ALLL Impact Still Uncertain: Credit Loss Model Changes Debated

By Steve Schick and Chris Ritter

In the wake of the recession, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) began working with the financial world to address concerns around the current credit loss model. The boards’ intention was to propose one global loss model.

However, FASB and IASB split off in separate directions. FASB wanted to concentrate on a current expected credit loss model and IASB focused on a “three bucket” approach that reflects the general pattern of deterioration of the credit quality in loans.

The boards issued their first exposure draft of a new standard and requested comment from the public in the second quarter of 2013. They met last September to deliberate. FASB decided that:

• An entity should use its historical average loss experience for future periods beyond which it can make or obtain reasonable and supportable forecasts.
• An entity should consider all contractual cashflows over the life of the related financial assets.
• An estimate of expected credit losses should always reflect the risk of loss, even when that risk is remote. However, an entity would not be required to recognize a loss on a financial asset in which the risk of nonpayment is greater than zero yet the amount of loss would be zero.

The IASB had other findings:

• It clarified that the model’s objective is to recognize lifetime expected credit losses on all financial instruments for which there has been a significant increase in credit risk, whether on an individual or portfolio basis. All reasonable and supportable information, including forward-looking information that is available without undue cost or effort, should be considered.
• It confirmed 12-month expected credit losses as the measurement objective for instruments in Stage 1.
• It will require a default definition consistent with credit risk management practices, and emphasized that qualitative indicators of default should be considered when appropriate (for example, financial instruments that contain covenants).

To date, there has been much discussion and debate as to the ultimate impact to a bank’s allowance for loan and lease losses. FASB published a Q&A document in response to the exposure draft that included the question of the board’s expectation for larger allowances. FASB contended that it did not intend to increase allowances based on this standard alone. However, policy makers and industry professionals expect a 20% to a 40% increase to the allowance for loan and lease losses.

The Office of the Comptroller of the Currency estimated that the impact on the allowance would be “in the neighborhood of 30 to 50 percent,” Comptroller Thomas Curry said in September.

While expressing support for the FASB proposal, Curry said he was concerned “about the operational impact the proposed standard may have on community banks” and urged FASB to modify disclosure requirements and the implementation time for smaller banks.

While the current expected timeline for a final standard is set for the first half of 2014, due to the lack of agreement on one model, a converged model appears unlikely. Should the current expected timeline not be adjusted, it is anticipated that a final standard will be issued by the FASB and convergence won’t occur.

While still speculative, the required timeline for implementation of the new standard could be as early as 2015 for public companies and 2016 for private companies.   <

Editor’s Note: Steve Schick and Chris Ritter are audit partners at Plante Moran. This article reflects their views.