The Future of Measuring Expected Credit Loss - Literature review Example

The Future of Measuring Expected Credit Loss Introduction Several credit impairment models exist in practice for financial instruments as per the existing Accepted Accounting Principle of the US. These models are broadly classified into a probable loss or incurred loss, and respond to an event that makes an entity to recognize a related credit loss provision for an impaired financial instrument or asset. Under the existing accounting rules, financial institutions recognize losses for impaired assets after an occurrence of a qualifying event. This made these models to receive criticism since they relied on historical or incurred losses for the credit losses to be recognized leading to its delay. A loss reserve for a mortgage is not posted until the mortgage reaches a given delinquency status (Milliman, 2014). The current models lack the ability to include a forecasting element that would assist in estimating future impairments on assets before the occurrence of a trigger event. According to Mcpeak and Bayer’s (2013) study, the 2008 financial crisis showed that many financial institutions had no adequate reserves to absorb the credit losses stemming from abnormal events that occur outside the normal business cycle. As a result, there was an increased scrutiny of financial institutions allowance for loan and lease losses as well as its underlying methodology. The fact that the US GAAP-supported models relied on historical losses, it became acute in times of highly deteriorating economic conditions. In response to the global economic down melt experienced in the financial crisis of 2008, the Financial Accounting Standards Board began a search for alternative methodologies that financial institutions would be relying on when accounting for credit losses by addressing the delayed recognition issues. The methodology that was arrived at is the Current Expected Credit Loss model. Current Expected Credit Loss Model This model will be used to estimate and develop provisions for credit losses at the origination for the asset’s lifetime. The financial institution will be required to replace the existing incurred loss models with the Current Expected Credit Loss model and allow for a single approach for financial assets that are not accounted for at fair value. This will greatly help in eliminating the complexity that is posed by the presence of several different impairment models (Milliman, 2014). The Current Expected Credit Loss model will affect transactions involving financial instruments such as trade receivables, lease receivables, loans, debt securities, loan commitments, and reinsurance. The Current Expected Credit Loss that the management of financial institutions will estimate will represent cash flows that they will not be expecting to collect (Doran, Althoff, Currie, Gerdau, & Rickli, 2013). These estimates should be a measure of the likelihood of a loss for the remaining assets life. The critical components that the management’s best estimate would consist: future loss estimates that are consistent with historical data using past data; future estimates that are consistent with reasonable as well as supportable forecast about the future; and future estimates that are consistent with current conditions (Byrne, 2014; Mcpeak & Bayer, 2013). Milliman’s (2014) study found that the main difference between the existing impairment models and the Current Expected Credit Loss lies on the forecasting component of credit loss by the Current Expected Credit Loss. All financial institutions will be updating their expected credit losses estimates at every reporting period based on variations on historical data, current conditions, business mix issues, including the volume in loans originating or maturing, and influencing factors supporting forecasts (Kellar & Schell, 2014). These adjustments in estimates would either give unfavorable and favorable adjustment to reported earnings. Milliman’s (2014) study further argued that, the credit loss allowance would be that representing a pool of assets bearing similar credit risks. The Current Expected Credit Loss and Allowance for Doubtful Accounts for Accounts Receivables The development of the Current Expected Credit Loss has made it to vary with the current guidance in the calculation of the allowance for loan and lease losses in several aspects. First, is its forward looking view. Under the Current Expected Credit Loss, forward-looking information and forecasts will be considered in the credit loss estimation (Mcpeak & Bayer, 2013). This is a critical change and differ from current models such as the allowance for doubtful accounts for receivable accounts that relies on the incurred losses to estimate loss rates. The second point lies on the time horizon. A study done by Kellar and Schell (2014) revealed that the Current Expected Credit Loss would estimate losses based on the credit assets lifetime as the time horizon instead in the next 12 month period as is the case with allowance for doubtful accounts for receivable accounts methodology. The forecasted estimates should be defensible, a possible challenge, particularly for longer term loans. The third difference lies in the removal of the probable threshold for loss recognition as is used under the allowance for doubtful accounts for receivable accounts methodology. This will make financial institutions assess whether or not losses existed at that time for the financial assets. The removal of this threshold under the Current