Clarifying the credit loss standard
Published January 15, 2020
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, will change the way banks and other creditors report losses from soured loans. With the implementation deadline looming for most public companies, accountants have some lingering questions about the details of the updated guidance. So, in November 2019, the Financial Accounting Standards Board (FASB) issued narrowly drawn amendments to clarify five issues.
Need for change
The FASB updated the credit loss reporting rules in the wake of the 2007–2008 global financial crisis. ASU 2016-13 requires financial institutions to immediately record the full amount of expected credit losses in their loan portfolios. It introduces an expected credit loss model for the impairment of financial assets measured at amortized cost basis. That model replaces the probable, incurred loss model for those assets.
ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments — Credit Losses, removes potential implementation hurdles as companies adopt the updated credit loss rules. These changes have the same effective date as ASU 2016-13. (See “FASB approves delay of the credit loss standard for certain entities.”)
“After issuing the current expected credit losses standard — also known as CECL — in 2016, the FASB received questions about certain confusing areas of the guidance,” FASB Chairman Russell Golden said in a statement. “The new ASU clarifies these areas of the guidance to ensure all companies and organizations can make a smoother transition to the standard.”
The amendments provide better guidance on how to report expected recoveries. This term refers to amounts a company expects to recover from soured financial assets after it had initially written off a portion or the full amount of the asset.
Removing implementation hurdles
ASU 2019-11 specifically addresses five major issues:
- Expected recoveries for purchased financial assets with credit deterioration. Financial statement preparers had asked the FASB whether expected recoveries were permitted on assets that had already shown credit deterioration at the time of purchase (PCD assets). The updated guidance clarifies that the allowance for credit losses for PCD assets should include in the allowance for credit losses any expected recoveries of amounts previously written off and expected to be written off by the entity. The estimate shouldn’t exceed the aggregate of amounts of the amortized cost basis previously written off and expected to be written off by an entity.
In addition, the updated guidance clarifies that, when a method other than a discounted cash flow method is used to estimate expected credit losses, expected recoveries shouldn’t include any amounts that result in an acceleration of the noncredit discount. An entity may include increases in expected cash flows after acquisition.
- Transition relief for TDRs. The updated guidance provides an accounting policy election to adjust the effective interest rate on existing troubled debt restructurings (TDRs) using prepayment assumptions on the date of adoption of Topic 326. Without this election, the entity must use the prepayment assumptions in effect immediately before the restructuring.
- Disclosures related to accrued interest receivables. The updated guidance extends the disclosure relief for accrued interest receivable balances to additional relevant disclosures involving amortized cost basis.
- Financial assets secured by collateral maintenance provisions. For financial assets secured by collateral maintenance provisions, entities may elect to use a practical expedient to measure the estimate of expected credit losses. The practical expedient compares the amortized cost basis of a financial asset and the fair value of collateral securing the financial asset as of the reporting date.
The updated guidance clarifies that an entity using the practical expedient should assess whether it reasonably expects the borrower to be able to continually replenish collateral securing the financial asset. An entity may determine there are no expected losses for the secured portion of the amortized cost basis.
- Replacement of an outdated reference in the business combinations guidance. The updated guidance makes an amendment to Accounting Standards Codification (ASC) Subtopic 805-20, Business Combinations — Identifiable Assets and Liabilities, and Any Noncontrolling Interest, removing the cross-reference to Subtopic 310-30, Receivables — Loans and Debt Securities Acquired with Deteriorated Credit Quality. Instead, the amendment correctly cross-references the guidance for purchased financial assets with credit deterioration in Subtopic 326-20, Financial Instruments — Credit Losses — Measured at Amortized Cost.
Investor groups generally welcome the changes under the updated credit loss standard. But many financial institutions argue that the standard’s costs outweigh its benefits. In light of these conflicting points of view, some members of Congress have asked the FASB to defer the standard’s implementation deadline pending further research. Instead, the FASB has decided to hold its course and issue ASU 2019-11 to help clarify matters. For more information on implementing the guidance for credit losses, contact your CPA.