United States: Accounting For Credit Impairment - FASB Proposes An Expected Loss Model

Summary

This publication summarizes the FASB's Exposure Draft on the impairment of financial instruments. Under the credit loss model in the proposed Accounting Standards Update (ASU), Financial Instruments – Credit Losses, an entity would be required to recognize an impairment loss on a financial asset (for example, a debt security or loan) based on the current estimate of contractual cash flows not expected to be collected as of the reporting date (an expected loss approach). The proposed model would mark a significant change from current accounting guidance by requiring an entity to recognize an impairment loss on a financial asset when the loss is expected rather than incurred. This change is intended to result in a more timely recognition of credit losses and to reduce complexity by establishing a single credit impairment model for all financial instruments. The switch to the expected loss approach would require an entity to consider a broader range of information in evaluating whether a financial asset is impaired than is currently required under U.S. GAAP.

Comments on the proposed model are due by May 31, 2013.

A. Background and overview of proposed expected loss model

The proposed Accounting Standards Update, Financial Instruments – Credit Losses, is the third attempt by the FASB to change how credit losses would be recognized and measured. The ASU proposes to replace the current "incurred" loss model with an "expected" loss model, which the FASB expects to result in the more timely recognition of credit losses, correcting a purported weakness in today's model. The proposed model would achieve that goal by requiring entities to consider a broader range of reasonable and supportable information (such as forecasts) and by removing the recognition threshold that a loss must have been incurred as of the reporting date to recognize an impairment. In other words, an allowance for credit losses would solely be a measurement issue, since there would no longer be a recognition threshold or "triggering event."

Change from today's impairment model to CECL

Today's incurred loss model is an income statement–driven approach that seeks to reflect in each statement of financial performance losses that occurred during that period. The allowance balance, therefore, simply reflects an estimate of past losses that have not yet been confirmed (and charged-off).

In contrast, the proposed current expected credit loss (CECL) model is focused on the balance sheet, as the statement of financial position would reflect the present value of future cash flows expected to be collected over the life of the assets on the balance sheet. As such, under the CECL model, credit deterioration would not be reflected in the income statement in the period of such deterioration unless it is unexpected. Instead, the income statement loss provisions would reflect expected credit losses in the period of origination or acquisition of the financial asset, with changes in expected credit losses due to further credit deterioration or improvement reflected in later periods.

In addition, the proposed ASU is intended to reduce complexity in accounting for credit losses by establishing a single credit impairment model for all financial instruments (for example, debt securities and loans) that are not measured at fair value through net income (FV-NI). The proposed model would amend or supersede the current impairment models for financial assets as follows:

• Amend the scope of FASB Accounting Standards Codification® (ASC) 450, Contingencies – Loss Contingencies (formerly FASB Statement 5, Accounting for Contingencies), to exclude items within the scope of the proposed ASU

Loss contingencies

The proposed ASU would create a difference in how loss contingencies are recognized and measured, depending on whether the loss contingency falls within the scope of ASC 450 or the proposed ASU. Loss contingencies not covered by this proposed ASU would continue to follow an incurred loss approach, while loss contingencies covered by this proposed ASU would follow an expected loss approach. This is a significant change in thinking from FASB Statement 5, Accounting for Contingencies, which concluded that all loss contingencies within its scope have common characteristics and should therefore be reported and accounted for consistently.

• Supersede the impairment guidance in ASC 310-10-35, Receivables (formerly FASB Statement 114, Accounting by Creditors for Impairment of a Loan)
• Supersede ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (formerly AICPA Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer)
• Supersede the other-than-temporary impairment guidance in ASC 320-10-35, Investments – Debt and Equity Securities
• Supersede ASC 325-40, Investments – Other: Beneficial Interests in Securitized Financial Assets, for a transferor's interests in securitization transactions that are accounted for as sales under ASC 860, Transfers and Servicing, and for purchased beneficial interests in securitized financial assets (formerly EITF Topic 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets")

Comparison to IASB model

The IASB has separately issued a proposal on measuring credit losses. While the IASB's "three bucket" model is also an expected loss model, there are some significant differences between the Boards' proposed models:

