Accounting for credit losses could change significantly under new FASB rules

A proposed change by the Financial Accounting Standards Board (FASB), as outlined in proposed Accounting Standards Update, Financial Instruments—Credit Losses (Subtopic 825-15), could significantly change the way banks account for credit losses.

Initial recommendation

On December 20, 2012, FASB proposed that loans held by banks or other financial institutions to maturity would have to follow what the FASB dubs the “Current Expected Credit Losses” (CECL) model.

The proposal would require that banks and other financial institutions recognize losses from loans and other financial assets earlier than they do under current US GAAP. In the early stages of the 2008 financial crisis, the FASB believes that many banks had balance sheets that looked healthy, even though losses were soaring as the mortgage market worsened.

The initial recommendations were more conservative than many banks preferred, requiring the timely recognition of all expected credit losses (as opposed to maintaining a threshold that must be met before all expected credit losses are recognized or permitting recognition of only some expected credit losses). Under the proposal, banks and other financial businesses would be required to assess all reasonable, future losses on all types of assets.

Because almost any loan or asset is at risk of deteriorating in the future, banks would be required to take a counterintuitive “day one” loss for all loans, regardless of credit quality. In addition, banks expressed concern that the new regulations could have a potential impact on regulatory capital requirements.

On the other hand, during FASB’s comment period, investors and non-bank users preferred a model that recognizes all expected credit losses, rather than maintaining a threshold that must be met before all expected credit losses are recognized or permitting recognition of only some expected credit losses.

Revisions and future changes

On March 12, 2014, after the comment period had ended, the FASB modified its plan, deciding that the model would apply only to instruments measured at amortized cost, as opposed to all financial products. In essence, the new model distinguishes between debt securities and loans, rather than treating all debt instruments as equivalent.

The FASB still has to settle how to apply the CECL model to financial assets that are measured at fair value with changes recorded in other comprehensive income, which is applied to debt instruments a bank plans to sell. For now, the board has decided to simplify the calculation of the assets' losses. A bank would not have to recognize the expected losses if the asset's fair value equals or exceeds its amortized cost basis.

The FASB also decided that if the asset's fair value is less than its amortized cost, it should apply a modified version of the CECL model by recognizing expected credit losses in net income. The loss that's recorded would be limited to the difference between an asset's fair value and its amortized cost basis. Essentially, these simplifications would apply to assets that are of high credit quality.

The FASB next plans to discuss whether it should explore loss-estimate guidance for assets measured at fair value with changes recorded in other comprehensive income. The board wants to finalize the impairment model and publish an update to US GAAP by the end of 2014, according to the project timeline on the FASB's website.

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