By Anne Rosivach
How to measure and disclose evidence that a loan or bond is not performing continues to be an issue in the ongoing deliberations of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The two boards have been working on a single, converged Accounting for Financial Instruments standard for years.
FASB announced recently that it will separately issue an exposure draft, possibly by the end of 2012, of a new model for disclosing credit impairment. The draft of the new approach, which FASB calls the "Current Expected Credit Loss Model" (CECL Model), may be viewed in FASB Technical Plan and Project Updates. The CECL Model applies a single measurement approach for credit impairment.
FASB developed the CECL Model in response to feedback from US stakeholders on the "three-bucket" credit impairment approach, previously agreed upon by the FASB and the IASB. US constituents found the three-bucket approach hard to understand and suggested it might be difficult to audit.
The IASB continues to propose the three-bucket approach.
FASB board members agreed that the CECL Model would apply in all cases where expected credit losses are based on an expected shortfall in the cash flows that are specified in a contract, and where the expected credit loss is discounted using the interest rate in effect after the modification. This would include troubled debt restructurings. The board has provided additional guidance.
The Technical Plan explains the CECL Model as follows:
"At each reporting date, an entity reflects a credit impairment allowance for its current estimate of the expected credit losses on financial assets held. The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect. . . .
"Under the CECL Model, the credit deterioration (or improvement) reflected in the income statement will include changes in the estimate of expected credit losses resulting from, but not limited to, changes in the credit risk of assets held by the entity, changes in historical loss experience for assets like those held at the reporting date, changes in conditions since the previous reporting date, and changes in reasonable and supportable forecasts about the future. As a result, the balance sheet reflects the current estimate of expected credit losses at the reporting date and the income statement reflects the effects of credit deterioration (or improvement) that has taken place during the period."
The FASB has tentatively decided to require disclosure of the inputs and specific assumptions an entity factors into its calculations of expected credit loss and a description of the reasonable and supportable forecasts about the future that affected their estimate. The entity may be asked to disclose how the information is developed and utilized in measuring expected credit losses.
In July, when the FASB decided to pursue a separate course from the IASB and develop a simpler Model, the FASB explained the three-bucket approach as follows:
"Previously, the Boards had agreed on a so-called 'expected loss' approach that would track the deterioration of the credit risk of loans and other financial assets in three 'buckets' of severity. Under this Model, organizations would assign to 'Bucket 1' financial assets that have not yet demonstrated deterioration in credit quality. 'Bucket 2' and 'Bucket 3' would be assigned financial assets that have demonstrated significant deterioration since their acquisition."
FASB states in its Technical Plan that the key difference between the CECL Model and the previous three-bucket model is that "under the CECL Model, the basic estimation objective is consistent from period to period, so there is no need to describe a 'transfer notion' that determines the measurement objective in each period."
The board also decided it will propose a cumulative-effect adjustment to a company's statement of financial position when a company would adopt the new accounting and specify some transition disclosures to help users of financial statements understand the transition.