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Current Expected Credit Loss Model Presentation


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In response to the 2008 financial crisis, regulators and investors put pressure on the FASB and IASB to develop models that would require financial institutions to recognize losses earlier in the credit cycle. Measuring credit loss on Pools of loans...

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Current Expected Credit Loss Model Presentation

  1. 1. FASB Project Current Expected Credit Loss Model (CECL) Exposure Draft November 20, 2013 Scott N. Drake, CPA Member of the Firm Information and training provided by Smith Elliott Kearns & Company, LLC is intended for reference only. As the information is designed solely to provide guidance to the participants, it is not intended to be a substitute for someone seeking personalized professional advice based on specific factual situations. Although Smith Elliott Kearns & Company, LLC has made every reasonable effort to ensure that the information provided is accurate, Smith Elliott Kearns & Company, LLC and its Members, managers and staff make no warranties, expressed or implied, on the information provided. The participant accepts the information as is and assumes all responsibility for the use of such information.
  2. 2. Background Proposal 2012-260 (Subtopic 825-15) is the culmination of 5 years of efforts by Financial Accounting Standards Board (FASB) to overhaul accounting standards for recognizing credit losses on financial instruments.
  3. 3. Background (continued) Current practice (“I incurred loss model”) allows for loss recognition when losses are “probable.” In response to the 2008 financial crisis, regulators and investors put pressure on the FASB and International Accounting Standards Board (IASB) to develop models that would require financial institutions to recognize losses earlier in the credit cycle.
  4. 4. Background (continued) At their core, the FASB and IASB’s models are similar in that they both require credit losses to be recognized earlier than current standards allow, but they can’t agree on a “converged” approach to do that. In October 2013, they agreed to further develop their individual proposals and then compare notes. The result will most likely be two different standards.
  5. 5. Overview The FASB’s proposal is a single credit loss model for ALL financial assets measured at amortized cost or Fair Value through Other Comprehensive Income. The proposal is based on estimating lifetime credit losses and setting reserves accordingly regardless of expected credit quality.
  6. 6. Overview (Continued) Proposal differs significantly from current US GAAP in that it: • Results in a single approach to credit loss accounting for all financial assets that are debt instruments • Removes the existing “Probable” threshold for recognizing credit losses in US GAAP • Requires the allowance for expected losses to reflect an estimate of contractual cash flows not expected to be collected • Requires estimates to be based on relevant info including reasonable & supportable forecasts
  7. 7. Overview (Continued) • Results in recognition of an allowance for expected credit losses for almost every debt instrument • Changes accounting for purchased credit-impaired assets by requiring an allowance to be recognized at acquisition date Key Point – with the removal of the “probable threshold,” the proposal would no longer require a triggering event to be identified before credit losses are recognized. The concept of credit losses would become primarily a measurement issue – not a recognition issue.
  8. 8. Overview (Continued) Key Point – Generally the proposal is expected to result in larger allowances for credit losses than those under current GAAP. The FASB’s research staff estimates that loss reserves under the proposed model would increase 20% to 45%
  9. 9. Current Expected Credit Losses (CECL) require immediate recognition of the Proposal would current estimate of credit losses expected over the remaining life of the underlying financial assets. Models used to develop the estimate would be required to incorporate each of the following: • Relevant information about expected losses • Time value of money • At least two outcomes, one of which reflects a possible credit loss
  10. 10. Current Expected Credit Losses Key Point – The proposal is principles-based in nature. Applying it in practice would require judgment and interpretations. While the measurement of credit losses would change, the proposal makes clear that many of the methodologies currently used could continue although the inputs used in those approaches would likely need to change.
  11. 11. Current Expected Credit Losses Relevant Information CECL would include historical loss experience, current conditions and reasonable and supportable forecasts. The proposal does not prescribe how current and forecasted conditions should be incorporated into an estimate of credit losses but would permit the following approaches which are consistent with current practice.
