FSR Insights Re-setting the standard for credit losses March 2016

FSR Insights
Financial Instruments, Structured Products & Real Estate Insights
March 2016
Re-setting the standard for credit losses
Post financial crisis, various constituents
expressed the need for the accounting standard
setters to address the perceived flaws in the
various current impairment models used for
financial reporting. For example:

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In an April 2009 report reflecting on the
causes of the global financial crisis, the
Group of 20, consisting of the finance
ministers and central bank governors of the
major economies, made several
recommendations. The report
recommended that accounting principles
related to loan loss provisioning be
improved to permit consideration of a
“broader range of credit information.”
The Financial Crisis Advisory Group,
formed to advise the FASB and IASB, said
in its July 2009 report that the financial
crisis exposed weaknesses in financial
reporting that included “the delayed
recognition of losses associated with loans,
structured credit products, and other
financial instruments by banks, insurance
companies and other financial institutions.”
They recommended that the boards explore
an approach that uses more forwardlooking information, such as an expected
loss model or fair value model.
The Basel Committee on Banking
Supervision stated in an August 2009
report that the IASB’s new financial
instruments standard should “reflect the
need for earlier recognition of loan losses to
ensure robust provisions.”
The FASB’s proposed impairment model seeks
to improve the decision usefulness of the
reporting of credit losses by moving away from
the incurred loss model that exists in practice
today to an expected loss model.
In 2016 the Financial Accounting Standards
Board (“FASB”) is expected to publish a final
Accounting Standards Update (“ASU”) related
to the recognition and measurement of credit
losses for certain financial instruments.
The proposed ASU is tentatively expected to be
effective for reporting periods beginning after:

December 15, 2018 for public business
entities (“PBE”s) that file financial
statements with the Securities and
Exchange Commission (“SEC”);

December 15, 2019 for PBEs that do not
meet the definition of an SEC filer; and

December 15, 2019 for annual reporting
periods of Non-PBEs and December 15,
2020 for interim reporting periods of
Non-PBEs.
The proposed ASU’s “go live” date may seem far
away, financial reporting stakeholders recognize
that the complexity posed by the proposed ASU
will require significant implementation efforts.
We want to share some perspectives on what we
know about the proposed ASU, what we don’t
yet know about the proposed ASU, how different
industry sectors might be impacted, and what
you should be doing now to prepare for
implementation.
FSR Insights March 2016
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What do we know?
The new guidance will impact most reporting
entities that hold financial assets within the scope
of the revised guidance. Financial assets within
the scope of the proposed guidance include:
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Loans.

Held-to-maturity debt securities.

Available-for-sale securities.

Loan commitments.

Trade receivables.

Lease receivables.

Reinsurance receivables and financial
guarantees.
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The proposed ASU changes the credit
impairment model for available-for-sale
(“AFS”) debt securities:
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Eliminates certain existing US GAAP on
qualitative considerations in a preparer’s
impairment review processes, including
consideration of the extent and duration
of an unrealized loss position and post
balance sheet date recoveries in value.
-
Requires the presentation of any
recognized credit losses as an allowance
for credit losses, as opposed to a direct
write down of the debt security ’s
amortized cost basis.
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Recoveries of credit losses would be
recognized through the reserve.
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Establishes a fair value “floor” on the
measurement of the credit loss amount,
meaning a company should not record
an allowance greater than the difference
between the amortized cost basis and
fair value of the security.
The key concepts of the proposed ASU are:

A current expected credit loss (“CECL”)
model for in scope financial assets held at
amortized cost (including loans and held-tomaturity securities) on the balance sheet:
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All relevant internal and external
information must be considered,
including historical experience of the
preparer, current conditions, and
forecasts.
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The proposed ASU will not prescribe any
specific modelling technique
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The model allows discretion with regards
to a preparer’s selection of a model that
does or does not incorporate time value
of money techniques.
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Expected credit loss estimation is
required on a “pooled” basis for assets
with similar credit risk characteristics
The CECL model will impact all
amortized cost assets with a significant
change from existing guidance on
impairment for held-to-maturity
securities.
Requires the recognition of expected
credit losses through a reserve for credit
losses upon acquisition or origination.

The model eliminates the “probable”
trigger in existing US GAAP for the
recognition of a credit loss reserve for
loans.
The proposed ASU changes the credit
impairment model for purchased credit
deteriorated (“PCD”) assets:
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The model will require the recognition of
a credit loss reserve upon acquisition,
recorded through a gross up to the
balance sheet.
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The model may apply to an increased
number of assets because it is required
for assets acquired with more than
insignificant deterioration in credit
quality since asset origination.
-
The new criteria for credit deteriorations
is a change from current US GAAP,
which requires that it is probable that
not all contractual cash flows will be
collected and there be a significant
deterioration in credit quality since
origination.
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FSR Insights March 2016
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Entities will have to comply with additional
disclosure requirements, including more
expansive disclosure for credit quality
indicators (“CQI”).

