In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The standard’s main goal is to improve financial reporting by requiring earlier recognition of credit losses on financing receivables and other financial assets in scope.
The new guidance represents significant changes to accounting for credit losses:
- Full lifetime expected credit losses will be recognized upon initial recognition of an asset in scope.
- The current incurred loss impairment model that recognizes losses when a probable threshold is met will be replaced with the expected credit loss impairment method without recognition threshold.
- The expected credit losses estimate will be based upon historical information, current conditions, and reasonable and supportable forecasts.
To complicate matters further, new guidance introduces two distinctive credit loss impairment models:
- CECL impairment model (Subtopic 326-20), applicable to financial assets measured at amortized cost (e.g., financing receivables, held-to-maturity debt securities, and trade receivables)
- available-for-sale debt securities impairment model (Subtopic 326-30).
While the new standard will have a significant effect on the financial service industry—particularly banks and others with lending operations (such as credit unions)—it will affect entities in all industries as a wide variety of financial instruments are within the scope of this new guidance, including trade receivables that result from transactions within the scope of Topics 605 and 606 on revenue and Topic 610 on other income.
Transitioning to the new standard
The transition process to the new standard will be challenging on many levels. From a data-collection perspective, entities will be required to maintain historical credit loss information on an aggregate basis for financial assets that share similar risk characteristics. Entities will also be required to adjust historical loss experience for current conditions to produce reasonable and supportable forecasts. ASC 326-20 does not prescribe one specific forecasting model for measuring expected credit losses. However, suggested methods include those based on:
- discounted cash flows
- methods that utilize an aging schedule.
On the other hand, ASC 326-30 does prescribe using the discounted cash flows method to determine the amount expected to be collected on the available-for-sale debt security to estimate expected credit loss at acquisition or origination date. The difference in these two impairment models will add an additional layer of complexity when transitioning to the new standard.
With the effective date rapidly approaching, what are some important issues management should be working through right now?
What assumptions impact the current expected credit losses estimate? Is the information available internally or does it have to obtained from the external sources? Some factors that might have material impact on the management’s estimate of the credit losses include the nature of the financial assets, borrower’s credit rating, prepayment rates, value of underlying collateral, regulatory environment, and changes and expected changes in economic conditions (e.g., unemployment rate, home prices, interest rates).
What are the data requirements? Is data relating to the company’s historical credit losses readily available at the asset level? Transitioning to the new standard will require companies to determine whether their existing technology can support the new standard and evaluate potential data solutions, if required. Additional data might need to be captured and retained for longer periods. Furthermore, external data might be needed in cases where internal data is not sufficient for purposes of the expected credit losses estimate.
What modelling technique should management use to determine the best estimate of current expected credit losses on the specific asset group? Based on the company’s portfolio, management might need to employ several modeling techniques for different types of the financial assets. Further, parallel runs and stress testing of several different models might be necessary to determine the model that produces the most accurate estimate of the current expected credit losses.
How will the company’s disclosure need to change to comply with the new standard requirements? The new standard will require companies to include robust disclosures relating to the credit risk inherent in the company’s portfolio of financial assets and how credit risk is being monitored by management. It also requires disclosure of the methods of estimating allowance for credit losses and key assumptions used to develop estimates.