Since the financial crisis, the Financial Accounting Standards Board (FASB) has been debating wholesale changes to the U.S. generally accepted accounting principles (GAAP) financial instruments model in two related projects. For the first of the financial instruments projects, the FASB wrapped up in January the bulk of its deliberations on the classification and measurement project and expects to issue a standard in mid-2015. The FASB has come full circle by largely retaining existing GAAP—which means the legal form drives the classification and measurement of financial instruments, namely securities and loans.
However, it will not be business as usual when the new standard goes live for financial institutions. There will be a handful of changes that affect financial institutions, the largest being the requirement for equity securities with readily determinable fair values to be carried at fair value through net income (FV/NI) rather than today’s option to carry them at fair value through other comprehensive income (equity method securities will not be FV/NI).
Of greater interest is the second project: credit impairment. The FASB completed the majority of its deliberations in March and expects to issue a final standard in the third quarter of 2015. This standard, which uses the current expected credit loss (CECL) model, fundamentally will change the way the allowance for credit losses is calculated. The standard will have a pervasive impact on all financial institutions, and questions are circulating about what changes are in store.
What Instruments Are Subject to CECL?
The FASB decided to apply CECL to financial assets measured at amortized cost. For financial institutions, CECL generally will apply not only to loans but also to held-to-maturity debt securities and loan commitments that are not classified at FV/NI.
How Is the Allowance Measured Under CECL?
A current estimate of all contractual cash flows not expected to be collected should be recorded as an allowance. When developing this estimate, institutions also need to consider reasonable and supportable forecasts of the cash flows for the financial asset’s life. Given that CECL effectively is a lifetime estimate, institutions will need to estimate the life of the asset by considering the contractual term adjusted for expected prepayments but not considering renewals or modifications unless the entity expects to execute a troubled debt restructuring (TDR). This new focus on payment speeds outside of an ALM calculation might be a challenge for some financial institutions in terms of both data availability and capability.
The FASB is focusing on making CECL as flexible as possible and is retaining other items that had been incorporated in the incurred loss model. For example, the allowance calculation still includes “relevant quantitative and qualitative factors” based largely on the business environment and similar factors that relate to their borrowers (such as underwriting standards). However, the CECL model is different from today’s incurred loss model because it removes the “probable” threshold and accelerates the recognition of losses.
What Are Some Other Changes?
- Purchased Credit-Impaired (PCI) Assets. The FASB is changing the definition of PCI and generally is simplifying the PCI model overall to require immediate recognition of changes in expected cash flows.
- TDRs. At modification, an adjustment will be recorded to the basis rather than as an allowance.
- Disclosures. The FASB retained the current disclosures with a few additions. For example, the FASB tentatively decided to require credit quality disaggregated by asset class and year of origination (in other words, vintage), subject to staff outreach.
What About Transition?
Once the standard is adopted, there will be a cumulative-effect adjustment to the balance sheet (credit allowance, debit retained earnings). For debt securities with recognized impairment, previous write-downs are not reversed. For PCI assets, an allowance is established with an offset to cost basis.
What Is Next?
At the March 11, 2015, meeting, FASB staff received permission to begin drafting the standard. The FASB will discuss at a future meeting any remaining issues identified during the drafting process, cost-benefit considerations and effective date.
What Does My Financial Institution Need to Do Now?
Top on the list for any financial institution is to begin to think about what data would be necessary to develop better forward-looking estimates of expected cash flows and whether that data currently is being retained.