This FASB staff Q&A only focuses on the guidance in Topic 326,
Financial Instruments—Credit Losses. This Q&A does not address other
regulatory, rules, or compliance requirements that entities may need to consider
when preparing and issuing financial statements.
Topic 326 contains
a requirement of applying a reasonable and supportable forecast and, if
applicable, reverting to historical loss information (if an entity is unable to
forecast credit losses over the estimated life of the instrument) when measuring
expected credit losses. As part of the Board's continuing commitment to educate
stakeholders, the staff has developed this question and answer (Q&A)
document to respond to some frequently asked questions about using historical
loss information, developing reasonable and supportable forecasts, and
requirements regarding applying the reversion to historical loss information.
The staff encourages entities also to read the Staff
Q&A Topic 326, No. 1, Whether the Weighted-Average Remaining Maturity
Method Is an Acceptable Method to Estimate Expected Credit
Losses, that was issued in January 2019.
For
contextual purposes, this Q&A includes information from Accounting Standards
Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326):
Measurement of Credit Losses on Financial Instruments, and certain
paragraphs in the basis for conclusions.
Update 2016-13 was
developed to be operably scalable and flexible. An entity must apply judgment in
estimating expected credit losses. An entity's estimate of expected credit
losses should reflect its expectations or its best estimate of expected credit
loss. All examples or numerical adjustments contained in this Q&A are
intended for educational purposes. Consequently, numerical adjustments should
not be misconstrued as a "starting point," that is, a required amount or the
Board's expectation regarding the level of allowance for expected credit losses
that a particular entity should record.
Does the application of the word forecast in paragraph
326-20-30-7 infer computer-based modeling analysis is required?
No, developing forecasts does not require an entity to perform
computer-based modeling. Topic 326 allows a quantitative or a qualitative
adjustment to be made when assessing current conditions and reasonable and
supportable forecasts. One way to apply a forecast on a qualitative basis is by
using qualitative factors (Q-factors). Similar to how many entities consider
Q-factors under existing practice in determining the allowance for credit
losses, another approach can be used for forecasting.
If an entity's actual credit losses differ from its estimate of expected
credit losses, is it required to modify its forecasting methodology?
The Board notes that estimates of expected credit losses often will not
predict with precision actual future events. The objective of the amendments in
the Update is for entities to present their best estimate of the net amount
expected to be collected on financial assets. The amendments do not require a
specific loss method; rather, an entity is required to use judgment in
determining the relevant information and estimation methods that are appropriate
in its circumstances. The Board understands that there generally is a range of
reasonable outcomes and, therefore, expects there to be differences between
estimates of expected credit losses and actual credit losses. Ultimately,
estimates of future losses and actual losses should converge to the same amount.
An entity should continue to refine future estimates of expected credit losses
based on actual experience. For example, if actual results indicate that
macroeconomic conditions are having a greater or lesser effect than originally
projected, an entity may need to adjust future loss projections to reflect this
change.
Can an entity's process for determining expected credit losses consider
only historical information?
No. The guidance states that an entity should not rely solely on past
events to estimate expected credit losses. When an entity uses historical loss
information to forecast expected credit losses, it should consider the need to
adjust historical loss information to reflect the extent to which management
expects current conditions and reasonable and supportable forecasts to differ
from the conditions that existed for the period over which historical loss
information was evaluated. The adjustments, if needed, to historical loss
information may be qualitative or quantitative in nature and should reflect
changes related to relevant data.
In addition, an entity should
consider adjustments to historical loss information for differences in current
asset-specific risk characteristics, such as underwriting standards, portfolio
mix, or asset term within a pool at the reporting date. An entity also should
consider whether historical loss information used covers a sufficient time
period such that it reflects the term of the financial asset or group of
financial assets.
How should an entity determine which historical loss information to use
when estimating expected credit losses?
In determining what historical loss period information best represents
the financial assets, an entity may use historical loss information that is
nonsequential (such as historical loss percentages based for each year since
origination as opposed to an average 5-year historical loss percentage). The
appropriate historical loss period can vary between loan portfolios, products,
pools, and inputs. An entity should consider both the appropriate historical
period and the appropriate length of the period when developing those
estimates.
