The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) will often revisit and revise accounting standards to respond to the changing business landscape.

While many businesses are still responding to ASC 842, there is a new standard that will need to be considered next: Financial Instruments — Credit Losses.

BACKGROUND

Though this update has a greater impact on financial institutions, entities that deal with financial assets, including trade receivables, lease receivables and loan commitments, are subject to the Current Expected Credit Loss (CECL) model. These entities should focus on identifying the financial assets that fall within the realm of CECL and evaluate whether they need to make changes to their existing impairment models to comply with the new standard.

Substantial losses suffered by financial institutions and other entities during the 2007–2008 financial crisis forced critical consideration of the existing methods for accounting for credit losses.

In most cases, prior to the CECL standard businesses applied the “incurred loss” approach, which assumed all loans and balances due would be repaid unless a clear triggering event like debtor bankruptcy or economic turmoil occurred. As a result, during the 2008 crisis regulators and market participants perceived the loss reserves as insufficient and the losses recognized too late.

Consequently, both the IASB and the FASB issued new pronouncements to address these delays and establish adaptable models for measuring credit losses that would provide timelier information to the users of the financial statements about the expected credit losses on financial instruments.

This blog will provide an overview of the new standards issued by the two standard-setting bodies and how they compare to each other.

THE PRECEDENT: INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

The IASB had overhauled the accounting model for credit impairment through the implementation of IFRS 9, Financial Instruments, effective for annual reporting periods beginning in January 2018. IFRS 9 introduced the “general approach” and the “simplified approach” for recognizing impairment losses.

General Approach: This model requires recognizing a financial asset’s current stage to measure expected credit losses and recognize interest income as follows:

Businesses have the flexibility to move through these three stages as the credit quality changes and to make an assessment at the end of each reporting period, based on historical and forward-looking financial and economic information related to the specific financial instrument or a portfolio of financial instruments. Therefore, for example, if the entity determines that the financial instrument’s credit risk did not significantly increase since initial recognition, it would measure and recognize the related loss allowance for that financial instrument in an amount equal to 12-month expected credit losses. If, however, the credit risk has significantly increased or the financial asset is credit-impaired, a loss allowance in the amount of lifetime expected losses would be recognized.

However, the good news is that for certain qualifying types of financial instruments, entities do not have to follow the above general model, and there is a simplified approach available.

Simplified Approach: There are many entities whose primary business is not providing loans or financing but, for example, selling goods or services. There is a simplified approach provided by IFRS 9 for recognizing and measuring loss allowances on qualifying trade receivables, contract assets and lease receivables. If the trade receivables and contract assets do not have a significant financing component, businesses shall always recognize lifetime expected credit losses right on initial recognition of the financial instrument, and they do not need to go from stage 1 to stage 2 or 3, thus reducing assessment complexities. The same approach may be followed for trade receivables and contract assets with a significant financing component, as well as lease receivables.

THE SUCCESSOR: U.S. GAAP

After long deliberations and evaluating various models for remedying the weakness in recognizing credit losses, FASB adopted an impairment model known as CECL via the Accounting Standards Update (ASU) 2016-13. The CECL approach is conceptually similar to IFRS 9 as this new model also recognizes loss allowances based on expected credit losses rather than incurred losses. The ASU 2016-13 and related amendments are effective for fiscal years beginning after December 15, 2022, for non-public business entities, and early adoption is permitted.

Estimated Lifetime Losses: A financial instrument’s estimated credit loss allowance should reflect the losses that are likely to occur over the contractual life of the asset. For this, the entity would consider all available information including details about past events, current conditions and reasonable forecasts and their implications on credit loss computations.

Having said that, is it always possible to forecast?

No, there is always an element of uncertainty associated with forecasting, and to simplify this, the CECL standard advocates that the entity is not expected to forecast conditions over the entire contractual life of the asset but to only estimate them for a period for which the entity can make reasonable and supportable forecasts.

The FASB believes that the loss allowance should reflect management’s expectations regarding the collectability on a financial asset, and because businesses manage credit risk differently, they should have flexibility in adopting the approach. So, an entity can select from a number of measurement approaches to determine credit loss, and some of them include:

Although the approach used to measure the loss allowance may vary for different types of financial assets, it should be consistently applied to a particular asset pool.

CONVERGENCE: AN INTEGRATED FRAMEWORK

The 2007–2008 financial crisis led to the FASB and the IASB’s overhauls of their existing accounting models for credit loss recognition. Though globalization paved the way for the convergence of standards, ultimately each of the standard-setters issued its own credit loss standard as they were not able to agree on the timing of the recognition of lifetime expected credit losses, as well as several other matters.

Both the impairment models under IFRS and U.S. GAAP are based on expected credit losses. Differences and similarities in the FASB’s and IASB’s credit impairment models can be summarized as follows:

Undoubtedly, both of the new standards bring key improvements to the accounting for financial instruments by incorporating more transparency and accuracy into the assessment of credit losses. However, despite some of the similarities, there are significant differences between the two, and entities that are subject to reporting requirements under both may want to consider developing an integrated implementation approach that takes advantages of the commonalities between them.

To learn more about this topic, please contact GHJ’s Audit and Assurance Team.