Defining Issues. FASB Accelerates Recognition of Credit Losses. June 2016, No Key Facts. Key Impacts

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Flora Gordon
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immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets.

1 Defining Issues June 2016, No FASB Accelerates Recognition of Credit Losses The FASB s new credit impairment standard will significantly change the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. 1 Entities may need to collect more data and make significant changes to their systems, processes, and internal controls to comply with the requirements of the standard. It is important for entities that will be most affected by the standard (such as banks and other financial institutions) to promptly begin analyzing its implications. Contents 10pt Univers Bold Scope Contents of the Body 9.5pt CECL Methodology Univers Light.. 2 Sale-Leaseback Transactions... 2 Purchased Credit-Deteriorated Arrangements Financial Assets with... Lease and 7 Non-Lease Components... 2 Available-for-Sale Debt Securities.. 7 Initial Measurement... 4 Guarantees....8 Effective Dates and Transition... 9 Key Facts Recognition of credit losses will accelerate, and therefore the amount of the allowance for credit losses generally will increase on adoption of the standard. An allowance for current expected credit losses (CECL) reduces the amortized cost basis of a financial asset to the amount that an entity expects to collect. For most financial assets within the standard s scope, an entity will effectively recognize losses when the assets are originated or purchased. An entity will be required to incorporate its forecast of future economic conditions into its loss estimates. For future periods for which an entity cannot forecast in a reasonable and supportable manner, the entity will revert to historical loss experience. The standard requires significant judgment because it is not prescriptive about certain aspects of estimating expected credit losses, including the specific methodology to use. Key Impacts An entity may experience larger and more volatile provisions for credit losses. Banks and financial institutions regulatory capital and ratios may decrease. Applying differing methodologies and judgments may lead to different loss estimates for similar assets. 1 FASB Accounting Standards Update No , Measurement of Credit Losses on Financial Instruments, available at

2 Scope of the CECL Methodology Common financial instruments and whether they fall within or outside the scope of the current expected credit loss guidance include: In Scope Out of Scope Loans Equity investments The new standard will add new disclosures (e.g., credit quality information by vintage) to the existing credit quality disclosures and retain most of the current disclosures. Trade receivables Debt securities classified as heldto-maturity Loan commitments Financial guarantee contracts that are not accounted for as insurance contracts Net investment in leases recognized by a lessor Reinsurance receivables Debt securities classified as available-for-sale All financial instruments measured at fair value through net income Loans and receivables between entities under common control Financial guarantee contracts that are accounted for as insurance Applying the new standard may cause significant differences in the timing and amount of credit losses recognized for securities depending on whether an entity classifies them as held-to-maturity or available-for-sale. The standard requires credit impairment that is recognized for held-tomaturity securities to include lifetime expected credit losses, which is a significant change to current practice. In contrast, the FASB made only targeted changes to the existing guidance for available-for-sale debt securities. Current Expected Credit Losses Recognition Loans Incurred losses probability threshold Lifetime losses no recognition threshold Held-to-Maturity Debt Securities Other-than-temporary impairment Credit losses reduce amortized cost basis Lifetime losses no recognition threshold Recognize credit losses using an allowance approach 2

