For community banks, accounting for credit losses — which are reflected in the allowance for loan and lease losses (ALLL) — is a critical process that can have a significant impact on earnings and capital. Recently, both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) proposed to change the way financial institutions determine when and how credit losses should be recognized.
At press time, both boards were reviewing comments to their respective proposals. Hopefully, they will issue a “converged” standard later this year.
A forward-looking approach
Many people believe that the 2008 financial crisis was caused, at least in part, by weaknesses in the way banks and other companies report credit losses. Under current standards, banks use an “incurred loss” model to account for credit losses on loans and other financial instruments.
In other words, a bank doesn’t recognize a credit loss until it’s determined that a “loss event” makes it probable that a loss has taken place. To make this determination, banks examine historical events as well as current conditions, but they need not take into account forecasts that affect expected collectibility in the future.
FASB and the IASB fear that this approach causes losses to be reported too late in the credit cycle. The board’s proposals, thus, are designed to require more timely recognition of credit losses while providing added transparency about credit risk. To accomplish this goal, the proposals replace the incurred loss model with an “expected loss” model.
According to FASB’s March 25 FAQ, its proposal would require “an allowance for credit losses at a present value, based on contractual cash flows not expected to be collected ….” Banks would be required to consider a broader range of information, including 1) historical loss information on similar assets with similar credit ratings, 2) current conditions, and 3) reasonable and supportable forecasts about future events that affect expected cash flow collections.
Differences between the proposals
The IASB also advocates an expected loss model, but with a significant difference: Under its proposal, a bank would recognize only a portion of expected loan losses (for one year following the reporting date) unless there’s been “significant credit deterioration” since origination of the loan, in which case it would recognize “lifetime expected credit losses.”
According to FAQ 19, FASB rejected a similar approach, concluding that a “credit deterioration” model is akin to an incurred loss approach rather than an expected loss approach.
The next steps
It remains to be seen whether FASB and the IASB can resolve their differences and arrive at a converged standard for accounting for credit losses. Although the details still need to be worked out, it seems clear that banks will soon be required to adopt an expected loss model for computing their ALLL.
The final standards likely won’t take effect until late 2014, but consider beginning preparations now. Ensure that your bank has policies and procedures in place to estimate expected losses and to evaluate the potential impact of the new standards on your financial statements.
For more information contact Scott Deters at [email protected] and Jon Plunkett at [email protected]