On Thursday, June 16, 2016 the Financial Accounting Standards Board (FASB) issued final guidance that significantly changes how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured at fair value through net income. Given the scope, this new standard will impact both financial services and non-financial services entities. In 2008, the FASB and the International Accounting Standards Board (IASB) established a Financial Crisis Advisory Group to advise the Boards on improvements in financial reporting in response to the financial crisis. That group recommended exploring more forward-looking alternatives to the “incurred loss” methodology embedded in current U.S. Generally Accepted Accounting Principles (U.S. GAAP). The new standard introduces an approach based on expected losses to estimate credit losses on certain types of financial instruments. It also modifies the impairment model for available-for-sale (AFS) debt securities and provides for a simplified accounting model for purchased financial assets with credit deterioration since their origination.
Current Expected Credit Loss Model
Current U.S. GAAP requires an “incurred loss” methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred. This model has been criticized for restricting an entity’s ability to record credit losses that are expected, but do not yet meet the “probable” threshold. The new model, referred to as the current expected credit loss (CECL) model, does not specify a threshold for the recognition of an impairment allowance. Rather, an entity will estimate its lifetime expected credit loss and record an allowance (contra-asset) that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. In other words, the allowance will represent the portion of the financial asset the entity doesn’t expect to collect.
Although the new standard does not require a specific method for estimating credit losses, the measurement should be based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. As a result, the estimate of expected credit losses will require significant judgment. In addition, entities will need to measure expected credit losses on assets that have a low risk of loss (e.g., investment-grade held-to-maturity debt securities) because the CECL model does not have a minimum threshold for recognition of impairment losses.
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 period, in a manner consistent with existing U.S. GAAP.
OBSERVATION: The CECL model will apply to:
- Financial assets subject to credit losses and measured at amortized cost
- Certain off-balance sheet credit exposures including loans, held-to-maturity debt securities, loan commitments, financial guarantees and net investments in leases, as well as reinsurance and trade receivables.
Available-for-Sale Debt Securities
The CECL model does not apply to AFS debt securities. Instead, the new standard amends the current other-than-temporary impairment model for debt securities. The new model will require an estimate of expected credit loss only when the fair value is below the amortized cost of the asset. The new model also requires credit losses be recorded through an allowance, rather than as a direct reduction of the amortized cost basis of the investment. This will allow subsequent reversals in credit loss estimates to be recognized in current income. In addition, the allowance on available-for-sale debt securities will be limited by the amount that fair value is less than the amortized cost.
OBSERVATION: The length of time the fair value of an AFS debt security has been below the amortized cost will no longer impact the determination of whether a credit loss exists. As such, it is no longer an other-than-temporary model.
Purchased Financial Assets with Credit Deterioration
The new standard defines purchased financial assets with credit deterioration (PCD assets) as “[a]cquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that, as of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.” This represents a change in the scope of what are considered PCD assets under current guidance. Under current U.S. GAAP, an acquired asset is considered credit-impaired when it is probable that the investor would be unable to collect all contractual cash flows as a result of deterioration in the asset’s credit quality since origination. Under the new standard, a PCD asset is an acquired asset that has experienced a more-than-insignificant deterioration in credit quality since origination. As a result, entities will need to use more judgment to determine whether an acquired asset has experienced significant credit deterioration.
For PCD assets, the new standard requires an entity’s method to be consistent with its method for measuring credit losses for originated and non-credit-deteriorated assets. However, the initial allowance for credit losses is added to the purchase price rather than being created through credit loss expense (a “gross-up” approach). After initial recognition, the accounting will follow the applicable model (CECL or AFS), with all adjustments being recognized immediately in the income statement.
For public business entities (PBE) that are Securities and Exchange Commission (SEC) filers, the new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (for a calendar-year entity, it would be effective January 1, 2020).
For PBEs that are not SEC filers, the new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020.
For all other organizations, the new standard is effective for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021.
Early applications will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.
Although the new standard will be particularly challenging for financial service entities, given the broad scope which includes trade and lease receivables, all entities will need to evaluate the impact. Specifically, the requirement to estimate expected credit losses will likely result in an increase in credit reserves for entities that currently apply the “incurred loss” approach. Changes to systems, processes and controls will likely be required to apply the new guidance and may require a substantial amount of time to implement.
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