An entity should use judgment in determining which
period or periods to consider when determining which historical loss information
is most appropriate for estimating expected credit losses. An entity does not
have to use historical losses from the most recent periods. For example, an
entity may determine that the historical loss information that best represents
the specific risk characteristics of the entity's current portfolio relates to
periods from 20X2–20X5. Using the historical loss information from 20X2–20X5 as
an input to the measurement of expected credit losses, an entity would then
consider how current conditions and reasonable and supportable forecasts affect
the estimate of expected credit losses. Once the historical period has been
chosen, an entity should consider adjustments to historical loss information for
differences in current asset specific risk characteristics, such as underwriting
standards, portfolio mix, or asset term within a pool at the reporting date or
when an entity's historical loss information does not reflect the contractual
term of the financial asset or group of financial assets. For periods beyond the
reasonable and supportable forecast period, an entity should revert to
historical loss information that may not be from the same period used to
estimate its reasonable and supportable forecast and should reflect the
contractual term of the financial asset or group of financial assets. In other
words, an entity should use historical loss information that is more reflective
of the remaining contractual term of the financial assets for periods beyond the
reasonable and supportable forecast period.
Is an entity required to consider all sources of available information
when estimating expected credit losses?
No, an entity is not required to consider all sources of available
information. Paragraph 326-20-30-7 states that "an entity is not required to
search all possible information that is not reasonably available without undue
cost and effort." Therefore, an entity should consider relevant information that
is reasonably available that can be obtained without undue cost and effort. An
entity should not ignore available information that is relevant to the estimated
collectibility of the reported amount. This should not be interpreted to mean
that an entity must always default to using only external data (for example,
consensus forecasts) if its internal data is sufficient and more appropriate in
the circumstances.
For example, external data may be available for
purchase, but an entity may conclude that obtaining that information will result
in an undue cost and to review the external information and incorporate this
external information into the entity's processes will require too much effort,
when internal information is sufficient in determining collectibility.
Therefore, the entity could develop an estimate of expected credit losses on
financial assets using internal data only.
Alternatively, an entity
may have limited internal data for a particular portfolio to estimate the
collectibility of the reported amount. Therefore, the entity will need to rely
on external data for the purposes of developing an estimate of expected credit
losses.
What if external data are not costly, but internal data are more relevant
to an entity's loss calculation? Is the entity required to obtain and/or use the
external data?
No. Certain facts and circumstances may arise for which internal data
more appropriately capture the credit-quality risk for a specific entity than
external data. Internal data may be more useful in estimating expected credit
losses than external data because an entity may have captured more information
that is unique to its business and the communities in which it operates than
what can be captured from an external resource.
For example, in a
recession, one or more portfolio segments may experience significant losses.
While there may be publicly available data, such as volume of permits granted,
there also may be internal data, such as profit margins which can be correlated
to losses. Therefore, an entity may choose to rely on trends from internally
gathered metrics, assuming the portfolio size is sufficient, on its own customer
base rather than publicly available data in determining expected credit
losses.
As another example, an entity may obtain information that
indicates a substantial local community water contamination issue. This
information could suggest a decline in property values, which could increase an
entity's estimate of expected credit losses. The guidance allows an entity to
use judgment in estimating expected credit losses, which includes the
flexibility to decide which information should be used in estimating expected
credit losses (internal or external data or a combination of both).
Should an entity use external data to develop estimates of credit losses
if internal information is available?
Paragraph 326-20-30-7 states "when developing an estimate of expected
credit losses on financial asset(s), an entity shall consider available
information relevant to assessing the collectibility of cash flows." The
guidance goes on to state that "information may include internal information,
external information, or a combination of both." The guidance does not prescribe
what type of information can be used in developing an estimate of expected
credit losses as long as that information is relevant to the entity, which means
that an entity can use internal information, external information, or a
combination of both internal and external forms of information in developing an
estimate of expected credit losses. However, if an entity does not have
the internal information that would be relevant to developing expected credit
losses, it should consider external information to develop an estimate of
expected credit losses. Similarly, an entity that has relevant internal
information may rely on that information without acquiring or referencing
external information. An entity is not required to search all possible
information that is not reasonably available without undue cost and effort.
May the length of reasonable and supportable forecast periods vary
between different portfolios, products, pools, and inputs?
Yes. The duration or length of the reasonable and supportable forecast
period is a judgment that may vary based on the entity's ability to estimate
economic conditions and expected losses. The reasonable and supportable
forecast may vary between portfolios, products, pools, and inputs. However,
specific inputs (such as unemployment rates) should be applied on a consistent
basis between portfolios, products, and pools, to the extent that the same
inputs are relevant across products and pools. It also is acceptable to have a
single reasonable and supportable period for all of an entity's products. An
entity is to disclose information that will enable users to understand
management's method for developing its expected credit losses, the information
used in developing its expected credit losses, and the circumstances that caused
changes to the expected credit losses among other disclosures about the
allowance for credit losses.
Does an entity need to include the full contractual period (adjusted for
prepayments) in its estimate of the reasonable and supportable forecast
period?
No. Some entities may be able to apply reasonable and supportable
forecasts over the estimated contractual term (that is, the contractual term
adjusted for prepayments). However, the guidance does not require an entity to
develop forecasts over the contractual term (adjusted for prepayments) of the
financial asset or group of financial assets (paragraph 326-20-30-9).
