Washington Watch


FASB proposes an impractical expected-loss accounting model

By James Kendrick

The saga continues in the Financial Accounting Standards Board’s push to alter impairment accounting for most financial instruments, including loans, investment securities and other receivables. Since the recent financial crisis of 2008-09, the accounting standard-setter in the United States has worked jointly with its international counterpart, the International Accounting Standards Board, to develop an agreeable financial reporting model that moves loss recognition forward in the credit cycle.

This push to change impairment accounting arises from critics who believe that low levels of loan-loss reserves in banks were a major contributor to distress in the financial markets as banks could not act fast enough to contain wave after wave of losses. The two boards worked extensively on this issue but could not agree on a unified response and have since gone their separate ways. After much deliberation and consideration, FASB has proposed the current expected credit-loss model.

The proposed credit-loss model represents a radical shift in impairment accounting. This approach would put forth a single loss-estimate methodology for receivables and would do away with the multiple impairment frameworks in place today that impair loans and securities in divergent ways and are anything but consistent or easily adopted.

Under this new model, impairment would be calculated as the net present value of cash flows not expected to be received over the life of the financial instrument as of the measurement date. A bank’s estimate for cash flows not expected to be received would be based on historical losses, current economic conditions and future expectations based on reasonable and supportable forecasts. Forecasts would require at least two possible outcomes with a prohibition on an expectation based solely on the most likely outcome.

Ill-fitting requirements

In what should be regarded as a shocking development in the life of this project, FASB would require the expected-loss calculation to be recorded when a loan is first recognized in the financial statements, creating a frontloading effect. This means that when a bank originates or otherwise acquires a loan or security, a provision for credit losses would immediately be taken through earnings and then adjusted over time as the economic and other factors that impact the loan change.

ICBA is quite concerned with the proposal’s impact on community banks as it now stands. While most community banks agree with FASB’s view that the recognition of credit losses should be moved up in the credit cycle to better handle extended periods of economic downturn, the approach that FASB would take to measure the reserve and the timing of loss recognition is not appropriate for community banks.

Quite simply, implementation of this proposal would become very expensive very quickly for most community banks. That’s because their straightforward business model and community-based lending platforms have thus far discounted the need to create and maintain complex models and forecasts that are openly accepted and adopted at the largest financial institutions. Complex modeling tools quickly become a burden for small institutions as the number of requested inputs becomes harder for them to identify and source, and as the number of potential outcomes to consider puts strain on their existing IT systems. The additional time and effort required by their management and their independent accountants to properly review the results of these modeling systems is also too costly for community banks to implement.

Additionally, FASB’s proposal would frontload credit losses by forcing banks to immediately recognize a loan-loss provision when a financial instrument like a loan or investment security is initially recognized on the balance sheet. The provision flows directly to earnings and immediately reduces retained earnings and all levels of regulatory capital under the finalized but yet-to-be-implemented Basel III capital framework. This immediate hit to regulatory capital could result in decreased lending and further risk mitigation as banks struggle to repair depleted capital balances.

Another solution

ICBA has proposed an alternative to the current expected credit-loss model that represents a common sense approach for community banks while achieving FASB’s goal of recognizing credit losses sooner in the credit cycle. The approach would exempt institutions below $10 billion in total consolidated assets from adopting the proposed current expected credit-loss model outright. Instead, these institutions would employ alternative methods that encourage simplicity to assess the adequacy of their loan-loss reserves.

Under ICBA’s alternative model, credit losses would be recognized based exclusively on a bank’s historical loss experience for similar assets over a pre-defined loss emergence period. As the loss emergence period develops for an originated or purchased asset, losses would be recognized ratably using a common sense methodology. Once an actual impairment event occurs where the bank determines that a credit loss is probable, the bank would measure an actual impairment loss similar to how impairment losses on loans are measured today. This model is superior to the model proposed by FASB because it’s simple to understand, implement, manage, audit and examine, while also meeting the board’s goal of building higher reserves to better protect against bad economic times.

Debate on this proposal continues as FASB considers feedback from interested parties, including community banks. Deliberations could wrap up early this year, with final guidance being released later in 2014.

ICBA has been at the forefront of this issue with its comments, a petition supporting the ICBA common sense alternative, options for community bankers to provide comments to FASB, educational calls with members and meetings with banking regulators and FASB’s board. Stay with ICBA to follow the latest developments as FASB considers this and other accounting changes that will affect community bank accounting.

James Kendrick (james.kendrick@icba.org) is ICBA’s vice president, accounting and capital policy.