3 Held-to-Maturity Debt Securities Prospectively adjust accretable yield if expectations of cash flows improve significantly subsequent to impairment recognition Recognize subsequent changes in expected credit losses (favorable and unfavorable) immediately in earnings by adjusting the allowance On initial recognition and at each reporting date, an entity recognizes an allowance for lifetime expected credit losses. The allowance reduces the amortized cost basis to the amount that an entity expects to collect. An entity immediately recognizes in earnings the subsequent changes (favorable and unfavorable) in expected credit losses. An entity has latitude to select a methodology to estimate and measure expected credit losses that is reasonable and appropriate for its circumstances. Generally, an entity will recognize credit losses immediately on originating or purchasing a non-credit deteriorated financial asset that is within the scope of the standard. Therefore, changes in the volume of loan originations or purchases of held-to-maturity debt securities will likely affect the comparisons of earnings measures between periods. Analysts and other stakeholders may want to understand the effect on key earnings measures from originating new loans or acquiring debt securities. Initial Adoption. The allowance generally will increase on adoption of the standard. The amount of the increase will depend on many factors including the remaining duration of the portfolio and forecasted future economic conditions (e.g., position in the credit cycle). Regulatory Capital. Increased allowance levels will decrease an entity s regulatory capital and ratios. It remains to be seen what actions, if any, banking regulators will take with respect to regulatory capital rules. Current Expected Credit Losses Measurement 2 Generally considers past loss experience and current conditions Measures incurred credit losses on loans considering a loss-emergence period Considers past loss experience, current conditions, and forecasts of future conditions Considers lifetime expected credit losses 2 This section does not incorporate guidance on beneficial interests in securitized financial assets. 3

4 Generally measures impaired loans and held-to-maturity debt securities on an individual asset basis using a discounted cash flow methodology Does not prescribe a specific methodology Requires collective assessment for financial assets with similar risk characteristics An entity may need to develop or change its processes for forecasting future events, including credit losses and future economic conditions. The standard does not prescribe a specific methodology for estimating lifetime expected credit losses. Thus, an entity may select from a range of methodologies for estimating and measuring expected credit losses including, but not limited to, discounted cash flow, loss-rates, roll-rates, and probability of default methods. Regardless of the specific methodology selected, specific guidance applies. An entity evaluates financial assets with similar risk characteristics on a collective (pool) basis. 3 An entity will remove a financial asset from a pool if its risk characteristics are no longer similar to the risk characteristics of the other financial assets in the pool. An entity will measure credit losses individually for a financial asset that does not share similar risk characteristics with other financial assets. An entity that uses a discounted cash flow method will discount expected cash flows (i.e., projected future principal and interest) at the effective interest rate. 4 An entity that uses a method other than discounted cash flows, bases the expected credit losses on the amortized cost basis at the reporting date. 5 An entity may, but is not required to, consider premiums, discounts, net deferred fees and costs, foreign exchange, and fair value hedge accounting adjustments separately from the remaining amortized cost basis when measuring expected credit losses. An entity must consider reasonably available information to assess the collectibility of contractual cash flows, including internal and external information about past events, current conditions, and reasonable, supportable forecasts of future conditions. Historical loss experience generally provides a basis for measuring expected credit losses. An entity adjusts this experience for differences between the conditions that existed during the historical period and current conditions and reasonable and supportable forecasts for future periods. The adjustment may be qualitative and should reflect changes related to relevant data (e.g., unemployment rates, property values, commodity values, and delinquency). 3 Similar risk characteristics may include any one or a combination of the following: internal or external (third-party) credit score or credit ratings, risk ratings or classification, financial asset type, collateral type, size, effective interest rate, term, geographical location, industry of the borrower, vintage, historical or expected credit loss patterns, or reasonable and supportable forecast periods. 4 The rate of return implicit in a financial asset, that is, the contractual interest rate adjusted for net deferred fees or costs, premium, or discount existing at the origination or acquisition of the financial asset. 5 The amortized cost basis is the amount at which a financing receivable or investment is originated or acquired, adjusted for applicable accrued interest, accretion or amortization of premium, discount, and net deferred fees or costs, collection of cash, write-offs, foreign exchange, and fair value hedge accounting adjustments. 4

For periods for which an entity cannot forecast conditions in a reasonable and supportable manner, the entity will revert to the historical loss experience used as the starting point for preparing

