FASB Releases New Financial Instruments Standard on Accounting for Credit Losses

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The Financial Accounting Standards Board issued Thursday its long awaited accounting standards update for credit losses, part of the convergence project on financial instruments that it has been working on with the International Accounting Standards Board for eight years.

The two boards diverged, however, in their approach to accounting for credit losses on loans and other financial instruments held by financial institutions and other organizations. The project took on particular urgency in the wake of the financial crisis when the value of mortgage loans and derivatives such as collateralized debt obligations plunged.

“The objective is to better align the credit risk that's being taken, the economics of the transaction, with the accounting for the economics,” FASB board member Hal Schroeder told Accounting Today. “What you saw clearly in the mid-2000s was loosening of underwriting standards and rapid growth in loans, but the reserves were not keeping up and in fact they actually decreased. In the four years before the crisis, loans went up 45 percent, but reserves went down 10 percent, and that illustrates the mismatch between the economics of lending and the accounting. This standard is an effort to realign one with the other.”

The accounting standards update requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates.

Many of the loss estimation techniques applied today will still be permitted, FASB noted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances.

“Because accounting for estimating loan loss reserves is a very subjective issue, we're looking to provide investors with some additional disclosures that would help them assess management's upfront expectations and measurements of expected losses,” said Schroeder. “The two takeaways here are that as loans are booked in pools on a collective basis, you’ll assess what your risk of loss is, you'll book that and you'll provide investors with information that allows them to assess the amount of loans that originated in the period and the reserves that are being set aside for those loans and then how those estimates change over time.”

The accounting standards update requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, along with the credit quality and underwriting standards of an organization’s portfolio. The disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.

In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.

FASB originally embarked on a project to improve the financial reporting of credit losses on financial instruments in 2008 in the wake of the financial crisis. Since that time, FASB has issued three documents for public comment that generated 3,360 comment letters.

“The new standard addresses concerns from a wide range of our stakeholders—including financial statement preparers and users—that the existing incurred loss approach provides insufficient information about an organization’s expected credit losses,” said FASB Chair Russell G. Golden in a statement. “The new guidance aligns the accounting with the economics of lending by requiring banks and other lending institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, providing investors with better information about those losses on a more timely basis.”

FASB pointed out that it conducted extensive outreach with diverse groups of stakeholders throughout the process. That outreach included meetings with more than 200 users of financial statements; over 85 meetings and workshops with preparers; over 10 roundtables with more than 100 representatives including users, preparers, regulators and auditors; and 25 fieldwork meetings with preparers from industries including banking institutions of various sizes, nonfinancial organizations and insurance companies.

Effective Dates
In April, FASB voted to defer the effective date of the new standard for one year, as it did earlier with the revenue recognition standard (see FASB Finalizes and Defers Credit Loss Standard). The ASU on credit losses will take effect for U.S. Securities and Exchange Commission filers for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2019. For public companies that are not SEC filers, the ASU on credit losses will take effect for fiscal years beginning after Dec. 15, 2020, and interim periods within those fiscal years. For all other organizations, the ASU on credit losses will take effect for fiscal years beginning after Dec. 15, 2020, and for interim periods within fiscal years beginning after Dec. 15, 2021.

Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. In other words, early adoption can be no earlier than 2019.

Unlike the revenue recognition standard, companies making the transition to the new credit loss standard won't need to maintain two sets of accounting records during the first year of adoption. “There's no reconciliation between their reserve under the incurred loss model and under the CECL model,” said Schroeder. “In the period that you make the change, any adjustment to the reserve up or down will go through retained earnings.”

Further information about the ASU—including a "FASB in Focus" overview, a "FASB: Understanding Costs and Benefits" document, and a video entitled "Why a New Credit Losses Standard?"—is available at www.fasb.org. A CPE webcast will be held in the coming weeks. Registration will be announced on the FASB website.

IFRS Divergence
FASB's credit loss standard differs in significant ways from the IASB's, although the two boards came under pressure from financial regulators to align their standards in the aftermath of the worldwide financial crisis. Eventually, the IASB issued its financial instruments standard under International Financial Reporting Standards, IFRS 9, in July 2014 (see IASB Releases Its Own Financial Instruments Standard).