  12. 12. Current Expected Credit Losses • Adjust historical loss rates to reflect current conditions and reasonable and supportable forecasts that affect expected cash flows. • Estimate a “credit risk adjustment” to supplement the quantitative calculation similar to how entities currently supplement their quantitative analysis with a qualitative overlay.
  13. 13. Current Expected Credit Losses Time Value of Money • Must be reflected either explicitly or implicitly. • Discounted cash flow approach would be an explicit application. • Application of historical loss rates to amortized cost basis to estimate uncollectible amounts would be an implicit application.
  14. 14. Current Expected Credit Losses Key Point – Proposal would not require specific approaches to be used. Key Point – Proposal does not specify when credit losses are to be estimated on an individual loan basis and when they are to be estimated on a pool basis, thus providing flexibility in the type of approaches and modeling to be used.
  15. 15. Current Expected Credit Losses Considerations for Loans ASC 310-10 and ASC 450-20 would be superseded by the proposal which does not provide any unit of measure guidance. Key Point – Entities could continue to follow the approach currently used for credit loss estimates of individual loans and portfolios of loans.
  16. 16. Current Expected Credit Losses Measuring Credit Losses on Individual Loans Discounted cash flow approach currently used by many entities to measure losses on individual loans would generally be acceptable under the proposal. Key Point – Current GAAP requires allowance to be remeasured only when there has been significant changes in expected cash flows. Proposal would require changes to the allowance each reporting period regardless of significance.
  17. 17. Current Expected Credit Losses Measuring Credit Losses on Individual Loans (Continued) • Collateral dependent loan would be defined as one in which repayment is expected to be provided “primarily” through the operation or sale of the collateral “by the lender” • Current GAAP requires collateral values to be used where foreclosure is probable. The proposal would permit, not require the use of collateral in those situations • Loan’s observable market price would no longer be permitted to measure credit losses
  18. 18. Current Expected Credit Losses Measuring Credit Losses on Pools of Loans Proposal changes the approach from measuring “probable” losses to one that measures expected losses over a loan’s lifetime. Key Point – This is most likely the area that would require significant adjustments to credit loss estimation models.
  19. 19. Current Expected Credit Losses Measuring Credit Losses on Pools of Loans (Continued) Approaches based on historical loss rates may satisfy the requirements of an expected loss model (e.g. time value of money and at least two possible outcomes) if the approach incorporates reasonable and supportable economic forecasts either through adjustments to individual loss rates or on overlay to calculated unmodified loss rates.
  20. 20. Current Expected Credit Losses Illustration 1: Estimation based on loss rate approach Entity A has developed current expected loss rates by risk rating for five year commercial mortgage loans based on historical loss data updated for current conditions and reasonable and supportable forecasts of collectability of cash flows Expected loss rates are applied to the amortized cost basis of the assets
  21. 21. Current Expected Credit Losses
  22. 22. Current Expected Credit Losses
  23. 23. Current Expected Credit Losses Illustration 2: Estimation using By-Vintage Basis Entity B provides four year amortizing loans for the purchase of farm equipment. Loans are tracked on the basis of calendar year of origination. The pattern of credit loss experience is based on the ratio of amortized cost in each vintage that was written off to original amortized cost basis reflected as a %
  24. 24. Current Expected Credit Losses
  25. 25. Current Expected Credit Losses Effective Date and Transition Proposal has not been finalized and effective date has not been set In fiscal year of adoption the standard would be applied by a cumulative-effect adjustment to retained earnings as of the beginning of the first period for which the guidance is effective
  26. 26. Current Expected Credit Losses Latest Developments On October 23, 2013 the FASB research staff came up with a new approach dubbed the “Gross-Up” approach. It would still require forecasting all foreseeable credit losses and recognize the credit allowance on the balance sheet, but the income statement impact would be amortized over time. The FASB’s pursuit of this approach would likely result in further delays in finalizing the proposal.
  27. 27. Scott N. Drake, CPA Member of the Firm 804 Wayne Avenue Chambersburg, PA 17201 717-263-3910