• The IASB model would have two measurement objectives, depending on whether there has been a significant deterioration in credit quality since origination ("transfer criteria") and on whether the financial assets were purchased. Under the IASB model, an entity would recognize an allowance for credit losses as the sum of (1) 12 months of expected credit losses for financial assets that have not met the transfer criteria and (2) lifetime expected credit losses for financial assets that have met the transfer criteria and purchased credit-impaired financial assets. In contrast, the FASB model would require an entity to recognize expected credit losses for all financial assets in an approach that is similar to the IASB's second measurement objective. As a result, we would generally expect that the IASB model would result in a lower allowance for credit losses when applied to the same portfolio of financial assets.
• The FASB model would retain the troubled debt restructuring guidance, which is unique to U.S. GAAP. The IASB model does not include a nonaccrual concept.
• The FASB model would require an entity applying a discounted cash flow approach to use the original effective interest rate, while the IASB model would allow an entity to use any reasonable rate between the risk-free rate and effective interest rate.
• There may be differences as to which specific financial assets would be subject to each Board's respective impairment project. Concurrent to the impairment phase of the financial instruments project, the Boards are still working on the classification and measurement phase of the project, which would require financial instruments to be separated into three measurement categories: (1) FV-NI, (2) fair value through other comprehensive income (FV-OCI), and (3) amortized cost. The IASB and FASB are separately considering changes on the classification and measurement phase of financial instruments.

Interaction with bank regulatory capital changes

Regulated financial institutions should consider the interaction of the proposed changes by the FASB (and IASB) on impairment and BASEL III. BASEL III is a "comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector." BASEL has published " Minimum principles for the recognition of credit-risk related impairment" as an appendix to a comment letter issued to the FASB and IASB shortly after the issuance of the FASB's Exposure Draft. It is expected that the changes to the accounting model would impact the regulatory capital framework.

Comment period

Comments on the proposed model are due by May 31, 2013.

B. Scope

The proposed guidance would apply to financial assets that are debt instruments classified at amortized cost or FV-OCI. A debt instrument is a receivable or payable that represents a contractual right or a contractual obligation to receive or pay cash (or other consideration) on fixed or determinable dates, whether or not there is any stated provision for interest. Examples of financial assets that are considered debt instruments include, but are not limited to, the following:

• Loans
• Debt securities
• Trade receivables
• Reinsurance receivables

The proposal would also apply to lease receivables recognized by the lessor in accordance with ASC 840, Leases, and to legally binding loan commitments to extend credit, including loan commitments that are revolving (such as credit card loans) and nonrevolving.

The proposal would not, however, apply to equity investments. Under another proposed ASU, Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities, equity securities either would be measured at FV-NI, or, if certain criteria are met, an entity would be permitted to measure equity investments without readily determinable fair values at cost, adjusted for both impairment and changes that result from observable price changes in orderly transactions for an identical or a similar investment from the same issuer.

Financial guarantees

It is not clear whether financial guarantees are within the scope of the proposed ASU. However, the FASB's proposed classification and measurement ASU, Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities, specifically excludes financial guarantee contracts that are within the scope of ASC 450, 460, 815, 840, or 944. Further, certain financial guarantees are subject to the FASB's separate project on insurance contacts. As a result, we do not believe that financial guarantees are generally within the scope of the FASB's proposed ASU on impairment.

Practical expedient for FV-OCI assets

Under the proposed guidance, entities would have the option, as a practical expedient, to forgo reflecting the effects of credit deterioration or improvement in the statement of financial performance for an FV-OCI asset if both of the following conditions exist:

• The fair value of the FV-OCI asset is greater than or equal to its amortized cost basis.
• Expected credit losses from the FV-OCI asset are insignificant.

The FASB proposed this practical expedient to lower the cost of complying with the proposed guidance, recognizing that FV-OCI assets would more likely be evaluated on an individual basis since the entity's business model would involve selling individual financial assets.

