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As a result of the credit crisis of 2008, many investors and financial statement users have questioned the need for improvements in the recognition and measurement of credit losses and helped pave the way for a multi-year accounting standard-setting project and a proposal that could bring sweeping changes to the accounting for impairment losses on financial instruments for entities of all sizes and in all industries.

In response to the criticisms of the current accounting model as well as convergence efforts, the FASB has proposed the establishment of a new impairment model that requires consideration of forward-looking information to assess the estimated cash flows to be received on amounts due from customers, investment securities and other financial instruments. This approach would apply to a wide range of financial assets that are subject to credit risk, including loans and loan commitments, debt securities, trade receivables, lease receivables, and reinsurance receivables. The far-reaching effects of these proposed changes have stirred debates among accountants and financial statement users, resulting in over 300 comment letters.

This Messenger summarizes the proposal and highlights many of the concerns raised in the letters.

July 2013

FASB’s Proposal on Credit Losses ─ Debate Heats Up on Single Impairment Model

The FASB’s proposal

In accounting terms, the FASB is proposing to replace the current multiple variations of the “incurred loss model” with a single “expected loss model.” The concepts underlying these approaches, the effects on the financial statements, and other requirements and resources are summarized below.

A. Comparison of the current and proposed approaches. A key difference is that the current approach delays recognition of credit losses until the losses are deemed to be incurred, while the proposed approach focuses on expected losses as a way to provide users of financial statements with more advanced notice.

• Current“incurredlossmodel.” Under the current approach, companies are required to recognize a credit loss when the loss is incurred, meaning when the loss has been actually incurred or when its occurrence is considered to be “probable” of having occurred. While there are several variations of this approach in current US accounting standards, companies generally consider only past events and current conditions in making the determination of whether it is probable a loss has been incurred. Table 1 provides references to the accounting standards with impairment models that would be superseded by the new model.

• Proposed “expected loss model.” Under the proposed approach, the FASB would remove the “probable” threshold and require instead that

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companies create an allowance for expected credit losses based on an estimate of “current expected credit losses” (CECL). This estimate reflects the amount of contractual cash flows that are not expected to be collected on financial assets held by the company over the entire life of the asset based on factors existing as of the reporting date. Estimated losses are based on relevant information about past events, including historical loss experience with similar assets, current conditions, and reasonable and supportable forecasts that affect the expected collectibility of the assets’ remaining cash flows. The expected losses are based on internal cash flow expectations, which may differ from those of market participants (as required in fair value measurements). Table 2 highlights some of the more controversial features of the CECL methodology.

B. Effects on financial statements. If the FASB’s CECL approach is adopted as proposed, there would be no change in financial assets accounted for at fair value through net income. The impact to the presentation on the face of the financial statements for other financial assets would be as follows:

• For financial assets that are carried at amortized cost less an allowance, the balance sheet would reflect the current estimate of the cash flows expected to be collected at the reporting date, and the income statement would reflect the

credit deterioration (or improvement) that has taken place during the period.

• For financial assets measured at fair value with changes in fair value recognized through other comprehensive income, the balance sheet would reflect the fair value and the income statement would reflect the credit deterioration (or improvement) that has taken place during the period.

• Practical expedient. As a practical expedient, a company may choose to not recognize expected credit losses on financial assets in this category if two conditions are met: (1) the fair value of the financial asset is greater than (or equal to) the amortized cost basis, and (2) expected credit losses on the financial asset are insignificant.

• For debt instruments that are acquired with existing evidence of credit deterioration since the origination date, an allowance for credit losses would be established at acquisition for an amount equal to the buyer’s assessment of the expected credit losses. The original purchase discount would be split between the portion attributed to expected credit losses (this portion will not be recognized in interest income) and the remaining portion (which will be recognized in income over the remaining life of the asset using an effective yield method). Any changes in the allowance for credit losses would be taken into income through the credit loss provision.