5 For periods for which an entity cannot forecast conditions in a reasonable and supportable manner, the entity will revert to the historical loss experience used as the starting point for preparing the estimate. An entity will have latitude to select the reversion method. For example, an entity could choose to revert to historical experience over time on a straight-line basis, or it could revert to historical experience immediately for periods beyond the forecasted periods. An entity measures credit losses over the entire contractual term of its financial assets. It should consider expected prepayments when estimating credit losses. However, it considers expected extensions, renewals, and modifications only if it reasonably expects a troubled debt restructuring will take place. The loss amount reflects the risk of nonpayment, even when that risk is remote. However, an entity will not be required to recognize a loss on a financial asset (e.g., U.S. treasury securities) when risk of nonpayment is zero based on historical loss experience adjusted for current conditions and reasonable and supportable forecasts. Illustration The following illustration shows one way an entity may estimate CECL. An entity has calculated historical losses for a portfolio of financial assets and determined that the historical annual loss rates increased in the early years of the term and declined thereafter as the portfolio moved towards its maturity. The entity forecasted that current and future economic conditions would lead to higher losses compared with historical experience. As a result, it increased projected loss rates during the period that it can reasonably forecast. Subsequent to that period, the entity uses a methodology that immediately reverts from the loss rate projected at the end of the period that could be reasonably forecasted to the historical loss rate. The loss curve below illustrates the build-up of the total expected credit loss. Reasonable and and supportable supportable forecast forecast period Symbol Description Historical losses Adjustment for current conditions and forecasted future conditions 5

6 Different Approaches. The standard does not prescribe certain aspects of the credit loss estimate, including: The specific methodology to be used; How to determine the reasonable and supportable forecast period; How to revert to historical losses beyond the reasonable and supportable forecast period; and How to determine historical losses. As a result, the standard allows various approaches. Different approaches may lead to diversity in practice and ranges of acceptable estimates of expected credit losses for similar assets. New Concepts. Estimating and measuring CECL requires new judgments that current U.S. GAAP does not require including: Estimating how economic conditions may change in the future and adjusting historical information based on those estimates; Determining the reasonable and supportable forecast period, and if applicable, reverting to historical losses beyond this period; and Estimating the effect of expected prepayments. Data Required. Historical data that will underlie CECL estimates will likely be lifetime loss data, which an entity may not have developed in the past. When selecting the methodology for estimating CECL, an entity may want to consider what relevant and reliable historical data is available and what additional data it may need to implement different methodologies. Qualitative Adjustments. The standard will not eliminate qualitative adjustments from estimates of credit losses. We expect that in many circumstances the adjustments may be different and the number and magnitude of these adjustments may be greater under the new standard than in current practice. In addition, lifetime credit loss estimates are made over a longer period and therefore it may be more challenging for management to support its estimates of these adjustments. Management will continue to be responsible for both the appropriate documentation for these adjustments, and for developing processes and related controls for determining the amount of the adjustments that are structured, repeatable, and transparent. Processes and Internal Controls. An entity will need to develop or revise accounting processes and internal controls. These processes and controls will require applying significant judgment, collecting additional data, and developing estimates. An entity may need to upgrade its IT systems to capture additional data to support the accounting and disclosure requirements. In some circumstances, an entity may need new internal controls over financial reporting for existing processes. 6

7 The definition of purchased creditdeteriorated financial assets under the new standard is different from the definition in current U.S. GAAP. This will require an entity to determine whether assets acquired after the adoption of the standard meet the new definition. Credit Cards. An entity makes a CECL estimate for commitments to extend credit only when the commitment is not unconditionally cancellable by the issuer (i.e., lender). As a result, if a credit card relationship gives the lender the unilateral ability to unconditionally cancel the undrawn commitment, the expected credit loss estimate would relate solely to the funded portion of the credit card relationship. Purchased Credit-Deteriorated Financial Assets No allowance recognized at acquisition (i.e., accretable difference) Discounted cash flow methodology required Allowance recognized at acquisition through a gross-up that increases the amortized cost of the assets with no effect on earnings No specific methodology required Effective yield increases when subsequent changes in expected cash flows are favorable Immediately recognize in earnings subsequent changes (favorable and unfavorable) in expected cash flows by adjusting the allowance If entities purchase credit-deteriorated (PCD) financial assets, there is no immediate effect to earnings because of the gross-up approach. 6 This is in contrast to purchases of non-pcd assets, which will generally result in recognizing a loss at the date of acquisition despite the absence of credit deterioration. Available-for-Sale Debt Securities 7 Credit losses recognized through a direct write down of the amortized cost basis Allowance approach 6 PCD financial assets are acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that, as of the date of acquisition, have experienced a more-thaninsignificant deterioration in credit quality since origination, as determined by an acquirer s assessment. 7 This section does not incorporate guidance on beneficial interests in securitized financial assets. 7