Applying the practical expedient

An entity would be prohibited from explicitly applying the practical expedient if the fair value of the financial asset is lower than its amortized cost due to factors other than credit risk, such as liquidity or changes in interest rates. As a result, the practical expedient may have limited applicability in certain economic cycles, such as during the recent credit crisis when many securities were underwater or in a rising interest-rate environment. While the FASB would prohibit the use of the practical expedient if the fair value is less than amortized cost, it is unclear whether an entity would be able to qualitatively determine that the expected credit loss is immaterial without developing a mathematical estimate of cash flows expected to be collected.

In evaluating whether expected credit losses are insignificant, an entity may be able to start with a qualitative assessment that considers factors such as published credit ratings or an entity's own internal credit evaluation. However, we believe that the evaluation would also need to consider expected changes in credit. In other words, consistent with an expected loss approach, an entity would not be permitted to forgo recognizing impairment simply because there has not been an observed decrease in a published credit rating.

C. Current expected credit loss model

Under the proposed current expected credit loss (CECL) model, an entity's statement of financial position would reflect management's current estimate of contractual cash flows not expected to be collected over the entire contractual term of the financial asset. As a result, the net amortized cost on the statement of financial position (that is, net of the allowance for credit losses) would reflect the present value of future cash flows expected to be collected. The proposed model would require that the effects of credit deterioration or improvement during the reporting period be reflected in the statement of financial performance as a provision for credit losses.

In applying the CECL model, there are five general principles an entity must consider:

• The entire contractual term of the financial asset
• Internal and external information about past events, current conditions, and reasonable and supportable forecasts that are relevant to the collectability of a financial asset's remaining contractual cash flows
• Time value of money
• Both the possibility that a credit loss will occur and the possibility that no credit loss will occur
• Whether and how much credit enhancements (other than freestanding contracts) mitigate expected credit losses on financial assets

Contractual term

The proposed model would require an entity to recognize an allowance for credit losses based on management's current estimate of contractual cash flows not expected to be collected over the entire contractual term of the financial asset. Under such an approach, an entity would consider expected prepayments. Additionally, an entity would not need to estimate the exact amount and timing of cash flows.

Contractual term vs. lifetime expected losses

Although the IASB's proposed approach refers to lifetime expected losses, the IASB's Exposure Draft indicates that its interpretation of lifetime expected losses is intended to be consistent with the FASB's approach. As noted by the FASB in BC18 of the Basis for Conclusions in the proposed ASU, lifetime expected losses is interpreted in many different ways.

Broader set of information to consider

In general, the CECL model would require entities to consider a broader set of information than under existing GAAP. The CECL estimate would be based on internal and external information about past events (including historical loss experience), current conditions, and reasonable and supportable forecasts that are relevant to the collectability of a financial asset's remaining contractual cash flows. Management would be required to consider quantitative and qualitative factors specific to borrowers and the economic environment in which the entity operates, including a current evaluation of borrowers' creditworthiness, as well as the current point in, and forecasted direction of, the economic cycle. For example, management might look to changes in lender-specific or industry-wide underwriting standards for evidence related to the economic cycle.

Gathering information under CECL

One concern with implementing an expected credit loss model that was expressed by stakeholders is the cost and effort required to gather relevant information for estimating expected credit losses. To help address this concern, the proposed guidance would require entities to consider only relevant information that is available without undue cost and effort.

It is unclear how longer-term forecasts should be weighted or considered under the proposed model. As noted in paragraph BC24 in the proposed ASU's Basis for Conclusions:

The Board also acknowledges that estimating expected credit losses over longer periods of time (such as the contractual term of financial assets) requires a significant amount of judgment, especially when discounted cash flow techniques are used. Although an entity is required to estimate credit losses over the entire contractual term of the financial assets, the Board recognizes that as the forecast horizon increases, the degree of judgment involved in estimating expected credit losses increases because the availability of detailed estimates for periods far in the future decreases.

Time value of money

In measuring CECL, an entity would be required to reflect the time value of money, explicitly or implicitly. For example, a discounted cash flow model would explicitly incorporate the time value of money. When using a discounted cash flow model, an entity would be required to use the financial asset's effective interest rate as the discount rate. In contrast, the FASB has indicated that other methods implicitly incorporate the time value of money. For example, an approach that relies on historical loss statistics, adjusted for current conditions and reasonable and supportable forecasts, would implicitly meet this requirement.

