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.
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.
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.