In October 2008, the U.S. Financial Accounting Standards Board and the International Accounting Standards Board established the Financial Crisis Advisory Group as part of a joint approach to address the credit-loss reporting issues arising from the global financial crisis and an ongoing effort to unify U.S. and international standards. In July 2009, the FCAG published a report, recommending alternatives to the incurred loss model that would use more forward-looking information. After working on separate models to address the FCAG recommendations, FASB and IASB published a joint proposal known as the three-bucket impairment model in 2011.
In July 2012, FASB began to express concerns about the complexity of the three-bucket approach, leading it to propose and issue for public comment “current expected credit-losses model.” In March 2013, the IASB responded by introducing its own “credit deterioration model.”
FASB’s CECL model has several distinguishing characteristics from previous guidance.
This model incorporates debt securities under the same model rather than under the current other than temporary impairment model. Current GAAP guidance requires the use of past and present events, but the new guidance would require an institution to utilize future information and supportable forecasts to estimate the allowance. Currently, a financial institution is not required to record a loss until a loss on the asset is deemed to be “probable and estimable.” CECL requires that an institution foregoes the worst-case or best-case scenario and instead evaluates the possibility that a loss exists or that it does not. It also requires the institution to estimate losses over the lifetime of the loan for all loans, thus expanding loss horizons used for estimating an allowance for its nonimpaired loans and causing the allowance for nonimpaired assets to rise from current levels.
The proposed guidance clarifies and updates the definition of a collateral-dependent asset, which could expand the scope of assets evaluated under this method.
Generally, allowance levels would likely rise with the implementation of this model, since institutions will now have to consider all losses that a loan will incur during its lifetime from day one. Many experts believe that the ALLL could increase by 10% to 50%, according to a survey conducted by SNL Financial. The actual amount will vary and will likely be determined by an institution’s portfolio composition, current methodology, forecasts of future events and other factors.
IASB’s credit deterioration model builds upon the three-bucket expected credit-loss model, identifying three different stages that reflect the general pattern of the deterioration of a financial instrument that ultimately defaults. The differences in accounting for each stage relate to the recognition of expected credit losses and, for financial assets, the calculation and presentation of interest revenue.
All entities holding financial assets and commitments to extend credit would be affected by this proposal, with the model applying to loans, debt securities and trade receivables, as well as lease receivables, irrevocable loan commitments and financial guarantee contracts.
The credit deterioration model would likely cause allowance levels to rise, albeit less than the CECL model. CECL projects expected losses over the life of all loans, whereas the credit deterioration model only calls for a projection of 12 months for those loans that have not shown evidence of credit deterioration since origination and would still look at life of loan for those that have. Essentially, it is the loans that you’re allowed to only project out 12 months, as opposed to life, that make the difference in expected reserve amounts between the two models.
Both models would require forward-looking requirements and immediate write-offs. The CECL model offers some improved definitions and clear guidance on PCI financial assets, but it offers little clarity on how to calculate future expected losses, and it carries the potential for large, immediate allowance level increases. IASB’s model, on the other hand, would not require lifetime losses for pass-rated loans, but like the CECL, it offers no clarity on how to calculate future expected losses, and there’s some ambiguity surrounding it’s stage 2 classification.
Since 2002, the intentions of the FASB and the IASB have been to ultimately align on all standards of accounting and financial reporting. Instead, the current divergence suggests that the FASB path to align with the IASB will mirror the U.S.’s path to align its system of measurement with the metric system prevalent throughout the rest of the world. It’s a great idea, but it may be difficult to achieve as long as we lack any true driving force to make the goal a requirement. It may very well take the precipice of another financial crisis to drive the FASB to reconverge with the IASB.
Assuming the two proposals are not modified into one, implementation from the FASB would start with a release of final guidance, which could be anytime from late third-quarter 2013 to second-quarter 2014. Implementation requirements would likely be staggered, with the first financial institutions required to implement as early as first quarter 2015. The tiers would likely be based on either asset size or public vs. private entity or a combination of the two. With a tiered timeline, complete implementation could take until first half of 2017.
Regan Camp is a senior risk management consultant at Sageworks. Contact 919-851-7474 ext. 532 or firstname.lastname@example.org