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The Financial Accounting Standards Board has proposed changing the way financial institutions compute impairment for certain financial assets.

Proposed Accounting Standard Suggests Modifying Calculations for Credit Losses

  • 1/16/2013

Proposed Accounting Standard Suggests Modifying Calculations for Credit Losses

The Financial Accounting Standards Board (FASB) issued a proposal on December 20, 2012, to change the way financial institutions compute impairment for certain financial assets. For most institutions, this will impact the impairment calculations for their loan portfolio, loan commitments, and investment portfolio.

“Overall, the changes have both favorable and unfavorable aspects. Under the proposed standard, financial institutions would need to estimate losses over the life of the loan. This will likely cause organizations to need higher reserves. On the positive side, the proposal reduces the number of impairment methods from five methods to only one method, which will help reduce confusion,” says Tom Danielson, a financial institutions partner at CliftonLarsonAllen.

Currently, losses on loans, loan commitments, and investments are recognized under an “incurred loss” model that delays recognition until a loss is probable or has been incurred. A number of financial statement users think this threshold has delayed the recognition of credit losses. In addition, current U.S. generally accepted accounting principles (GAAP) includes five different models for computing credit impairment losses on the financial assets addressed by this proposal, which many believe makes the accounting unduly complex.

As a result, FASB’s exposure draft suggests replacing the existing five methods with a single “current expected credit loss” model, which will apply to loans, debt securities, and loan commitments.

“Let’s say a bank originates a portfolio of a four year higher-risk car loan and charges a higher interest rate to compensate for the risk it has taken. Under the proposed expected credit loss model, the bank must record a bad debt expense equal to four years of expected charge-offs upon booking the loans. The loans appear to be unprofitable when booked since the losses are all recognized up-front, but the income is recognized over the term of the loan,” explains Danielson.

Key changes

The amount of impairment would be measured based on the current estimate of contractual cash flows not expected to be collected. This estimate will be based on all available information, including historical loss data, current conditions, and reasonable and supportable forecasts. The amount of information that can be considered is broadened.

In addition, losses must now be estimated over the remaining life of the asset. This longer timeframe may cause financial institutions to record larger provisions for credit losses.

The concept of “other than temporary impairment” for available-for-sale investment securities would disappear. The existing rules state that once a credit loss has been recognized, subsequent improvements cannot be immediately recognized. Under the proposed rule, the balance sheet would reflect the fair value of the investments, and the income statement would reflect credit deterioration (or improvement) that has occurred during the period.

Opportunity for comment

Comments on the proposal are due to FASB by April 30, 2013, but no implementation dates have been set.

“If you have concerns about the changes, this is your chance to be heard. FASB takes comment letters seriously — in fact, the overwhelming response to a 2010 exposure draft triggered this major rewrite,” notes Danielson.

How we can help

We encourage all of our financial institution clients to become aware of the implications of this major overhaul to the impairment standard. If you want additional information on how the proposed rule may affect you, please contact your engagement partner.

Tom Danielson, Financial Institutions Partner or 612-376-4795