Preparing for the New Credit Loss Impairment Rules
On June 16, 2016, the Financial Accounting Standards Board (FASB) released Accounting Standards Update 2016-13, Financial Instruments-Credit Losses (Topic 326)- Measurement of Credit Losses on Financial Instruments (ASU 2016-13). ASU 2016-13 is applicable for entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The most significant change relates to the establishment of the Current Expected Credit Loss (CECL) impairment model for loans measured at amortized cost. ASU 2016-13 also amends the credit loss model for available-for-sale debt securities.
The effective date of ASU 2016-13 is fiscal years and interim fiscal periods after Dec. 15, 2019, for public business entities registered with the U.S. Securities and Exchange Commission (SEC) and fiscal years beginning after Dec. 15, 2020, for all other entities. Early adoption is available for fiscal years and interim periods beginning after Dec. 15, 2018.
The CECL impairment model changes the timing of the recognition of credit losses from the current incurred loss model to a model that estimates the lifetime losses as of the reporting date. The change to a lifetime losses model will require entities to consider more forward-looking data and analysis as compared to the current requirements under U.S. Generally Accepted Accounting Principles (U.S. GAAP). Depending on the nature, extent, and complexity of an entity's use of financial instruments, updating internal policies and processes to meet the requirements may require significant changes.
ASU 2016-13 consolidates several instrument-specific credit impairment models, including troubled debt restructuring, purchased financial assets with credit deterioration, beneficial interests, off-balance sheet exposure and business combinations.
Current U.S. GAAP requires the application of an "incurred loss" credit impairment model for financial instruments measured at amortized cost. Many different impairment models apply depending on the nature, type, and classification of the financial instrument. Credit impairment losses are currently recognized only when they are incurred or when a triggering event indicates it is probable that the instrument will have credit impairment. Financial statement users have argued that such a model may not be an accurate depiction of an instrument's risk, a concern that was raised as a result of the global financial crisis. Many users felt that an expected loss impairment model would result in earlier recognition of expected losses, therefore, providing more timely information to investors regarding the underlying quality of the loan portfolios.
Following the global financial crisis, the FASB sponsored a Financial Crisis Advisory Group, which resulted in recommendations on how to improve credit loss reporting. The two primary focuses were to eliminate delayed recognition losses and include more forward-looking information. As a result, the FASB proposed several exposure drafts with differing versions of a credit impairment model. Certain proposed models were significantly different than the model finalized in ASU 2016-13, and were criticized for being overly complex in nature.
ASU 2016-13 seeks to incorporate some of the Financial Crisis Advisory Group's recommendations and address concerns with the delayed recognition of credit losses under the incurred loss credit impairment model. It also addresses the fractured, instrument-specific approach to credit loss impairment used in U.S. GAAP today.
A Closer Look at CECL
The CECL impairment model eliminates the probable recognition threshold as the measure for when a loss should be recognized for assets measured at amortized cost. Instead, entities will record an estimate of lifetime expected losses at the acquisition date as an allowance contra account.
The allowance for credit losses (also referred to as a CECL reserve) is a valuation account deducted from the amortized cost basis. The FASB chose not to require any one specific method for estimating the lifetime losses; therefore, a number of methods may be acceptable for determining the allowance, including a discounted cash flow, loss-rate, roll-rate and the probability-of-default method.
Regardless of the method selected, entities will need to consider more information than under current U.S. GAAP. Determining the allowance will require data for the entire contractual life of long-dated financial assets, historical information with current specific risk characteristics and information relevant to assessing the collectability of cash flows. One significant difference will be the need to consider the impact of projected future economic conditions. However, historical loss information may still be used for periods beyond the time frame for which reasonable and supportable forecasts can be developed. The estimated losses should include the risk of loss, even if such risk is assessed to be remote. This implies that an estimate of no expected credit losses will be rarely be an appropriate conclusion.
Entities can consider instruments collectively (as part of a pool) when similar risk characteristics exist, including impaired instruments that share a similar risk profile. Instruments that do not share similar risks must be evaluated separately. The expected credit loss must be measured even if the risk has only a remote chance of occurring.
