to be disciplined and to prioritize. The essence of this is to reduce the weight that one may feel being generated by the liabilities that they have. It is aimed at first reducing the debts that one has then after recovery from that, accumulated resources to purchase assets. It is a very practical way of getting oneself out of credit impairment and into stability financially.
It has been a problem for some time, and as all problems are, they require solutions. It is this reality that has led to the formation of various bodies to try and come up with ways that can eradicate this issue. When they were starting out, it was simply identifying the current state. It involved calculating the loss also and the damage that was there at the time. At this point, knowing what the problem had been was the primary thing. Various methods were used to identify this and while some worked, others failed. At the point that some processes used to find out the problem worked and the problem was found, the task of rectifying the problem was now at hand, and this did not prove to be simple as we are going to see.
Credit Impairment Approaches
The first module that was formed was the incurred loss module (Shannon 2013). This kind of approach assesses the damage that has been made and quantifies it. It is where the investments that a business or an individual has made are considered invalid or inapplicable for future cash flow. There may be many reasons for this such as great financial strain, defaulting or even severe economic change. With a current projection, one may see that there is a reduction in the quality, strength or the value of the asset such that with time, losses will have been incurred however gradual it may be.
To calculate the cost impairment using this incurred loss module, one would subtract the carrying amount from the recoverable amount. The incurred loss method shows what one has lost, and this might not prove effective (Financial Accounting Standard Board1973). One would have to experience many outcomes as this to then be able to study the matter in depth. It is because one has to wait and collect data so as to use the data collected then get the results. It has helped but there is still more that can be done, or that should be done. It is for this reason that the Financial Accounting Standard Board (FASB) came to disagree with the (IASB). The two have been trying to work on new standards that will help with credit impairment, and the FASB holds the second module effective.
FASB call this module the Current Expected Credit Loss (CECL) approach (Ernst and Young 2012). It could also be called the Expected loss approach, but the concept is the same. It creates a single credit loss model for financial assets that can detect losses early. This kind is meant to preempt or predict the occurrence of losses. With this, individuals and companies are not left helpless because they can do something before the current state worsens. FASB have said that they are currently finalizing on the amendments and that once they are done, it will help numerous people. Their approach will affect banks and applicable asset portfolios. These are the likes of loans, leases, and debt securities. It will affect the very source of the loans, so when one looks at it, it looks like something that will last and help.
Their approach has incorporated a constant continuous evaluation of the individual or business’s cash flow. It ensures that no ignorance is left thriving and that evaluation done shows all the flaws even as they develop. It is easier to deal with a problem before it grows and becomes uncontrollable. When it is small, you can contain it and do away with it. When they do so, there is minimized impaired credit incurred. An awareness of credit risk is also created. It promotes planning and strategizing of events and investments thus the management would have to be up to the task as it would require their commitment greatly. They must be prepared to deal with the issue head on and not shy away. They must confront the problem and rectify it.
The risk assessment process should be practical, sustainable and understandable so as to produce effective results (Fine 2015). As far as practicality goes, the assessment must be one that is applicable. There would not be any need of having a method of assessment that one cannot apply yet they would require it to make changes. Some things cannot be done virtually; they must be put on paper and gauged to ensure accuracy and progress. Secondly, we have sustainability. It involves the life of the assessment and the durability. If one would like to predict the next ten years, they would have to use a criterion that is not just logical but logically stable. In other words, what they would choose as a criterion should be able to withstand time without disintegrating. It is not at all easy to come up with such assessment criterion, but that is the exact reason it calls for some time to think and plan so as to assess effectively. Finally under this category we have the aspect of understanding of the process. The main point in assessment is to come up with a result that outdoes the previous one. Therefore, one must identify through understanding the downsides of one aspect as they identify solutions. When man understood gravity, he was able to build a dam because as long as it rained, the water would always flow. The same thing applies here regarding understanding. If the process is understood, it is relatively easy to implement it. It is also evident that with such understanding, effective results would be produced.
Some steps to following this process would be first to develop an assessment criterion. The assessment criterion is where we come up with a process through which scrutiny will be carried out. It involves a keen selection of a criterion that will serve the purpose. Different needs cannot be met in the same way neither can the solutions of problems that differ be similar. It, therefore, follows that there are some that would be close to the solution, but there would be another that would be more accurate.
