The Financial Accounting Standards Board (FASB) recently issued a new accounting standard that will significantly change how financial institutions report credit losses in their financial statements. The amendments in Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326), will affect a variety of assets, including loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, and reinsurance receivables. Among other matters, the new standard requires financial institutions to report their credit losses earlier, which will affect current-period earnings.
The need for a new model
Under existing generally accepted accounting principles in the United States (US GAAP), financial institutions must apply an incurred loss model to recognize credit losses on financial assets measured at amortized cost. The model puts off recognition until it is “probable” that the financial institution has incurred a loss. Users and preparers of financial statements complained that this model restricts a financial institution’s ability to record expected credit losses that have not yet met the “probable” threshold.
According to the FASB, financial statement users worked around this problem by using forward-looking information to estimate expected credit losses and then devaluing financial institutions — before US GAAP allowed the institutions to recognize the losses themselves. This practice demonstrated that US GAAP’s requirements were not meeting the needs of financial statement users and preparers.
In 2008, in recognition of the issue which was prompted largely by concerns arising from the global financial crisis, the FASB and the International Accounting Standards Board (IASB) formed the Financial Crisis Advisory Group. The group recommended that the standards-setting bodies explore more forward-looking alternatives to the incurred loss model. The FASB responded by launching a project to better align financial reporting for credit losses with the needs of financial statement users. The board considered a variety of expected credit loss models and reviewed more than 3,360 comment letters before selecting the “current expected credit loss” (CECL) model. (The IASB issued its own standard, which adopted a different model, in 2014.)
The CECL model for financial reporting
The new standard adopts a model that requires financial institutions to immediately record the full amount of expected credit losses in their loan portfolios, instead of waiting until the losses qualify as “probable.” The FASB expects this shift to the CECL model to produce more timely and relevant information.
Specifically, under ASU 2016-13, financial institutions must present assets measured at amortized cost at the net amount expected to be collected. They will then deduct an allowance for credit losses from the financial asset’s amortized cost to present its net carrying value on the balance sheet.
The income statement will show the measurement of credit losses for newly recognized financial assets and the expected increases or decreases of expected credit losses occurring during the relevant reporting period. The measurement of expected credit losses will consider relevant information about past events (including historical experience), current conditions, and, where available, the “reasonable and supportable” forecasts that affect the collectibility of the reported amount. Financial institutions can use historical information beyond the timeframe that those forecasts are supportable.
Currently, companies generally evaluate only past events and current conditions when measuring the incurred loss. However, the FASB has made clear that financial institutions won’t need to forecast economic conditions over the entire contractual life of long-lived financial assets.
The standard does not mandate a specific technique for estimating credit losses; it allows companies to exercise judgment to determine the method that is appropriate for their circumstances. Moreover, the updated guidance permits companies to continue to use many of the loss estimation techniques already employed, such as loss rate methods, probability of default methods, discount cash flow methods and aging schedules. However, the inputs of those techniques will change to account for the full amount of expected credit losses and the use of reasonable and supportable forecasts.
In addition, the new guidance changes the financial reporting for credit losses on purchased financial assets with credit deterioration (PCD) since origination. The allowance for credit losses on these assets will be determined in a manner similar to that of other financial assets measured at amortized cost, but the initial allowance will be added to the purchase price, not recorded as credit loss expense. The change is intended to make PCD assets easier to compare with originated and non-PCD assets.
ASU 2016-13 also enhances financial institutions’ current disclosures of credit quality indicators related to the amortized cost of financing receivables. It requires that disclosures be disaggregated according to their years of origination (or “vintage”). The disclosures should 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.
Slight changes to AFS debt security reporting
The standard will make little change to the accounting for credit losses on available-for-sale (AFS) debt securities, which will remain similar to existing US GAAP. However, ASU 2016-13 will require credit losses to be recorded through an allowance for credit losses, rather than through a one-time write-down. The allowance will allow the recognition of subsequent reversals in credit loss estimates in current-period earnings. (The allowance for credit losses will be limited by the amount the fair value is less than the amortized cost.) This approach should align the income statement recognition of credit losses with the reporting period in which changes will occur. Existing US GAAP prohibits companies from reflecting improvements in credit loss estimates in current-period earnings.
Effective dates and transition
Financial institutions must apply the changes in ASU 2016-13 through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective — also known as a modified-retrospective approach. A prospective transition approach is required for certain assets, including PCD assets. Smaller public companies that are not Securities and Exchange Commission (SEC) filers may take advantage of transition relief for the first three years that the standard is applied.
The new standard will take effect for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019.
For public companies that are not SEC filers, the new standard will take effect for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years.
For all other organizations, the new standard will take effect for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021.
The FASB has indicated that many financial institutions will need to update their processes and controls to ensure they’re properly measuring credit losses under the new guidance. Institutions may also need to collect additional data related to the expected credit loss model they determine to be appropriate for their asset types and sophistication level.
The FASB has also concluded that, once the new standard has been implemented and a financial institution’s processes have been fully updated, the continuing costs of preparing the allowance for credit losses won’t typically be significantly more than the costs to comply with the incurred loss model under existing GAAP.