On the Radar
The approach used to recognize impairment losses on financial assets has long been
identified as a major weakness in current U.S. GAAP, resulting in delayed
recognition of such losses and leading to increased scrutiny. Accordingly, the FASB
issued ASU 2016-13 to amend its guidance on the impairment of
financial instruments. The ASU adds to U.S. GAAP an impairment model known as the
current expected credit loss (CECL) model, which is based on expected losses rather
than incurred losses. The objectives of the CECL model are to:
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Reduce the complexity in U.S. GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments.
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Eliminate the barrier to timely recognition of credit losses by using an expected loss model instead of an incurred loss model.
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Require an entity to recognize an allowance of lifetime expected credit losses.
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Not require a specific method for entities to use in estimating expected credit losses.
Guidance Applies to More Than Just Banks
The new guidance will significantly change the accounting for
credit impairment. Although the new CECL standard has a
greater impact on banks, most nonbanks have financial
instruments or other assets (e.g., trade receivables,
contract assets, lease receivables, financial guarantees,
loans and loan commitments, and held-to-maturity [HTM] debt
securities) that are subject to the CECL model. While banks
and other financial institutions (e.g., credit unions and
certain asset portfolio companies) have been closely
following standard-setting activities related to the new
CECL standard, are actively engaged in discussions with the
FASB and the TRG, and are far along in the implementation
process, many nonbanks may not have started evaluating the
effect of the CECL model. Nonbanks that have yet to adopt
the guidance should (1) focus on identifying which financial
instruments and other assets are subject to the CECL model
and (2) evaluate whether they need to make changes to
existing credit impairment models to comply with the new
standard.
Reduction in Impairment Models
The FASB set out to establish a one-size-fits-all model for measuring expected
credit losses on financial assets that have contractual cash flows. Ultimately,
however, the FASB determined that the CECL model would not apply to
available-for-sale (AFS) debt securities, which will continue to be assessed for
impairment under ASC 320.
No impairment model is needed for financial assets
measured at fair value (e.g., trading securities or
other assets measured at fair value by using the
fair value option) because the assets are measured
at fair value in every reporting period.
The diagram below depicts the impairment models
in current U.S. GAAP that are being replaced by the CECL model.
Although the FASB was not able to develop a single impairment model for all
financial assets, it did achieve its objective of reducing the number of
impairment models in U.S. GAAP.
Expected Losses Versus Incurred Losses
Unlike the incurred loss models in existing U.S. GAAP, the CECL model does not
specify a threshold for recognizing an impairment allowance. Rather, an entity
will recognize its estimate of expected credit losses for financial assets as of
the end of the reporting period. Credit impairment will be recognized as an
allowance — or contra-asset — rather than as a direct write-down of the
amortized cost basis of a financial asset.
Estimates Represent Lifetime Losses
An entity’s estimate of expected credit losses should reflect
the losses that occur over the contractual life of the financial asset. When
determining the contractual life of a financial asset, an entity is required to
consider expected prepayments either as a separate input in the method used to
estimate expected credit losses or as an amount embedded in the credit loss
experience that it uses to estimate such losses. The entity is not allowed to
consider expected extensions of the contractual life unless (1) extensions are a
contractual right of the borrower or (2) the entity has a reasonable expectation
as of the reporting date that it will execute a TDR with the borrower.1
An entity must consider all available relevant information when estimating
expected credit losses, including details about past events, current conditions,
and reasonable and supportable forecasts and their implications with respect to
expected credit losses. That is, while the entity can use historical charge-off
rates as a starting point for determining expected credit losses, it has to
evaluate how conditions that existed during the historical charge-off period may
differ from its current expectations and accordingly revise its estimate of
expected credit losses. However, the entity is not required to forecast
conditions over the contractual life of the asset. Rather, for the period beyond
the period for which the entity can make reasonable and supportable forecasts,
the entity reverts to historical credit loss experience.
