By Charles Soranno, Managing Director
Financial Reporting Compliance and Internal Audit
Four U.S. regulatory agencies – the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) – have issued a set of frequently asked questions (FAQs) in an effort to assist banks and other financial institutions with the implementation process for the Financial Accounting Standards Board’s (FASB) new accounting standard. The FASB standard introduces the current expected credit loss (CECL) methodology for estimating allowances for credit losses under U.S. generally accepted accounting principles (U.S. GAAP), and many firms are grappling with how to implement it.
Aside from reiterating the reasons behind the need for the new standard, the FAQs highlight some key areas that firms need to take notice of.
By issuing the new CECL standard, the FASB:
- Removed the current “probable” threshold and the “incurred” notion as triggers for credit loss recognition and instead adopted a standard that states that financial instruments carried at amortized cost should reflect the net amount expected to be collected over the life of the instrument.
- Broadened the range of data that is incorporated into the measurement of credit losses to include forward-looking information, such as valid forecasts, in assessing the collectability of financial assets.
- Introduced a single measurement objective for all financial assets carried at amortized cost.
In terms of changing current GAAP, the new standard:
- Introduces a new credit loss methodology – The new allowance for credit losses will be an estimate of the expected credit losses on financial assets measured at amortized cost, which is measured using relevant information about past events and other factors.
- Recognizes credit losses earlier – By removing the “probable” threshold and the “incurred” notion, CECL eliminates the triggers used for recognizing credit losses under existing U.S. GAAP and will require entities to record expected losses earlier, where appropriate.
- Will allow leverage of existing credit risk management practices – Management will continue to incorporate qualitative and quantitative factors, including information related to underwriting practices, when estimating allowances for credit losses under CECL, but better alignment and timing will be necessary.
- Will need to incorporate forward looking information in the models – CECL is forward-looking and broadens the range of data that must be considered in the estimation of credit losses. It must consider not only past events and current conditions, but valid forecasts that affect expected collectability.
- Will reduce the number of credit impairment models – The existing guidance is complex because it encompasses multiple impairment models for different asset types. In contrast, CECL introduces a single measurement objective to be applied to all financial assets.
- Will introduce the concept of purchased credit-deteriorated (PCD) financial assets – This replaces purchased credit-impaired (PCI) assets under existing U.S. GAAP. The difference in the PCD criteria means that more purchased loans held for investment, more debt securities held to maturity, and more available-for-sale (AFS) debt securities will be accounted for as PCD financial assets.
- Will modify today’s accounting for impairment on AFS debt securities – Under this new standard, institutions will recognize a credit loss on an AFS debt security through an allowance for credit losses, rather than a direct write-down as is required by current U.S. GAAP.
- Will require vintage disclosures by public business entities (PBE) in U.S. GAAP financial statements – Under the new accounting standard, disclosures of credit quality indicators need to be disaggregated by vintage year to provide users of financial statements greater transparency regarding the credit quality trends within the portfolio from period to period.
The new guidance is effective for PBEs beginning on January 1, 2020, and for non-PBEs beginning a year later, on January 1, 2021.
We summarized the impact and challenges of the CECL earlier this year in a point-of-view paper and a blog post, which provide more details on the methodology, timeline and action points for firms. Although the expected timeline gives the industry several years to implement the updates, the main message to organizations is that they need to begin the planning process now in order to meet the expected deadline.