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GAAP Volume 13, Issue 3 February 15, 2013

UPDATE SERVICE GAAP

Summary & Highlights

PRONOUNCEMENT: Proposed Accounting Standards Update (ASU), Financial Instruments—Credit Losses (ASC 825-15) (Part 1)

EFFECTIVE DATE: Entities would be required to apply the proposed guidance by making a cumulative-effect adjustment in the balance sheet as of the beginning of the fi rst reporting period in which the guidance would be effective. The effective date will be established when the fi nal guidance is issued.

The Financial Accounting Standards Board (FASB) issued the proposed Accounting Standards Update (ASU), Financial Instruments—Credit Losses (ASC 825-15), on December 20, 2012. Comments on the proposal are due by April 30, 2013.

This is Part 1 of a two-part series discussing the proposed ASU. Part 1 discusses the following topics:

Overview; Scope; Recognition; Subsequent measurement; Other presentation matters; and Disclosure.

The following topics will be discussed in Part 2:

Implementation; Transition; and Questions for respondents on the proposal.

Analysis and Implementation

Overview

This proposal is a component of the joint project of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (the Boards) to revise and improve their respective guidance on account- ing for fi nancial instruments. The project began before the global economic crisis in 2008, which exposed weaknesses in the existing accounting standards. One of those weaknesses is the overstatement of assets due to the delayed recognition of credit losses related to loans and other fi nancial instruments that were not recog- nized until it was probable that a loss will be incurred. The objective of the project on accounting for the impairment of fi nancial assets is to simplify the accounting guidance and to provide guidance that is useful for decision-making. Currently, there are fi ve different models in U.S. generally accepted accounting principles (GAAP) for accounting for the impairment of fi nancial instruments. A model that includes forward-looking information is needed to assess the impairment of fi nan- cial instruments.

To address that issue, among others, the FASB issued proposed ASU, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, in May 2010. That document included proposed guidance on classifi cation and measurement, credit impairment, and hedge accounting require- ments. Under that proposal, an entity would have been required to recognize a credit impairment when it does not expect to collect all contractual amounts due. The IASB also issued a proposal in November 2009. As a result of the Boards’ con- siderations of the comments on their respective proposals, they decided to develop a model that varies from the original proposal. In January 2011, the Boards issued a Supplementary Document, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Impairment, which was a joint proposal that introduced the concept of two different measurement objectives, one for a “good book” of performing loans and another for a “bad book” of loans. Based on comments received on that proposal, the Boards developed a “three-bucket model,” which would have eliminated an initial recognition thresh- old, and used two different measurement objectives for the credit impairment allowance that would be subject to the extent of credit deterioration or recovery since a fi nancial instrument’s origination or acquisition. After considerable discus- sion with stakeholders who raised many concerns about the three-bucket model, the FASB decided not to proceed with that model and has agreed on the proposed model, which retains certain sound concepts from other models considered during its discussions and avoids concepts that are complex, inoperable, and believed to be problematic.

Proposed ASU

The proposed guidance below would be included as new Subtopic ASC 825-15 in the FASB Accounting Standards Codifi cationTM (ASC) 825, Financial Instruments.

Scope

The guidance in the proposed ASU applies to all entities holding the following fi nancial assets that are susceptible to losses related to credit risk and are not clas- sifi ed at fair value through net income: (1) debt instruments classifi ed at amortized cost, debt instruments classifi ed at fair value with changes in fair value recognized in other comprehensive income, receivables from revenue transactions under the scope of ASC 605, Revenue Recognition, or reinsurance receivables resulting from insurance transactions under ASC 944, Financial Services—Insurance; (2) lease receivables recognized by a lessor under ASC 840, Leases; or (3) loan commitments.

Recognition

An allowance for expected credit losses on fi nancial assets, which is a current estimate of all contractual cash fl ows that an entity does not expect to collect, would be recognized at each reporting date. As a practical expedient, an entity may elect not to recognize expected credit losses for fi nancial assets measured at fair value with qualifying changes in fair value recognized in other comprehensive income if both of the following conditions are met:

The individual fi nancial asset’s fair value exceeds or equals the fi nancial asset’s amortized cost basis; and Expected credit losses on the individual asset are insignifi cant based on a con- sideration of where that asset’s credit-quality indicator is placed in a range of expected credit losses on the reporting date.

Estimating expected credit losses. Under the proposal, an entity would be required to estimate expected credit losses based on relevant information from internal and external sources (e.g., information about past events, historical loss experience with similar assets, or current conditions), as well as the implications for expected credit losses based on reasonable forecasts that can be confi rmed. That information would have to include quantitative and qualitative factors (e.g., a current evaluation of borrowers’ creditworthiness and the current and forecasted direction of the economic cycle), corresponding to the reporting entity’s borrowers and the environment in which the entity operates. Information relevant to the estimated collectability of contractual cash fl ows that is available without excessive cost and effort would be considered.

Estimates of expected credit losses would be required to refl ect the time value of money explicitly or implicitly. If expected credit losses are estimated using a discounted cash fl ows model, the discount rate used would be the fi nancial asset’s effective interest rate.