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Table 1: Comparison of Current and Proposed ApproachesCurrent impairment models Proposed impairment modelASC 310-30, Receivables – Loans and securities acquired with deteriorated credit quality (formerly SOP 03-3)

Financial Instruments – Credit Losses (Subtopic 825-15)

ASC 320-10-35, Investments – Debt and equity securities – recognition of other-than-temporary impairment (formerly FSP FAS 115-2)ASC 325-40, Investments – Beneficial interests in securitized financial assets (formerly EITF 99-20)ASC 450, Contingencies (formerly FAS 5)

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C. Other requirements and other resources. The FASB’s proposal also addresses related matters, including charge-offs of financial assets for which the company has no reasonable expectation of future recovery, required disclosures, and implementation guidance and illustrations. Table 3 provides a summary of the additional disclosure requirements. In addition, the FASB has released the following supplemental documents.

• A Q&A document released in March 2013 to provide answers by the FASB staff to frequently

asked questions. The Q&As are not a typical part of the FASB’s due process for standards at the proposal-stage, but the FASB believed they would be helpful for this particular proposal since the concepts are controversial and sometimes believed to be misunderstood by the FASB.

• A summary of the feedback received from investors dated June 11, 2013. Both the feedback summary and Q&As are posted on the FASB’s website on the page for the impairment project.

Table 2: Controversial Features of Single Impairment ModelCurrent Expected Credit Losses (CECL)Some of the more controversial features of the CECL model are as follows:

• Economic forecasts. As part of the CECL model, companies would be required to consider quantitative and qualitative factors specific to the borrower (including the company’s current evaluation of the borrower’s creditworthiness). In addition, companies would need to consider general economic conditions (including an evaluation of both the current point in, and the forecasted direction of, the economic cycle). The proposal notes that the FASB expects most companies will be able to complete this evaluation by leveraging their current risk monitoring systems and expanding the systems as necessary to accommodate additional inputs. But some companies argue their systems will require costly upgrades.

• Prohibition against most likely estimate. The CECL method would prohibit companies from estimating expected credit losses based solely on the “most likely outcome,” (an average known in statistics as the “mode”). Instead, the company would need to consider both the possibility that a credit loss results and the possibility that a credit loss does not result, then combine the two using probability-weighted averages. In effect, this means there will be some amount of allowance for every financial asset, even if the most likely outcome measured by the statistical mode is zero. Some companies feel this approach is overly conservative. But the FASB believes this methodology is consistent with the techniques most commonly used to estimate credit losses.

• Life-of-loan estimate. The CECL approach requires that companies estimate and recognize all expected credit losses over the entire contractual term of the financial asset. The FASB has clarified that a company would not need to forecast events and conditions over the remaining life of the asset. Instead, the company might revert to unadjusted historical averages for future periods beyond which management is able to make or obtain reasonable and supportable forecasts, or it might freeze the furthest reasonable and supportable forecast and use that for the remaining future periods. Even with this clarification, some accountants feel a life-of-loan estimate would be unreliable because it involves too much subjectivity or could differ significant from expected losses of a market participant, and some fear it would set up unrealistic expectations of a level of accuracy that is not attainable.

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TheinformationinthisMHMMessengerisabriefsummaryandmaynotincludeallthedetailsrelevanttoyoursituation.PleasecontactyourMHMserviceprovidertofurtherdiscusstheimpactonyourfinancialstatements.

Next Steps

The challenges and concerns raised in the comment letters sent to the FASB are summarized on the appendix. Although the FASB and IASB issued separate exposure documents, they expect to discuss the comments jointly at their July or September 2013 meetings. A final standard could be available sometime in 2014, depending on whether the FASB decides to issue a revised exposure draft.

Table 3: Disclosure RequirementsAdded or expanded disclosure requirements for FASB’s expected loss modelThe FASB’s proposal would retain many existing disclosure requirements, and it would add to the already extensive list. Most notably, the proposal would:

• Expand the scope of the current disclosure requirements about credit quality to include debt securities and other financial assets.

• Add requirements about the estimate of expected credit losses and the effect of collateral on that estimate. For example, reporting entities would be required to disclose qualitative information about how expected credit loss estimates are developed, including factors that influence the current estimate of expected credit losses, changes in those factors that affect the estimate, and changes in accounting policies, methodologies, or estimation techniques. Reporting entities would also be required to describe the nature of any collateral, the extent to which collateral secures their financial assets, and any changes in the extent to which collateral secures financial assets.

• Add requirements related to expected credit losses on purchased credit-impaired assets, including a reconciliation of the amount paid for the purchased credit-impaired asset to the asset’s par value.

• Add roll-forward disclosure requirements for debt instruments measured at amortized cost and for debt instruments measured at fair value through other comprehensive income.