Expected Credit Loss the timing for when financial institutions will be required to recognize impairment will be accelerated (Mcpeak & Bayer, 2013; Milliman, 2014). Developing an estimate of Expected Credit Losses under the Current Expected Credit Loss Model The financial institutions will be required to examine inputs, the unit of account as well as the probability or path in establishing how they will evaluate and estimate credit losses (Kellar & Schell, 2014). Inputs These are factors relating to the expected credit loss drivers as well as the expected life. For financial instruments whose measurement is at amortized costs, current estimates of all contractual cash flows whose collection is in doubt must be recognized as an allowance for expected credit loss (Financial Accounting Foundation [FAF], 2012). As aforesaid, past events, current conditions as well as reasonable and supportable forecasts will be considered by financial institutions when developing their estimates of contractual cash flows over the concerned assets’ lives. According to Kellar and Schell’s (2014) research, the relevant quantitative, as well as qualitative factors surrounding the businesses, should also be considered. Equally important, some similar factors that relate to the borrowers such as the underwriting standards should also be considered. To estimate the expected assets’ lives, financial institutions will have to consider the expected prepayments and not the expected extensions, renewals or modifications (Doran et al., 2013). The type of loan commitment, either funded or unfunded, will determine the measurement of the expected life of a loan commitment. The expected credit losses of funded loans are determined by considering the cash flows over its expected life, including prepayments, but not renewals, extensions or modifications (Kellar & Schell, 2014). On the other hand, for unfunded loan commitments, their expected credit losses will be estimated in a manner that it reflects its full contractual period. According to the view of this paper, the adoption of the Current Expected Credit Loss Model and abandonment of the incurred loss model, which required credit losses to be probable before being recognized is a sound move since the Current Expected Credit Loss Model represents all contractual cash flows whose collection in doubts. This will be a radical change in financial institutions since they will have to alter their allowance methodologies and data needs. Another observation is that the treatment of the held to maturity instruments by the other-than-temporary impairment approach will no longer be required. However, much change might not be recorded in regard to how residential mortgage backed securities’ credit losses are evaluated because in the current practice, internal and external data and other statistics for similar instruments are used during their evaluations. Unit of account Financial institutions will be required to evaluate the expected credit losses on their financial instruments on a pool basis, especially where such instruments share similar risk characteristics and their measurement is at amortized cost (Kellar & Schell, 2014). Where a financial institution does not have instruments with similar risk characteristics, it will evaluate such instruments on an individual basis, where under the Current Expected Credit Loss Model the relevant internal information and external information such as credit loss information and credit ratings is considered (FAF, 2012). The provision of the Current Expected Credit Loss Model that financial instruments can be evaluated for credit risk loss on an individual basis has led to the removal of the best estimate idea (American Bankers Association [ABA], 2015; Doran et al., 2013). According to the view of this paper, the inclusion of the relevant external and internal information is likely to encourage financial institutions to consider, based on the loss expectations for pools of similar financial instruments that might be externally available, a likelihood of expected losses on such individual assets. The need for assessing credit risk losses based on a pool of financial instruments that have similar risks means that even the held to maturity instruments that are measured at amortized cost are included in this scope of the Current Expected Credit Loss Model. This would be a change from the current treatments of such instruments. Probability or path The Financial Accounting Standards Board stated under the Current Expected Credit Loss Model that financial institutions will always be required to reflect the loss risk even where such risk is remote (Cosper, 2013; Doran et al., 2013). However, financial institutions will be required to recognize zero losses if there is s probability of default, and there is enough collateral over the same. To estimate the estimated credit losses, financial institutions would start with the historical losses and adjust for any differences based on current conditions as well as reasonable and supportable forecasts (Kellar & Schell, 2014). This move of referring to the historical trends and making adjustments would not be used to estimate the expected life of financial instruments. Instead, the reversion to the mean1 should be used. In consideration of this factor, this papers view is that financial institutions will have to consider the likelihood of loss or non-payment based on all available information. However, information that indicates a probability of loss will be offset by the presence of collateral and