The new concept of recognizing impairment of financial instruments based on expected credit losses, which FASB is developing, will represent a substantial change in industry philosophy and practice, according to board member Lawrence Smith.
“I think we’ve changed the concept totally,” Smith said Friday during a webcast devoted to explaining the new Current Expected Credit Loss (CECL) model.
Smith said existing U.S. GAAP recognizes impairment as the result of an incurred loss event whose occurrence was probable as of the reporting period. The CECL model treats impairment as the amount that an entity is not expecting to collect.
“What the board has done … is really to move away from the ‘impairment concepts’ [incurred loss model] and really move to a model that reflects the credit riskiness on an ongoing basis and is continually updating the estimate for expected credit losses based on what you are actually expecting to come in, all told,” FASB Practice Fellow Steven Kane said during the webcast.
FASB’s joint project with the International Accounting Standards Board (IASB) grew out of the financial crisis. The Financial Crisis Advisory Group, which the boards set up in October 2008, found problems with the delayed recognition of losses associated with loans and other financial instruments, as well as the complexity of multiple impairment approaches.
The advisory group recommended exploring an alternative to the incurred loss model that would use forward-looking information. The current project’s objective is to fulfill that recommendation.
The CECL model described by Smith and Kane has been the topic of considerable interest because of the way it came about. In the convergence project on accounting for financial instruments, FASB had agreed with the IASB on a “three-bucket model” that eliminated the initial recognition threshold and introduced two measurement objectives.
For Bucket 1, an entity would recognize lifetime expected losses for which a loss event is expected in the next 12 months. For Buckets 2 and 3, an entity would recognize lifetime expected losses. Transfer from Bucket 1 to Bucket 2 would occur when deterioration in credit quality has been more than insignificant and it is at least reasonably possible that some or all of the contractual cash flows may not be collected.
When FASB consulted with its constituents, Smith said, the board was “bombarded” with questions about the three-bucket model. The angst over the model was caused by the use of two different measurements.
So while the IASB continued moving toward an exposure draft using the three-bucket model, FASB separately developed the CECL model to alleviate stakeholders’ concerns.
Both boards are scheduled to release EDs on impairment of financial instruments in the fourth quarter of this year—using separate models for credit risk impairment. Smith said he expects the boards to gather comments, compare the two models, and get together to redeliberate them.
“If people are thinking that the possibility of convergence is dead here, I would say from one board member’s perspective, it’s not dead,” Smith said. “And I would expect that we would try to learn from each other to come up with a final standard.
The CECL model, which FASB has tentatively agreed to expose, uses a single expected credit loss measurement objective. The expected credit losses reflect management’s current estimate of contractual cash flows that the entity does not expect to collect.
This estimate is based on information about past events, current conditions, and reasonable and supportable forecasts about the future. Under the CECL model, expected credit losses would be re-estimated every reporting period. Favorable and unfavorable changes would be reported in earnings.
FASB expects that the expected credit losses reported on the balance sheet will be easy for investors to understand because it is based on a single measurement objective. For preparers, the model leverages internal credit risk management tools and systems, although the inputs to the measure will change.
Since estimates are involved, judgment is necessary.
“I think, from our discussions with investors, they understand the judgmental nature involved with the estimate,” Kane said. “But largely what the board is doing here is giving the goal post for what companies should be shooting for.”
—Ken Tysiac (email@example.com) is a JofA senior editor.