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Fair Value and the Allowance for Credit Losses: What Does the Future Hold?

May 11th, 2011 |

These two topics, near and dear to bankers, are in the process of being addressed by the Financial Accounting Standards Board’s (FASB) financial instruments project. The financial instruments proposal, issued in May 2010, was a monster–fair value, impairment and hedging all rolled into one.

Adding to the complexity, remember that FASB is trying to converge with the International Accounting Standards Board (IASB)–but IASB is using timetables that differ from FASB’s. In this post, I’m setting aside hedging to focus on the two areas that affect everyone: fair value and the allowance for credit losses.

Fair Value

red-pin-finances.jpgFASB’s past proposal to carry most financial instruments (loans, securities and deposits) on the balance sheet at fair value was received with little enthusiasm, for two primary reasons. First, robust market data doesn’t exist for many of those instruments, raising concerns about the reliability of the fair values that would be used. Second, the proposal did not take into account management’s intent–when management does not intend to ever sell most of those instruments, what is the point in recording them at fair value?
 
The good news is that FASB has reconsidered its initial proposal. The board has moved away from broadly requiring fair value for most financial instruments. Instead, the determination of whether an instrument is carried at fair value will depend on (1) the characteristics of the financial asset and (2) the business strategy. The result is three categories:


Fair Value–Net Income: Measured at fair value with all changes in fair value recognized in net income. It includes items held in trading or for sale.

  1. Fair Value–Other Comprehensive Income: Measured at fair value with qualifying changes in fair value recognized in other comprehensive income. It includes financial assets for which the business objective is investing with a focus on managing risk exposures and maximizing total return, typically characteristics of an investment portfolio category.
  2. Amortized Cost: Measured at historical cost and for assets, evaluated for impairment. It includes financial instruments for which the business strategy is managing the instruments through a lending, borrowing or customer financing activity, typically characteristics of a loan portfolio category. This category would also include those liabilities (deposits) that the bank intends to hold.

If you think this overall model looks similar to what we have today, you are correct. However, there is an important shift. Today, the accounting model is driven primarily by the form of the instrument. That is, we follow one model if the asset is deemed to be a loan and another model if the asset is deemed to be a security. The shift is really toward one model, but then drivers are the marketability of the instrument (Is there a readily available market for the asset?) and management’s intent (What is the plan for the asset? Is the intent to hold the asset and collect the cash flows the typical intent for a loan? Or is the intent to manage interest rate risk and liquidity, which is typical for an investment portfolio?).
 
While there are many nuances with this area of the project, the key point is that FASB has moved away from essentially requiring fair value for the majority of the balance sheet. Stay tuned–FASB plans to make its final decisions in the third quarter of 2011.

Allowance for Credit Losses

Near and dear to bankers is the allowance for loan and leases losses (ALLL), an area in which FASB’s financial instruments project seeks to make some changes. For decades, we have struggled with the accounting in this area in large measure because of the confusion about what the allowance does and doesn’t represent. Today, losses cannot be recorded until they are probable and incurred. Those are words of art meaning that a loss has indeed happened and that a future event will likely confirm the loss. In other words, the allowance does not represent all possible or expected losses in the portfolio.

However, these concepts are being reevaluated. In late January, FASB and the IASB published a joint proposal for comment that is focused primarily on loans evaluated on a pool basis. Think about that in the context of loans that are not individually flagged being problematic. The proposal seeks to change the allowance from a probable and incurred loss model to a more forward-looking model–that is, closer to an expected loss model.

However, the two boards differ. FASB favors an approach that looks to the foreseeable future but not one that includes losses over the life of the portfolio. IASB favors an approach that takes expected losses over the portfolio and records those losses over time. The new proposal is really a hybrid of the two approaches. Essentially, bankers would have to determine the outcome of both approaches and record the lesser of the two amounts. So, for pools, the allowance for credit losses would be calculated based on the lower of a time-proportional amount (the IASB model) or losses expected to occur in the foreseeable future, which can’t be less than 12 months (the FASB model).

Unsurprisingly, the comment letters did not yield a consensus of opinion. So, with a goal of reaching a consensus by late June, the boards are back to the drawing board. Depending on the outcome, we may see yet another exposure draft. Stay tuned–more fun to come!

sgarmong

Sydney Garmong, partner in financial institutions services with Crowe Horwath LLP, addresses accounting and regulatory issues affecting financial institutions. You can connect with Sydney Garmong by calling 202.333.0375, by email or by viewing her profile on LinkedIn.

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