For example, three separate lenders, each based in three different
communities, loaned money to borrowers employed by a manufacturer that has
operations in three separate communities. Many borrowers in each of the three
communities are employed by one of the manufacturing plants in their community.
The manufacturer has announced plans to close one of its manufacturing plants in
18 months. However, it is not yet known which plant the manufacturing company
will close. Each entity should apply judgment in developing reasonable and
supportable forecasts when considering the effect of a possible plant closure on
its ability to collect any principal and interest on outstanding loan balances
from those borrowers who work at this plant. Each of the three entities may have
different estimates of expected credit losses, including the inputs,
assumptions, or durations for their reasonable and supportable forecast period.
For example, entities may be able to reasonably forecast losses beyond the
period of the plant closure or may determine that their forecasts are reasonable
only up to the period of the plant closure.
Another example is when
a wholesaler has short-term receivables from a retailer in a local mall that is
experiencing financial difficulty. This wholesaler may be able to forecast all
expected credit losses on the receivable, and, therefore, the reasonable and
supportable forecast period would include the contractual term of the
receivable.
Should an entity reevaluate its reasonable and supportable forecast
period each reporting period?
Yes. An entity should consider the appropriateness of its reasonable and
supportable forecast period, as well as other judgments applied in developing
estimates of expected credit losses each reporting period. If the reasonable and
supportable period does not cover the full expected contractual term (adjusted
for prepayments), an entity should consider the appropriateness of the duration
of its reversion period (that is, the periods beyond the reasonable and
supportable period) and the methodology applied when reverting back to
historical loss information. For example, an entity may determine that it is
appropriate to shorten or lengthen its reasonable and supportable forecast
period from prior periods because of changes in the uncertainty of some or all
of the inputs and assumptions used to measure expected credit losses.
Is an entity required to correlate reasonable and supportable forecasts
to macroeconomic data, such as nationwide or statewide data?
No. An entity is not required to correlate or reconcile reasonable and
supportable forecasts to macroeconomic data, such as the national unemployment
rate. Instead, when developing an estimate of expected credit losses on
financial assets, the entity should consider available information relevant to
assessing the collectibility of cash flows.
For example, a business
closure may not correlate to any macroeconomic phenomena. Instead, an entity may
decide to move to another state to receive a more lucrative tax treatment. In
this instance, the macroeconomic factors may indicate a very strong job market
with low nationwide or statewide unemployment rates, but the business closure
may have a significant effect for the entity in the local economic environment
when assessing the collectibility of amounts owed by its borrowers. In this
instance, correlating a local economic event to macroeconomic data may not be
appropriate because the macroeconomic data are not relevant.
In
other instances, an entity may consider whether a national trade agreement will
have a favorable or unfavorable effect on its ability to collect contractually
owed cash flows from its borrowers. The entity may decide to review its internal
information that has not indicated any changes in employment to date, but based
on a government decision, there may be an effect on the entity's local economy
that will result in a change to expected credit losses.
When developing a reasonable and supportable forecast to estimate
expected credit losses, is probability weighting of multiple economic scenarios
required?
No. Topic 326 does not require an entity to probability weight multiple
economic scenarios when developing an estimate of expected credit losses. One
entity may choose to probability weight multiple economic scenarios when
developing its estimate of expected credit losses, while another entity may rely
on a single economic scenario to develop reasonable and supportable
forecasts.
Is there a standard threshold that can be used to adjust historical loss
information? For example, in the most recent FASB Staff Q&A, Topic 326, No.
1, Whether the Weighted-Average Remaining Maturity Method Is an Acceptable
Method to Estimate Expected Credit Losses (Q&A 1), the staff assumed a
0.25 percent qualitative adjustment to represent both current conditions and
reasonable and supportable forecasts.
No, there is no specific standard threshold regarding adjustments for
current conditions and reasonable and supportable forecasts. The objective of
Topic 326 is to present an entity's estimate of the net amount expected to be
collected on the financial asset or group of financial assets. The standard does
not require a specific credit loss method; rather, it requires that an entity
use judgment in determining the relevant information and estimation methods that
are appropriate in its circumstances. This includes adjustments to historical
loss information for current conditions and reasonable and supportable
forecasts. The 0.25 percent adjustment used in Q&A 1 was an example of one
way to incorporate a qualitative adjustment for both current conditions and
reasonable and supportable forecasts. How management quantified the qualitative
adjustment was not highlighted in the example.
What should an entity do if it cannot forecast estimated credit losses
over the entire contractual term (adjusted for prepayments)?
