The information below concerns Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Statements.
Points to Know About the ASU Regarding Credit Losses
- The new standard changes the impairment model for nearly all financial assets and will impact almost all entities.
- The new “expected loss” standard is a forward looking model that will, in most circumstances, result in earlier recognition of credit losses.
- The new “expected loss” standard is applicable for trade and other receivables, held-to-maturity debt securities, loans and other instruments.
- Unrealized losses on available-for-sale securities will continue to be measured as they were before the new standard; however, the losses will be recognized as allowances rather than deductions in the amortized cost of the securities.
- The new standard requires additional disclosures including credit quality metrics tracked by institutions. These measures are to be by year of origination for most financing receivables.
- The standard is effective for public entities that are SEC filers for reporting periods beginning after December 15, 2019. For public entities that are not SEC filers and all other entities, the standard takes effect for fiscal years beginning after December 15, 2020.
- Early adoption is permitted for all entities for periods beginning after December 15, 2018.
Some Key Considerations
Under current generally accepted accounting principles (GAAP) entities measure credit losses using an “incurred loss” model where a credit loss is not recognized until the loss is probable. GAAP defines probable as a “future event or events that are likely to occur.” As used in paragraph 25 of FASB Concepts Statement No. 6, Elements of Financial Statements, “probable” is that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved. Under the new standard the probability factor is no longer applicable.
Assets Measured at Amortized Cost Basis
The amendments in the ASU require assets measured at amortized cost basis to be presented at the net amount expected to be collected. The measurement of the expected credit losses to arrive at the net amount expected to be collected is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. These factors and others are used by entities to make judgments about estimates of collectability and are no longer required to meet the “probable” threshold under the old model. This will most likely result in credit losses being recognized earlier in the financial statements.
Available-for-Sale Debt Securities
Credit losses from available-for-sale debt securities will now be recorded through an allowance for credit losses. The amendments limit the amount of the allowance for credit losses to the amount by which fair value is below amortized cost basis.
Allowance for Loan Losses (ALLL) Considerations
The new standard requires that a group of financing receivables be classified based on risk characteristics and the entity’s method for monitoring and assessing the credit risk. Under the old model a group of financing receivables was classified based on an initial measurement attribute (e.g. amortized cost or credit impaired). ALLL estimates will now need to consider risk characteristics of the asset type. Financial institutions with several types of loan products (e.g. auto loans, consumer real estate, commercial real estate, agricultural, etc.) will now need to identify the specific risk characteristics of these types of loans and the entity’s specific method for assessing and monitoring the credit risks with these types of loans. Financial institutions should generally already have this information and may already have it organized and documented in a way that meets the new standard.
The new “expected credit loss” model requires an entity to estimate the lifetime expected credit loss and record an allowance. The standard does not define “expected credit loss,” but does state the “expected credit loss” should be based on the asset’s amortized cost, accurately reflect losses expected over the remaining contractual life of the asset (considering prepayments), incorporate available relevant information about the collectability of the contractual cash flows, and reflect the risk of loss, even when that risk is remote, suggesting a zero allowance is extremely rare.
The standard allows entities the latitude to develop and use techniques for estimating the expected credit losses that are practical and relevant as long as they are applied consistently over time, are relevant under the circumstances, and are management’s best estimate of expected credit losses using the concepts in the standard.
The changes described in the standard will require management to maintain lifetime loss data instead of annual loss data for a relatively shorter period of time (e.g. 3, 5, or 7 years). The standard will also require management to forecast future economic conditions and then quantify the effect of those conditions on the entity’s estimate of expected credit losses.
The new standard has several new disclosures including the following more significant disclosures:
- For amortized cost basis financial assets an entity will be required to disclose how it developed its allowance and the changes to the factors that influence that estimate. Factors that influence the allowance estimate are selected by management. Examples include unemployment rates, gross domestic product, credit trends, real estate price appreciation or depreciation, housing starts, etc.
- Further disaggregation of financing receivables and net investment in leases measured at amortized cost by year of origination. This disaggregation may include days past due by various aging categories for consumer loans where delinquencies are used to monitor the credit quality.
- A rollforward of the allowance and an aging analysis will be required for available-for-sale securities where the securities are past due.
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