The Financial Accounting Standards Board (“FASB”) has issued a proposal to change impairment accounting so that the allowance for credit losses on loans and debt securities would be based on expected losses rather than on any of the multiple impairment models in current U.S. generally accepted accounting principles (“GAAP”). The December 20 proposal, issued in a FASB exposure draft titled Financial Instruments—Credit Losses (Subtopic 825-15), is intended to require more timely recognition of credit losses and provide additional transparency about credit risk, according to FASB. Under the proposal, the existing “probable” threshold in U.S. GAAP for recognizing credit losses would be removed and the range of information to be considered in measuring the allowance for expected credit losses would be broadened. A bank’s management would be required to estimate the cash flows that it does not expect to collect, using all available information, including historical experience and reasonable and supportable forecasts about the future. Under FASB’s proposal, the balance sheet would reflect the current estimate of expected credit losses at the reporting date and the income statement would reflect the effects of credit deterioration or improvement that has taken place during the period. Public comments on the proposal are due by April 30, 2013.

     Nutter Notes: It is possible that the FASB proposal could change not only the processes required to estimate the allowance for credit losses, but also may increase allowance balances for many banks. According to FASB, a bank would be able to choose not to recognize expected credit losses on financial assets measured at fair value under the proposal, with changes in fair value recognized through other comprehensive income, if both the fair value of the financial asset is greater than or equal to the amortized cost basis, and expected credit losses on the financial asset are insignificant. FASB said that it expects that different types of entities would leverage their current risk monitoring systems in implementing the proposed approach, with banks using regulatory risk categories, but that the inputs used to estimate the allowance for credit losses may need to change to implement the expected credit loss approach. Current U.S. GAAP includes five different incurred loss credit impairment models for instruments within the scope of the proposal, according to FASB. Those existing models generally delay recognition of credit loss until the loss is considered “probable.” FASB said that this initial recognition threshold may have interfered with the timely recognition of credit losses and overstated assets during the recent global economic crisis.