After the worst recession since the Great Depression, financial institutions have had to reassess the adequacy of their allowance for loan and lease losses (ALLL). This reevaluation has included questions, such as: (1) Should I shorten or extend the historical loss period? (2) Are my qualitative factors enough to adjust the historical loss factor? (3) And, most importantly, is the allowance sufficient to cover the losses included in my loan portfolio? The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have been developing a new ALLL methodology to include estimates of future losses in addition to the losses inherent in the loan portfolio.
On December 20, 2012, FASB issued Proposed Accounting Standards Update No. 2012-260, Financial Instruments – Credit Losses (Subtopic 825-15). The proposed standard introduces a Current Expected Credit Loss (CECL) model. The CECL model requires an entity to impair its existing financial assets on the basis of the current estimate of contractual cash flows not expected to be collected. The significant difference from current GAAP would be to eliminate the “probable” initial recognition threshold and replace it with the current estimate of expected credit loss. It is believed the CECL model will likely result in increased reserves as compared to current accounting.
The proposed standard has gone through multiple transformations, including potential convergence with IASB after its initial exposure document in November 2009. For its part, the IASB had proposed a three-bucket approach to accounting for the expected losses. The IASB approach includes Bucket 1 whereby an entity would recognize expected losses for which a loss event is expected in the next
12 months. Bucket 2 includes assets that have been affected by the occurrence of observable events that indicate a direct relationship to possible future defaults within the lifetime of the credit. Bucket 3 consists of loans where information is available that specifically identifies that credit losses are expected to, or have, occurred on individual credits within the credit’s lifetime. A transfer from Bucket 1 to Bucket 2 would occur when the deterioration in credit quality has been more than insignificant and at least some or all of the contractual cash flows may not be collected. The FASB, as part of its movement toward convergence with international standards, was considering the IASB model. However, due in part to concerns over transfers between buckets, the FASB broke away from convergence with the IASB.
The CECL model was introduced in August 2012 and, now with this recent exposure draft, may replace the five existing impairment models (FAS 5, FAS 114, SOP 03-3, FAS 115, EITF 99-20) for debt instruments in current U.S. GAAP, with a single expected credit loss measurement objective for the allowance for credit loss. The CECL model focuses on “expected credit loss and the current recognition of the effects of credit deterioration on collectability expectations.” This estimate should reflect the future contractual cash flows that the entity does not expect to collect using current probabilities of default, current historical loss rates, changes in credit risk (risk rates, credit scores), and other changes in reasonable and supportable forecasts.
In theory, as the level of risk inherent in loans increases, the expected loss would increase and require a commensurate level of allowance. In order to fully substantiate the estimate of expected credit losses, all assumptions will have to be based on supportable information that is relevant in making the forward-looking estimates.
Disclosures and transition guidance included in the new exposure draft for the CECL model include: (1) credit-quality information, (2) allowance for expected credit losses,(3) roll forward for certain debt instruments, (4) reconciliation between fair value and amortized cost for debt instruments classified at fair value with qualifying changes in fair value recognized in other comprehensive income, (5) past-due status, (6) nonaccrual status, (7) purchased credit-impaired financial assets, and (8) collateralized financial assets. The FASB has proposed the transition be a cumulative-effect approach, where the cumulative-effect adjustment would be recorded in the beginning of the first reporting period for which the guidance is effective, with appropriate transition disclosures detailing the transition.
The exposure draft has a comment period that ends April 30, 2013. All interested parties are encouraged to read the exposure draft and provide a comment letter to the FASB for consideration.