Consideration of the time value of money

The CECL model would require that the estimate of expected credit losses always reflect both the possibility that a credit loss results and the possibility that no credit loss results. The model would also require that an entity reflect the time value of money either explicitly or implicitly. The FASB believes that many commonly used methods today satisfy these requirements.

Estimation method

Under the CECL model, management's estimate of expected credit losses should represent neither a best case nor a worst case scenario. Rather, it would reflect both the possibility that a credit loss will occur and the possibility that no credit loss will occur. Accordingly, entities would not be permitted to estimate expected credit losses solely based on the most likely outcome. However, entities would not be required to utilize a probability-weighted approach that considers the likelihood of more than two outcomes. An estimation method that relies on a population of historical loss data would implicitly satisfy these criteria, so long as the data reflects situations where an actual loss was incurred and situations where no loss was incurred. The FASB believes that many commonly used measurement methods implicitly satisfy this requirement. Examples of methods cited by the FASB as meeting this requirement include a loss-rate method, a roll-rate method, a probability-of-default method, and a provision matrix method, assuming the inputs to such approaches consider data that results in both a loss and no loss. The FASB also believes that applying the fair value of the collateral practical expedient for collateral-dependent financial assets would also satisfy this requirement.

Consideration of various scenarios under CECL model

The CECL model would require that the estimate of expected credit losses always reflect the possibility that a credit loss results and the possibility that no credit loss results. It is unclear how such principal would be applied in all scenarios, but the model seems to require that an entity always recognize an allowance for credit losses, even if there is strong evidence that impairment is unlikely.

Consider the following scenarios in light of the proposed guidance:

• A bank that has made a loan that is fully secured by a certificate of deposit held by the bank: One could argue that impairment is unlikely. However, would such conclusion change if the collateral is instead real estate that more than adequately covers the lender?
• A manufacturer that has a large receivable with a highly rated counterparty in which it has done a full credit review: Further presume that the manufacturer has information available shortly after the balance sheet date and before report issuance that further shows the receivable has been collected in full.

Credit enhancements

Under the proposed CECL model, the estimate of expected credit losses must incorporate the effect of an embedded credit enhancement, such as a guarantee. The estimate would consider the financial condition of the guarantor, as well as the ability of subordinated interest holders to absorb expected credit losses. An entity would not be permitted to consider the effect of a freestanding credit enhancement, such as a purchased credit default swap, that might mitigate expected credit losses on a financial asset or group of financial assets.

FDIC loss share agreements

We do not expect that the proposed guidance on credit enhancements would change the accounting for loss share arrangements (LSA). Currently, loss share agreements are accounted for separately from the covered assets because the LSA is not embedded in the covered assets.

D. Other considerations under the CECL model

Unit of account: individual or pooled basis

The CECL model does not stipulate any parameters regarding the unit of account to which the model would be applied. In other words, there is no specific guidance on determining whether to apply the model on an individual asset or a pooled basis. While it appears that the model could be applied on a pooled basis, the proposed ASU does not provide any guidance on this issue or, alternatively, on how one would segment a portfolio of financial assets, such as loans or debt securities.

Individual or pooled basis

Although the proposed model does not specify when the model should be applied on an individual or a pooled approach, the FASB has developed a model that is expected to provide principles-based guidance that could be applied on either basis. We expect that many entities would apply the proposed model so that certain assets are measured for impairment on an individual basis and certain assets are measured for impairment on a pooled basis. However, the proposed model does not have a recognition threshold, and companies would therefore need to determine (presumably through an accounting policy election) when financial assets should be evaluated on a pooled or an individual basis.

Also, the proposed model does not provide any guidance related to how the model would be applied in a pooled approach. For example, the model does not specify whether the pools, once created, would be required to be maintained on a consistent basis (that is, static pools) until the loans are collected or otherwise disposed of. As such, it appears that pools may be allowed to be constantly changing over time.