Secondly assigning a value to each risk and opportunity would be very important. Imaginary solution seeking can be effective and serve as an ideal but in this case, the real and actual nature of the risk is what is being looked into. Therefore, assigning values to the risks and opportunities give a real impression and result to a keenness that would not otherwise be there. The third step would be considering risk interaction. Considering risk interaction is an aspect that most people would tend to leave out from the beginning. The consideration of a single risk occurring may be manageable but when these risks are combined, it could be disastrous. Some risks are linked or complimentary that in the occurrence of one, the other would follow or that both would happen at the same time. An example of this would be a case where one would take a loan to mine for diamond. In the process, a mine collapses and kills an employee. There would be the need to compensate the employee’s family and also pay the loan. A consideration of such incidences would lead one to think of a probable solution. It could be insuring the employees and so on. The illustration is not a stereotype, but it can help us understand the kind of thing that compound risk would bring about.
Fourthly, we have to prioritize the risk and to respond to it. Some risks may come in very distinct ways as compared to others and so in this case, there would be a difference in the damage caused too. Some may be high while others would be low regarding calamity occurrence. If one can prioritize the risk regarding the intensity, they could know what to deal with first and what follows especially when such happen in a combined manner. After this has been established, we would have to respond. The response is very vital and key especially because it is what gives us results. The way we respond to various things matters a lot. It shows our mastery and our skill in the area. These steps would help us in risk management and assessment. Therefore, it would enable us to invest wisely because we are not in the dark. However, some are in opposition with FASB’s declaration of remedy. They say that the cost that could be incurred by community banks in implementing this approach would be very high. It would be overly expensive and very few people would afford it. If the majority cannot access such, why would we have it as a standard? A standard is by definition something that all people under the related sector can subscribe. If not all can access it, what would be its need? It would result in a kind of oppression to those who cannot access it. This matter calls for a keen scrutiny, especially as regards how to go about finding a suitable solution to this problem of credit impairment. I believe that once management has been improved, cases of credit impairment would be minimized.
When the matter comes to the individual, it cannot be denied that it will cost a lot of money. Part of the reason it would cost a lot would be because there are many processes involved. Most of these steps need manpower and a workforce to execute it. Subscribing to this as an individual would be frustrating. On the flip side, businesses may be able to tap into the juice from this tree but they would not have enough of it. They would only be able to experience it superficially and not in depth. It may help to scrape the surface but for lasting change, there would be a need to go deeper and get more. Once a business indulges in this process, it would be hard for them to withdraw from it because it seems like it is the only remedy. That would lead to an insatiable pump of resources to this kind of service. Unfortunately, that would lead to it becoming more impaired than it initially was. Instead of the money being used to settle the current monetary disputes, it would be used to service a “liability” thus a worsening state.
The most important thing is to know why credit impairment comes about. They said that knowledge is power and rightly so. The knowledge that we have about credit impairment is vital and critical in preventing us from sinking deeper into it. It helps us plan ourselves efficiently and not haphazardly. It necessitates time to think and strategize. Most credit impairments occur as a result of miscalculation or poor management and especially not being able to incorporate a risk response in the plan (Ernest 2012). Thus noticed is the ability to move forward depends on the ability to plan effectively from the beginning. Some may claim that there are financial calamities that can come and sweep one off their feet whether they like it or not. With a response plan or without it, but as much as this is true, there is the need to consider effective and flexible planning. Change and improved management look like the foremost remedy to credit impairment. It can greatly help and transform our economic sector.

References
American Bankers Association. (2012). Discussion Paper: Credit Impairment Model Proposal.
Retrieved on September 15, 2012, from
http://www.aba.com/Issues/Index/Pages/issues_CreditImpairmentModel.aspx
Ernst and Young. (2012). The new impairment model: US financial institutions weigh in on the
new impairment model being developed by the FASB and IASB. February.
Etheridge, H., & Kathy Hsiao Yu, H. (2013). FINANCIAL INSTRUMENT CREDIT
IMPAIRMENT MODELS – A RIFT IN THE CONVERGENCE OF IASB AND FASB
ACCOUNTING STANDARDS. Academy Of Accounting & Financial Studies Journal,
17(1), 119-126.
Financial Accounting Standards Board. (1973). Financial Accounting Standard 5 “Accounting
for Contingencies”. March.
Fine, C. R. (2015). Misguided guidance. Independent Banker, 65(10), 7. Retrieved from
http://ezproxy.umuc.edu/login?url=http://search.proquest.com/docview/1721972613?
accountid=14580
Shannon, C. (2013). Credit impairment: A closer look. Equipment Leasing & Finance, 29(4), 42
43. Retrieved from http://ezproxy.umuc.edu/login?
url=http://search.proquest.com/docview/1428976864?accountid=14580