An entity is not required to develop forecasts over the entire
contractual term (adjusted for prepayments) of the financial asset or group of
financial assets. For periods beyond which the entity is able to make or obtain
reasonable and supportable forecasts of expected credit losses, it is required
to revert to historical loss information that reflects expected credit losses
during the remainder of the contractual term (adjusted for prepayments) of the
financial asset or group of financial assets.
Update 2016-13
provides entities with flexibility to determine the expected credit losses and
does not require an entity to develop reasonable and supportable forecasts for
the entire expected remaining life of a loan (that is, contractual term adjusted
for prepayments), such as a 30-year mortgage. Therefore, the Board included
guidance on how an entity should estimate expected credit losses for those
periods beyond the reasonable and supportable forecast period. The periods after
the reasonable and supportable forecast periods are often referred to as the
"reversion period" and "post-reversion period," as applicable. When reverting to
historical loss information, an entity should (1) consider whether the
historical loss information is still relevant to estimating expected credit
losses (that is, in accordance with paragraph 326-20-30-8, an entity may
consider adjusting its historical loss information for differences in current
asset-specific risk characteristics) and (2) not adjust historical loss
information in the reversion period and post-reversion periods for existing
economic conditions or expectations of future economic conditions.
Can an entity adjust the historical loss information used in the
reversion period for existing economic conditions or expectations of future
economic conditions when developing estimates of expected credit losses?
No. For periods beyond which an entity is able to make or obtain
reasonable and supportable forecasts of expected credit losses, it should revert
to historical loss information determined in accordance with paragraph
326-20-30-8 that reflects expected credit losses during the remainder of the
contractual term (adjusted for prepayments) of the financial asset or group of
financial assets. The entity should not adjust historical loss information for
existing economic conditions or expectations of future economic conditions for
periods that are beyond the reasonable and supportable period.
The
Board decided to require that an entity revert to historical loss information
without adjusting historical loss information for economic conditions beyond the
reasonable and supportable period to simplify the estimation process. However,
this historical loss information should be adjusted for differences in current
asset-specific risk characteristics in accordance with paragraph 326-20-30-8.
The Board understands that an entity may need additional guidance on how to
measure expected credit losses as it estimates losses in periods of increasing
uncertainty and decreasing precision. The reversion to an entity's
historical loss information emphasizes the relevance of known loss experience
that has occurred in the past on similar financial assets or groups of financial
assets and addresses preparers' concerns about the reliability of estimating
those credit losses in periods of declining precision.
Is an entity required to revert to historical loss information on a
straight-line basis?
No. Although an entity is required to revert to historical loss
information for periods that cannot be forecasted based on reasonable and
supportable information, the Board did not prescribe a single methodology for
reverting to historical loss information. Instead, the Board stated that an
entity may revert to historical loss information immediately on a straight-line
basis or using another rational and systematic basis. In addition, the guidance
permits an entity to apply different reversion methods for different inputs and
asset classes.
The Board understands that an entity may need
additional guidance on how to measure expected credit losses as it estimates
losses in periods of increasing uncertainty and decreasing precision. The
reversion to an entity's historical loss information emphasizes the relevance of
known loss experience that has occurred in the past on similar financial assets
and addresses preparers' concerns about the reliability of estimating those
credit losses in periods of declining precision.
Ultimately, an
entity should use judgment in determining which reversion technique is most
appropriate at the reporting date. For example, an entity identifies that a
factory in its local economy will be closing in two years. As part of the
entity's reasonable and supportable forecast, it considers the effect the
closure will have on collecting its outstanding loan balances. The expected
contractual term (adjusted for prepayments) of remaining loans exceeds the
two-year reasonable and supportable forecast period, and, therefore, the entity
will need to revert to historical loss information. The entity decides to apply
a straight-line technique when reverting to historical loss information because
the factory closing will continue to affect the collectibility of outstanding
loan balances for periods beyond the reasonable and supportable forecast period.
In this instance, it may not be appropriate to immediately revert to historical
loss information because there may be a prolonged effect on the entity's ability
to collect on contractually owed cash flows because employees of the factory may
be unemployed for a long time. Alternatively, an entity may capture the extended
impact of the closure in its qualitative adjustments.
In contrast,
an immediate reversion methodology could be appropriate when an entity may be
able to develop a reasonable and supportable forecast only for a market-based
input (such as home prices) that covers one year.
The reversion
method is not a policy election but rather a component of the overall estimate
of expected credit losses. Like other components used to measure expected credit
losses, an entity should support the reversion methodology and period it uses to
develop its estimates of expected credit losses. Additionally, reversion to
historical loss information, whether immediately or on a straight-line basis or
using another reasonable methodology, is required only for periods that cannot
be forecasted based on reasonable and supportable information.