Changes Ahead: Credit Losses of Financial Instruments
By Morgan Bauserman, CPA, Manager and Christopher Cox, CPA, Senior Associate
The FASB recently issued its 13th Accounting Standards Update (ASU) of 2016. In the spirit of providing more decision useful information, this ASU eliminates the requirement to use the incurred loss method to recognize credit losses on financial instruments. Upon adoption, the expected credit loss method will be used, which incorporates prior experiences, current conditions and reasonable predictions of future events.
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Why the change?
During the financial crisis of 2008, many entities expected credit losses to their financial instruments but didn’t record the loss because the “probable” threshold was not met. The expected credit loss method requires the consideration of a broader range of information, including forecasted information, to develop a valuation allowance for credit losses.
Which financial instruments are impacted?
- Financial assets measured at amortized cost, including:
- Trade receivables
- Debt securities
- Reinsurance receivables
- Net investment in leases
- Off-balance-sheet credit exposures
Which financial instruments are excluded?
- Loans made to participants by defined contribution employee benefit plans
- Policy loan receivables of an insurance entity
- Promises to give (pledges receivable) of a not-for-profit entity
- Loans and receivables between entities under common control
How will this work in practice?
Entities will establish an allowance based on management’s expected credit losses on financial instruments. The amount reported on the balance sheet will reflect the net amount expected to be collected for the financial instrument. Changes in the allowance will flow through the income statement as a credit loss expense. At the end of each reporting period entities will review and update the allowance, if necessary, using the same methodology established in the year of adoption.
What else do you need to know?
Credit losses on available-for-sale debt securities will be measured similar to current GAAP. However, the credit losses will be presented as an allowance rather than a write-down, which permits reversals in the allowance. Further, the requirement to consider past fair value volatility in the credit loss allowance has been eliminated.
Effective Dates and Transition Requirements
The ASU is effective for SEC filers beginning after 12.15.19, for all other public business entities beginning after 12.15.20 and for all other entities beginning after 12.15.21. Early adoption is permitted, but no earlier than the effective date for SEC filers. Most amendments in this ASU will be recorded as a cumulative effect adjustment to beginning retained earnings in the year of adoption. However, if an other-than-temporary impairment on a debt security was recognized prior to the year of adoption, that amendment must be applied prospectively to maintain the amortized cost basis of the security.
For detailed information on the ASU, including the InFocus and Understanding Costs and Benefits publications, visit FASB’s Credit Losses project page here.
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