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impairment

The Financial Accounting Standards Board (FASB) Recently Issued New Guidance

The Financial Accounting Standards Board (FASB) recently issued new guidance that makes a paradigm shift in how entities will measure credit losses for most financial assets and certain other instruments that aren’t measured at fair value through net income. The new standard responds to criticism that existing guidance delays recognition of credit losses to point when credit event occurs.

The standard will replace today’s “incurred loss” approach with an “expected loss” model for instruments measured at amortized cost and require entities to record allowances for available-for-sale (AFS) debt securities rather than reduce the carrying amount, as they do today under the other-than-temporary impairment (OTTI) model. It also simplifies the accounting model for purchased credit-impaired debt securities and loans.

The requirements of this standard differ significantly from the three-stage expected credit loss model of IFRS 9, Financial Instruments, which the International Accounting Standards Board issued in July 2014. Under the new model if the credit risk of a financial asset has not increased significantly since its initial recognition, the financial asset will attract a reserve equal to 12-month expected credit losses. However, if its credit risk has increased, significantly, it will attract a reserve equal to lifetime expected credit losses, thereby increasing the amount of impairment recognised.

Key changes

The new standard requires entities to use the following models:

  • The new “expected credit loss” impairment model, which is codified in Accounting Standards Codification (ASC) 326-20 and will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans,held-to-maturity (HTM) debt securities, net investments in leases and off-balance-sheet credit exposures (e.g., loan commitments, standby letters of credit)
  • An AFS debt security impairment model (codified in ASC 326-30) that is a modification of today’s OTTI model.
  • The existing model for beneficial interests that are not of high credit quality (ASC 325-40),amended to conform to the new impairment models for HTM and AFS debt securities The existing loss contingency model in ASC 450-20 will apply to instruments outside the scope of these models, including receivables between entities under common control,participant loans made by a defined contribution plan, pledges receivable of a not-for-profit entity and policy loan receivables of an insurance entity.

The standard also eliminates today’s accounting model for purchased credit impaired loans and debt securities. Instead, entities will gross up the initial amortized cost for so-called purchased financial assets with credit deterioration (PCD assets). Under this approach, an entity will record as the initial amortized cost the sum of (1) the purchase price and (2) the estimate of credit losses as of the date of acquisition. Thereafter, the entity will account for PCD assets using the models listed above.

The new ‘expected credit loss’ model

The standard requires an entity to estimate its lifetime “expected credit loss” and record an allowance that, which when deducted from cost basis of the instruments, presents the net amount expected to be collected on the financial asset. The standard says an expected credit loss estimate should:

  • Be based on an asset’s amortized cost (including premiums or discounts, net deferred fees and costs, foreign exchange and fair value hedge accounting adjustments)
  • Reflect losses expected over the remaining contractual life of an asset, considering the effect of voluntary prepayments
  • Consider available relevant information about the collectibility of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts
  • Reflect the risk of loss, even when that risk is remote, meaning that an estimate of zero credit loss would seldom be appropriate.

How it affects us

Moving from today’s “incurred loss” model to the new “expected credit loss” model will require entities to change their impairment processes, even for simple financial assets such as receivables. These would include (i) Maintaining and using lifetime loss information instead of annual loss data and (ii) forecasting future economic conditions and quantifying the effect of those conditions on expected losses.

AFS debt security liability

The standard amends the impairment model for AFS debt securities and requires entities to determine whether all or a portion of the unrealized loss on an AFS debt security is a credit loss. The standard also indicates that management may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists,as they are permitted to do today.

Under the new guidance, an entity will recognize an allowance for credit losses on AFS debt securities as a contra-account to the amortized cost basis rather than as a direct reduction of the amortized cost basis of the investment, as is currently required. As a result, entities will recognize improvements to estimated credit losses on AFS debt securities immediately in earnings rather than as interest income over time, as they do today.

Transition 

Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective.

