In case you’ve missed it, significant efforts are currently underway to align U.S. accounting practices with standards that are followed in other parts of the world (the convergence process). To accomplish this monumental task, the U.S.-based Financial Accounting Standards Board is working closely with the International Accounting Standards Board. The IASB and FASB met in mid-December 2011 and reached tentative conclusions concerning new methods to account for the allowance for loan losses. These new methods will result in significant changes to current practice, and, in my opinion, will create even more complexity, confusion and diversity in practice compared with current accounting standards.
Accounting practices in the United States currently operate under what is referred to as an “incurred loss” model. Under this framework, an ALL component is established when it is probable, based on events that have already occurred, that a lender will not be able to collect principal and interest payments that are required under the contractual terms of the loan. Some critical characteristics of the incurred loss model include the existence of an impairment event and the likelihood that deficient principal and interest payments will meet the definition of “probable” (as compared to remote, reasonably possible or more likely than not).
Typically, ALL balances for a retail loan portfolio approximate one year’s worth of estimated charge-offs under the incurred loss model.
The “expected loss” model is an attempt to measure the amount of cumulative loan losses that will be recognized over the entire life of a loan, regardless of whether the impairment event has already occurred. Therefore, the expected loss model will result in much higher ALL balances as compared to the incurred loss model, and will result in lower amounts of capital. And depending upon the final accounting rules, it will also likely result in lower levels of earnings as loan portfolios grow.
The boards outlined an approach whereby all loans would be categorized into three different buckets, with each receiving unique accounting treatment. The three buckets are explained in the accompanying table with a comparison to current accounting practices required under GAAP.
To illustrate the impact of the reasonably possible criteria, consider a portfolio of first trust deed loans in the sand states that were underwritten to secondary market conditions and, at the time of underwriting, had loan-to-value ratios of less than 80%. Today, assume there is a large segment of this portfolio with LTVs above 140%.
Under current GAAP, an ALL component would be established when a loss event has occurred, rendering it probable that the lender will not be able to collect principal and interest according to the contractual terms of the loan. A loss in underlying property value certainly increases the risk characteristics of the loan, but this characteristic alone probably does not result in a probability of default. However, depending upon how “reasonably possible” is defined, a significant ALL component might now be required for such loans.
The boards have many issues to consider before the final rules are issued and adopted for practice. However, it is very clear the impact of these new standards will have a major impact on credit unions and other financial institutions. Those charged with governance should closely monitor the decisions being made by FASB under this conversion topic. And credit unions and industry trade groups should work closely with the NCUA to ensure the regulatory impact of these changes to GAAP are handled in an efficient and effective manner.
Michael J. Sacher is a principal at Sacher Consulting.
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