Credit the Financial Crisis, Major Changes Coming to Credit Loss Recognition


 

The 2007-2008 financial crisis promised to reshape much of the global economy, led by a dramatic shift in the esoteric workings of the financial industry, both domestically and abroad.  While some of those proposed changes have been realized, many have faded into the relative obscurity of the hyperbolic world.  In a dedicated effort to reform accounting policy, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) established a Financial Crisis Advisory Group (FCAG) in 2008 to serve as an advisor on financial reporting improvements.

 

The two primary goals of the group were to present stakeholders with a more accurate and transparent view of company financial statements, and subsequently, prevent another global financial crisis. The FCAG identified delayed credit loss recognition as one of the most substantial weaknesses in financial reporting, both in generally accepted accounting principles (GAAP) and in international financial reporting standards (IFRS).

 

With a newly released Accounting Standards Update (ASU) 2016-13 in June of 2016, FASB and IASB have lived up to their word about significantly altering how companies measure credit losses on financial instruments. The new standards will not become effective for GAAP purposes until fiscal periods ending Dec. 15, 2019, Dec. 15, 2020, and Dec. 15, 2021 for SEC filers, Non-SEC filing Public Business Entities, and all other entities, respectively. Regardless, companies are already beginning to internally adopt to the expected changes that are for now, increasingly imminent.

 

Current FASB and IASB guidance requires the use of the incurred loss model, where credit losses can’t be recognized in the financial statements until an incurred loss is “probable.” Both users and firms expressed concerns that GAAP and IFRS limited a company’s ability to record credit losses that the company had already projected, but did not meet the “probable” threshold of the standards. Unfortunately, this limitation forced users to forecast the inherent valuation deduction as the result of potential credit losses using their own models. This created a severe disconnect between how regulatory agencies viewed financial statements and those users searching for “general-purpose financial statements” viewed them. The new guidance, instigated by the FCAG, strives to nullify this disconnect and accelerate the process of converging incurred credit losses and expected credit losses to more accurately value risk-weighted assets.

 

GAAP:

 

FASB and IASB requirements diverge on credit losses recognition. Under the U.S. amendments, ASU 2016-13, Financial Instruments – Credit Losses (Topic 326), there will be a transition from the incurred loss model to the current expected credit losses model (CECL). The new GAAP will adopt a more “forward-looking” perspective on credit losses recognition for financial assets valued at amortized cost. It requires recognition of full lifetime expected credit losses upon initial recognition, and adjustments on the allowance account.

 

ASU 2016-13 will affect available-for-sale debt securities (AFS) differently than those valued at amortized cost. Credit losses on AFS securities will be reflected as an allowance, not a write-down. This affords companies the luxury of reversing overestimated credit losses on the balance sheet and aligning credit losses more precisely with the period in which they actually occur (think “matching principle”).

 

IFRS:

 

In an attempt to alleviate some transitional nausea, IASB has issued a more subdued version on credit losses recognition than its FASB peer (dubbed IFRS – 9). In its quasi multi-tiered model (3 tiers), the most substantial accounting divergence is the timeframe over which the projected credit losses must be immediately recognized.  FASB is clear that credit losses must be estimated over the course of the asset’s life. In contrast, Tier 1 assets under IFRS--assets that do not fall under tiers 2 or 3--only require companies to forecast credit losses out over the course of a single year.

 

Tier 2 assets, financial instruments that have had a “significant increase in initial credit risk,” require lifetime expected credit losses to be recognized, similar to GAAP. Tier 3 assets, instruments with “objective evidence of impairment,” will not only require lifetime credit losses recognition, but in addition, will mandate interest revenue be calculated on the value of the asset after a reduction of the allowance for credit losses.

 

In addition there could be a hidden effect of the new financial reporting requirements on credit loss recognition. Capital requirements for financial institutions are based on the capital adequacy ratio: Tier 1 Capital + Tier 2 Capital / risk-weighted assets (RWA) (FDIC, 2016). As RWA’s rise, so must the physical capital to maintain a constant ratio. Could the change in accounting policy regarding credit losses lead to another credit crunch?

 

For Example:

 

CNBC calculated that among 2,000 nonfinancial companies, their collective debt balance was $6.6 trillion, versus $1.84 trillion cash balance, resulting in the highest debt to cash ratio in nearly 10 years (CNBC, 2016). Companies are more reliant on debt than at any time in the post-financial crisis world. If banks are unable to lend due to heightened capital requirements amid the substantial increase in recognized credit losses, the economy could headed for more turbulence.

 

The simple answer is another credit crunch is entirely possible, but unlike the 2007-2008 financial crisis, this time a warning shot has been fired. In a time with an ever-increasing demand for transparency, it will be up to the financial industry to be proactive in its adjustment. Heavy reliance will be placed on the accounting world, both internally and externally, to navigate the changes to distant shores.

 

Editor’s Take:

Upon pushback from those with inside knowledge within the accounting industry, FASB will amend GAAP to reflect a more IFRS-like approach to credit losses. Ultimately, a more balanced platform that incorporates a longer projection timeframe than current GAAP permits will prevail. The effect on current year earnings, particularly on more heavily weighted financial securities portfolios, will be felt, albeit not to a “doomsday” level. This will subsequently lead to a moderate credit crunch (the Fed’s reaction will determine the severity). Longer than three years lead time for SEC filers will be substantial enough for banks to raise adequate capital (general provisions and specific provisions) to offset the expected losses. The real play here may be the evolution of financial analysis, in conjunction with information technology, required to mitigate the effects of ASU 2016-13. If the changes to GAAP are indeed permanent and as-written, a complete overhaul to the way we view and accept credit risk is on the horizon.

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By Todd Cheney