The Financial Accounting Standards Board has finalized its long-awaited standard giving companies a new, more forward-looking way to account for credit losses in their portfolios.
Undertaken in the wake of the financial crisis, where troubled loans didn’t become apparent to investors and even regulators until an enormous unraveling occurred, Accounting Standards Update No. 2016-13 will require companies to reflect the possibility of loss when they enter a new credit instrument into the books. FASB published a summary of the new standard and posted a video to the board's website to explain the new requirements.
The new standard will require companies to reflect expected credit losses on financial assets based on their historical experience, current market conditions, and even forecasts. Those expected losses must be recorded on day one, even if the instrument is fully performing, to give investors and other users of financial information more information about risk in the portfolio.
That’s a stark contrast from today’s accounting, where companies are prohibited under accounting rules from making any kind of mark down in a loan instrument until a loss is at least “probable.” Given the rapid descent seen during the financial crisis, that can play out disastrously for investors who are looking for earlier warning. Even financial institutions did not like the accounting.
The new standard addresses concerns from a wide range of FASB stakeholders that the existing incurred loss approach is insufficient, said FASB Chair Russ Golden in a statement. “The new guidance aligns the accounting with the economics of lending by requiring banks and other lending institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, providing investors with better information about those losses on a more timely basis,” he said.
In terms of the mechanics of the new requirements, this new allowance for credit losses will be reflected as a valuation account deducted from the amortized cost of the financial asset. That calculation gives investors a number for the net amount that a company reasonably expects to collect. The income statement will reflect expected credit losses for new instruments as well as changes in expected credit losses for instruments carried forward from a prior period.
The standard also requires plenty of disclosure, to help users of financial statements better understand the assumptions and judgments that went into estimating the loss. Companies will have some latitude to determine how they will arrive at their loss estimates. The standard does not prescribe a uniform method every company must follow, but allows each company to use its own judgment about what information and estimation methods are most relevant to them.
Although FASB initially sought to issue a standard that would be converged with the rules under International Financial Reporting Standards, the new standard is different from the forward-looking approach chosen by the International Accounting Standards Board. Under IFRS, companies will not begin reflecting losses before a given instrument begins to show signs of trouble, although the method under IFRS will still accelerate the recognition compared with current accounting.
Getting plenty of pusback from smaller banks on how the requirements would be scaled to their needs, FASB took the unusual step of publishing a separate cost-benefit analysis to explain the new standard. "Overall, the FASB concluded that the expected benefits of the amendments in the new ASU justify the anticipated costs," the board wrote.
The new standard takes effect for calendar-year public companies in 2020, the year after a new standard for lease accounting takes effect, and two years after new rules on revenue recognition and financial instruments are adopted, both of which take effect in 2018.