Troubled Debt Restructuring
Historically, the troubled debt restructuring (TDR) model has not been intuitive. In current U.S. GAAP, entities write a TDR asset down to its fair value and reconstruct the effective interest rate and the cash flow to be recognized in the financial statements.
ASU 2016-13 aims to simplify the approach. It does not change the definition of a TDR or the disclosure requirements, but it does apply the CECL model to TDR credit loss impairment assets. When applying the CECL model, the allowance for credit losses should include concessions granted to the borrower. Entities use the effective interest rate of the original loan (rather than the impaired loan) when determining the effective interest rate to discount expected future cash flows.
Purchased Financial Assets with Credit Deterioration
Under current U.S. GAAP, the accounting requirements for purchased financial assets with credit deterioration (PCD assets) can often result in two sets of accounting records. When a loan is acquired that has experienced significant credit deterioration since the loan was originated, the loan is recorded at fair value. However, no allowance for loan loss is established under current US GAAP. As a result, entities must often calculate the new effective interest rate as of the date of acquisition, which will likely be different than the contractual rate on the agreement. Subsequent changes to the estimated cash flows are either recorded as an allowance (reduction in estimated cash flows) or an adjustment to the crediting interest rate (increase in estimated cash flows).
ASU 2016-13 changes the accounting model to a more simplistic approach that is more aligned with the CECL approach for other financial assets. Loans purchased with more than insignificant credit deterioration will be recorded at amortized cost on the date of acquisition, with a day one allowance recorded for an amount equal to the expected credit losses of that particular asset. The result is a "gross up" of the loan balance presentation, presented net on the face of the balance sheet in the same manner as other financial assets within the scope of the CECL model. Subsequent changes in the allowance are reported as credit loss expense or income (reversal of expense).
To the extent that additional discounts are reflected in the acquisition price, those should be accreted to interest income using the effective interest model. Premiums will also be accounted for as purchased premiums reflected in the effective interest rate.
Interestingly, the FASB chose not to place a fair value floor for held-to-maturity (HTM) classified securities, therefore, an entity's expected credit losses determined using the entity's assumptions and conclusions regarding credit losses may differ from those of the financial market as reflected in the security's fair value. As discussed later, a fair value floor was established for available-for-sale (AFS) classified securities.
The definition of beneficial interests will not change under ASU 2016-13, however the guidance will be amended to clarify that beneficial interests should be classified as either AFS securities or HTM securities and then follow the applicable accounting. Thus, for those financial assets classified as HTM, entities will account for expected credit losses using the CECL model. Beneficial interests classified as AFS will follow the AFS Credit Impairment model.
Entities will apply the credit deterioration model if there is a significant difference in the contractual and expected cash flows at the date of acquisition. This includes instruments that may not meet the definition of a PCD asset, such as investments in a residual tranche at issuance.
Off-Balance Sheet Exposures
Accounting for financial guarantees remains essentially unchanged. For financial guarantees that are within the scope of the credit loss impairment guidance in ASU 2016-13, however, an entity will be required to recognize a contingent liability for expected losses separate from the financial guarantee liability. The contingent liability represents the expected losses based on an assessment of the likelihood of funding and expected losses on funding. The contingent liability for credit loss on a financial instrument with off-balance sheet risk (including financial guarantees and financial standby letters of credit) is recorded as a liability rather than a contra account (i.e., allowance account) and should be presented as a credit loss expense in the reporting entity's income statement.
Loans and other financing receivables are currently recorded at fair value when acquired in connection with an asset or business combination, resulting in a difference between the contractual cash flows and the balances reflected in the financial statements. The result is similar dual set of accounting records as that experienced with PCD assets. ASU 2016-13 changes current U.S. GAAP such that when an entity acquires loans or other financing receivables, the entity will record those loans at the fair value representing the contractual balance and any purchased premiums or discounts with a corresponding allowance for loan loss reflecting the expected lifetime losses reported on the opening balance sheet of the acquired entity.
As discussed above, ASU 2016-13 did not prescribe a method of estimating the expected lifetime losses under the CECL model. Therefore, differences may arise between the estimated losses derived from the market expectations used to determine fair value and those determined using the reporting entity's expected losses model. In such instances, the differences between the expected losses determined using the CECL model and those embedded in the fair value would result in an adjustment to the premium or discount to be reflected in the effective interest rate.