8 Credit losses can exceed total unrealized losses No reversals of previously recognized credit losses Fair value floor for credit losses Allows immediate reversals of credit losses The targeted amendments to the current other-thantemporary impairment model for available-forsale debt securities may result in earlier impairment recognition. An entity will continue to apply a credit loss model similar to the current otherthan-temporary impairment model to debt securities classified as available-forsale. The standard made several targeted amendments to the current impairment model: Recognize the impairment amount through an allowance account and allow immediate reversals of previously recognized credit losses; Limit impairment to the difference between the amortized cost basis and fair value; and When evaluating whether a credit loss exists, an entity: Would not be permitted to consider the length of time the fair value has been less than amortized cost; and May, but is not required to, consider (1) changes in fair value after the balance sheet date; and (2) the historical or implied volatility of the fair value. Guarantees An entity will measure and account for an allowance for expected credit losses separately from the financial guarantee liability. Consistent with current U.S. GAAP, an entity will recognize and initially measure a guarantee liability at fair value. 8 Under the new standard, an entity will measure expected credit losses associated with guarantees similar to the expected credit losses for loans and held-to-maturity debt securities. The guarantor will recognize separate liabilities for the guarantee (at fair value) and the allowance for expected credit losses related to that guarantee. The guarantor will recognize a loss when it enters into the guarantee arrangement (for an amount that will generally equal the amount recognized as the allowance for expected credit losses). 8 FASB ASC Topic 460, Guarantees, available at 8

9 Effective Dates and Transition Both U.S. GAAP and IFRS have new impairment requirements, however, they have different mandatory effective dates. IFRS 9 must be adopted before the new U.S. GAAP impairment standard is effective. Question When does Topic 326 take effect? Can entities early adopt? How does the transition work? The entity is a public business entity that is an SEC filer 9 Annual and interim periods in fiscal years beginning after 12/15/2019 any other entity Annual and interim periods in fiscal years beginning after 12/15/ All entities can adopt Topic 326 for annual and interim periods in fiscal years beginning after 12/15/2018. Cumulative effect adjustment in retained earnings as of the beginning of the year of adoption. Specific prospective transition guidance for PCD financial assets and other-than-temporarily impaired availablefor-sale debt securities. Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Mark Northan, Mahesh Narayanasami, and Danielle Imperiale Earlier editions are available at: Legal The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP. 9 An SEC filer is an entity that is required to file or furnish its financial statements with either (a) the SEC or (b) with respect to an entity subject to Section 12(i) of the Securities Exchange Act of 1934, as amended, the appropriate agency under that Section. Financial statements for other non-sec filers whose financial statements are included with another filer s SEC submission are not included in this definition. 10 For non-public business entities, including not-for-profit entities, and employee benefit plans within the scope of ASC Topics 960, Defined Benefit Pension Plans; 962, Defined Contribution Pension Plans; and 965, Health and Welfare Benefit Plans, the standard is effective for annual periods in fiscal years beginning after 12/15/2020 and interim periods in fiscal years beginning after 12/15/

Credit impairment. Handbook US GAAP. March kpmg.com/us/frv

Credit impairment. Handbook US GAAP. March kpmg.com/us/frv Credit impairment Handbook US GAAP March 2018 kpmg.com/us/frv Contents Foreword... 1 About this publication... 2 1. Executive summary... 4 Subtopic 326-20 2. Scope of Subtopic 326-20... 14 3. Recognition