FASB's new credit impairment model: At a loss for what to do The Dbriefs Financial Executives series

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1 FASB's new credit impairment model: At a loss for what to do The Dbriefs Financial Executives series Bob Uhl, Partner, Deloitte & Touche LLP Jon Howard, Partner, Deloitte & Touche LLP Jonathan Prejean, Managing Director, Deloitte & Touche LLP Eric Murphy, Senior Manager, Deloitte & Touche LLP Colin Kronmiller, Manager, Deloitte & Touche LLP July 25, 2016

2 Agenda The Big Picture Overview of the Current Expected Credit Loss (CECL) Model Available for Sale (AFS) Amendments Operational Implications Key Phases of Implementation Question and Answer Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 2

3 Keep in mind This webcast does not provide official Deloitte & Touche LLP interpretive accounting guidance. Check with a qualified advisor before taking any action. See FASB s web site for official minutes and ratified consensuses. Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 3

4 Learning objective To enhance participants understanding of FASB s new credit impairment model. Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 4

5 Poll question #1 How much do you expect the adoption of the Current Expected Credit Loss (CECL) model will impact your organization? a) Not at all b) Very little c) Moderate cost and effort d) Substantial cost and effort e) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 5

6 The Big Picture Key takeaways from the new credit losses standard FASB tried to make things easy Simplified existing impairment models in U.S. GAAP Did not prescribe methodology Impairment based on expected losses rather than incurred losses No recognition threshold Estimate represents lifetime losses Consider the past, current, and future Effective 2020 but don t wait to assess impact Incremental disclosures = incremental data Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 6

7 Overview of the Current Expected Credit Loss Model (CECL) Copyright 2016 Deloitte Development LLC. All rights reserved. 7

8 Overview of CECL Reduction in credit impairment models ASC Receivables ASC Loss Contingencies ASC Purchased Credit Impaired ASC Beneficial Interests ASC Debt Securities ASC Current expected credit loss (CECL) model Special considerations for: ASC AFS Debt Securities (subject to amendments) Purchased creditdeteriorated (PCD) assets Troubled debt restructurings (TDRs) Certain beneficial interests Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 8

9 Overview of CECL Scope In scope Out of scope Lease receivables recognized by lessor Trade receivables that result from revenue transactions All debt instruments (e.g., debt securities and loans) except AFS debt securities and fair value through NI Financial guarantee contracts Reinsurance receivables that result from insurance transactions Loan commitments AFS debt securities / fair value through NI Equity securities Equity method investments Derivatives Loans made to participants by defined contribution employee benefit plans Policy loan receivables of an insurance entity Related party loans and receivables between entities under common control Pledge receivables (promise to give) of a not-for-profit entity Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 9

10 Overview of CECL CECL model: expected credit losses Recognition Measurement & Unit of Account No minimum threshold for recognition of impairment losses Practical expedients & Write-offs Valuation account deducted from amortized cost basis to present net amount expected to be collected CECL Model In certain situations an entity can recognize zero credit losses. However, no explicit guidance is provided on what these situations would be Purchased credit deteriorated ( PCD ) assets - recognize an allowance at acquisition but no impact to earnings Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 10

11 Overview of CECL CECL model: expected credit losses Measurement Measurement & Unit of Account Estimate represents lifetime losses Practical expedients & Write-offs An entity must measure expected credit losses over the contractual term of the financial asset Consider information about historical loss experience, current conditions, and reasonable and supportable forecasts Not required to develop forecasts of projected losses over the contractual term of financial assets if those forecasts are not supportable CECL Model No prescribed methods to develop an estimate of current expected credit losses Permitted to project future principal and interest losses (e.g., DCF) or only principal losses Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 11

12 Overview of CECL CECL model: expected credit losses Unit of Account Measurement & Unit of Account Practical expedients & Write-offs Credit losses should be evaluated on a collective (i.e., pool) basis when similar risk characteristics are shared (including HTM securities) When similar risk characteristics are not shared, a financial asset should be evaluated for impairment individually CECL Model Asset cannot be included in individual and collective assessment Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 12