other available payment sources. Financial institutions will also be required to make expected loss projections based on how they can reasonably estimate the future. As the Financial Accounting Standards Board provides, financial institutions will assume that the expected credit losses will have returned to their unadjusted mean historical credit losses over the remaining financial instrument’s term. Current Expected Credit Loss Challenges to Borrowers and Benefits to Investors ABA’s (2015) research findings showed that the introduction of the Current Expected Credit Loss Model came with challenges and they greatly revolve around the life of a loan loss concept, where expected credit losses over the loan’s life are effectively recorded upon origination. The Current Expected Credit Loss Model will impact on the vintage analysis in the estimation of the allowance for loan and lease losses. This could increase the workload required by many bankers by multiples. According to Cosper’s (2013) research, the requirement that full recognition of expected losses be done upon origination fails to reflect the economics of lending transactions. The requirement by the Current Expected Credit Loss Model that financial instruments subject to credit risks and that are purchased or originated at market terms be initially reflected in the statement of financial position after considering the credit risk loss allowance is inconsistent with the market transaction economics. Cosper’s (2013) study established that it would be wrong to conclude that the transaction price of a financial instrument included an inherent credit risk and gave loss on day one. The ABA’s (2015) study was also concerned with how the origination of a financial instrument would immediately create an accounting event of loss expectations. As such, additional detailed processes would be necessary to ensure that the factors underlying loss expectations are appropriately established and tracked. Another issue is raised I regard to the use of historical data, whereby, according to the ABA’s (2015) study, the current annual charge-off data will not be required under the Current Expected Credit Loss Model. The use of historical averages as a starting point for allowance for loan and lease loss estimate would involve significant adjustments based on the judgment of the management so as to arrive at the actual loss expectation. The credit quality evaluation and disclosures will increase so as to address the requirements of vintage analysis (FAF, 2012; Mcpeak & Bayer, 2013). In addition, investors will be guided more on the related capital buffers. The Current Expected Credit Loss will require new models to assess the allowance for loss and lease losses and which will be under regulatory model risk management standards (ABA, 2015). If this requirement existed at the time when the ABC Corporation purchased Lehman mortgage assets in 2008, it would not have suffered such losses since it would have been well insured. Conclusion Following the financial crisis of 2008, the Financial Accounting Standards Board made significant efforts to address the accounting concerns raised in regard to the impairments of financial instruments. There were several credit impairment models that tried to match the credit loss recognition with interest incomes, but were too operationally complex to apply. The Current Expected Credit Loss model was developed featuring a single measurable objective for credit loss allowance. Under this model, the management of financial institutions are required to estimate the contractual cash flows that their institutions do not expect to collect after an assessment of credit risk. The Current Expected Credit Loss model offers a wide scope of information to guide in estimating credit lost. The past events, current conditions, as well as reasonable and supportable forecasts, are considered in evaluating the credit loss risk. The notable sources of credit risk losses include changes in the financial instruments credit risk, changes in conditions from the prior reporting date, and variations in reasonable forecasts about the future. If the Current Expected Credit Loss existed, ABC Corporation and other investors who invested in Lehman would not have suffered during the 2008 financial crisis. References American Bankers Association. (2015). CECL Implementation Challenges: The Life of Loan Concept. Washington D.C.: American Bankers Association. Byrne, L. T. (2014). Accounting for Financial Instruments: Difficulties with Fair Value Measurement and Reporting. New Hampshire: University of New Hampshire. Cosper, S. (2013). Comments on FASBs Proposed Accounting Standard Update. Financial instruments - Credit Losses (Subtopic 825-15). Florham Park, New Jersey: PwC. Doran, D., Althoff, J., Currie, C., Gerdau, C., & Rickli, C. (2013). Credit losses on financial assets An overview of the FASBs current expected credit loss model. PwC. Financial Accounting Foundation. (2012). Proposed Accounting Standards Update—Financial Instruments—Credit Losses (Subtopic 825-15) - Exposure Draft. Norwalk, Connecticut: Financial Accounting Standard Board. Kellar, R. C., & Schell, M. A. (2014). FASB’s CECL Model: Navigating the Changes- Planning for Current Expected Credit Losses (CECL). Chicago, Illinois,: Crowe Horwath LLP. Mcpeak, T., & Bayer, E. (2013). FASBS CECL Model: How to Prepare Now. Raleigh, North Carolina: Sageworks. Milliman. (2014). Current Expected Credit Loss: Implementation and Implications, White Paper. Seattle, Washington: Milliman. Read More