By now, we’ve all heard the headlines: ASC 326 introduces a new way of measuring credit losses inherent in financial assets. No longer will entities apply the old “incurred loss model” when measuring impairment of financial assets. This incurred loss model required an entity to book a loss when it was probable that a loss-causing event had occurred, and the amount of loss was reasonably estimable. Instead, ASC 326 introduces new credit loss models depending on the type of financial asset being measured for impairment. You can read an overview of each of the new impairment models here. Today, we’ll focus on one model in particular.
For most instruments measured at amortized cost, such as loan receivables and trade receivables, the new model is known as the Current Expected Credit Loss model, or the CECL model. Under this CECL model, there is no threshold for recognition (in other words, it does not need to be probable that a loss event has occurred). Instead, as Rachel wrote about in this blog post, the guidance requires entities to utilize an allowance for credit losses to reflect lifetime expected credit losses on in-scope financial assets (in other words, we’re recognizing the credit risk in a portfolio, regardless of probability of loss). Lifetime. This means, at the time of asset origination or acquisition, the entity must estimate lifetime losses and recognize these losses via the establishment of a loss allowance, with the offsetting entry via net income. This entry is made even if the risk of loss is remote (unless, of course, the entity can assert that the risk of loss is zero, which we discussed in this post). That is a huge change in thought from current practice!
Forecasting expected credit losses
Forecasting the expected credit losses over the lifetime of an asset involves a large degree of judgement and subjectivity. FASB requires forecasts of future conditions and notes they need to be both reasonable and supportable. However, no definition was given for “reasonable and supportable.”
Some of the factors that an entity should consider when making reasonable and supportable forecasts include:
- Environmental factors of the entity’s credit concentrations or borrower
- Regulatory, legal or technological environment
- Market condition of geographical area or the industry
- Expected changes in international, national, regional and local economic and business conditions
Potential information sources include publicly available external forecasts, internal experts, and external experts. The bottom line about forecasts: data, documentation, and transparency are of utmost importance, because, if you do not document your logic, how can you support it?
So, what about the forecast period? What does “life of loan” really mean? When we teach companies and accounting firms about the new credit impairment standard in the classroom, one of the questions we often get about the forecast period is:
What if we have a portfolio of 30-year mortgage loans. Are you telling me that my entity has to make an estimate of credit losses over the next 30 years?
Well, not necessarily! In today’s post, we’ll explore the guidance in ASC 326, which states that:
Some entities may be able to develop reasonable and supportable forecasts over the contractual term of the financial asset or a group of financial assets. However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information that is reflective of the contractual term of the financial asset or group of financial assets.
Reversion to historical loss information
A forecast does not need to be developed for the full remaining contractual life. Instead, entities are able to revert to historical loss information. The FASB is flexible here as well, with three reversion method options:
- Any other “rational and systematic” approach
What’s more? When an entity does revert back to historical information, it should NOT adjust historical loss information for current economic conditions or expectations about future economic conditions for periods that are beyond the reasonable and supportable forecast period.
Let’s look at some simplistic examples of how these various reversion methods could look in practice. Consider the following case facts:
As you can see, we are assuming no prepayments and no troubled debt restructurings (TDRs) to allow us to simplify this illustration. Let’s look at immediate reversion first.
As you can see, the adjustment factor is taken in full in Year 1. Then, for the remaining years in the contractual term, only the historical loss percentage is applied. As we’ll see, this will result in a lower allowance for credit losses than the straight-line reversion method. All in all, it’s a fairly straightforward process. Now, let’s look at straight-line reversion.
In straight-line reversion, the full adjustment factor is still taken in Year 1. However, for the remaining years in the contractual term, only a portion of the adjustment factor is applied. In this scenario, the 0.60% adjustment factor is divided by 5 years (the contractual term) to arrive at a 0.12% reduction of the adjustment factor each year. This means that, all things being equal, this will result in a higher allowance for credit losses than the immediate reversion method.
And, of course, there is always the third option of some “other rational and systematic approach”. But remember, the approach taken should be applied consistently to pools of financial assets and should be driven by the approach the results in the best estimate of expected credit losses…NOT the approach that either pads the allowance for credit losses or keeps the entity’s allowance for credit losses low.
Remember, ASC 326 is not meant to be a prescriptive standard. It allows for a lot of flexibility to allow entities to choose the methodology that best reflects the pools of financial assets they have on the books. Collecting the right data, documenting your methodology, and applying the guidance consistently are key to achieving a sound, GAAP-compliant allowance for credit losses. Looking to stay up to date with all the discussions regarding CECL implementation? Make sure you check out the FASB’s TRG page.
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