Collateral dependent

The proposed ASU would change the guidance on when it is appropriate to measure impairment based on the fair value of the collateral. The proposal would permit such an approach when repayment is expected to be provided "primarily or substantially through the operation of the collateral by the lender or sale of the collateral." In contrast, today's GAAP allows a creditor to measure impairment if the repayment of the loan is expected to be provided solely by the underlying collateral, which has been interpreted to include the sale by the creditor or operation of the collateral by the debtor or creditor.

Collateral-dependent approach

While the CECL model would appear to increase the frequency of measuring impairment based on the fair value of collateral by changing the threshold from "solely" to "primarily or substantially," we believe it could actually reduce the applicability of this approach for certain entities by limiting its application to situations where the lender operates the collateral. Current practice is not necessarily limited to such situations. For example, if repayment of the loan is based on rentals from an apartment building (operation of the collateral, not sale of the collateral) and the borrower has no other sources of repayment, some entities would consider the loan collateral-dependent. Under the proposed model, we believe the lender would not be able to apply the collateral-dependent approach if repayment is expected through operation of the collateral by the borrower. This would be a significant change for many entities, especially for financial institutions.

Troubled debt restructurings

The proposed ASU would retain the troubled debt restructuring (TDR) guidance in ASC 310-40, Receivables: Troubled Debt Restructurings by Creditors. While the proposed model would reduce the significance of the TDR concept due to the removal of the required application of the ASC 310-10-35 (FAS 114) impairment measurement model and the removal of impairment disclosures, TDRs would continue to apply the original effective interest rate (rather than the revised interest rate) to measure impairment. As a result, a TDR would require an entity to charge-off the difference between the amortized cost basis before modification and the present value of the modified contractual cash flows discounted at the original effective interest rate.

Lease receivables

To estimate expected credit losses on a lease receivable under a discounted cash flow model, an entity would use the cash flows and discount rate that are used to measure the lease receivable under ASC 840, Leases, as the contractual cash flows and effective interest rate, respectively.

Loan commitments

For loan commitments not categorized as FV-NI, the proposed model would call for estimating credit losses over the full contractual period during which the entity is exposed to credit risk, unless the commitment can be cancelled unconditionally by the issuer. Management's estimate of expected credit losses would consider both the likelihood that funding will occur as well as expected credit losses on loan commitments expected to be funded.

Hedging

If an entity adjusts the carrying amount of a debt instrument that has been designated as the hedged item in a fair value hedge, the effective interest rate would be the rate that equates the adjusted carrying amount of the debt instrument to its remaining contractual cash flows.

Application to debt securities: differences between OTTI and proposed model

The proposed ASU would eliminate the concept of other-than-temporary impairment (OTTI). The following table compares the current OTTI model for debt securities with the proposed CECL model, which, as noted above, does not apply to equity securities.

Purchased credit-impaired financial assets

The proposed ASU would eliminate the guidance in ASC 310-30. As a result, the subsequent (day two) accounting for purchased credit-impaired (PCI) financial assets is intended to be the same as accounting for originated financial assets and other purchased financial assets.

Non-PCI acquired assets

For acquired financial assets for which there is no significant deterioration, the entire discount (or premium) would be recognized as a yield adjustment under the CECL model. That is, no allowance would be recognized at acquisition. The entire premium or discount would be recognized in interest income on a level-yield basis consistent with ASC 310-20, Receivables – Nonrefundable Fees and Other Costs.

Interest income on PCI assets

The Board has provided limited guidance on recognizing interest income for PCI assets. Proposed ASC 825-15-25-9 indicates that "when recognizing interest income on purchased credit-impaired financial assets, an entity shall not recognize as interest income the discount embedded in the purchase price that is attributable to the acquirer's assessment of expected credit losses at the date of acquisition." It also indicates that the allowance for PCI assets "shall be an estimate of all contractual cash flows not expected to be collected." The Board intends for this to result in the impairment accounting model for originated, non-PCI, and PCI assets to be the same after acquisition.

We believe the guidance in proposed ASC 825-15-25-9 is unclear as to what is meant by "shall not recognize as interest income the discount embedded in the purchase price that is attributable to the acquirer's assessment of expected credit losses at the date of acquisition." More specifically it is unclear whether the interest income that should not be recognized relates only to the credit discount at acquisition (which would be a discounted amount to reflect the time value of money) or an undiscounted amount for the credit discount at acquisition.