No Prescribed Method
The FASB believes that the impairment allowance should reflect
management’s expectations regarding the net amounts expected to be
collected on a financial asset and that, because entities manage credit risk
differently, they should have flexibility when reporting those expectations. As
a result, the FASB did not require entities to use a specific method when
measuring their estimate of expected credit losses. Accordingly, an entity can
select from a number of measurement approaches to determine the allowance for
expected credit losses. Some approaches project future principal and interest
cash flows (i.e., a discounted cash flow [DCF] method), while others project
only future principal losses. ASU 2016-13 emphasizes that an entity should use
methods that are “practical and relevant” given the specific facts and
circumstances and that “[t]he method(s) used to estimate expected credit losses
may vary on the basis of the type of financial asset, the entity’s ability to
predict the timing of cash flows, and the information available to the entity.”
Although the method used to measure expected credit
losses may vary for different types of financial
assets, the method used for a particular financial
asset should be consistently applied to similar
financial assets.
The table below summarizes various measurement approaches that an entity could
use to estimate expected credit losses under ASU 2016-13.
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Measurement Approach
|
High-Level Description
|
|---|---|
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DCF method
|
Expected credit losses are determined by comparing the
asset’s amortized cost with the present value of the
estimated future principal and interest cash flows.
|
|
Loss-rate method
|
Expected credit losses are determined by applying an
estimated loss rate to the asset’s amortized cost
basis.
|
|
Roll-rate method
|
Expected credit losses are determined by using historical
trends in credit quality indicators (e.g., delinquency,
risk ratings).
|
|
Probability-of-default method
|
Expected credit losses are determined by multiplying the
probability of default (i.e., the probability the asset
will default within the given time frame) by the loss
given default (the percentage of the asset not expected
to be collected because of default).
|
|
Aging schedule
|
Expected credit losses are determined on the basis of how
long a receivable has been outstanding (e.g., under 30
days, 31–60 days). This method is commonly used to
estimate the allowance for bad debts on trade
receivables.
|
Looking Ahead
Although the FASB has issued several ASUs that amend certain
aspects of ASU 2016-13, the Board continues to seek feedback on the new
guidance. As a result of that feedback, in March 2022, the FASB issued
ASU
2022-02, which eliminates the accounting guidance on TDRs
for creditors in ASC 310-40 and amends the guidance on “vintage disclosures” to
require disclosure of current-period gross write-offs by year of origination.
For entities that have already adopted ASU 2016-13, the amendments in ASU
2022-02 are effective for fiscal years beginning after December 15, 2022,
including interim periods within those fiscal years. For entities that have not
yet adopted ASU 2016-13, the amendments in ASU 2022-02 are effective upon
adoption of ASU 2016-13. Early adoption is permitted in certain circumstances.
See Section 10.2.1
for more information.
In addition, on June 27, 2023, the FASB issued a proposed ASU that would broaden the
population of financial assets that are within the scope of the gross-up
approach currently applied to PCD assets under ASC 326. Accordingly, an asset
acquirer would apply the gross-up approach to all financial assets acquired in a
business combination in accordance with ASC 805 rather than first determining
whether an acquired financial asset is a PCD asset or a non-PCD asset. For
financial assets acquired as a result of an asset acquisition or through
consolidation of a variable interest entity (VIE) that is not a business, the
asset acquirer would apply the gross-up approach to seasoned assets, which are
acquired assets unless the asset is deemed akin to an in-substance origination.
A seasoned asset is an asset (1) that is acquired more than 90 days after
origination and (2) for which the asset acquirer was not involved with the
origination. In addition, the gross-up approach would no longer apply to AFS
debt securities. Comments on the proposed ASU are due by August 28, 2023. The
Board will determine the effective date, as well as whether to permit early
adoption, after considering stakeholder feedback on the proposed ASU.
Footnotes
1
ASU 2022-02, issued in March 2022, eliminates the
concept of a TDR from a creditor’s accounting. As a result, an entity
that has adopted ASU 2022-02 will no longer be able to extend the
contractual term for expected extensions, renewals, and modifications
when it reasonably expects, as of the reporting date, that a TDR will be
executed with the borrower.