On December 20, 2012, the Financial Accounting Standards Board (FASB) issued its long-awaited exposure draft on the impairment model for financial instruments. As discussed in a previous MA Alert, the FASB began discussions on the so-called current expected credit loss model in August 2012. The impairment model is one portion of the FASB’s overall financial instruments project being jointly deliberated with the International Accounting Standards Board (IASB), although the two boards have diverged on this specific topic.
The proposed impairment model represents a fundamental shift in the way entities will evaluate financial assets for impairment, moving it from one based on probable incurred losses to a model that incorporates expectations about future events and conditions and how those events and conditions affect the cash flows an entity expects to collect from a financial asset. At each reporting date, an entity would recognize an allowance for expected credit losses on all financial assets within the scope of the guidance.
The overarching principle of the guidance is that the allowance for credit losses represents a current estimate of all contractual cash flows not expected to be collected. An entity should base its estimate on relevant internal and external information that includes information about past events, current conditions, and reasonable and supportable forecasts of future conditions.
The proposed model requires that an entity’s estimate always consider at least two scenarios: one in which a credit loss occurs and another in which no credit loss occurs. The final estimate of credit losses should represent neither a worst-case nor best-case scenario. Increases or decreases to the allowance are recognized as a provision for (benefit from) credit losses in net income during the period in which the change occurs.
Inclusion of past events, such as historical losses with similar assets, and consideration of current conditions are bedrocks of the current impairment model. However, the FASB’s model breaks significant new ground by explicitly requiring inclusion of “reasonable and supportable forecast of future conditions” when estimating cash flows expected to be collected. The forecast of future conditions includes consideration of anticipated changes in a borrower’s creditworthiness, an evaluation of the forecasted direction of the economic cycle, macroeconomic conditions, and similar information that can be considered “reasonable and supportable.” In general the FASB has adopted a principles-based approach that allows flexibility and requires significant judgment.
The proposed model applies to a significant number of financial assets, including:
Debt instruments carried at amortized cost
Debt instruments carried at fair value through other comprehensive income
Receivables from revenue transactions within the scope of Accounting Standards Codification (ASC) Topic 605
Lease receivables recognized by a lessor
The FASB granted a practical expedient for debt instruments carried at fair value through other comprehensive income if:
The fair value of the individual asset is greater than (or equal to) its amortized cost basis
Expected credit losses on the individual asset are insignificant, and this determination may be made considering general expectations of credit losses using general credit quality indicators (such as credit ratings)
If both of these conditions are met, an entity may elect not to recognize expected credit losses for an individual financial asset.
The exposure draft also, for the first time, provides guidance in US GAAP on ceasing the recognition of interest income (currently referred to as “nonaccrual” status). According to the draft, if it is not probable that an entity will receive substantially all the principal or interest, it shall cease accrual of interest income.
The FASB’s proposal would eliminate the existing five different financial impairment models in US GAAP and replace them with the unified model described above. The proposal also eliminates the accounting for purchased credit impaired loans in ASC Subtopic 310-30 (originally issued as AICPA Statement of Position 03-3) and replaces it with limited guidance for the recognition of interest income for the newly defined “purchased credit-impaired financial asset.”
The exposure draft, if ultimately finalized in its current form, would affect entities in nearly every industry, particularly since trade receivables are within its scope. Certain industries, such as financial institutions, investment funds, not-for-profits, or other entities that hold large amounts of financial assets, would be significantly affected. (You can read more on how this proposed model would affect financial institutions here.)
The IASB is set to propose its own “three-bucket” impairment model in the near future. Its proposal will have some elements in common with the FASB’s proposed guidance, such as the incorporation of future conditions when estimating cash flows not expected to be collected. However, the tentative decisions reached by the IASB have certain meaningful differences from the FASB proposal, including the use of three separate classifications and two different measurement objectives to arrive at the allowance for credit losses. Applying the IASB model will require entities to consider the level of credit deterioration since origination and determine the appropriate classification and measurement approach for a financial asset.
Comments are due on the proposal by April 30, 2013. The FASB has committed to also considering feedback on the IASB’s proposed financial instrument impairment model, which has not yet been released and which will likely extend the timetable for redeliberation. In addition, the FASB plans to issue its financial instrument classification and measurement exposure draft during the first quarter of 2013.
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Moss Adams LLP continues to monitor developments at the FASB and IASB regarding the proposed credit impairment model, and we’ll keep you informed of further developments. In the meantime, for questions about how this new model could affect your organization, please contact your Moss Adams professional.
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