FASB instead broke the project into separate accounting standards updates for U.S. GAAP. It issued one of the ASUs, on the recognition and measurement (previously referred to as classification and measurement) of financial instruments in January of this year (see FASB Issues Standard for Financial Instruments Recognition and Measurement). An exposure draft on a proposal for the final major component, hedging, is expected to be released in August or September of this year. However, the credit loss standard is an important one that has been heavily debated and discussed by FASB and various constituencies such as banks, credit unions and investors. Finishing the oft-delayed financial instruments, leasing and revenue recognition standards has been a major focus of the two boards. With the release of the revenue recognition standard in 2014 and the lease accounting standard in February of this year, they are finally on their way to that goal, even though none of the standards has yet taken effect.

“We were working with the IASB,” Schroeder recalled. “In fact, when I joined the board we thought we were close to some agreement. But I think that when we started to analyze the impact that this would have, we didn’t see the IASB's approach as an improvement to where the application of current GAAP was in the U.S., meaning that we didn’t see the changes if you were to apply the new IASB standard to the current situation in the U.S., that that would be an improvement, certainly for investors in terms of what reserves were being booked in the disclosures. We opted to move in a different direction that resulted in the CECL [current expected credit loss] model.”

Investors and analysts will need to do some analysis in order to translate a bank's loan loss figures between U.S. GAAP and IFRS. “There’s no requirement in either standard to reconcile one to the other,” said Schroeder. “That was something that was actually discussed, but I think it was clear to both boards that it would require in effect two different accounting systems—one to track it under the U.S. model and one to track it under IFRS—and that, from a cost/benefit standpoint, wasn't supportable. Will you be able to delineate the two? I think, from the disclosures, you'll be able to make an assessment as to what IFRS is doing and what the reserves are under CECL, but it will definitely take some analysis. The investors will have to do that work to make that assessment.”

Transition Resource Group
FASB has assembled a Transition Resource Group to help with implementation of the standard and provide any additional guidance that is needed. Unlike the joint TRG that was established to help with implementation of the converged revenue recognition standard, though, the IASB will not be involved because of the differences between the two sets of standards.

“It will not be a joint TRG like we have under revenue recognition because our standards are notably different,” said Schroeder. “We will be on our own on the TRG. There are no meetings set up yet in terms of specific dates, although we have had two meetings—one in private and one in public—with all the members of the TRG. They stand ready to address issues as they develop.”

FASB first wants to give preparers an opportunity to read through the new standard and then raise any issues and concerns they may have after thoroughly examining the document. The final pages explain the differences under U.S. GAAP and IFRS.

“If there's a lack of clarity in the standard, they can come back to us and ask for either additional clarity or if they say there's a particular problem, that can be addressed by the TRG,” said Schroeder. “We’ll probably accumulate any of those types of issues and decide on when is the most efficient time to hold a meeting to help people in developing their implementation plans, but no meeting is set up at this point.”

Industry Impact
The new standard will affect more types of companies than just banks, credit unions and financial firms. Schroeder does not think industry-specific guidance will be necessary, however.

“Keep in mind the scope of this standard is all financial assets that are accounted for at amortized cost,” he said. “That's one way of expressing it. The other way to say it is all financial assets that are accounted for, other than those at fair value, through net income. The first way of saying it is easier, but the second way of saying it is more accurate.”

He pointed out that could include any entity that holds loans and debt securities at amortized cost.

“That could be a bank, or it could a finance company embedded within a industrial company like Caterpillar, Boeing or Ford," said Schroeder. "They all have finance operations. Or it could be a tech company that has cash and it's holding a pool of debt securities.”

Unlike the revenue recognition standard, however, in which different industries may have different approaches to satisfying performance obligations, FASB does not believe there is a need for industry-specific guidance for the new credit loss standard. "Banks and credit unions and those who deal in volume of lending may have just different pools of loans and may think about their pools of loans a little differently," said Schroeder. "Their process of assessing credit may be a little different, but the basic underlying concepts of what did I lend out and what do I expect to collect back are true regardless of industry."

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