The New Challenge-Current Expected Credit Loss
By Roberto Bolanos
The Financial Accounting Standards Board issued Accounting Standards Update 2016-13, Financial Instruments – Credit Losses – Measurement of Credit Losses on Financial Instruments (ASU 2016-13) on June 16, 2016. ASU 2016-13 impacts entities holding financial assets and net investment in leases that are not accounted for at fair value through net income.
This is in response to the distinct flaw in the incurred loss methodology – recording credit losses only when it is probable that a loss has been incurred. It replaces the incurred loss methodology with an expected loss methodology, a forward-looking and progressive approach of recording credit losses.
ASU 2016-13 affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.
The expected loss methodology referred to as current expected credit losses (CECL) model presents new challenges to entities. Although a financial institution’s core business may be affected the most, all other entities that have assets that represent the right to receive cash that are carried at amortized cost will be affected.
Under the CECL model, an entity is required to recognize the expected credit loss based on the estimate of contractual cash flows that are expected to not be collected over the life of the financial asset.
On Day 1 (upon initial recognition), entities are required to estimate the expected credit losses over the life of the financial assets or pool of financial assets. The estimate is based on past events, historical credit loss experience with similar assets, current economic conditions (including macroeconomic factors), and reasonable and supportable forecasts. This will generally result in the early recognition of credit losses and will also likely result in the recognition of larger allowances.
ASU 2016-13 requires that financial instruments with similar risk characteristics be aggregated when estimating the expected credit losses. It also does not prescribe a particular method to estimate the credit losses, so it will require significant judgment on the part of management.
The initial estimate and subsequent changes in the estimates are reported in current earnings. The allowance for losses is recorded in the balance sheet.
There is a significant change from the current model of recognizing other-than-temporary impairment for available-for-sale (AFS) securities. Under the CECL model, an estimate of expected credit losses is required only when the fair value is below the amortized cost of the asset.
The length of time an AFS security’s fair value is below the amortized cost will no longer impact the determination of whether a credit loss exists. Under the CECL model, credit losses on AFS securities are limited to the difference between the fair value and the amortized cost.
Entities are required to recognize an allowance for credit losses, rather than reduce the amortized cost of the AFS, which is the current practice. This approach will allow entities to reverse the allowance for credit losses once there is an improvement in credit and the resulting change is immediately recognized in current earnings.
For assets purchased with deteriorated credit quality that are measured at amortized cost, the allowance for credit loss determined on Day 1 is added to the purchase price and not recognized as credit loss expense. Only subsequent changes in the allowance are recognized as credit losses in current earnings.
Interest income on these assets is recognized based on the effective interest method and should exclude the allowance for credit losses determined on Day 1.
Public business entities that are U.S. Securities and Exchange Commission (SEC) filers are required to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination (or vintage). The vintage information disclosure is not required for all other reporting entities.
For AFS securities, a roll forward of the allowance for credit losses is required. Entities are also required to disclose information about changes in the factors that management used to determine the estimate of credit losses, including the reasons for the changes.
ASU 2016-13 supersedes other impairment models, and will result in reduced complexity and a consistent measurement approach. Since the CECL model does not prescribe a particular method, it allows entities to use a variety of models in estimating the expected credit losses.
There are a number of challenges in the implementation of CECL. These include availability and transparency of data; capability to design and build models; effective coordination among finance, credit, IT and others; and changes to systems and control processes.
Comparison with IFRS 9 – Financial Instruments
The impairment model in ASU 2016-13 and IFRS 9 would both result in earlier recognition of credit losses. Some high-level differences include:
- Timing of when the expected credit losses are recognized. Under the CECL model, the full amount of expected credit losses are recognized for all financial assets measured at amortized cost on Day 1, whereas IFRS 9 requires that an allowance for credit losses equal to the 12 month expected credit losses be recognized on Day 1, and adjusted only when there is a significant increase in credit risk when lifetime expected credit losses are recognized.
- Under the CECL model, aggregation of instruments with similar risk characteristics is required to estimate the expected credit losses. Under IFRS 9, the measurement of expected credit losses must reflect a probability-weighted amount. IFRS 9 allows collective evaluation of credit losses based on shared risk characteristics; however, unlike the CECL model, the probability-weighted outcomes must first be considered.
- For public entities, the CECL model requires the amortized cost basis of financing receivables and net investment in leases to be disclosed by credit quality indicator, disaggregated by year of origination. Under IFRS 9, an entity is required to disclose a reconciliation of the financial assets relating to the allowance for credit losses from the opening balance to the closing balance. Entities are also required to explain how significant changes in the gross carrying amounts of financial assets during the period contributed to the changes in the allowance for credit losses.
Interaction with IFRS 9 and Basel III
Basel III’s main goal is the timely recognition of, and provision for, credit losses to promote safe and sound banking systems and play an important role in bank regulation and supervision. The IFRS 9 and CECL models introduce fundamental qualitative and quantitative changes to banks’ provisioning practices, as higher provisions are possible with the lifetime loss concept and the inclusion of forward-looking information in assessing and measuring credit losses.Furthermore, the new provisioning guidance might cause more volatility in regulatory capital.
There are points of convergence between Basel III, IFRS 9 and CECL. Inputs used in Basel III processes can be used in building the IFRS 9 and CECL models including credit loss/delinquency data, trading and market and other external data. Banks can mine these data as key inputs when building expected credit loss models.
Under Basel III, the expected loss estimates use a 12 month probability of default. Furthermore, collection costs are factored in when estimating the expected credit loss. Under the IFRS 9 and CECL models, collection costs are not included.
These differences could result in a higher or lower credit loss compared to IFRS 9 and the CECL models. Although a shift to the lifetime expected credit loss approach would likely result in a higher provision in many cases.
For public entities that are SEC filers, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For all other entities, it is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.
Early application is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
IFRS 9 is effective for annual reporting periods beginning on or after January 1, 2018. Earlier application is also permitted under IFRS 9.
There are a lot of moving pieces involved in implementing the CECL model – the key is to plan ahead. As early as now, entities should identify which financial assets are affected, consider which processes and controls should be changed, and estimate the impact. When implemented properly, the CECL model presents opportunities for improving the operational and business processes of an organization.