13 Overview of CECL CECL model: expected credit losses Practical Expedients Measurement & Unit of Account Collateral-dependent financial asset* Allowance = Difference between amortized cost and collateral s FV Practical expedients & Write-offs Financial assets secured by collateral maintenance provisions (e.g., repurchase agreements) Allowance = Limited to the difference between amortized cost and collateral s FV Write-offs CECL Model Write off the carrying amount of a financial asset when the asset is deemed uncollectible (no change from current U.S. GAAP) * Under the new guidance, a collateral-dependent financial asset is an asset in which the repayment of the financial asset must be expected to be provided substantially through the operation or sale of the collateral and the borrower must be experiencing financial difficulty at the reporting date Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 13

14 Poll question #2 When estimating expected credit losses, an entity must pool financial assets when similar risk characteristics are shared. a) True b) False c) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 14

15 Overview of CECL PCD Assets Scope Asset has experienced more than an insignificant deterioration in credit quality (lower threshold than existing U.S. GAAP definition) Certain beneficial interests in the scope of ASC Measurement Measurement is consistent with the measurement of expected credit losses on originated and non-pcd assets Expected credit losses are recognized Special as an allowance through a gross up of the balance sheet at acquisition Considerations (i.e., no day 1 P&L impact) Subsequent Recognition Increases / decreases in expected credit losses recognized immediately in earnings as provision for credit losses (same as originated and non-pcd assets) Interest income based on expected cash flows at day 1 (yield held constant) Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 15

16 Overview of CECL Gross-up approach Entity O pays $50 for a loan classified at amortized cost that has a par amount of $80. This loan meets the definition of a PCD asset. At the time of purchase, the expected credit loss on the loan is estimated to be $20. The acquisition-date journal entry follows: Loan par amount $80 Loan noncredit discount 10 Allowance for credit losses 20 Cash 50 Under the gross-up approach, the allowance for expected credit losses is recognized as an adjustment that increases the cost basis of the asset. As a result, there is no impact to the entity s earnings upon acquiring the asset. Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 16

17 Overview of CECL Loan commitments Funded Calculate the estimate of expected credit losses consistently with other loans Unfunded Estimate expected credit losses over the full contractual period where there is exposure to credit* Consider (1) likelihood of funding and (2) expected credit losses on funded portion *If an entity has an unconditional ability to cancel the unfunded portion of the loan commitment, the entity would not be required to estimate expected credit losses on that portion, even if the entity has historically never exercised its cancellation right. Copyright 2016 Deloitte Development LLC. All rights reserved. 17

18 AFS Amendments Targeted changes CECL Model (ASC ) does not apply to AFS debt securities Under the revised impairment model (ASC ): Allowance approach (vs. permanently writing down the security s cost basis) Length of time fair value has been less than amortized cost should not be used as a factor in determining credit loss existence Prohibit an entity from considering recoveries of fair value after the balance sheet date when assessing whether a credit loss exists Amortized cost less credit losses must not be less than fair value ( fair value floor ) Write-off guidance will apply to AFS debt securities The amendments do not apply to an AFS debt security that an entity intends to sell or will more likely than not be required to sell. Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 18

19 AFS Amendments Illustrative examples The following examples illustrates how an entity would measure the allowance for AFS debt securities: Facts Example 1 Example 2 Example 3 Amortized Cost $100 $100 $100 Fair Value $97 $103 $94 Credit Loss Amount Allowance Amount $2 $5 $9 $2 $0 $6 Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 19

20 Poll question #3 The difference between loan par amount and purchase price of a PCD loan will be recognized in interest income over the life of the loan. a) True b) False c) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 20

21 Overview of CECL Effective date and transition EFFECTIVE DATE* Early adoption permitted for any entity (including interim periods) Public business entity SEC filers (including interim periods) Public business entity non-sec filers (including interim periods) and nonpublic business entities Interim periods for non-public business entities *For a calendar year-end entity TRANSITION Modified retrospective application with cumulative-effect adjustment recognized in first period of adoption PCD assets and beneficial interests prospective Gross up on effective date and recognize non-credit discount in interest income AFS and HTM debt securities prospective No change in amortized cost Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 21

