Until May 31, 2013, the U.S. accounting standard-setter, the Financial Accounting Standards Board (FASB), is seeking comments on its lengthy, 158-page proposed accounting standards update, Financial Instruments—Credit Losses (Subtopic 825-15), issued on December 20, 2012. The proposed guidance would change how companies determine when and how a credit loss should be recognized.
Interestingly, the accounting standard-setter for international accounting standards, the International Accounting Standards Board (IASB), which is also proposing new guidance addressing this accounting issue, is proposing a different solution. The 149-page IASB proposal, Financial Instruments—Expected Credit Losses, was issued on March 7, 2013, with a comment period that ends on July 5, 2013.
Yes, this has been a joint “convergence” project of the two accounting boards, but, if the boards don’t change their conclusions, how a company measures its credit losses will differ depending on whether the company follows U.S. generally accepted accounting principles (U.S. GAAP) established by the FASB or International Financial Reporting Standards (IFRS) established by the IASB.
The Importance of a Single Set of Requirements
As I have covered in various blog articles over the past year, the FASB and IASB have been striving to develop a set of accounting principles that can be used by any company no matter whether it is issuing financial statements in Australia, Canada, France, the United States, or almost anywhere else in the world. The Securities and Exchange Commission (SEC), the regulator of public company financial reporting in the United States, has been considering whether to allow U.S. companies to follow IFRS instead of U.S. GAAP. As I noted in my prior blog article, “SEC Staff ‘Punts’ on IFRS Decision,” the SEC has not adopted IFRS reporting by U.S. companies yet. The SEC can’t be too thrilled with the development of diverging FASB and IASB views on credit losses.
Why the Issue of Credit Losses?
Many believe that the global financial crisis that occurred in 2008 resulted from “less than desirable” accounting rules on when and how companies (notably banks) report credit losses. As a result, both the FASB and IASB decided that they should consider the matter, which gave rise to the above-described exposure drafts. Undoubtedly, political pressure and concerns from regulators motivated this decision, as well as input from the Financial Crisis Advisory Group (FCAG) that was set up by the two boards in October 2008 to advise them on financial reporting issues arising from the global financial crisis.
Currently, both U. S. GAAP and IFRS require a lender to report losses on loans it has made using a concept of “incurred losses” rather than the concept of “expected losses” that is currently being proposed by the FASB and the IASB. In short, the existing rules provide that a lender should not report a credit loss until it has concluded a loss has occurred—based on “an event.” An entity considers past events and current conditions when measuring impairment but does not “look down the road” for problems.
Some would argue that in 2008 when the financial meltdown occurred, banks were encountering losses that were larger than recognized or reported. But since the banks had not determined whether a credit loss had been incurred, no loss was recognized in their financial statements, leading some to believe “life was better than expected” and continue to make additional and potentially bad loans.
The Proposed New Approach
Both the FASB and IASB are proposing an approach that would require an entity to recognize expected credit losses on financial assets and on commitments to extend credit, using current estimates of expected shortfalls in cash flows on those financial instruments as of the reporting date. The entity would recognize those expected credit losses as a loss allowance (for financial assets) or as a provision (for commitments to extend credit). Recognition of credit losses would no longer be dependent on the entity first identifying a credit loss event.
Further, the range of information that an entity must consider when assessing credit risk and measuring expected credit losses would be broader. For example, the estimate of expected credit losses would be based on the relevant information that is available without undue cost or effort, including information about:
Past events, such as the historical loss experience for similar financial instruments.
Reasonable and supportable forecasts that affect the expected collectability of future cash flows on the financial instrument.
How the Proposed FASB and IASB Solutions Are Different
The FASB and IASB have been working to develop a more forward-looking impairment model based on expected credit losses. Initially, the boards worked together to jointly develop a single proposed rule and, until July 2012, they were substantially in synch. Shortly thereafter, the FASB decided to revisit its previous tentative decisions on that joint model and decided to develop an expected credit loss model in which no distinction has been made between those financial instruments that have deteriorated in credit quality since initial recognition and those that have not. Under the FASB’s proposed Current Expected Credit Loss (CECL) model, expected credit losses are always recognized at what is described as “lifetime expected credit losses” in the IASB’s proposals. This is in contrast to the IASB’s proposal to measure expected credit losses for some financial instruments at an amount equal to 12-month expected credit losses.
Resolving the Differences
No doubt the FASB and IASB would like to issue a standard covering impairment of financial instruments that is the substantially the same under U.S. GAAP and under IFRS. They have successfully worked together on revenue recognition and, barring some unexpected developments, will issue a converged standard by June 30, 2013, on this immensely important accounting topic. Further, the boards have generally been in synch on lease accounting and plan to issue a revised exposure draft later this year.
The comment periods on both the IASB and FASB approach for addressing credit losses are still open. However, a fairly common “complaint” raised in early comment letters received by the FASB was that the exposure period should be extended, preferably to match that set by the IASB—July 5, 2013. It appears that constituents desire a single and converged approach.
On March 25, 2013, the FASB staff issued a “frequently asked questions” document on the credit loss proposal. The FASB staff provided guidance on various application issues and explains the rationale for proposing an approach that differs from the IASB’s. Specifically, in Question 19, the following statement is made (footnotes omitted):
The IASB’s March 2013 Exposure Draft proposes that an entity would only recognize a portion of expected credit losses (namely, 12 months of expected credit loss) until a specific recognition trigger has been met (that is, when there has been significant credit deterioration). Some have asked the FASB why it did not pursue such a model.
The Board believes that one of the lessons learned from the global financial crisis of 2008 is that investors need timelier reporting of credit losses on loans and other financial instruments. Waiting until significant credit deterioration occurs before recognizing a loss defeats the purpose of moving from an incurred loss model to an expected loss model. Delaying recognition of part of an estimable loss until an event has occurred is akin to an incurred loss approach instead of an expected loss approach. The FASB’s proposed model is intended to fix the problem that the FCAG identified with current U.S. GAAP related to the delayed recognition of credit losses.
The issue of impairment of financial instruments is complex, requiring the boards to spend many pages explaining the guidance and rationale for the proposed new accounting approach. As previously stated, it will be most relevant to the banking industry but the guidance could affect many companies that have financial instruments (that are not accounted for at fair value through net income) as defined in the exposure drafts. Such financial instruments include loans, debt securities, trade receivables, lease receivables, loan commitments, reinsurance receivables, and most other receivables that represent the contractual right to receive cash in the future.
Recent Developments—An Extended Comment Period
On March 28, 2013, the FASB held a board meeting to specifically address the length of the comment period on its exposure draft. The initial expiry date for the comment period was set for April 30, 2013, but, as previously noted, commenters were not particularly keen on the FASB having a comment period that ends before the date provided in the IASB exposure draft. While the FASB was sympathetic to the views in comment letters already received, the FASB decided not to extend its exposure period to July 5, 2013, to match the exposure period adopted by the IASB. However, it did conclude that another month should be added to its original deadline of April 30, 2013, resulting in a new deadline of May 31, 2013. In reaching this decision, the FASB considered the fact that a related FASB exposure draft on classification and measurement of financial instruments ends on May 15, 2013, and believes that an overlap of time might give users a chance to look at both credit losses and classification and measurement together.
About the Author
Ron Pippin is an experienced CPA based in Wheaton, IL. His 40 plus year career includes being an audit partner in Arthur Andersen, a member of Andersen’s Professional Standards Group (“national office”) in Chicago, the Director of Financial Reporting for a Fortune 50 company and most recently, the editorial director of CCH’s Accounting Research Manager. Currently, Ron does independent writing and analysis together with accounting consultation on a variety of topics.