Purpose
The Financial Accounting Standards Boards (FASBs), ASC 326, Financial Instruments- Credit Losses provide comprehensive guidance on accounting for credit losses on financial instruments and disclosures. Under legacy GAAP, the credit losses on financial instruments were recognized under “incurred loss” methodology i.e., credit losses were recognized only when it was probable that a loss has been incurred. This approach did not encourage the preparers of financial statements to record credit losses that were expected but did not yet meet the “probable” criteria and failed to prevent the events leading up to the global financial crisis of 2008. Post-crisis, various stakeholders, including regulators acknowledged the limitation of existing guidance and realized the need for a comprehensive and forward-looking approach towards estimating expected credit losses, resulting in the introduction of a new credit impairment model- Current Expected Credit Losses (CECL). This publication provides an overview of the requirements, implementation matters, and key considerations related to the CECL impairment model (ASC 326-20) for financial assets measured at amortized cost and the available-for-sale (AFS) debt security impairment model (ASC 326-30). The technical views and accounting positions on the framework continue to evolve depending on further technical evaluations and their outcomes. We sincerely hope you find the enclosed publication informative. We will be happy to participate in any discussions to clarify our views, which are enclosed in the attached publication. We look forward to hearing from you.
Background
In order to address the concern of stakeholders that credit losses were identified and recorded “too little, too late” in the period under, incurred loss model of credit impairment, In 2016, FASB issued the Accounting Standard Update (ASU) 2016-13 codified under ASC Topic 326 Financial Instruments – Credit Losses replacing the “incurred-loss” methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to estimate the credit losses on financial instruments. The ASU adds to US GAAP an impairment model known as the current expected credit loss (CECL) model, which is based on expected losses rather than incurred losses. The objectives of the CECL model are to:
- Reduce the complexity in US GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments.
- Eliminate the barrier to timely recognition of credit losses by using an expected loss model instead of an incurred loss model.
- Require an entity to recognize an allowance of lifetime expected credit losses.
- Not require a specific method for entities to use in estimating expected credit losses.
Impairment Model- “Expected Loss” Vs “Incurred Loss”
The table below summarizes the key differences between the legacy credit Impairment model and the Current Expected Credit Loss (CECL) model under ASC 326
To read more, download the pdf.
Summary of Topic
Current Expected Credit Loss Impairment model (ASC 326-20)
The first and foremost step in determining credit impairment loss is the identification of financial assets within the scope of ASC 326.
(a) Scope Inclusion:
Category 1: Financial assets measured at amortized cost
Category 2: Net investment in leases recognized by a lessor
Category 3: Off-balance-sheet credit exposures not accounted for as insurance
Category 4: Reinsurance recoverable
(b) Scope Exclusion:
Financial assets measured at Fair Value – Loans and Debt Securities measured at fair value through net income are not within the scope of CECL. Changes in fair value are recognized immediately in earnings.
Leases (ASC 842) – Receivables arising from Operating leases are accounted for under ASC 842 and are not subject to CECL. CECL focuses on financial instruments subject to amortized cost measurement.
Promises to give (pledges receivable) of a not-for-profit entity – Pledges made by donors to not-for-profit organizations indicating their commitment to providing financial support in the near future.
Loans and receivables between entities under common control – Loans and receivables exchanged between entities that are under common control, typically within the same corporate group, are exempt from CECL.
Loans made to participants by defined contribution employee benefit plans – CECL does not apply to financial instruments within the scope of ASC 960 (Defined Benefit Pension Plans) and ASC 965 (Other Post-employment Benefits).
Policy loan receivables of an insurance entity – Policy loans made by insurance entities are excluded from the CECL model.
CECL Core Concepts
To read the full section, download the pdf.
Determination of Risk of loss over Contractual Life
Determining the contractual life of the asset is a key part of estimating expected credit losses because it is the time horizon over which an entity will be exposed to credit risk related to a particular financial asset. Longer time horizons generally present more uncertainty in expected cash flows, which will affect the estimate of expected credit losses. Contractual life is the expected duration during which an entity anticipates being exposed to credit risk associated with a particular financial asset. Instead of relying solely on the stated/ initial term of a financial instrument, contractual life considers various factors that may impact the actual period over which credit risk is present. If there are terms that can affect the timing of repayment (e.g., prepayment options, renewal options, call options, extension options), the entity may need to consider them in determining an asset’s contractual life. In some cases, payment terms aren’t specified, or customers routinely make payments after the stated due date. In these situations, an entity will need to determine the period of time over which it will be exposed to credit risks (i.e., the expected life) in estimating credit losses. The expected life of such a receivable should be determined based on historical experience, current conditions, and reasonable and supportable forecasts of future economic conditions. For example, suppose an entity requests payment within 30 days but expects customers to pay within 90 days. In that case, the entity should incorporate a reasonable and supportable forecast for a period of 90 days rather than 30 days.