For more information

MHM’s Professional Standards Group will monitor progress on the FASB’s and IASB’s credit loss proposals. We provided our input to the FASB in our comment letter. If you have any specific questions, comments or concerns, please share them with Mike Loritz of MHM’s Professional Standards Group or your MHM service professional. You can reach Mike at mloritz@cbiz.com or 913-234-1226.

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MHM Messenger 12-13 Appendix: FASB’s Proposal on Credit Losses Challenges and Concerns Raised in Comment Letters

Most comment letters expressed support for the FASB’s overall goals of providing more decision-useful information to investors and also reducing the complexity of the existing approaches. But many letters also take issue with various aspects of the proposal and suggest carve outs, modifications, or alternatives to the single impairment model. Following is a brief recap of the central issues and suggestions.

1. Is there still hope that the FASB and IASB may reach a converged solution?

Some letters expressed frustration with the lack of a converged solution to accounting for credit losses, especially since the topic is described in one letter as “...arguably the single most important accounting issue for commercial banks.”

Challenges:

a. Separate FASB and IASB proposals. The FASB’s proposal was released in December 2012 with a comment deadline that was later extended to May 31, 2013, while the IASB issued its proposal in March 2013 with a comment period ending July 5, 2013. Both proposals use expected loss models, but the details differ. The FASB’s proposal uses the CECL model, while the IASB uses a model known as the “credit deterioration model” (formerly the “three bucket” model). Under the IASB’s proposed model, an entity would apply certain criteria to determine how the credit losses would be measured. For some assets, all lifetime expected losses would be recognized; for other assets, lifetime expected losses would be recognized only if a loss event is expected in the next 12 months.

b. Lack of a converged solution. Some accountants would have preferred that the comment periods end on the same date. They also suggest the two standard setting bodies should work together to develop illustrations of how to apply their differing methods to the same examples, so the two proposals could be studied and commented on simultaneously. But the biggest frustration for some is the continuing lack of a converged solution and the lack of a single global accounting standard. Some letters expressed concern that the differences between the FASB’s and IASB’s proposed approaches are too great and would generate vastly different results.

Suggestions:

a. Continue the dialogue. Many letters urged the two boards to continue their efforts to agree on a single global standard, and some letters suggested compromises.

b. Use life-of-loan estimates in limited circumstances. One compromise might be to limit the allowance for credit losses so that it covers 12 months of expected losses, rather than expected lifetime losses. Another might be to require recognition of all expected credit losses only when there has been a significant deterioration in credit or there is a probability of a loss becoming incurred in the next 12 months.

c. Use the bankers’ compromise. Representatives from a group of well-known banks suggested a compromise that would measure expected losses over the greater of the next 12 months or the period that is reliably estimable and predictable. The latter could be (but would not necessarily be) the remaining contractual life.

2. Are the boards willing to consider an approach other than an expected loss model?

Both the FASB and the IASB have moved away from the incurred loss model that exists in practice today. Some letters agree with this approach, while others question whether it is necessary.

Challenges:

a. Subjectivity and front-loading. Some letters expressed concerns about the level of subjectivity involved in forecasting future events. They said it would introduce unnecessary complexity, set up unrealistic expectations for the reliability of the estimates, increase the cost of an audit, and result in diversity in practice. There are also concerns that the FASB’s measurement technique would result in greater “front-loading” of credit loss recognition in the initial years than either the current US standard or the proposed IASB standard. This front-loading would result from the requirement to consider the likelihood of a loss on every debt instrument and recognize all expected credit losses at the first reporting date following the origination of a loan.

b. Economic realities and added risks. The front-loading is troublesome for several reasons. Some say it does not reflect the economics of lending transactions because credit assets are generally priced at initial recognition to include consideration of the credit risk. Others say it would negatively impact regulatory capital levels and result in higher prices for products such as consumer credit cards and small business loans, thereby harming the economy. Still others say it would add to the potential for earnings management if banks are incentivized to smooth earnings by accelerating future losses into current periods. The FASB’s Q&A document anticipated these concerns, and it provides a list of reasons why the FASB feels this accounting is appropriate.

c. Implementation costs. Overall, the comment letters say that adoption of the expected loss model would be time-consuming to implement and would require costly operational and systems changes, with the expectation that long periods of time would be necessary for orderly transitions and adoption.

