FASB Makes New Standard on Credit Losses Official
A new standard issued by the Financial Accounting Standards Board (FASB) on June 16 is intended to improve how credit losses on financial assets are communicated to investors and other users of financial reports.
Under Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, banks and other lending institutions will be required to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.
“This is a historic standard because, for the first time, banks’ accounting models for credit losses will include forward-thinking information that require a high degree of risk data and judgment, which will be subject to management controls, as well as financial audit,” Reza Van Roosmalen, KPMG’s Accounting Advisory lead for Financial Instruments Accounting Change, told AccountingWEB. “The standard further aligns the risk and finance departments as part of a bigger transformation of the risk function of banks and, for the first time, subjects some parts of the risk organization, process, systems, and data to internal controls designed for financial statements.”
Current GAAP requires an “incurred loss” approach for recognizing credit losses that delays recognition until it is likely a loss has been incurred.
“The new standard addresses concerns from a wide range of our stakeholders – including financial statement preparers and users – that the existing incurred loss approach provides insufficient information about an organization’s expected credit losses,” FASB Chairman Russell Golden said in a prepared statement. “The new guidance aligns the accounting with the economics of lending by requiring banks and other lending institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, providing investors with better information about those losses on a more timely basis.”
The FASB voted to proceed with the new credit loss rules in late April. At that time, the board agreed to defer the original effective dates by one year, giving financial statement preparers more time to review and plan for the changes before the standard goes into effect. Those new effective dates are:
- For public companies that meet the definition of a US Securities and Exchange Commission (SEC) filer, the standard will take effect for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2019.
- Public companies that are not SEC filers will be required to apply the guidance for fiscal years beginning after Dec. 15, 2020, including interim periods within those fiscal years.
- For all other organizations, the standard will take effect for annual periods beginning after Dec. 15, 2020, and interim periods within fiscal years beginning after Dec. 15, 2021.
- Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018.
The FASB first embarked on this project in 2008, following the start of the financial crisis.
“In the lead-up to the financial crisis, [financial statement] users were making estimates of expected credit losses and devaluing financial institutions before accounting losses were recognized, highlighting the different information needs of users from what was required by GAAP,” the FASB states in the ASU. “Similarly, financial institutions expressed frustration during this period because they could not record credit losses that they were expecting but had not yet met the probable threshold.”
Under the new standard, many of the loss-estimation techniques applied currently will still be permitted, but the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations and financial statement preparers will continue to use judgment in determining what loss-estimation method is appropriate for their circumstances.
Enhanced disclosures will assist investors and other financial statement users to better understand the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.
“This will increase transparency over the credit trends and the loan portfolios, and that’s a big win for investors,” FASB member Hal Schroeder says in a video on the new standard.
In addition, the standard amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.
“Investors will have the information they need. They’ll no longer have to make their own estimates about expected credit losses,” FASB member Marc Siegel says in the video.
Throughout the duration of the project, the FASB has issued three documents for public comment that generated 3,360 comment letters. The board also conducted extensive outreach with diverse groups of stakeholders, including:
- Meetings with more than 200 financial statement users.
- More than 85 meetings and workshops with preparers.
- More than 10 roundtables with users, preparers, regulators, and auditors.
- Twenty-five fieldwork meetings with preparers from banking institutions of various sizes, nonfinancial organizations, and insurance companies.
“Current expected credit loss (CECL) marks the biggest change in the history of bank accounting and has the very real potential to affect how banks do business,” Rob Nichols, president and CEO of the American Bankers Association (ABA), said in a written statement. “ABA has worked closely with FASB over the last six years in an effort to create an improved credit impairment model for most debt securities and purchased loans. We appreciate the significant time and consideration FASB has given to bankers’ views as they worked on this extremely complex and difficult issue.
“While we continue to have strong concerns with the costs related to CECL’s life of loan loss concept, we are committed to working with both regulators and auditors to ensure banks of all sizes can meet the implementation challenges of the new standard,” he added.
Prepare Now for the Standard
According to Van Roosmalen, there are several steps preparers should take now to address the financial statement impact of the new credit loss standard:
1.Set up a steering committee charter and project scope, roadmap, and budget. The first step to CECL implementation is to meet with internal stakeholders and business process owners to bring together all the required decision-makers and develop an expectation of project scope or high-level phasing and timing, then level-set and educate on the specific changes required by CECL. These stakeholder groups usually involve finance, accounting policy, risk, and IT.
2.Accounting gap analysis. Compare the new standard against the current standard and evaluate accounting options under the new standard.
3.Credit risk model assessment. Assess existing Basel III, CCAR/DFAST, or other internal risk models as a starting point for CECL forward-looking lifetime expected credit loss modeling. Compare existing models to CECL requirements and recommend enhancements.
4.Data, systems, and process gap analysis. Focus on risk and finance data, processes, and systems, and address the needs for the new state.
5. Target operating model changes. CECL design and implementation plans should be tailored to the entity’s business model, balance sheet, and capital planning.