22 Overview of CECL Early questions CECL Model Similar risk characteristics Contractual life of credit card receivables Zero losses outside of U.S. Treasuries Probability of default Collateral Collateral dependent practical expedient Troubled debt restructurings Beneficial interests PCD model AFS Debt Securities Floor on credit losses Assess for credit losses earlier? Subsequent events Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 22

23 Poll question #4 For a calendar year end entity, what is the earliest ASU may be implemented? a) January 1, 2018 b) January 1, 2019 c) January 1, 2020 d) January 1, 2017 e) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 23

24 Operational implications

25 Operational implications Governance and risk management Implementation of standardized processes and integration of tools, systems, and processes Leading practices in data management to ensure data quality and integrity Delineation of roles and responsibilities for personnel involved in the allowance estimation process Separation of roles of lending personnel and risk grading personnel Accounting Policy Credit Risk Policy Regulatory Requirements Operational Policies and Procedures Data Governance Framework Internal Controls Interaction and Relationships between Departments and Functions Development of consistent, rigorous allowance estimation policies Determination of whether a modification should be accounted for as a troubled debt restructuring Development of framework for evaluating reasonableness of qualitative adjustments using quantitative metrics Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 25

26 Operational implications Portfolio segmentation Segmentation requirements Credit losses will be evaluated on a collective/pool basis Entities are required to evaluate financial assets on a collective (i.e., pool) basis when similar risk characteristics are shared Groups should be sufficiently granular to allow banks to group exposures into portfolios with shared credit risk characteristics so that banks can reasonably assess changes in credit risk HTM debt securities Financial asset should be evaluated for impairment individually if common characteristics do not exist Assets cannot be included in individual and collective assessment Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 26

27 Operational implications Data requirements Expected Loss Model Requirements Data quality/limitations will influence choices made during implementation Certain nuances that can cause more pronounced effects over the lifetime of a loan if leveraging data and methodologies from regulatory capital and stress testing calculations: Probabilities of default (PDs) used for regulatory capital stress testing need to be adjusted to cover a loan s life instead of the one year horizon prescribed in the rule CECL forecasts should reflect management s views of the economic environment and its effect on loss forecasts (i.e. not best or worst case scenarios) As is the case with other modeling efforts, vendor data used for CECL needs to be relevant to the portfolio s loss history, and that relevance needs to be demonstrated Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 27

28 Poll question #5 How significant an effort will collecting data needed for your CECL model be? a) Very significant b) Moderate c) Not significant d) Not sure d) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 28

29 Operational implications Credit modeling Define Expected Loss in order to determine the modeling objective - Are you including interest? - Will you implement on a discounted basis? - How will you treat securities (same as your current OTTI process, but removing the effective yield discounting mechanics)? - How will you treat loan commitments? Determine reasonable and supportable forecasts Compare to current ALLL methods - While the standard has been refined to be less onerous for small banks, it s not a matter of just extending current calculations to the maturity date of a loan - Qualitative adjustments still exist, but should have quantitative support - Are CECL and fair value two sides of the same coin? Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 29

30 Operational implications Credit modeling (cont d) Historical Models FAS 5 allowance modeling has previously relied on an entity s historical portfolio experience for formulating projections Retail - simple transition matrices based on payment status Commercial - transition matrices or loss factors for risk grades Description: Predictive Models Credit Ratings/Score Based/Transition Matrix Credit ratings derived from judgmental or statisticallybased scorecards, which are then aggregated into a transition matrix to examine transitions from one credit state (rating) to another Reduced Form Generally implemented as a logistic regression with a binary response variable (default/no default) which estimates probability of default directly Structural Risky debt issued by a firm is assumed to be an option on firm value and may be valued using optionpricing techniques Applicability: Commercial/Retail Commercial/Retail Commercial Example: S&P Capital IQ, Fair Isaac KRIS RiskCalc Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 30