To read the full section, download the pdf.
CECL model and components of risk
- Initial recognition and at each reporting date, an entity recognizes an allowance for remaining lifetime expected credit losses. The allowance is deducted from the amortized cost basis of a financial asset or a group of financial assets so that the balance sheet reflects the net amount an entity expects to collect.
- Subsequent changes (favorable and unfavorable) in expected credit losses are recognized immediately in net income as a credit loss expense or a reversal of credit loss expense.
1. Segmentation of financial assets
An entity estimates expected credit losses of financial assets with similar risk characteristics on a collective (pool) basis. A financial asset is measured individually only if it does not share similar risk characteristics with other financial assets. Both credit and non-credit related characteristics are relevant in determining whether certain assets share similar risk characteristics. If a financial asset’s risk characteristics change, it should be evaluated to determine whether it is appropriate to keep the same in its existing pool or move to a different pool that may be more consistent with its current risk characteristics. ASC 326-20-55-5 provides a list of risk characteristics that can be utilized to pool assets. An organization is allowed to consider one or more risk characteristics when assessing its pooling.
To read the full section, download the pdf.
2. Method for determining losses
ASC 326-20 does not prescribe a specific method for estimating expected credit losses. Given the subjective nature of the estimate, the FASB decided that an entity should use judgment to develop an approach that faithfully reflects expected credit losses for financial assets and can be applied consistently over time.
To read the full section, download the pdf.
3. Historical losses and adjustment
Estimation of expected credit losses should reflect available information that is relevant to assessing the Collectability of cash flows. That information should include historical loss information adjusted:
- For current asset-specific risk characteristics
- For current conditions
- For reasonable and supportable forecasts of future economic condition.
3a. Historical losses and adjustment for Asset-Specific Risk Characteristics and Current condition
Historical credit loss experience for similar assets is likely a relevant and starting data point for estimating the expected credit losses that will emerge for assets currently held by the entity. The following categories of historical information relevant to the entity’s expected credit loss experience may be required to satisfy the requirements of the standard:
- Asset characteristics (e.g., term, amortization period, collateral type, borrower type)
- Loss experience, including migration statistics, charge-offs and recoveries, and the components of amortized cost affected by the default event
- The effect of modifications, prepayments, and extensions on loss experience
- Macroeconomic conditions that correlate to historical loss experience
To read the full section, download the pdf.
3b. Adjustment for Reasonable and supportable forecasts of future economic conditions
Estimation of expected credit losses shall consider the effect of forecasted future economic conditions. This includes adjustments for external economic factors that are expected to differ in future periods and are not already reflected in the historical loss experience. In the absence of explicit guidance, it is very difficult to forecast future economic conditions in terms of how a forecast should be developed or how long the forecast period should be. Significant judgment will be required to develop the forecast. If an entity is unable to make or obtain a reasonable and supportable forecast of future economic conditions beyond a certain point in time, there is no basis to determine what economic adjustments should be made in those periods. Therefore, for periods beyond the reasonable and supportable forecasts, an entity may consider using the historical credit loss information – adjusted for asset-specific risk characteristics and the effect of the reversion method without further adjustments for future economic conditions. In other words, in periods for which an entity can no longer reasonably and supportably forecast economic conditions, the entity cannot estimate zero credit losses. At the point that the reasonable and supportable forecast is no longer a better estimate of expected credit losses than “using historical loss information, entities should revert to historical loss information for the remaining contractual term of the financial asset.”
Write-off and Recoveries
To read the full section, download the pdf.
CECL Reversal
Available for Sale (AFS) Debt Securities impairment model (ASC 326-30)
One of the key principles for applicability of CECL credit impairment model is that “it is based on amortized cost”. The impairment model for debt securities classified as AFS differs from the CECL model because AFS debt securities are measured at fair value rather than amortized cost. Considering the nature of classification, the proceeds can be realized by either selling them or collecting the contractual cash flows. Consequently, the guidance requires an estimate of expected credit losses only when the fair value of an AFS debt security is below its amortized cost basis, and credit losses are limited to the amount by which the security’s amortized cost basis exceeds its fair value.
To read the full section, download the pdf.
Key Presentation and Disclosure Considerations
Presentation requirements
Disclosure requirements
The primary objective of disclosure requirements is to enable the users of the financial statements to understand:
- The credit risk inherent in a portfolio and how credit quality of portfolio is monitored by management,
- Management’s estimate of expected credit losses,
- What are the changes in the estimate of expected credit losses during the period.
To read the full section, download the pdf.
Implementation Challenges and Way Forward
For the effective implementation of the new guidance, entities are required to review existing policies, procedures, credit risk monitoring systems & processes, and storage, and maintenance of historical loss data. In addition to the internal systems and policies, entities may be required to involve external vendors and models to compute CECL.
To read the full section, download the pdf.
