Fitch Ratings is warning that approval of a Financial Accounting Standards Board proposal on the treatment of credit losses for loans and other financial assets could eventually force U.S. banks to book expected losses early, putting pressure on their reserve levels and reported earnings.

Leslie Seidman

FASB proposed the changes as part of its financial instruments project in December (see FASB Proposes More Timely Recognition of Expected Credit Losses).

Fitch said it sees the potential for use of the loss model under the new FASB proposal to drive U.S. institutions to report asset values more conservatively than international counterparts applying the proposed new IFRS credit loss standard. The International Accounting Standards Board has proposed a different approach than FASB in the expected credit losses model (see IASB Diverges from FASB in Revised Loan Loss Proposals).

The FASB loan loss proposal is open for public comment until April 30 and would change the way in which banks account for expected losses on loans and other debt securities and financial assets. Unlike the current loss reserve rules that allow institutions to wait until losses are incurred before boosting provisions, the new approach would require a more timely recognition of future losses as expected cash flows change, Fitch pointed out.

In contrast to the current system, in which multiple impairment models relying on an "incurred loss" approach are used, the new framework would lead to a single "expected credit loss" model, in which management would be required to incorporate more forward-looking information in reporting on credit losses. As well as using available current and historical data, they would also need to consider forecasts of future losses.

On the balance sheet, U.S. banks would be required to reflect current loss expectations in the "allowance for credit losses" account. The income statement would capture deterioration or improvement in credit loss expectations through changes in the provision for bad debt expense.
Fitch said it believes that the use of this model is likely to lead to quarterly adjustments in expected loss projections, possibly leading to more volatility in provision expense and reported earnings. However, banks could also conceivably take large one-time charges at first signs of distress in their loan portfolios, then look for opportunities to smooth earnings volatility over time through reserve releases or reverse provisions

If the proposal is adopted, the rule would likely take some time to go into effect. Banks will require time to improve their accounting and reporting systems to collect the type of data that will be needed to estimate prospective losses. We believe the rule would not go into effect until 2015 or later. At that time, assuming a prospective approach to loan losses leads to increased bookings of provisions, most banks would likely report one-time hits to earnings. FASB did not immediately respond to a request for comment.

Like FASB, the IASB is seeking public comment on the proposed changes in credit loss treatment. The IASB exposure draft on the subject (open for comment until July) does not go as far as the FASB proposal in encouraging a move away from the levels of provisions booked under an "incurred loss" standard. This could set up a situation in which U.S. banks are ultimately required to report greater expected credit losses, leading to more conservatism in reporting and potentially larger loss provisions relative to their European, Canadian and other international competitors.

This could derail the process of international accounting convergence on credit losses and lead to less clarity in comparing bank balance sheets and income statements around the world, Fitch warned. However, the accounting standard-setters have expressed the hope that they will unite around a common standard for loan impairment once they receive feedback from stakeholders on the latest exposure drafts of their standards.

Ultimately, Fitch noted, the method used by banks to estimate expected losses, as well as the time horizon over which these estimates are made, will be important in providing a reasonable picture of banks' financial positions.

FASB defended the approach it was taking in its credit loss proposals, but said it would take into account the feedback it received. “One of the lessons learned from the global financial crisis of 2008 is that investors need more timely financial reporting of credit losses on loans and other financial instruments,” FASB Chairman Leslie F. Seidman said in a statement.  “Waiting until significant credit deterioration occurs before recognizing a loss defeats the purpose of moving from an incurred loss model to an expected loss model. The FASB’s proposed model is intended to fix the problem that the Financial Crisis Advisory Group (FCAG) identified with current GAAP related to the delayed recognition of credit losses. 

“The FASB model and the IASB model both would require that expected credit losses be estimated based on past events, current conditions and reasonable and supportable forecasts about the future,” she added. “The amount of credit loss that is ultimately recognized would be the same under both the FASB and the IASB impairment models. The difference relates to when losses that are currently expected would be recognized.  Under the FASB model, an entity would record its current estimate of expected credit losses every period.  The IASB model would record a portion of the expected credit losses until a significant credit deterioration has occurred, at which point the full estimate of expected credit losses would be recognized.  While estimating credit losses involves significant judgment under any accounting approach, the FASB believes that using a consistent measurement principle and removing any threshold for recognition reduces management's discretion as to when expected losses should be recognized. The FASB encourages stakeholders to share their views on this important topic. We will consider the feedback received on our proposal, as well as the input the IASB receives on its proposed model.“