31 Operational implications Credit modeling (cont d) Intuitive checks of reasonableness of CECL estimates: Are ALLL estimates consistent with the marginal pricing of newly originated loans with similar risk characteristics? Are ALLL estimates for loans consistent with the P&I estimates you d make for securities with the same collateral? Are ALLL estimates for syndicated loans/shared national credits consistent with visible fair value, or with other debt of the borrower? Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 31

32 Poll question #6 To what extent do you expect your institution to align and create interdependencies between CECL, stress testing, regulatory capital and credit risk modeling processes? a) Little or no alignment b) Some alignment c) Full alignment d) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 32

33 Key phases of implementation

34 Key phases of implementation CECL implementation approach and timeline Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Understand Current State Impact Assessment Roadmap to Future State Additional implementation time for non- SEC filers Implementation Post-Implementation Efforts US GAAP Today New Credit Impairment Standard Is Issued Effective Date IFRS 9 Effective Date CECL Milestone Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 34

35 Key phases of implementation How do we get there? Understand Current State Gain an understanding of current capabilities related to: Governance and risk management Data collection and aggregation Credit risk modelling and forecasting expected losses Controls, processes, and technology Financial and regulatory reporting systems, applications and processes Impact and Gap Assessment Perform an impact and gap assessment across various components of the loss estimation framework: Data collection and aggregation Control environment and process flow sequencing Related system considerations Processes to source and compile disclosures Three-Phased Approach Road Map to Target State Identify key similarities and differences between modeling techniques used for CCAR, ICAAP, Basel, loan loss reserve and impairment under US GAAP, IFRS, and other regulatory requirements Develop a road map for implementation Current State US GAAP and IFRS today Governance and Risk Management Data collection and aggregation Credit risk modelling and forecasting expected losses Control environment and process flow sequencing Integration of dependent programs (CCAR, DFAST, Basel, ICAAP) Target State IFRS January 2018 CECL January 2020 End-to-end Plan Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 35

36 Poll question #7 Now that the effective date of the standard has been confirmed, when do you expect to begin your organization s CECL implementation plan? a) Already started b) During 2016 c) During 2017 d) During 2018 e) After 2018 f) Don t know / Not applicable Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 36

37 Question and answer Copyright 2016 Deloitte Development LLC. All rights reserved. 37

38 Join us September 19 at 2 p.m. ET as our Financial Reporting series presents: Quarterly accounting roundup: An update on important developments Copyright 2016 Deloitte Development LLC. All rights reserved. 38

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40 Contact information Bob Uhl Partner Deloitte & Touche LLP Connect with me on LinkedIn Jon Howard Partner Deloitte & Touche LLP Connect with me on LinkedIn Jonathan Prejean Managing Director Deloitte & Touche LLP Connect with me on LinkedIn Colin Kronmiller Manager Deloitte & Touche LLP Connect with me on LinkedIn Eric Murphy Senior Manager Deloitte & Touche LLP Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 40

41 Acronyms used in presentation AFS Available for Sale AICPA American Institute of Certified Public Accountants ALLL Allowance for Loan and Lease Losses ASC Accounting Standards Codification ASU Accounting Standards Update CCAR Comprehensive Capital Analysis & Review CECL Current Expected Credit Losses DCF Discounted Cash Flow DFAST Dodd-Frank Act Stress Testing FAS Financial Accounting Standards FV Fair Value HTM Held to Maturity IASB International Accounting Standards Board ICAAP Internal Capital Adequacy Assessment Process IFRS International Financial Reporting Standards NI Net Income OTTI Other Than Temporary Impairment P&L Profit & Loss SEC Securities & Exchange Commission Copyright 2016 Deloitte Development LLC. All rights reserved. FASB's new credit impairment model: At a loss for what to do 41

42 This presentation contains general information only and Deloitte is not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this presentation. Copyright 2016 Deloitte Development LLC. All rights reserved. 42

43 About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee ( DTTL ), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as Deloitte Global ) does not provide services to clients. Please see for a detailed description of DTTL and its member firms. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright 2016 Deloitte Development LLC. All rights reserved. 36 USC Quarterly accounting roundup: An update on important developments