Last week, the Financial Accounting Standards Board (the “FASB”) issued its long-anticipated update to Financial Instruments – Credit Losses (ASC Topic 326) – Measurement of Credit Losses on Financial Instruments (the “Revised Credit Loss Methodology”). The Revised Credit Loss Methodology, when implemented, will replace U.S. GAAP’s current “incurred loss” approach to the recognition of credit losses on financial assets measured on an amortized cost basis with a “forward-looking” approach based on the expected credit loss over the life of the instrument. Under U.S. GAAP’s current approach, an entity does not reflect credit losses in its financial statements until such losses are probable or have been incurred and generally consider only past events and current conditions in making these determinations.
For SEC reporting companies, the Revised Credit Loss Methodology will become effective “for fiscal years beginning after December 15, 2019, including interim periods within such years” such that the first reporting period under the new methodology will be for the quarter ending March 31, 2020 for calendaryear filers. Early adoption is permitted for fiscal years beginning after December 15, 2018.
The principal elements of the Revised Credit Loss Methodology include:
- Financial assets, including receivables, loans and held-to-maturity debt securities, measured on an amortized cost basis will be reflected on the entity’s financial statements net of expected credit losses over the contractual term of the relevant asset.
- The measure of expected credit losses must be “based on relevant information about past events, including historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of the reported amount.”
- Changes in expected credit losses – both increases and decreases – will be reflected in the entity’s net income
- With respect to financial assets with more than an insignificant amount of credit deterioration since origination that are purchased by an entity, the initial allowance for credit losses will be added to the purchase price rather than reported as a change in expected credit losses.
- When effective, entities will need to initially apply the Revised Credit Loss Methodology through a one-time adjustment to retained earnings – that is, not through net income – with respect to financial assets already existing on the balance sheet as of the beginning of the first applicable reporting period.
The Revised Credit Loss Methodology generally does not specify a particular methodology to be used in determining expected credit losses. Instead, the FASB indicates that an entity is allowed “to apply methods that reasonably reflect its expectations of the credit loss estimate.” Furthermore, an entity’s “estimate of expected credit losses shall include a measure of the expected risk of credit loss even if that risk is remote, regardless of the method applied to estimate credit losses. However, an entity is not required to measure expected credit losses on a financial asset . . . in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero.” This appears to indicate that the FASB does not expect all financial assets necessarily to have an associated future credit loss charge recorded at the origination or purchase of the financial asset.
Concurrently with the FASB’s release, the U.S. Federal banking agencies (the “Agencies”) issued a Joint Statement on the New Accounting Standard on Financial Instruments – Credit Losses setting forth their initial supervisory views regarding Revised Credit Loss Methodology, including:
- The Agencies believe that smaller and less complex banking organizations “will be able to adjust their existing allowance methods to meet the requirements of the new accounting standard without the use of costly and complex models.”
- Banking organizations may, but will not be required to, engage third-party service providers to calculate their expected credit losses.
- As part of the implementation process, institutions should “collect data to support estimates of expected credit losses in a way that aligns with the method or methods that will be used to estimate their allowances for credit losses. Depending on the method selected, institutions may need to capture additional data. Institutions also may need to retain data longer than they have in the past on loans that have been paid off or charged off.”
- In any event, the specific process developed by each banking organization to implement its credit loss estimation methodology will need to be thorough, disciplined, consistent, well-documented and subject to strong internal controls.
As banking organizations of all sizes begin to prepare for the ultimate implementation of the expected credit loss approach, there are a number of issues, questions and uncertainties that arise at the intersection between the bank regulatory requirements and the Revised Credit Loss Methodology. Most notably:
- Because the Revised Credit Loss Methodology is likely to increase assumed credit losses for financial reporting purposes, and thereby decrease regulatory capital, as well as increase the potential volatility of credit losses and capital over time, banking organizations will need to re-evaluate their capital levels to maintain sufficient buffers above regulatory minimums and other related supervisory standards and expectations.
- This is particularly important for banking organizations subject to the Federal Reserve’s capital plan rule and CCAR stress testing exercise (that is, bank holding companies with $50 billion or more in total consolidated assets (“CCAR Banking Organizations”)) which must meet regulatory capital minimums under severely adverse macroeconomic conditions in order to pay dividends and other capital distributions.
- It is unclear how the Agencies will treat the potential cliff effect of the one-time adjustment to retained earnings, and therefore Common Equity Tier 1, upon the initial implementation of the Revised Credit Loss Methodology (for example, whether the Agencies will consider a phase-in of the adjustment). This is particularly important for CCAR Banking Organizations, although the nine-quarter planning horizon for the next set of capital plans (which are to be filed in early April 2017) will not be affected by the new approach unless the BHC elects early adoption, the planning horizon for capital plans filed in April 2018 extends through March 31, 2020 and, accordingly, will be impacted by the new approach’s one-time adjustment to Common Equity Tier 1.
- Reduced earnings due to the operation of the Revised Credit Loss Methodology will serve to decrease the legal dividend capacity of depository institutions.
- Moreover, the capital planning process and CCAR itself are based on modeled estimates of expected credit losses. Once financial statements already incorporate expected credit losses over the life of the relevant assets under baseline macroeconomic conditions – as opposed to only probable and incurred credit losses as is currently the case under GAAP – presumably the capital planning and CCAR exercises will need to be modified to only reflect incremental changes to expected credit losses due to changes in expected conditions over the shorter nine-quarter stress testing horizon.
- Similarly, banking organizations subject to the advanced model-based approaches to determining regulatory capital and CCAR will likely need to appropriately harmonize their implementation of the Revised Credit Loss Methodology with the relevant portions of their advanced approaches capital and separate stress testing calculations.
- A number of aspects of banking regulation – for example, lending limits, investment limits and the bases against which permitted extensions of credit by depository institutions to affiliates are calculated under Section 23A of the Federal Reserve Act – use capital and surplus as the base for relevant calculations. Implementation of the Revised Credit Loss Methodology will impact each of these calculations. It will be important for banks for which the adjustment on implementation is material to plan ahead to accommodate the one-time cliff effect mentioned above.
- It is also unclear how the Agencies and the SEC may evaluate situations in which different banking organizations produce different expected credit loss estimates for the same shared national credit held by different members of a loan syndicate.
- Banking organizations will need to decide how to disclose the potential impact of the Revised Credit Loss Methodology in their next 10-Q and subsequent SEC filings.