Accounting For Credit Impairment - FASB Proposes An Expected Loss Model

Author:Ms Grant Thornton's Audit Practice Group
Profession:Grant Thornton LLP


This publication summarizes the FASB's Exposure Draft on the impairment of financial instruments. Under the credit loss model in the proposed Accounting Standards Update (ASU), Financial Instruments - Credit Losses, an entity would be required to recognize an impairment loss on a financial asset (for example, a debt security or loan) based on the current estimate of contractual cash flows not expected to be collected as of the reporting date (an expected loss approach). The proposed model would mark a significant change from current accounting guidance by requiring an entity to recognize an impairment loss on a financial asset when the loss is expected rather than incurred. This change is intended to result in a more timely recognition of credit losses and to reduce complexity by establishing a single credit impairment model for all financial instruments. The switch to the expected loss approach would require an entity to consider a broader range of information in evaluating whether a financial asset is impaired than is currently required under U.S. GAAP.

Comments on the proposed model are due by May 31, 2013.

A. Background and overview of proposed expected loss model

The proposed Accounting Standards Update, Financial Instruments - Credit Losses, is the third attempt by the FASB to change how credit losses would be recognized and measured. The ASU proposes to replace the current "incurred" loss model with an "expected" loss model, which the FASB expects to result in the more timely recognition of credit losses, correcting a purported weakness in today's model. The proposed model would achieve that goal by requiring entities to consider a broader range of reasonable and supportable information (such as forecasts) and by removing the recognition threshold that a loss must have been incurred as of the reporting date to recognize an impairment. In other words, an allowance for credit losses would solely be a measurement issue, since there would no longer be a recognition threshold or "triggering event."

Change from today's impairment model to CECL

Today's incurred loss model is an income statement-driven approach that seeks to reflect in each statement of financial performance losses that occurred during that period. The allowance balance, therefore, simply reflects an estimate of past losses that have not yet been confirmed (and charged-off).

In contrast, the proposed current expected credit loss (CECL) model is focused on the balance sheet, as the statement of financial position would reflect the present value of future cash flows expected to be collected over the life of the assets on the balance sheet. As such, under the CECL model, credit deterioration would not be reflected in the income statement in the period of such deterioration unless it is unexpected. Instead, the income statement loss provisions would reflect expected credit losses in the period of origination or acquisition of the financial asset, with changes in expected credit losses due to further credit deterioration or improvement reflected in later periods.

In addition, the proposed ASU is intended to reduce complexity in accounting for credit losses by establishing a single credit impairment model for all financial instruments (for example, debt securities and loans) that are not measured at fair value through net income (FV-NI). The proposed model would amend or supersede the current impairment models for financial assets as follows:

Amend the scope of FASB Accounting Standards Codification® (ASC) 450, Contingencies - Loss Contingencies (formerly FASB Statement 5, Accounting for Contingencies), to exclude items within the scope of the proposed ASU Loss contingencies

The proposed ASU would create a difference in how loss contingencies are recognized and measured, depending on whether the loss contingency falls within the scope of ASC 450 or the proposed ASU. Loss contingencies not covered by this proposed ASU would continue to follow an incurred loss approach, while loss contingencies covered by this proposed ASU would follow an expected loss approach. This is a significant change in thinking from FASB Statement 5, Accounting for Contingencies, which concluded that all loss contingencies within its scope have common characteristics and should therefore be reported and accounted for consistently.

Supersede the impairment guidance in ASC 310-10-35, Receivables (formerly FASB Statement 114, Accounting by Creditors for Impairment of a Loan) Supersede ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (formerly AICPA Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer) Supersede the other-than-temporary impairment guidance in ASC 320-10-35, Investments - Debt and Equity Securities Supersede ASC 325-40, Investments - Other: Beneficial Interests in Securitized Financial Assets, for a transferor's interests in securitization transactions that are accounted for as sales under ASC 860, Transfers and Servicing, and for purchased beneficial interests in securitized financial assets (formerly EITF Topic 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets") Comparison to IASB model

The IASB has separately issued a proposal on measuring credit losses. While the IASB's "three bucket" model is also an expected loss model, there are some significant differences between the Boards' proposed models:

The IASB model would have two measurement objectives, depending on whether there has been a significant deterioration in credit quality since origination ("transfer criteria") and on whether the financial assets were purchased. Under the IASB model, an entity would recognize an allowance for credit losses as the sum of (1) 12 months of expected credit losses for financial assets that have not met the transfer criteria and (2) lifetime expected credit losses for financial assets that have met the transfer criteria and purchased credit-impaired financial assets. In contrast, the FASB model would require an entity to recognize expected credit losses for all financial assets in an approach that is similar to the IASB's second measurement objective. As a result, we would generally expect that the IASB model would result in a lower allowance for credit losses when applied to the same portfolio of financial assets. The FASB model would retain the troubled debt restructuring guidance, which is unique to U.S. GAAP. The IASB model does not include a nonaccrual concept. The FASB model would require an entity applying a discounted cash flow approach to use the original effective interest rate, while the IASB model would allow an entity to use any reasonable rate between the risk-free rate and effective interest rate. There may be differences as to which specific financial assets would be subject to each Board's respective impairment project. Concurrent to the impairment phase of the financial instruments project, the Boards are still working on the classification and measurement phase of the project, which would require financial instruments to be separated into three measurement categories: (1) FV-NI, (2) fair value through other comprehensive income (FV-OCI), and (3) amortized cost. The IASB and FASB are separately considering changes on the classification and measurement phase of financial instruments. Interaction with bank regulatory capital changes

Regulated financial institutions should consider the interaction of the proposed changes by the FASB (and IASB) on impairment and BASEL III. BASEL III is a "comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector." BASEL has published " Minimum principles for the recognition of credit-risk related impairment" as an appendix to a comment letter issued to the FASB and IASB shortly after the issuance of the FASB's Exposure Draft. It is expected that the changes to the accounting model would impact the regulatory capital framework.

Comment period

Comments on the proposed model are due by May 31, 2013.

B. Scope

The proposed guidance would apply to financial assets that are debt instruments classified at amortized cost or FV-OCI. A debt instrument is a receivable or payable that represents a contractual right or a contractual obligation to receive or pay cash (or other consideration) on fixed or determinable dates, whether or not there is any stated provision for interest. Examples of financial assets that are considered debt instruments include, but are not limited to, the following:

Loans Debt securities Trade receivables Reinsurance receivables The proposal would also apply to lease receivables recognized by the lessor in accordance with ASC 840, Leases, and to legally binding loan commitments to extend credit, including loan commitments that are revolving (such as credit card loans) and nonrevolving.

The proposal would not, however, apply to equity investments. Under another proposed ASU, Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities, equity securities either would be measured at FV-NI, or, if certain criteria are met, an entity would be permitted to measure equity investments without readily determinable fair values at cost, adjusted for both impairment and changes that result from observable price changes in orderly transactions for an identical or a similar investment from the same issuer.

Financial guarantees

It is not clear whether financial guarantees are within the scope of the proposed ASU. However, the FASB's proposed classification and measurement ASU, Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities, specifically excludes financial guarantee contracts that are within the scope of ASC...

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