Approach #1

We believe one potential interpretation of recognizing interest income on PCI assets would have the income statement effect of grossing up interest income and recognizing a provision for credit losses in future periods (due to the time value of money). This would be because the FASB has indicated that the day one allowance would be recognized as an adjustment that increases the cost basis of the asset and that the allowance for credit losses would be an estimate of all contractual cash flows not expected to be collected. So, in other words, the effective yield would be multiplied by a cost basis that was "grossed up" by the day one allowance (not the cost basis in which the yield was determined). As a result, even if the entity's estimate of expected cash shortfalls was perfect at acquisition, a provision for credit losses would be required in each subsequent reporting period. This subsequent provision would offset the interest income recognized on the grossed-up asset.

Approach #2

However, the FASB has also indicated in the Basis for Conclusions (BC40) that "recognizing interest revenue on the basis of contractual cash flows for all purchased assets could result in situations in which an entity accretes to an amount that it does not expect to collect, which would result in artificially inflated yields ... as such it is inappropriate to accrete from the purchase price to the contractual cash flows ... it is more representationally faithful to recognize yield by accreting from the purchase price to the cash flows expected to be collected at acquisition. As a result, the Board decided that the discount embedded in the purchase price that is attributable to credit losses at the date of acquisition of a purchased credit-impaired asset should never be recognized as interest income." This guidance included in the Basis for Conclusions appears to contradict the guidance included in proposed ASC 825-15-25-9.

Based on the guidance in the Basis for Conclusions, we believe that interest income would be recognized in a manner that is similar to ASC 310-30, such that no provision for loan losses is required in subsequent periods if there is no change in the acquirer's cash flow estimates. In other words, the acquirer would recognize a lower yield than would be the case under Approach #1 (as the yield determined in Approach #1 would be based on the cost basis of the asset without the credit loss adjustment gross-up).

Under the first approach, we believe an entity would (1) recognize interest income it does not expect to collect, which would need to be offset by a provision for credit losses in each future period, and (2) recognize a provision for credit losses in future periods, even if its estimate of cash flows at acquisition was perfect. In contrast, the second approach would appear to achieve the Board's objective in the Basis for Conclusions that "it is more representationally faithful to recognize yield by accreting from the purchase price to the cash flows expected to be collected at acquisition." However, Approach #2 would appear to be inconsistent with proposed ASC 825-15-25-1, which indicates that expected credit losses are a current estimate of all contractual cash flows not expected to be collected.

It should be noted that both approaches appear to result in the same net income recognized during a period; however, the amounts recognized as interest income and the provision for credit losses amounts would be different.

The following table compares the accounting under ASC 310-30 with the CECL model in the proposed ASU.

Nonaccrual

The proposed ASU would introduce into GAAP guidance for when a financial asset should be placed on nonaccrual status. Although many financial institutions currently apply a nonaccrual policy based on bank regulatory guidance, this new guidance would enhance the comparability between regulated financial institutions and nonregulated companies.

Under the proposed ASU, an entity would cease accruing interest income on a financial asset when it is not probable that the entity will receive substantially all the contractual principal or interest income:

• If it is not probable that the entity will receive substantially all the principal, all cash receipts would be recognized as a reduction of the financial asset's carrying amount until the carrying amount is reduced to zero. Thereafter, cash receipts would be recognized as a recovery of amounts previously charged-off, with any excess recognized as interest income.
• If it is probable that the entity will receive substantially all of the principal but not substantially all of the interest, cash receipts would be recognized as interest income, and amounts in excess of interest income that would have been recognized if the asset were not on nonaccrual status would be recognized as a reduction to the asset's carrying amount.