The proposed ASU will not represent
convergence with International Financial
Reporting Standards (“IFRS”) 9 on the
recognition and measurement of credit losses
for financial assets.
What don’t we know?
Financial reporting stakeholders are already
asking how some of the principles articulated in
the proposed ASU may impact their existing
accounting operations, financial reporting and
disclosure processes.
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provide transparency to the staff on the impact of
implementation on its constituents. The TRG is
expected to play an active role as the FASB moves
towards issuance in 2016.
What is the potential impact?
We expect the proposed ASU’s impact will vary,
based upon entity-and portfolio-specific
considerations, across industry sectors in relation
to modelling methodology, data and
infrastructure, and processes and controls.
The impact of the ASU’s impact on financial
reporting and operational processes will affected
by:

The mix of asset types held in a portfolio;

Existing accounting policies and balance
sheet classification of financial assets;

The state of the entity ’s accounting
information systems, data warehousing, and
use of third party vendors;

Existing credit loss projection capabilities,
including regulatory reporting models; and

Whether the entity performs reporting under
IFRS.
Hot topics include:

Interpretation of the proposed ASU by
regulatory bodies.

Application of the proposed ASU on existing
US GAAP for certain beneficial interests in
securitizations.

Measurement of the credit loss by comparing
expected cash flows to the amortized cost
basis of the underlying asset when modelling
techniques do not explicitly incorporate time
value of money considerations.

Definition and interpretation of what will be
considered “reasonable and supportable”
forecasts.

Incorporation of macro-economic forecasts
into credit loss projection methodologies.

Application of the standard for expected
lifetime loss projection periods for revolving
assets where the lender has the unilateral and
irrevocable ability to revoke revolving
privileges.

Development of data and reporting
capabilities to comply with the proposed
ASU’s disclosure requirements.
The FASB has formed a Transition Resource
Group (“TRG”) to facilitate discussions with the
FASB staff as implementation issues arise and to
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The ASU’s impact will differ by product type
measurement attribute. The products and
accounting policies in certain industries will drive
implementation focus points.
For example, the insurance industry and
corporate treasury departments likely will
maintain significant available-for-sale security
portfolios and leverage automated investment
accounting platforms for impairment, valuation,
and income recognition on these assets. The
modifications to the available-for-sale debt
securities impairment guidance in the proposed
ASU likely will require system updates to enable a
reserve-based model. In addition, a reduction in
qualitative considerations available in the credit
loss assessment for available-for-sale securities
may require changes to existing operational
processes and controls that identify and measure
impaired instruments.
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FSR Insights March 2016
Regulators continue to focus on third-party
vendors. The implementation of the proposed
ASU will require enhancements to reporting firms’
data and infrastructure capabilities to ensure
management has the information to support their
loss projections. Vendor due diligence and risk
management will play a critical role in
implementing the new model and the on-going
operations of reporting firms.
Many regulated financial institutions have been
subject to regulatory reporting and forecasting
requirements involving extensive modelling.
These reporting entities will focus on finding ways
to leverage existing credit loss projection models
and revising qualitative frameworks to capture the
new financial reporting requirements for credit
impairment. The insurance and banking
regulators likely will influence implementation of
the proposed standard in those sectors. Reporting
entities likely will seek operational efficiencies
through potential alignment of GAAP and
regulatory reporting processes.
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resources and capabilities, access to data on
credit losses, and existing processes, controls,
and documentation for loss reserves.

Human capital considerations. The
cross functional impact will require
coordination and technical expertise.

Model methodology and development.
Entities should evaluate how to leverage
existing modeling capabilities to address the
differences between regulatory and
accounting concepts of expected credit losses.
Entities that rely on vendor models for
forecasting should undertake due diligence to
vendor compare capabilities and develop
processes to assess vendor model outputs
through review and testing. It is important
that appropriate controls exist at companies
relying on vendor models. We expect all
entities will require investment in their
modeling processes.

Data capabilities and infrastructure.
Projecting lifetime losses on financial
instruments may be data intensive. Some
entities will need to gather new data and/or
enhance existing data sources. In addition,
entities will need to evaluate the sufficiency of
data retention practices. This could be
accomplished by enhancing existing systems
or leveraging vendor solutions.

Operational processes, controls, and
documentation. Any updates to modelling
methodology and data infrastructure will
require considerations of operational impact
and internal controls. In addition, the
proposed ASU will require enhancements to
existing controls and reporting processes to
meet the enhanced disclosure requirements.

Dual filers should continue getting
ready for IFRS 9. The IFRS 9 model has
similarities and differences with the proposed
ASU. Reporting entities may find synergies
and gaps during the process of a dual
implementation approach.
The divergence of the ASU and IFRS 9 will present
challenges for dual-filing entities. GAAP and IFRS
divergence will increase control and disclosure
complexity for financial and regulatory reporting.
What should you do now?
A critical first step towards implementation will be
the construction of a formal governance program
involving cross-functional skills including
accounting policy, credit risk management, model
risk and validation, regulatory reporting, financial
reporting, internal audit, investor relations, tax,
and treasury.
An effective implementation will require
coordination amongst all stakeholders to assess
the current state of reporting capabilities, and
to identify gaps, and develop actions in the
implementation program. Reporting entities must
maintain adequate systems, data, and processes to
support credit loss forecasts. Several areas will be
key to implementation:

Readiness assessments and planning.
Entities should take stock of modeling
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FSR Insights March 2016
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Who is here to help you through the
implementation process?
Dave Lukach
Partner
646 471 3150
[email protected]
Jessica Pufahl
Director
646 574 2159
[email protected]
Frank Serravalli
Partner
646 742 7510
[email protected]
Robert Kianos
Senior Manager
973 236 7854
Chris Merchant
Partner
202 346 5050
[email protected]
Matt Keller
Manager
646 471 6742
[email protected]
Mike Shearer
Managing Director
646 471 5035
[email protected]
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