For the past few years, the Financial Accounting Standards Board (FASB) has been discussing the adoption of the "expected loss model" for the Allowance for Loan and Lease Losses (ALLL).
On Dec. 20, 2012, FASB issued a Proposed Accounting Standards Update that finally defines the actual accounting framework and clearly differentiates this proposal from the current accounting standard. The proposal calls for an entity to recognize an allowance for credit losses based on supportable forecasts of contractual cash flows not expected to be collected.
Under the "incurred loss" model presently employed, a loss is not recorded until it is probable that a loss event has occurred. This model has been criticized for a number of reasons but primarily because the loss is recorded too late in the credit cycle.
The FASB's proposed model eliminates any threshold required to record a credit loss and allows entities to consider a broader information set when establishing their allowance for loan losses. In addition, the model aims to simplify current practice by replacing today's multiple impairment models with one model that applies to all debt instruments.
The Potential Impact
It is very likely that this proposed standard will have a profound impact on financial institutions. Below you will find a few possible impacts of these new standards.
* ALLL levels may rise significantly as loss measurements would be measured over the life of the loan rather than on only losses that have been incurred as of the balance sheet date.
* The result of increased ALLL balances would inversely reduce net income levels.
* The "probable loss" threshold will be removed, and estimates will be based on "possible" estimates.
* Financial institutions will need to implement revised calculation methodology that will be scrutinized and presumably challenged by your auditors and examiners.
* Significant changes to required disclosures.
* Removal of SOP 03-3 accounting requirements.
All entities that hold financial assets subject to credit losses will be affected by the FASB's proposed model.
The FASB board plans to consider various alternatives for an effective date as well as providing different effective dates for public versus non-public entities and regulated versus non-regulated entities.
What Steps Can You Take?
The primary steps to take right now are ones that should be consistently applied on an ongoing basis regardless of any upcoming changes.
* Review effective loan review systems and controls.
* Ensure the current ALLL evaluation process is acceptable.
* Properly document support for all assumptions, valuations and judgments.
* Take steps to reduce the manual risk potential in the ALLL process.
What can you do? Comments on the FASB's proposal are due April 30, 2013. Make sure someone at your credit union makes your comments and thoughts heard. We plan to issue an update in the coming weeks/months that will provide more information and our insights on the proposal as issues become clearer.
Vimal Patel works for Sageworks, which has the largest database of real time private company financial information in the U.S. That data is incorporated into its risk-management products for financial institutions, including credit analysis, stress testing, and ALLL estimation solutions. Regan Camp and Ed Bayer contributed to this article. For info: www.sageworksinc.com.
