The Financial Accounting Standards Board (FASB) has released a long-awaited accounting standard that responds to some of the concerns prompted by the global financial crisis about financial institutions’ reporting on credit losses. In addition to its effect on current-period earnings, the updated guidance will affect the amounts banks, credit unions and other entities report for such assets as loans, securities, bond insurance and many receivables.
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326), requires earlier measurement of credit losses, expands the range of information considered in determining expected credit losses and enhances disclosures.
Criticism of existing reporting requirements
Under existing U.S. Generally Accepted Accounting Principles (GAAP), financial institutions must apply an “incurred loss” model when recognizing credit losses on financial assets measured at amortized cost. This methodology delays recognition until it’s “probable” that a loss has been incurred. Both users and preparers of financial statements have criticized this model for restricting a company’s ability to record expected credit losses that don’t yet meet the “probable” threshold.
The FASB found that, leading up to the global financial crisis, financial statement users made estimates of expected credit losses using forward-looking information and then devalued financial institutions before the institutions were permitted to recognize the losses. This disparity made it clear that the requirements under GAAP weren’t meeting the needs of financial statement users.
In 2008, the FASB and the International Accounting Standards Board (IASB) established the Financial Crisis Advisory Group, which recommended exploring more forward-looking alternatives to the incurred loss model. In response, the FASB launched a project to better align financial reporting for credit losses with the needs of financial statement users. The board considered various expected credit loss models and reviewed more than 3,360 comment letters before settling on the “current expected credit loss” (CECL) model. (The IASB issued its own standard in 2014, which adopted a different model.)
A new reporting model
The CECL model requires financial institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, rather than waiting until the losses are deemed probable. The FASB expects this change to result in more timely and relevant information.
Specifically, ASU 2016-13 requires financial institutions to present assets measured at amortized cost at the net amount expected to be collected. An allowance for credit losses will be deducted from the amortized cost of the financial asset to present its net carrying value on the balance sheet.
The income statement will reflect the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the relevant reporting period. The measurement of expected credit losses will be based on relevant information about past events (including historical experience), current conditions, and the “reasonable and supportable” forecasts that affect the collectibility of the reported amount.
Under existing GAAP, companies generally consider only past events and current conditions in measuring the incurred loss. The FASB has assured financial institutions that they needn’t forecast economic conditions over the entire contractual life of long-dated financial assets. Historical information may be used beyond the timeframe that those forecasts are supportable.
The updated guidance doesn’t prescribe a specific technique to estimate credit losses — rather companies can exercise judgment to determine which method is appropriate for their circumstances. Recognizing the importance of providing a scalable approach for institutions of all sizes, ASU 2016-13 allows companies to continue to use many of the loss estimation techniques currently employed, including loss rate methods, probability of default methods, discount cash flow methods and aging schedules. But the inputs of those techniques will change to reflect the full amount of expected credit losses and the use of reasonable and supportable forecasts.
The new standard also changes the reporting for credit losses on purchased financial assets with credit deterioration (PCD) since origination. The allowance for credit losses for such assets will be determined in a manner similar to that of other financial assets measured at amortized cost, except that the initial allowance will be added to the purchase price rather than recorded as credit loss expense. This change is intended to increase the comparability of PCD assets with originated and non-PCD assets. Currently, these loans have no Day One allowance. Under this new standard, PCD loans will have an allowance recorded on Day One
In addition, ASU 2016-13 expands the disclosures of credit quality indicators related to the amortized cost of financing receivables currently required. The disclosures must be disaggregated by their years of origination (or “vintage”). These disclosures are intended to help users better assess changes in the underwriting standards and credit quality trends in asset portfolios over time, the effect of those changes on credit losses, and management’s initial credit loss estimates. Disaggregation by vintage will be optional for nonpublic institutions.
AFS debt securities
Accounting for credit losses on available-for-sale (AFS) debt securities will remain similar to existing GAAP. The updated guidance will, however, require credit losses to be recorded through an allowance for credit losses, rather than a one-time write-down. The allowance will permit subsequent reversals in credit loss estimates to be recognized in current-period earnings. (The allowance for credit losses will be limited by the excess of amortized cost over fair value.) This approach should align the income statement recognition of credit losses with the reporting period in which changes will occur. Existing GAAP prohibits reflecting improvements in credit loss estimates in current-period earnings.
The FASB predicts that many institutions will need to change their processes and controls to ensure they’re properly measuring credit losses under ASU 2016-13. Institutions may also need to gather additional data relevant to the expected credit loss model they find appropriate for their asset types and sophistication level.
But the FASB has concluded that, once implementation of the new standard is complete and an institution’s processes have been fully updated, the ongoing costs of preparing the allowance for credit losses won’t usually be significantly higher than the costs of complying with the incurred loss model under existing GAAP.
Making the transition
The updated guidance requires companies to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective — what’s known as a modified-retrospective approach. For certain assets — including PCD assets — a prospective transition approach is required. Transition relief is available to smaller public companies that aren’t Securities and Exchange Commission filers for the first three years that the standard is applied.
The new standard goes live for calendar year-end public companies in 2020. It takes effect for other calendar year-end entities in 2021. Early application is permitted for all companies in 2019. This standard is one of the most significant changes to take place in the financial services industry. If you have questions about how the new standard will affect the reporting of your credit losses, please contact us.