Under the proposal, an estimate of expected credit losses would always have to represent the possibility that a credit loss would occur and the possibility that it would not occur, rather than representing a worst-case scenario or a best-case scenario. Estimating expected credit losses based on the most likely outcome (i.e., a statistical calculation) would be prohibited. Estimates would be required to rep- resent how credit enhancements would reduce expected credit losses on fi nancial assets, such as consideration of a guarantor’s fi nancial condition or whether subor- dinated interests could absorb credit losses on underlying fi nancial assets. However, an entity would not be permitted to combine a fi nancial asset with a separate free- standing contract intended to reduce a credit risk loss in its estimate of expected

credit losses. Consequently, an entity would not be permitted to offset a legally detachable and separately exercisable contract (e.g., a credit default swap) that may reduce expected credit losses on a fi nancial asset or a group of fi nancial assets against estimated expected credit losses on the related fi nancial asset or group of fi nancial assets.

Recognition of changes in the allowance for expected credit losses. The amount of a credit loss or a reversal of previous amounts recognized in the allowance for expected credit losses required to adjust the allowance in the balance sheet for the current period would be recognized in the income statement as a provision for credit losses.

Interest income. Except for the guidance in this section, the proposed guidance in ASC 825-15 would not address how a creditor should recognize interest income. An entity that recognizes interest income on purchased credit-impaired fi nancial assets, which are defi ned in the ASC Glossary as “[a]cquired individual fi nancial assets…that have experienced a signifi cant deterioration in credit quality since origination, based on the assessment of the acquirer…” would not be permitted to recognize interest income on the discount embedded in the purchase price as a result of the acquirer’s assessment of expected credit losses at the acquisition date. An entity would be required to discontinue the accrual of interest income when it is not probable that the entity will receive substantially all of the principal or substantially all of the interest and would be required to account for payments as follows:

1. Payment of substantially all of the principal is not probable. An entity would be required to recognize all cash receipts from a debt instrument as a reduction in the asset’s carrying amount. Payments received after the carrying amount has been reduced to zero would be recognized in the allowance for expected credit losses as recoveries of amounts written off in previous periods. Payment in excess of amounts written off would be recognized as interest income.

2. Payment of substantially all of the principle is probable but payment of substantially all of the interest is not probable. An entity would be required to recognize interest income on a debt instrument when cash payments are received. Cash receipts in excess of interest income that would be recognized in the period if the asset had not been placed on nonaccrual status would be recognized as a reduction of the asset’s carrying amount.

If the conditions in (1) and (2) no longer exist, interest income would be rec- ognized in the manner it had been recognized before those conditions occurred.

Subsequent Measurement

Writeoffs. When an entity determines that it has no reasonable expectation of future recovery of the carrying amount of a fi nancial asset, it would directly reduce its cost basis in the fi nancial asset or portion thereof in the period in which that determination is made. The entity also would reduce the balance of the allowance for expected credit losses by the amount of the fi nancial asset’s balance that was written off. A recovery of a fi nancial asset that had been written off in a previous period would be recognized as an adjustment of the allowance for expected credit losses only if consideration is received to satisfy some or all of the contractually required payments.

Other Presentation Matters

The fi nancial statement presentation of estimates of expected credit losses for recognized fi nancial assets under the scope of ASC 825-15 would be as follows:

Financial assets measured at amortized cost. The estimate of expected credit losses would be presented in the balance sheet as an allowance reducing the assets’ amortized cost. Financial assets measured at fair value with changes in fair value recognized in compre- hensive income. The estimate of expected credit losses would be deducted from the assets’ amortized cost, which is presented on the balance sheet as a net amount. Recognized purchased credit-impaired assets not measured at fair value with all changes in fair value recognized in current income. The estimate of expected credit losses would be presented on the balance sheet as an allowance reducing the sum of the assets’ purchase price and the expected credit losses on the assets at acquisition. Loan commitments. The estimate of expected credit losses would be presented on the balance sheet as a liability.

Disclosure

The purpose of the proposed disclosures is to help fi nancial statement users to understand the following:

The portfolio’s underlying credit risk and how management monitors the port- folio’s credit quality; Management’s estimate of expected credit losses; and Changes in the estimates of expected credit losses that occurred during the period.

Information about credit quality. The information disclosed would have to enable users of fi nancial statements to do both of the following:

Understand how management manages the credit quality of its debt instru- ments; and Evaluate the quantitative and qualitative risks resulting from its debt instru- ments’ credit quality.

An entity would be required to provide quantitative and qualitative information by class of fi nancial asset about its credit quality, including the following:

A description of the of the credit-quality-indicator; The amortized cost, by credit-quality indicator; and For each credit-quality indicator, the date or range of dates in which the infor- mation was last updated for that credit-quality indicator.

An entity that discloses information about internal risk ratings would be required to provide qualitative information on how the internal risk ratings are related to the possibility of loss.

The above proposed disclosures requirements would not apply to short-term trade receivables related to revenue transactions under ASC 605.

Allowance for expected credit losses. The purpose of the proposed disclosures would be to enable fi nancial statement users to understand:

How management developed its allowance for expected credit losses; The information management used to develop its current estimate of expected credit losses; and Economic circumstances causing changes in the allowance for expected credit losses, which results in a related credit loss expense or reversal recognized during the period.

