This week, the FASB issued a proposal that introduces a new model for accounting for credit losses on debt instruments.1 The proposal calls for an entity to recognize an allowance for credit losses based on its current estimate of contractual cash flows not expected to be collected.
Many believe that the global economic crisis exposed weaknesses in the "incurred loss" model currently used to account for credit losses on financial instruments. Under the "incurred loss" model, losses are not recorded until it is probable that a loss event has occurred. This model has been criticized as having too high of a threshold to recognize a credit loss such that losses are recorded too late in the credit cycle.
The FASB’s proposed model eliminates any threshold required to record a credit loss and allows entities to consider a broader information set when establishing their allowance for loan losses. In addition, the model aims to simplify current practice by replacing today’s multiple impairment models with one model that applies to all debt instruments.
The FASB’s model, referred to as the "current expected credit loss" (CECL) model, has the following key elements.
The CECL model applies to all financial assets subject to credit losses and not recorded at fair value through net income (FV-NI). The scope of the CECL model includes loans, debt securities, loan commitments, reinsurance recoverables, lease receivables, and trade receivables.
The analysis requires entities to consider multiple scenarios. When estimating the amount of contractual cash flows not expected to be collected, entities will have to consider at least two possible scenarios. The analysis should consider one scenario where a credit loss occurs and one scenario where a credit loss does not occur. In other words, the analysis cannot be based solely on the most likely scenario.
Practical expedient for assets carried at FV-OCI
Assets accounted for at fair value with changes in fair value recorded in other comprehensive income (FV-OCI) will be allowed a practical expedient. The practical expedient allows an entity not to recognize expected credit losses if fair value is at or above amortized cost and the expected credit losses on the individual asset are insignificant.
Purchased credit impaired assets
The accounting for debt instruments purchased with evidence of credit deterioration since origination will change from current practice. The CECL model requires an allowance for loan losses to be established at acquisition that represents the buyer's assessment of expected credit losses. The portion of the original purchase discount attributed to expected credit losses will not be recognized in interest income. The remaining portion of the discount not attributed to expected credit losses will be recognized in interest income over the remaining life of the asset using an effective yield method. The effective yield determined at acquisition will be held constant and any changes in expected cash flows (i.e., changes in the allowance for loan losses) will be recorded as gains and losses through the credit loss provision.
The FASB's proposed model is not converged with the IASB’s model2. After jointly deliberating a proposed model earlier this year, the FASB and IASB decided to pursue different approaches. While both models consider expected losses, the FASB’s model contains no threshold to meet prior to recognizing a credit loss. The IASB’s model, referred to as the "credit deterioration" model, requires either a loss event expected in the next twelve months or a significant deterioration in credit quality since origination before recording a credit loss. The IASB expects to issue its proposal in the first quarter of 2013.
All entities that hold financial assets subject to credit losses will be affected by the FASB's proposed model. Therefore, the model is expected to impact the majority of constituents.
During the redeliberation process, the board plans to consider various alternatives for an effective date. The board will also consider providing different effective dates for public versus non-public entities and regulated versus non-regulated entities.
Comments on the FASB's proposal are due April 30, 2013. We plan to issue a Dataline in the coming weeks that will provide more information and our insights on the proposal.
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
1Proposed Accounting Standards Update, Financial Instruments—Credit Losses (Subtopic 825-15)
2Also see In brief 2012-32, FASB decides to explore a revised impairment model for financial assets, and In brief 2012-37, FASB makes key decisions about the revised impairment model for financial assets.
In Brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwC’s online resource for financial executives.