FASB’s Proposed Accounting Standards Update: Financial Instruments—Credit Losses — FAQs
Why is FASB proposing changes to the allowance for credit losses? There is a general consensus that the recent financial crisis was caused and prolonged by the delayed recognition of credit losses stemming from the adoption of the incurred loss model. The lack of forward-looking information in loss estimates and the reliance on multiple credit impairment models resulted in carrying values for financial instruments that were overstated.
How does the proposal change the current provisioning method? The current incurred loss model and the historical loss model would be replaced by an expected credit loss model that would require the bank to generate an estimate of contractual cash flows not expected to be collected. The generation of estimated cash flows would be based on reasonable and supportable forecasts. Banks would be prohibited from generating an estimate of credit losses based solely on the most likely outcome. The proposed expected credit loss model would apply to both loans and investment securities.
When is FASB expected to issue a final accounting standards update on these changes? FASB has announced that they expect to finalize the allowance changes in the first quarter of 2014.
Does the proposal result in a day one loss for new loans recorded on the balance sheet? Yes. When a loan is initially recognized on the balance sheet the net present value of contractual cash flows not expected to be collected would be recorded under the loan loss provision.
How often would the forecast need to be updated? The bank’s estimate of contractual cash flows not expected to be collected would need to be updated at least quarterly.
Will my bank need to update its loss mitigation and measurement systems? Because the bank will need to produce multiple outcomes when generating an estimate of contractual cash flows not expected to be collected, in many cases modeling techniques and methods will need to be enhanced and scrutinized continually.
What if my bank rarely experiences credit losses? Can I exempt my institution from the expected credit loss model? Even for banks that have immaterial credit losses, it is expected that a robust credit loss model would produce some probability of loss. Regardless of whether the bank records the provision, the estimate would need to be generated.
Do the bank regulators support the FASB’s proposed expected loss model? The banking regulators have stated publicly that they support the FASB’s shift from the incurred loss model to the expected loss model.
What is ICBA’s proposed alternative to the FASB proposal? ICBA recognizes that your bank’s ability to increase reserves earlier in the credit cycle is crucial to prudent credit risk management and loss mitigation. The ICBA proposal also recognizes an allowance earlier but using a more common sense methodology. Community banks would build reserves over time based primarily on historical loss experience for the bank or the bank’s peer group for a particular asset class. Expected losses would be recognized ratably over the economic life of the financial instrument as opposed to the FASB’s day-one-loss methodology. As actual incurred loss events occur, the historical loss estimate is replaced by an estimate of actual credit loss for an impaired asset based on today’s incurred loss model. Community banks would be permitted to make projections about future events that impact estimated loss amounts but projections would not be required.
Why is the ICBA proposed alternative superior to the FASB proposal? Quite simply, the ICBA alternative is simple, straight forward, easy to understand for stakeholders, easy for management to implement, and cheaper. The ICBA alternative does not rely on complex modeling techniques to estimate future expected losses. Data on historical losses is easily attainable and the incurred loss model for actual loss events is an existing requirement for loan loss provisioning today. The ICBA alternative also fully meets FASB’s intended objective with the impairment proposal—to recognize credit losses earlier in the credit cycle.
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