A new Accounting Standards Update (ASU) affects entities holding financial assets and net investments in leases that are not accounted for at fair value through net income. The Financial Accounting Standards Board (FASB) recently issued ASU 2016-13: Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The main objective of this update is to provide financial statement users with more useful information for decision making concerning expected credit losses on financial instruments. The amendments in this update replace the incurred loss impairment methodology in current generally accepted accounting principles (GAAP) with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit losses estimates.
Current GAAP requires an “incurred loss” methodology for recognizing credit losses that delay recognition until it is probable a loss has been incurred. Both financial institutions and users of financial statements expressed concern that current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the “probable” threshold.
The global financial crisis highlighted those concerns as users analyzed credit losses by utilizing forward-looking information to assess an entity’s allowance for credit losses on the basis of their own expectations. Consequently, in the lead-up to the financial crisis, users were making estimates of expected credit losses and devaluing financial institutions before accounting losses were recognized, highlighting the different informational needs of users from what GAAP required. Similarly, financial institutions expressed frustration during this period because they could not record credit losses that they were expecting, but had not yet met the probable threshold.
The Financial Advisory Crisis Group identified the delayed recognition of credit losses that result in the potential overstatements of assets as a weakness in current GAAP, so it recommended exploring more forward-looking alternatives to the incurred loss methodology.
The amendments in this ASU affect loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.
In the near future, PYA will issue a white paper which will cover in greater detail the changes included in this new standard and how it will affect your business in transitioning to the new measurement of credit accounting.
For more information about this ASU and reporting expected credit losses, contact one of our executives below at (800) 270-9629.