To meet the objectives discussed above, the following information about an enti- ty’s accounting policies and method used to estimate the allowance for expected credit losses would be disclosed by portfolio segment:

How expected estimates are developed; Factors infl uencing management’s current estimate of expected credit losses, including past events, current conditions, and reasonable and supportable fore- casts about the future; Risk characteristics relevant to each portfolio segment; Changes in the factors infl uencing management’s current estimate of expected credit losses and reasons for those changes (e.g., change in portfolio composi- tion, change in volume of purchased or originated assets, or signifi cant events or conditions affecting the current estimate that were not considered during the previous period); Changes, if any, to the entity’s accounting policies or methods from the prior period and the entity’s rationale for the change, if applicable; Signifi cant changes, if any, in techniques used to make estimates and reasons for the changes, if applicable; and Reasons for signifi cant changes in the amount of writeoffs, if applicable.

To help fi nancial statement users to understand activity in the allowance for expected credit losses for each period by portfolio segment, an entity would be required to separately provide the following quantitative disclosures for fi nancial assets classifi ed at amortized cost and fi nancial assets classifi ed at fair value with qualifying changes in fair value recognized in other comprehensive income:

Beginning balance in the allowance for expected credit losses; Provision for credit losses in the current period; Writeoffs charged against the allowance; Recoveries of amounts previously written off; and Ending balance in the allowance for expected credit losses.

An entity that used the practical expedient discussed above and did not measure expected credit losses for certain fi nancial assets classifi ed at fair value with qualifying changes in fair value recognized in other comprehensive income would be required to disclose the amortized cost balance of those assets at the portfolio segment level. The amortized cost for purchased credit-impaired assets would be the sum of the assets’ purchase price plus the expected credit losses on the assets at acquisition.

Roll forward for certain debt instruments. A roll forward of an entity’s portfolio of debt instruments classifi ed at amortized cost would be required from the begin-

ning of the period to the end of the period, separated at the portfolio segment level. It would include the following information:

Beginning amortized cost; Originations; Purchases; Sales; Repayments; Writeoffs; and Ending amortized cost.

A roll forward of a portfolio of debt instruments classifi ed at fair value with qualifying changes in fair value recognized in other comprehensive income would be required from the beginning of the period to the end of the period separated at the portfolio segment level. Disclosure of the information listed above would be required, at a minimum.

The above disclosures would not apply to the following:

Receivables as a result of revenue transactions under the scope of ASC 605; Reinsurance receivables as a result of insurance transactions under the scope of ASC 944; and Loan commitments not measured at fair value with changes in fair value recog- nized at net income.

Reconciliation between fair value and amortized cost for debt instruments classifi ed at fair value with qualifying changes in fair value recognized in other comprehensive income. If an entity has not already presented all of the following items on the balance sheet, it would be required to disclose a reconciliation of the difference between the fair value and amortized cost for assets measured at fair value with qualifying changes in fair value recognized in other comprehensive income:

Amortized cost; Allowance for expected credit losses; Accumulated amount needed to reconcile amortized cost less the allowance for expected credit losses to fair value; and Fair value.

Past due status. To help users understand the extent that an entity’s fi nancial assets are past due, an entity would be required to provide an aging analysis of the amortized cost for debt instruments that are past due as of the reporting date, sepa- rated at the portfolio segment level. An entity would also be required to disclose when a debt instrument is considered to be past due.

Nonaccrual items. To help users to understand the credit risk and interest income recognized on fi nancial assets on nonaccrual status, an entity would be required to disclose the following information separated at the portfolio segment level:

Amortized cost of debt instruments on nonaccrual level as of the beginning of the reporting period and the end of the reporting period; Amount of interest income recognized during the period on nonaccrual instruments;

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Amortized cost of debt instruments that are 90 days or more past due, but not on nonaccrual status as of the reporting date; and Amortized cost of debt instruments on nonaccrual status for which there are no related expected credit losses at the reporting date because the debt is a fully collateralized fi nancial asset.

Purchased credit-impaired fi nancial assets. An entity that has purchased credit-impaired fi nancial assets during a reporting period would be required to pro- vide a reconciliation of the difference between the assets’ purchase price and their par value, including:

Purchase price; Discount because of expected credit losses based on the acquirer’s evaluation; Discount or premium because of other factors; and Par value.

Collateralized fi nancial assets. An entity would be required to describe the type of collateral by class of fi nancial assets. In addition, a qualitative description would be required of the extent to which an entity’s fi nancial assets are secured by collat- eral. A qualitative explanation by class of fi nancial asset would be required regard- ing signifi cant changes in the extent to which collateral secures an entity’s fi nancial assets, which may occur because of general deterioration or some other reason.

About the Author

Judith Weiss, CPA, has been attending EITF meetings regularly since 1991. She was a technical manager in the AICPA Accounting Standards Division and a senior manager in the national offi ces of Deloitte & Touche LLP and Grant Thornton LLP. Ms. Weiss is also one of the authors of the GAAP Guide.

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