FASB issues final standard on credit losses
INSIGHT ARTICLE |
On June 16, 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited new standard on credit losses, namely Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU applies to all entities and most financial assets that are not measured at fair value through net income, including trade and other receivables, loans and debt securities. It represents the culmination of what has been a long and arduous process to address the complexity and perceived shortfalls of existing guidance, including the perception that credit losses are currently recognized too little and too late.
The underlying premise of the ASU is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset. This is in contrast to existing guidance whereby credit losses generally are not recognized until they are incurred. With the exception of purchased financial assets with a more than insignificant amount of credit deterioration since origination (PCD assets), the initial allowance, as well as subsequent increases or decreases in expected credit losses on assets measured at amortized cost, will be recognized through the income statement as credit loss expense. The initial allowance for credit losses on PCD assets will be added to the purchase price rather than being reported as credit loss expense.
We anticipate the ASU will generally result in notable increases to entities’ allowances for credit losses on assets measured at amortized cost due to the movement from an incurred loss model to an expected loss model, as well as the following nuances:
- The need to consider the risk of loss even if it is remote
- The need to recognize expected credit losses on held-to-maturity (HTM) securities, regardless of the relationship between fair value and amortized cost
- The recognition of an allowance on purchased financial assets
- The inability to conclude no allowance is necessary based solely on the current value of collateral, unless justified through an allowable practical expedient
Some other particularly noteworthy changes brought about by the ASU relevant to financial assets measured at amortized cost include the requirements to evaluate assets (including HTM securities) on a pooled basis when similar risk characteristics exist and to give consideration to reasonable and supportable forecasts that affect collectibility when estimating expected losses.
Credit losses on financial assets measured at fair value through other comprehensive income, namely available-for-sale debt securities, will continue to be measured in a manner similar to existing guidance; however, the credit losses will be recorded through an allowance rather than as a direct writedown to the security. Unlike existing guidance, whereby subsequent improvements in expected cash flows are accreted into income over the remaining life of a security as a yield adjustment, both subsequent increases and decreases in expected cash flows will be recognized immediately through credit loss expense. Similar to existing guidance, the amount of impairment recognized (i.e., the allowance) will be limited to the excess of the amortized cost of an available-for-sale security over its fair value, under the premise that the fair value could be realized through a sale of the security.
The ASU provides for staggered effective dates. Namely, SEC filers will be required to adopt the ASU in fiscal years beginning after December 15, 2019, including interim periods within those years. All other public business entities will be required to adopt the ASU in fiscal years beginning after December 15, 2020, including interim periods within those years. Entities that are not public business entities will be required to adopt the ASU in fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. All entities will be permitted to early adopt the ASU as early as their fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted.
While the ASU does not start coming into effect for a few years, we anticipate that implementation will be a time-consuming process for entities that hold long-term assets subject to the ASU. Financial institutions, in particular, are expected to be significantly impacted. However, the reach of the ASU is extensive as it applies to instruments that commonly exist outside of the financial institution industry, including trade accounts receivable, net investments in leases recognized by a lessor, debt securities and reinsurance receivables.
We will be issuing a whitepaper in the coming weeks that will explore the ASU in more depth.