Heads Up — FASB settles on single impairment model for financial assets
Volume 19, Issue 33
by Sara Glen, Adrian Mills, and Ana Zelic, Deloitte & Touche LLP
Introduction
On December 20, 2012, the FASB issued a proposed ASU1 to obtain feedback on its current expected credit loss (CECL) model for accounting for the impairment of financial assets. Unlike the current impairment models under U.S. GAAP, the proposed CECL model is a single impairment approach for financial assets measured at amortized cost or fair value through other comprehensive income (FV-OCI) that would apply regardless of the form of the asset (e.g., loan versus debt security).2 Under the CECL model, a reporting entity would recognize an impairment allowance equal to the current estimate of expected credit losses (i.e., all contractual cash flows that the entity does not expect to collect) for financial assets as of the end of the reporting period. Comments on the proposal are due April 30, 2013.
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Editor’s Note: The CECL model is the third impairment model the FASB has exposed for comment (this proposal and the first model were FASB-only, and the second model was a supplementary document published jointly with the IASB in January 2011). Through June 2012, the FASB and the IASB jointly deliberated a three-bucket impairment model for financial assets. However, after constituents expressed significant concerns that the joint model could be difficult to understand, operationalize, and audit, the FASB separately decided to develop an alternative impairment model. Because it did not receive similar feedback from its constituents, the IASB tentatively decided to continue deliberations of the jointly developed model and has recently concluded those deliberations. However, the boards may resume joint deliberations after they receive comments on their respective proposals. The IASB plans to issue an exposure draft on impairment in the first quarter of 2013. See Appendix E in the attached PDF for a comparison of the FASB’s proposed model and the IASB’s current thinking on impairment. |
Overview
Scope
The CECL model would apply to all financial assets measured at amortized cost or FV-OCI;3 however, in certain limited circumstances, a practical expedient would be permitted (see Relief From the CECL Model for Certain High-Quality Debt Instruments below). Reinsurance receivables that result from insurance transactions within the scope of ASC 944,4 trade and lease receivables, and loan commitments not measured at fair value through net income (FV-NI) would be included in the model’s scope.
Expected Loss Approach
Under the current impairment models in U.S. GAAP (often referred to as incurred loss models), an impairment allowance is recognized only after a loss event (e.g., default) has occurred or its occurrence is probable. The CECL model, however, does not include a recognition threshold. Rather, at the end of each reporting period, the impairment allowance is recognized on the basis of expected credit losses (i.e., contractual cash flows not expected to be collected). Further, the CECL model would not prescribe a unit of account (e.g., an individual asset or a group of financial assets) to be used in the measurement of credit impairment.
Credit impairment would be recognized as an allowance — or contra-asset — rather than as a direct write-down of the amortized cost basis of a financial asset. An entity would, however, write off the carrying amount of a financial asset if “the entity [ultimately] determines that it has no reasonable expectation of future recovery. The allowance for [the] expected credit losses shall be reduced by the amount of the financial asset balance written off. Recovery of a financial asset previously written off shall be recognized by recording an adjustment to the allowance for expected credit losses only when consideration is received.”
If financial assets are measured at FV-OCI and the practical expedient5 is not used, the estimate of expected credit losses would be recognized in earnings6 and presented as a contra-asset that reduces the amortized cost of the asset, while a change in fair value resulting from noncredit components would be recognized in OCI.
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Editor’s Note: Both the FASB’s and the IASB’s proposed impairment models are based on expected credit losses and may address some constituents’ concerns that recognition of incurred losses is “too little, too late.” |
In addition, the CECL model would replace the current guidance under U.S. GAAP (ASC 310-30, formerly SOP 03-37) on the accounting for purchased credit-impaired (PCI) assets (see Appendix A in the attached PDF for additional information) and would add explicit nonaccrual accounting guidance (see Appendix B in the attached PDF for more information, including other aspects of the new model).
For a comparison of current U.S. GAAP and the FASB’s proposed impairment model, see Appendix D in the attached PDF.
Measurement of Expected Credit Losses
The proposed ASU requires the estimate of current expected credit losses to:
- Incorporate the time value of money.