Nonaccrual principle to follow incurred loss approach

The CECL model is based on an expected loss approach, but the nonaccrual principle in the proposed ASU appears to continue to follow an incurred loss approach, allowing an entity to place a financial asset on nonaccrual only when it is not probable that the entity will receive substantially all the principal or substantially all of the interest. In other words, an entity would still recognize interest income even if it does not expect to collect all contractual cash flows and would only cease to recognize interest income when it is not probable that the entity will receive substantially all principal or substantially all of the interest. Further, it is unclear how the nonaccrual principal would interact with the principal in proposed ASC 825-15-25-1 that "expected credit losses are a current estimate of all contractual cash flows not expected to be collected." In other words, by placing an asset on nonaccrual, the entity is accounting for the decrease in expected cash flows by recognizing less interest income rather than a provision for credit losses.

Charge-offs and recoveries

Under the proposed guidance, an entity would reduce the cost basis of a financial asset in the period it determines there is no reasonable expectation of future recovery. When such determination is made, the entity would reduce the carrying amounts of both the asset and the allowance for credit losses. Recoveries of amounts previously written-off would be recorded as an adjustment to the allowance for credit losses when consideration is received. A recovery would be recognized only when consideration is received.

Charge-off timing

An entity would reduce the cost basis of a financial asset in the period it determines there is no reasonable expectation of future recovery. Entities would need to evaluate whether this principal is consistent with the entity's current charge-off policy. For example, an entity may have a policy to charge-off a certain loan type when it is 180 days past due. Such policy may not be consistent with the FASB's proposed principal and may be inconsistent with current bank regulatory requirements for charging-off loans.

If an entity's current charge-off policy is inconsistent with the FASB's proposed principal, an entity would need to determine how its historical loss factors would need to be adjusted to account for this difference.

Additionally, we believe the proposed principal may result in fewer recoveries being recognized than under current practice.

E. Presentation and disclosures

Net versus gross presentation

For a financial asset measured at amortized cost (including PCI loans), the allowance for credit losses would be separately presented on the statement of financial position as a reduction of the asset's amortized cost. For a financial asset categorized as FV-OCI, management's estimate of expected credit losses would be reported as a contra-asset that would reduce the financial asset's amortized cost basis, which would be presented net on the statement of financial position.

Disclosures

The objective of the proposed disclosure requirements is to enable users to understand

• The credit risk inherent in an entity's portfolio and how management monitors the portfolio's credit quality
• Management's estimate of expected credit losses
• Changes in management's estimate of expected credit losses during the reporting period

Similar to the disclosure requirements introduced in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, the proposed ASU would require entities to disclose disaggregated information either by portfolio segment or by class of financial asset. However, the proposed guidance would expand certain credit quality disclosures introduced by ASU 2010-20 to cover all financial assets within the scope of the proposed ASU (not just financing receivables).

While many existing disclosure requirements would be retained under the proposed guidance, the shift from an incurred loss model to an expected loss model would require additional disclosures, primarily related to management's estimate of expected credit losses.

As a result of the proposed changes in accounting for purchased credit-impaired financial assets, an entity would be required to disclose a reconciliation of such assets' purchase price to par value in the period of acquisition so that users can understand the discount attributed to expected credit losses.

In addition, the proposed guidance would require rollforward disclosures of the amortized cost basis and allowance for credit losses for debt instruments categorized as either amortized cost or FV-OCI.

F. Effective date and transition guidance

Although an effective date has not been determined, the FASB has proposed to require a cumulative-effect transition method as of the beginning of the first reporting period in which the guidance is effective.

Transition implications

Purchased credit impaired and OTTI

In our view, the proposed transition guidance does not provide detailed information for certain transition issues that entities may encounter. For example, we believe that additional guidance is needed on transitioning from the current ASC 310-30 models for PCI loans and the existing OTTI guidance to the proposed model. Would an entity be required to determine the amount of credit vs. noncredit discount for PCI loans? Would an entity be required to compute a new effective yield for PCI loans? How would previously recognized OTTI impairment be reflected?

Regulatory capital

In addition, the proposed model may require entities to increase their allowance for credit losses as of the adoption date. The offsetting entry to record such an increase would be a reduction in retained earnings. While we would expect some transition relief for the potential decreases in regulatory capital that may result from applying the proposed ASU, the banking and credit union regulators have not yet announced any formal plans to do so.

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