Addressing an issue that arose in the early days of the financial crisis, the Financial Accounting Standards Board today put out an Accounting Standards Update (ASU)  “requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations,” according to a FASB press release.

Departing from the current “incurred loss model,” which critics say substantially delayed reporting of credit losses, the new current expected credit loss (CECL) model “is taking away the threshold to booking your reserves, and as a result, your reserve gets booked on day one,” FASB member R. Harold Schroeder told CFO. “That is the big notable change that people are referring to as the ‘Day 1 Loss.’”

FASB member R. Harold Schroeder

FASB member R. Harold Schroeder

Another purpose of the standard is to help investors “better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio,” according to the press release. “These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.”

Under the current incurred loss accounting methodology, banks, insurance companies, and other corporations holding debt and securities at cost must put off the recognition of credit losses until they judge that it’s “probable” that a loss has been incurred. In practice, that has meant that a company must be as much as 80% confident that a loss has occurred, according to Schroeder.

That threshold is considered very high. In the period right before the economic crisis starting in 2008, many banks found it hard to assign such a high likelihood to the probability that each loss in their entire loan pool would actually occur. But they and their investors had expectations that hard times were coming.

At the same time, following the incurred loss model, the banks’ auditors advised financial officers that they shouldn’t book incremental losses — much less entire pools of them — because they weren’t “probable” yet. The incurred loss model has thus been widely characterized as producing a situation of “too little and too late”:  By estimating too few losses in current financial statements, companies will have nothing in reserve when the losses actually do occur.  

Frustrated Bankers and Investors

The update seeks to allay “significant frustration on the part of both bankers and investors,” Schroeder says. “The frustration for bankers was that they could see problems in their portfolios that current accounting rules did not allow them to adjust to and book additional reserves for the expected losses that were embedded in their portfolios.”

For their part, investors were frustrated because they could see the mismatch between the accounting and the actual economics of the banks’ arrangements. That forced investors to develop their own estimates using external data “that they could use as a rough proxy for losses that they could expect to see in the future,” he adds.

That proxy tends to be the product of  “a very time-consuming process that results in a more imprecise number than you would like as an investor. But investors are willing to accept an imprecise number if it’s closer to what they believe will be true, than a highly precise, inaccurate number,” according to Schroeder, a former investment executive himself.

“There was frustration on the part of bankers and investors and this standard will do a lot to relieve that frustration,” the standard setter says.

While the discussion of the anticipated effects of the new standard has mainly focused on banks, “I hope it’s going to improve financial reporting [more broadly] by giving a more current look at what entities expect to have in the way of credit losses on their financial assets,” said Jonathan Howard, a partner in the national office accounting services unit of Deloitte & Touche, who acknowledged that he hadn’t had time yet to read the entire 285-page ASU.

Howard thinks that the standard could have a big effect on the balance sheets of holders of large amounts of real estate receivables, especially with the issuance of the new FASB leasing standard. The standard requires lessees to put the financial results of their operating leases on their balance sheets.

To be sure, FASB members defined the scope of the standard by the accounting issues covered, rather than by industry. The new standard applies to all corporate investments that are carried at cost rather than at fair value, “whether they’re loans or debt securities or net investments in leases or receivables,” notes Schroeder.

Asked which industries could be most affected, he replied that “the financing divisions of industrial companies would have to think about this. Technology companies that have taken excess cash and invested in bond portfolios if they’re carrying them at something other than fair value” are also likely to covered, he adds.

At the same time, the standard is “going to take some significant time and effort for entities to transition into this new standard, which is why we have an effective date that’s delayed all the way to 2020,” Deloitte’s Howard says.

The credit losses update will take effect for Securities and Exchange Commission filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. For public companies that are not SEC filers, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. For all other organizations, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021.

The standard update had its origins in 2008, when FASB and the International Accounting Standards Board set up a Financial Crisis Advisory Group (FCAG) “to advise the Boards on improvements in financial reporting in response to the financial crisis. The FCAG recommended exploring more forward-looking alternatives to the incurred loss methodology,” according to a FASB publication.

The ASU was passed by a 5-2 vote by the board, with Lawrence Smith and James Kroeker dissenting.

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One response to “FASB Requires Timelier Recording of Credit Losses”

  1. Yeah, banks in 2006 and 2007 were really frustrated they couldn’t book more reserves because of FAS 5.

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