Suggestions:

a. Use the Banking Industry Model. Some letters suggest the FASB could adopt the US Banking Industry Model instead of an expected loss model. Under this approach, entities would estimate losses that are “foreseeable with reasonable confidence.”

b. Modify the incurred loss model. Others suggest the FASB should retain a variation of the incurred loss model. For example, the threshold for recognition of credit losses could be lowered from “probable” to “more likely than not,” and the FASB could provide more implementation guidance.

c. Rethink the expected loss model. If the FASB is determined to stay with an expected loss model, some letters suggest the FASB should allow the use of a best estimate of the most likely outcome or adopt a model that recognizes only losses deemed to be “more than remote.”

d. Modify the disclosure requirements. Several letters focus on the use of disclosure requirements. For example, one letter suggests that the FASB might rely on incremental disclosure requirements for financial assets with significant credit risk, rather than change the basic impairment model. This approach would be especially helpful for nonpublic reporting entities that provide financial statements in accordance with statutory requirements rather than GAAP but still wish to provide sufficient information for users to reconcile their financial statements to GAAP financial statements. Other letters suggest the FASB might need to expand the disclosure requirements in any event to help guard against an expectation gap. One way this might be done is to require a description of the economic assumptions used to estimate expected losses (similar to the disclosures used by the banking regulators and financial institutions that participate in the annual Comprehensive Capital Analysis and Review evaluation).

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3. If the FASB moves forward with the expected loss approach, what carve-outs will be made?

The vast majority of the letters requested that certain entities or assets be scoped out from the single impairment model and/or disclosure requirements.

Challenges:

a. No one-size-fits-all solution. Although the FASB’s intent was to simplify the accounting, some letters say that changes made solely to achieve a single credit loss model will add unnecessary costs and complexities for certain types of entities or financial assets. For example, the disclosure requirements appear excessive to entities that are not engaged in providing financial services, and different impairment models may be warranted for financial instruments whose risk profiles differ from loans, (e.g., in terms of ease of exchangeability and length of contractual or expected lives).

b. If it isn’t broke, don’t fix it. The letters point out the issues related to loans by financial institutions date back to financial crisis of 2008 (and even before 2008). But there are no similar known issues for loans by other types of lenders, such as member-owned credit unions, or for other types of contractual rights to receive cash, such as trade receivables and debt securities.

Suggestions:

a. Carve out scope exclusions. Limit the scope of the proposed standard on credit losses in one or more of the following ways:

• Restrict the scope to financial institutions and other financial services entities.

• Exclude trade receivables and debt securities because the existing bad debt guidance and other-than-temporary impairment model appear to be well-understood and have not raised significant practice issues and because credit risk can be difficult to separate out from other risks. For example, the impairment guidance for debt securities was revised during the credit crisis to better reflect impairments due to market disruptions rather than credit losses.

• Exclude reinsurance receivables and recoverables because their credit risks are difficult to separate out from other risks, such as dispute risk. These assets should be discussed as part of the FASB’s separate standard-setting project on insurance contracts.

• Exclude lease-related receivables because the time and effort involved in developing estimates for these high volume and high turnover instruments would exceed the benefits. These assets should be discussed as part of the FASB’s separate standard-setting project on leases.

• Exclude loan commitments because of the difficulties involved in obtaining relevant information. A letter from a credit union points out that it would be difficult to make an accurate assessment of historical experience with factors such as percentage use of lines of credit, timing of transnational activity on open-ended commitments, and average realized lives.

b. Set differential disclosure requirements. Many letters suggest the FASB should vary the disclosure requirements for different entities to better align costs and benefits. Examples: The roll forwards might be eliminated for all companies. For public companies, some of the qualitative disclosures might be better positioned in the Management’s Discussion and Analysis section of annual reports on Form 10-K, where safe harbor provisions apply. In addition, several letters suggested less onerous disclosure requirements for nonpublic entities, including credit unions, and for entities that are not in the financial services industry and do not provide financial services.

c. Provide more examples for different types of assets and entities. If the FASB does not carve out exceptions, a common theme in the letters was that the Board should provide more illustrative guidance and examples for certain kinds of financial assets, such as consumer revolving credit loans, and certain types of entities, such as credit unions and companies that do not provide financial services.

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