How the AFS Model Works
Targeted changes were made to the AFS debt securities model, but many of the concepts remain the same. An AFS debt security is considered to be impaired when the fair value is less than the amortized cost basis. The main difference between the existing and new impairment model is that the impairment related to credit losses will now be recorded as an allowance rather than as a direct write-off as it is under current U.S. GAAP. As a result, the credit losses recognized through the allowance account may subsequently be reversed if those expected losses are later determined to be recoverable through a reversal of the allowance account.
A credit loss exists if the present value of cash flows expected to be collected is less than the amortized cost basis. Expected cash flows should consider past events, current environmental, economic, geographic and political conditions and reasonable and supportable forecasts. They should also be discounted to reflect the effective interest rate implicit in the security at the date of acquisition.
As in existing U.S. GAAP, each AFS debt security asset must be assessed at the individual security level, which is one of the ways that AFS Credit Loss Impairment model differs from the CECL model.
Rather than accounting for impairment related to credit losses as a direct write-off to the asset, entities will account for credit losses through an allowance. This change allows for reversals of credit losses, which eliminate the concepts of "other than temporary," "length of time" and "volatility" from the current AFS impairment model. Any impairment not attributable to credit loss will be recorded through accumulated other comprehensive income and reduce the asset directly.
Allowances for credit losses in ASU 2016-13 are limited to the amount that the fair value of the security is less than the amortized cost basis, which differs from the determination of expected losses for HTM securities. In each reporting period, entities must account for an allowance for credit losses that reflects the amount of credit loss impairment at the reporting date. Changes in allowances will be recorded through the income statement.
If it has been decided it is more likely than not that a security will be sold, entities will write off the allowance for credit losses. The security should be recorded at fair value and any impairment would be recorded in earnings.
AFS Debt Securities with Credit Deterioration
Similar to the impairment model for financing receivables, AFS debt securities with a more-than-insignificant amount of credit deterioration will be "grossed up" to reflect the expected loss estimate on the date of issuance. An initial allowance for credit losses would be added to the purchase price rather than reported as a credit loss expense. Subsequent changes in the allowance for credit losses would be recorded as a credit loss expense or reversal.
The CECL model for assets with credit deterioration does not have a prescribed method to use to estimate expected losses, but AFS debt securities with credit deterioration must use the discounted cash flow model. Interest income should be recognized based on the effective interest model, excluding the discount embedded in the purchase price that is attributable to the acquirer's assessment of credit losses at acquisition.
Transition & Disclosure Requirements
Public business entities will be required to adopt ASU 2016-13 for fiscal years and interim periods beginning after Dec. 15, 2019. Private entities will be required to adopt for fiscal years beginning after Dec. 15, 2020, and interim periods within fiscal years beginning after Dec. 15, 2021. All entities may early adopt for fiscal years beginning after Dec. 15, 2018.
The standard is adopted using a cumulative-effect adjustment to the opening retained earnings in the statement of financial position as of the date of adoption. Purchased assets with credit deterioration previously following the guidance of ASC Subtopic 310-30 will be classified as purchased assets with credit deterioration under the new standard at the date of transition. This will result an adjustment to the amortized cost that reflects the addition of the allowance for credit losses at the date of adoption.
AFS debt securities formerly following Other-than-Temporary Impairment Accounting will follow a prospective transition approach.
Many of the disclosure requirements will remain the same as current U.S. GAAP, with the language updated to reflect the change from the incurred loss impairment model to the CECL model. Entities will also continue to disclose credit quality indicators in relation to the amortized cost of financing receivables but will further disaggregate the information by year of origination (or vintage). This is, however, an optional disclosure for entities that are not public.
The impact of the standard on important financial ratios that financial institutions use for loans and the potential volatility the profit and loss statement make it essential that organizations begin to model out the effects of adopting the standard well in advance of its effective date.
For More Information
If you have specific comments, questions or concerns about the new credit loss impairment model, please contact Mike Loritz or Christine McAlarney of MHM's Professional Standards Group. Mike can be reached at email@example.com or 816.945.5611. Christine can be reached at firstname.lastname@example.org or 727.572.1400. Published on February 03, 2017