A new accounting standard on credit losses goes into effect in 2020 for public companies and 2021 for private companies. It will result in earlier recognition of losses and expand the range of information considered in determining expected credit losses. Here is how the new methodology differs from existing practice.
Existing model
Under existing U.S. Generally Accepted Accounting Principles, financial institutions must apply an ‘incurred loss’ model when recognizing credit losses on financial assets measured at amortized cost. This model delays recognition until a loss is ‘probable’ (or likely) to be incurred, based on past events and current conditions.
The Financial Accounting Standards Board (FASB) found that, leading up to the global financial crisis, financial statement users made independent estimates of expected credit losses using forward-looking information and then devalued financial institutions before the institutions were permitted to recognize the losses. This practice made it clear that the requirements under GAAP were not meeting the needs of financial statement users.
New-and-improved model
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326), introduces a new “current expected credit loss” (CECL) model. The CECL model requires financial institutions to immediately record the full amount of expected credit losses in their loan portfolios based on forward-looking information, rather than waiting until the losses are deemed probable based on what has already happened. The FASB expects this change to result in more timely and relevant information.
The measurement of expected credit losses will be based on relevant information about past events (including historical experience), current conditions, and the “reasonable and supportable” forecasts that affect the collectibility of the reported amount.
Specifically, an allowance for credit losses will be deducted from the amortized cost of the financial asset to present its net carrying value on the balance sheet. The income statement will reflect the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the relevant reporting period.
Companies will be allowed to continue using many of the loss estimation techniques currently employed, including loss rate methods, probability of default methods, discount cash flow methods, and aging schedules. In addition, the inputs of those techniques will change to reflect the full amount of expected credit losses and the use of reasonable and supportable forecasts.
We can help
The updated guidance does not prescribe a specific technique to estimate credit losses — rather, companies can exercise judgment to determine which method is appropriate. Contact us if you need help finding the optimal method for identifying and quantifying credit losses, along with complying with the expanded disclosure requirements.