- Reflect all “internally and externally available information considered relevant in making the estimate. That information includes information about past events, including historical loss experience with similar assets, current conditions, and reasonable and supportable forecasts and their implications for expected credit losses.”
- Reflect at least two possibilities: (1) that a credit loss exists and (2) that no credit loss exists. A probability-weighted calculation that includes more than these two possibilities is not required but may be used. Furthermore, the estimate would not represent a best- or worst-case scenario or the entity’s best point estimate of expected credit losses.
- Reflect “how credit enhancements (other than those that are freestanding contracts) mitigate expected credit losses.”8
Although the estimate of expected credit losses must incorporate multiple possible outcomes and the time value of money, entities would not be required to perform a discounted cash flow analysis for individual securities at the end of each reporting period. A number of measurement approaches satisfy the requirements of the CECL model and could therefore be used by entities to develop an estimate of expected credit losses. Some alternatives specifically mentioned in the proposed ASU include “loss-rate methods, roll-rate methods, probability-of-default methods, and a provision matrix method using loss factors.” The FASB also notes in the proposed ASU that using the fair value of collateral (less estimated costs to sell) for collateral-dependent loans implicitly satisfies the requirements.
In addition, for loan commitments within the proposal’s scope, an entity would be required to “estimate [expected] credit losses over the full contractual period over which the entity is exposed to credit risk [under an unconditional] present legal obligation to extend credit.” Such an estimate would take into account both the likelihood that funding will occur and the expected credit losses on commitments to be funded.
Relief From the CECL Model for Certain High-Quality Debt Instruments
During the FASB’s outreach activities, some constituents expressed concerns about potentially having to record small impairments on high-quality debt instruments in a gain position (i.e., fair value exceeds carrying amount) because the proposed model would require the calculation of an expected value that incorporates the possibility of loss. To alleviate this concern, the FASB decided to provide a practical expedient for financial assets measured at FV-OCI. Under the practical expedient, entities would not be required to record an impairment allowance for such assets if both of the following conditions are met:
- The fair value of the financial asset exceeds its amortized cost.
- The amount of expected credit loss for the financial asset is insignificant.
Impact on Entities
The guidance in the proposal could significantly affect entities whose financial assets are within its scope. Such entities may need to perform an assessment of their financial systems to evaluate their ability to support a new set of impairment procedures, which will have to be applied to all financial assets within the proposal’s scope (not just those with “incurred losses”).
Effective Date and Transition
The proposed ASU would require entities to record a cumulative-effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is effective. An effective date for the final guidance has not yet been proposed.
Appendixes A–F
Appendixes on the following specific topics related to the new impairment model are included in the 11-page Heads Up attached below.
- Appendix A — Application of the CECL Model to PCI Financial Assets
- Appendix B — Other Aspects of the CECL Model
- Appendix C — Presentation and Disclosure Requirements
- Appendix D — A Comparison of Current U.S. GAAP and the FASB’s Proposed Model
- Appendix E — A Comparison of the IASB’s Tentative Decisions and the FASB’s Proposed Model
- Appendix F — Impairment Models Under U.S. GAAP
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1 FASB Proposed Accounting Standards Update, Financial Instruments — Credit Losses.
2 Note that the proposed model replaces several existing U.S. GAAP impairment models. See Appendix F in the attached PDF for a tabular summary of those models.
3 These two categories (amortized cost and FV-OCI) stem from the FASB’s project on the classification and measurement of financial instruments. For more information about the FASB’s tentative decisions on classification and measurement, see Deloitte’s September 24, 2012, Heads Up.
4 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
5 See discussion in Relief From the CECL Model for Certain High-Quality Debt Instruments.
6 In addition, as decided by the FASB in its project on classification and measurement of financial instruments, foreign-currency gains and losses on foreign-currency-denominated debt securities classified at FV-OCI would also be recognized in earnings.
7 AICPA Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer.
8 The proposed ASU states, “A freestanding contract is entered into either: (a) Separate and apart from any of the entity‘s other financial instruments or equity transactions (b) In conjunction with some other transaction and is legally detachable and separately exercisable.”
