The latest Financial Accounting Standards Board’s exposure draft on accounting for credit losses could bring sweeping changes to the way CFOs, accounting heads, and finance directors at banks and other financial institutions account for credit losses on their firms’ balance sheets.
An FASB exposure draft recently released requires companies to record on their balance sheets extra losses from the bonds or loans they are holding sooner than they used to. The proposal would also require corporate executives to forecast the future cash flows that they do not expect to collect because of deterioration in the value of financial instruments for the life of those financial instruments. Currently, using the existing impairment models under generally accepted accounting principles (GAAP), losses do not have to be recognized until they are actually incurred.
In short, a corporation’s balance sheet would now show the current estimate of expected credit losses at the firm’s reporting date, while its income statement would show how much a financial instrument may have deteriorated during the most recent quarter or year.
FASB has not yet actually field-tested the proposal to estimate the extra losses banks and other financial institutions would have to book using the new expected loss model. In answer to a reporter’s question, FASB chair Leslie Seidman said on a press call that she estimates that U.S. banks and other financial institutions would see their losses increase by about 50% from what they are now even if they adopt only part of the proposal.
Just because an investment is currently doing well doesn’t mean that will be the case for the duration of the bond or loan, noted Seidman in explaining FASB’s reasoning. “You can’t avoid a loss just because an asset is currently performing,” she added.
“We do expect some increase in the reserves for financial institutions based on the anecdotal information so far. But that’s something we will be learning more about during the comment period,” said Seidman. FASB has put its proposal out for comment until April 30, 2013.
While Seidman acknowledged that loan-loss accounting is one of the most subjective forms of accounting, she does not think this approach is more subjective than current GAAP or a different approach to credit loss impairment proposed by the International Accounting Standards Board (IASB). “We’re removing an object of subjectivity from the approach.”
Still, Seidman expects the new exposure draft to be the final step in allaying the ongoing stalemate between FASB and the IASB over which credit impairment model to use.“With the benefit of an additional round of commentary we will be in a better position to ultimately come to a converged approach that people around the world view as an improvement. I am hopeful this is the last lap on this.”
The IASB and FASB have moved closer over the years to converging their respective accounting standards. But financial instruments, revenue recognition, leases, and insurance contracts have remained sticking points. Unlike the previous GAAP standard, which allows for several credit impairment models to be used in accounting for losses on a firm’s balance sheet, FASB’s new proposal uses a single expected-credit-loss measurement objective in determining credit losses.
IASB and FASB had agreed on a “three-bucket” credit-impairment model before the U.S. standard-setter, responding to an outcry from U.S. financial institutions over that model’s complexity, opted for its latest model.
In addition to the extra reporting steps, the new proposal would require considerable operational system challenges, according to an Ernst & Young survey of financial executives conducted in February. Corporations would now be expected to forecast expected losses for the duration of the life of a bond or loan.
The time period in determining expected losses has been hotly contested. FASB is against limiting the loss projections to 12 months, which it believes would not appropriately show how losses unfold in a loan or bond portfolio, according to Seidman. Both FASB and IASB have discussed a timeframe of either 12 or 24 months, but some bank executives have favored a shorter timeframe.
FASB will review comments during the summer and then will “re-deliberate,” on the exposure draft, said Seidman.
IASB, for its part, is due to release its own proposal on the topic for public comment in the first quarter of 2013. “We continue to cooperate with the FASB on this important topic,” says a spokesperson at IASB. Its new proposal will be “based on a simplified version of the previously agreed approach,” he says.