The Financial Accounting Standards Board (FASB) released new financial instrument guidance on the timing of reporting credit losses.

"“The new standard addresses concerns from a wide range of our stakeholders—including financial statement preparers and users—that the existing incurred loss approach provides insufficient information about an organization’s expected credit losses,” stated FASB Chair Russell G. Golden."

Currently, credit losses are recorded using an "incurred loss" methodology, which only allows them to be counted if the loss is "probable," or likely to occur. The FASB said this caused trouble during the 2008 crisis because banks were unable to record credit losses that weren't probably, but were still expected. This however led to financial statement users estimating credit losses before the actual accounting loss was recorded. 

"This highlights the information needs of users differ from what GAAP has required," said a supplemental info sheet. 

The delayed recognition of losses could have also led to the overstatement of assets during the crisis, said the exposure draft. The Financial Crisis Advisory Group, established by the FASB, recommended a more forward-looking impairment model as a result. With this in mind, the new standard eliminates the probable initial recognition threshold, where only past events and current conditions could be used in measuring an incurred loss. 

Under the new standard, a financial asset (or group of financial assets) measured at amortized cost basis needs to be presented at the net amount expected to be collected, with credit losses deducted from the asset's amortized cost basis. This measurement applies both to newly recognized financial assets as well as expected increases or decreases of expected credit losses that have taken place during the period. 

So what does "expected" mean? The FASB standard notes that entities must use their own judgment in determining the relevant information and estimation methods. It should, though, be based on past events, including historical experience, current conditions and reasonable and supportable forecasts that affect the collectabiltiy of the reported amount. 

Entities will need to disclose exactly how their expected loss estimates were developed, as well as describe its accounting policy and methodology to estimate allowance for credit losses. Other disclosures include:

* Exactly how they developed their estimates;
* what factors went into the estimation;
* the risk characteristics relevant to each portfolio segment
* changes in the factors that went into management's estimate of expected losses and the reasons for them;
* identification of changes to the entity's accounting policies and methodologies from the prior period, as well as a rationale for those changes and their quantitative effects; 
* reasons for significant changes in the amount of writeoffs, if applicable; 
* the reversion method used for periods beyond the reasonable and supportable forecast period; 
* the amount of any significant purchases of financial assets during each reporting period; and 
* the amount of any significant sales of financial assets, or reclassification held for sale during each reporting period. 

Credit loss allowances for assets purchased with a more-than-insignificant amount of credit deterioration since origination are measured similarly to other assets purchased, provided both are purchased at amortized cost basis. However, in this case, the initial allowance for credit losses is added to the purchase price, versus being reported as a credit loss expense. Credit loss expenses are only recorded in the event of subsequent changes in the allowance for credit losses. If the asset produces interest income, it should be recognized based on the effective interest date, excluding the discount embedded in the purchase price attributable to the acquirer's assessment of credit losses at acquisition. 

Credit losses relating to available-for-sale debt securities, under the new standard, are recorded through an allowance for credit losses. This allowance, however, is limited to the amount by which fair value is below the amortized cost. This is because the classification of available for sale is based on investment strategies that recognize that the investment could be sold at fair value if doing so results in realizing an amount less than fair value. 

The standard is the result of the convergence project between the FASB and International Accounting Standards Board (IASB). While the intention was to produce a uniform approach between both boards, the FASB's expected impairment model is different than the one ultimately adopted by the IASB, which the Journal of Accountancy said is driven more by cash flow characteristics and the business model in which the assets are held. 

In the standard's text, the FASB acknowledged critics who said the changes may inhibit lending through the requirement to record the full estimate of expected losses. The board, however, argued that the standard is more about the measurement, not the economics, of lending. 

"The same loss ultimately will be recorded, regardless of the accounting requirements. What changes is an accounting threshold for the recognition of credit losses, which affects only the timing of when to record credit losses, not the ultimate amount realized on the financial assets," said the FASB.