Trying to make improvements to the accounting for the allowance for loan and lease losses (ALLL) has been an endeavor for standard-setters for many years.
Because ALLL is the most significant estimate on the balance sheet for most, if not all banks, any changes to the accounting for credit losses is particularly important to the financial institutions industry.
Before the most recent proposals, the American Institute of Certified Public Accountants (AICPA) had taken up the cause and issued a proposal in June 2003, but based on the feedback received, that project did not move forward.
Motivated by the credit crisis, the Financial Accounting Standards Board (FASB) formally took on the project and issued a comprehensive proposal in May 2010. The proposal would apply to all banks, both public and private, and introduces a new model that is widely thought to result in an increase the amount of the ALLL.
The proposal was largely thought of as the “fair value proposal,” but it also addressed credit losses. At the same time, the International Accounting Standards Board (IASB) also was seeking to make improvements to its credit losses guidance. After hearing from their constituencies a desire to have a converged solution, the two boards sought to work together to require more timely recognition of credit losses and additional transparency about exposure to credit risk.
The first attempt was a proposal issued in January 2011. The proposal received mixed reviews, so the boards decided to explore alternative models. The boards jointly developed a “three-bucket” approach in which an allowance would be established by capturing three different phases of deterioration in credit quality. After hearing numerous concerns about how understandable, operable, and auditable the model would be, the FASB chose an alternative model known as the “current expected credit loss” (CECL) model, which was issued as a proposal, “Financial Instruments – Credit Losses (Subtopic 825-15),” on Dec. 20, 2012.
The CECL model considers more forward-looking information than is permitted under current U.S. generally accepted accounting principles (GAAP). Under the CECL model, the estimate for credit losses would be based on relevant information about past events, current conditions, and reasonable and supportable forecasts. Simply stated, this requires “life of the loan” estimates and recording of day one losses. Under GAAP, losses are not recorded until it is probable that an asset is impaired or a loss has been incurred. In addition to covering loans, the proposal also addresses debt securities, so the current other than temporary impairment (OTTI) model would be replaced.
Comments on the CECL model were due April 30, 2013, and the FASB received more than 360 letters. The FASB also performed additional outreach to approximately 70 analysts to understand whether the proposal would improve financial reporting for users and conducted 17 field visits with preparers to understand the cost of application and operational considerations.
The FASB found that users’ views differ significantly from preparers’ views. By a margin of nearly three to one, users prefer a model that recognizes all expected credit losses. In contrast, most preparers prefer a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses can be recognized. Not surprisingly, financial institutions raised significant concerns about the potential impact of the model on regulatory capital.
The FASB learned that many preparers are under the impression that management would be expected to forecast economic conditions over the remaining life of the assets – which was not the FASB’s intent. Upon comprehending the FASB’s expectations about estimating expected credit losses, nearly all preparers indicated that the measurement of lifetime expected credit losses would be operational. However, the preparers cited the incremental costs and effort of moving to a “life of loan” expected credit loss model and reiterated a preference for a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses are recognized.
Meanwhile, the IASB proceeded with issuing its proposal, “Financial Instruments: Expected Credit Losses,” on March 7. The proposal retains the tenets of the “three-bucket approach” but now refers to it as the “three-stage approach.” The comment period ended July 5.
On July 23, the two boards discussed feedback received on their respective proposals. The meeting was informational, and no decisions were made. Based on the outreach performed, each board found support for its respective models: the IASB from both users and preparers and the FASB from users. Russell Golden, the chair of the FASB, suggested a next step to convene the users that both boards engaged in order to try to reconcile the competing views. Stay tuned – it will be interesting to see if the boards can come together with a converged solution.
Read the Crowe Horwath LLP article, “Is the Third Time the Charm? The FASB Proposes Major Changes for Credit Losses,” for a more in-depth discussion of the proposal.