The standard is effective as follows:

  • For public business entities (PBEs) that meet the definition of a Securities and Exchange

Commission (SEC) filer, the standard is effective for annual periods beginning after

15 December 2019, and interim periods therein.

  • For other PBEs, the standard is effective for annual periods beginning after 15 December

2020, and interim periods therein.

  • For all other entities, the standard is effective for annual periods beginning after 15 December

2020, and interim periods within annual periods beginning after 15 December 2021.

Early adoption is permitted for all entities for annual periods beginning after 15 December

2018, and interim periods therein.

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Current GAAP Requires That Goodwill be Tested for Impairment At Least Annually

Background 

Current GAAP requires that goodwill be tested for impairment at least annually using a two-step process as follows:

Step 1: an entity compares the fair value of its reporting units with their carrying value, including goodwill. If the fair value of a reporting unit (including goodwill) exceeds its carrying amount, the goodwill of the reporting unit is not considered impaired and step 2 is not applicable. If, however,the fair value of the reporting unit (including goodwill) is less than its carrying amount,an entity must proceed to step 2 to determine the amount of the impairment loss.

Step 2:If the carrying amount of a reporting unit is greater than its fair value, a reporting entity must calculate the implied fair value of goodwill by performing a hypothetical application of the acquisition method as of the date of the impairment test. In other words an entity assigns the fair value of a reporting unit determined in first step step 1, to all the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The goodwill impairment, if any, is equal to the excess of the carrying amount of goodwill over its implied fair value.

Due to concerns about the cost and complexity of the annual goodwill impairment test, the FASB on November 25, 2013, the FASB added a project to its agenda on the accounting for goodwill for public business entities and not-for-profit entities.

Subsequently on October 28, 2015, the FASB decided to proceed with the project under a phased approach. The first phase is to simplify the impairment test. In the second phase of the project, the FASB plans to work concurrently with the IASB to address any additional concerns.

Subsequent Measurement

The Board decided to simplify the impairment test by removing the requirement to perform a hypothetical purchase price allocation when the carrying value of a reporting unit exceeds its fair value (step 2 of the impairment model in current GAAP). The Board considered but decided not to allow entities an option to perform step 2.

The Board decided that entities should apply the same impairment model for a reporting unit with a zero or negative carrying amount as the model for a reporting unit with a positive carrying amount by comparing the fair value of the reporting unit to its carrying amount. This reverses the Board’s previous decision to require the write-off of goodwill allocated to reporting units with zero or negative carrying amounts.

Presentation

The Board decided not to make any changes to the presentation requirements in current GAAP.

Disclosures

The Board decided that in addition to the current disclosure requirements, entities with reporting units with zero or negative carrying amounts should disclose the following:

  • Identification of reporting units with zero or negative carrying amounts
  • The amount of goodwill attributable to each reporting unit with a zero or negative carrying amount.

Transition

The Board decided that entities would be required to adopt the simplified impairment test prospectively.

Transition Disclosures

The Board decided that entities should provide the applicable disclosures described in paragraphs 250-10-50-1(a), which requires disclosure of the nature of and reason for the change in accounting principle, and 250-10-50-2, which states that the required transition disclosures should be included in both interim and annual financial statements in the period of the change.

Source: FASB website

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US GAAP UPDATES

FASB Issues Accounting Standards Update 2016-08—Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)

In March 2016 the FASB issued Accounting Standard Update 2016-08 to address issues related to guidance on principal versus agent arising from the discussion of Transition Resource Group meetings. While the amendments in this Update do not change the core principle of the guidance (i.e. the 5 step revenue recognition model), the amendments clarify the implementation guidance on principal versus agent considerations.

When another party is involved in providing goods or services to a customer, an entity should evaluate whether the nature of its promise is to provide the specified good or service itself (that is, the entity is a principal) or to arrange for that good or service to be provided by the other party (that is, the entity is an agent). When an entity is a principal, the entity recognizes revenue in the gross amount of consideration to which it is entitled in exchange for the specified good or service.Conversely as an agent, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the specified good or service to be provided by the other party.

The amendments in this Update are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations by clarifying the following:

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