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Portfolio Project Option #1: Case: The Future of Measuring Expected Credit LossDuring 2013, the FASB directed its staff to move forward with the drafting of an impairment standard containing a “Current Expected Loss (CECL) Model” with the purpose to better disclose to corporate stakeholders a net realizable measurement for financial assets and liabilities. This FASB measure came about specifically to address the concerns from the Great Recession regarding the true net value of long-term financial assets, like mortgage loan assets held by financial institutions and traded debt, such as the $30 billion in mortgage debt sold to the public during 2008 before it went bankrupt. Currently, Jed Miller is the corporate controller for ABC Corporation looking to purchase high-yielding Citibank mortgage assets at low market price.Required: As an accountant of ABC Corporation, after reading the two articles in required reading and locating two additional peer-reviewed sources on the topic, provide an appraisal of the expected loss model for Mr. Miller of the CECL. Be sure to compare it to the allowance for doubtful accounts for accounts receivables and address the huge monetary loss the CECL model might have saved ABC Corporation, who purchased Lehman mortgage assets in 2008.Your well-written paper must be 8-10 pages, in addition to title and reference pages. The paper should be formatted according to the CSU-Global Guide to Writing and APA Requirements. (Links to an external site.)Links to an external site. Cite at least five peer-reviewed or academic sources, in addition to the required reading for the module.
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GAAP
UPDATE SERVICE
Volume 13, Issue 3
February 15, 2013
PRONOUNCEMENT:
Proposed Accounting Standards Update
(ASU), Financial Instruments—Credit
Losses (ASC 825-15) (Part 1)
EFFECTIVE DATE:
Entities would be required to apply
the proposed guidance by making a
cumulative-effect adjustment in the
balance sheet as of the beginning of
the first reporting period in which
the guidance would be effective. The
effective date will be established when
the final guidance is issued.
Summary & Highlights
The Financial Accounting Standards Board (FASB) issued the proposed Accounting
Standards Update (ASU), Financial Instruments—Credit Losses (ASC 825-15), on
December 20, 2012. Comments on the proposal are due by April 30, 2013.
This is Part 1 of a two-part series discussing the proposed ASU. Part 1 discusses
the following topics:
Overview;
Scope;
Recognition;
Subsequent measurement;
Other presentation matters; and
Disclosure.
The following topics will be discussed in Part 2:
Implementation;
Transition; and
Questions for respondents on the proposal.
Analysis and Implementation
Overview
This proposal is a component of the joint project of the Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board
(IASB) (the Boards) to revise and improve their respective guidance on accounting for financial instruments. The project began before the global economic crisis
in 2008, which exposed weaknesses in the existing accounting standards. One of
those weaknesses is the overstatement of assets due to the delayed recognition of
credit losses related to loans and other financial instruments that were not recognized until it was probable that a loss will be incurred. The objective of the project
on accounting for the impairment of financial assets is to simplify the accounting
guidance and to provide guidance that is useful for decision-making. Currently,
there are five different models in U.S. generally accepted accounting principles
(GAAP) for accounting for the impairment of financial instruments. A model that
includes forward-looking information is needed to assess the impairment of financial instruments.
To address that issue, among others, the FASB issued proposed ASU, Accounting
for Financial Instruments and Revisions to the Accounting for Derivative Instruments and
Hedging Activities, in May 2010. That document included proposed guidance on
classification and measurement, credit impairment, and hedge accounting requirements. Under that proposal, an entity would have been required to recognize a
credit impairment when it does not expect to collect all contractual amounts due.
The IASB also issued a proposal in November 2009. As a result of the Boards’ considerations of the comments on their respective proposals, they decided to develop
a model that varies from the original proposal. In January 2011, the Boards issued
a Supplementary Document, Accounting for Financial Instruments and Revisions to
the Accounting for Derivative Instruments and Hedging Activities—Impairment, which
was a joint proposal that introduced the concept of two different measurement
objectives, one for a “good book” of performing loans and another for a “bad book”
of loans. Based on comments received on that proposal, the Boards developed a
“three-bucket model,” which would have eliminated an initial recognition threshold, and used two different measurement objectives for the credit impairment
allowance that would be subject to the extent of credit deterioration or recovery
since a financial instrument’s origination or acquisition. After considerable discussion with stakeholders who raised many concerns about the three-bucket model,
the FASB decided not to proceed with that model and has agreed on the proposed
model, which retains certain sound concepts from other models considered during
its discussions and avoids concepts that are complex, inoperable, and believed to
be problematic.
Proposed ASU
The proposed guidance below would be included as new Subtopic ASC 825-15 in
the FASB Accounting Standards CodificationTM (ASC) 825, Financial Instruments.
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© 2013 CCH. All Rights Reserved.
Scope
The guidance in the proposed ASU applies to all entities holding the following
financial assets that are susceptible to losses related to credit risk and are not classified at fair value through net income: (1) debt instruments classified at amortized
cost, debt instruments classified at fair value with changes in fair value recognized
in other comprehensive income, receivables from revenue transactions under the
scope of ASC 605, Revenue Recognition, or reinsurance receivables resulting from
insurance transactions under ASC 944, Financial Services—Insurance; (2) lease
receivables recognized by a lessor under ASC 840, Leases; or (3) loan commitments.
Recognition
An allowance for expected credit losses on financial assets, which is a current
estimate of all contractual cash flows that an entity does not expect to collect,
would be recognized at each reporting date. As a practical expedient, an entity
may elect not to recognize expected credit losses for financial assets measured at
fair value with qualifying changes in fair value recognized in other comprehensive
income if both of the following conditions are met:
The individual financial asset’s fair value exceeds or equals the financial asset’s
amortized cost basis; and
Expected credit losses on the individual asset are insignificant based on a consideration of where that asset’s credit-quality indicator is placed in a range of
expected credit losses on the reporting date.
Estimating expected credit losses. Under the proposal, an entity would be
required to estimate expected credit losses based on relevant information from
internal and external sources (e.g., information about past events, historical loss
experience with similar assets, or current conditions), as well as the implications
for expected credit losses based on reasonable forecasts that can be confirmed. That
information would have to include quantitative and qualitative factors (e.g., a
current evaluation of borrowers’ creditworthiness and the current and forecasted
direction of the economic cycle), corresponding to the reporting entity’s borrowers
and the environment in which the entity operates. Information relevant to the
estimated collectability of contractual cash flows that is available without excessive
cost and effort would be considered.
Estimates of expected credit losses would be required to reflect the time value
of money explicitly or implicitly. If expected credit losses are estimated using a
discounted cash flows model, the discount rate used would be the financial asset’s
effective interest rate.
Under the proposal, an estimate of expected credit losses would always have
to represent the possibility that a credit loss would occur and the possibility that
it would not occur, rather than representing a worst-case scenario or a best-case
scenario. Estimating expected credit losses based on the most likely outcome (i.e.,
a statistical calculation) would be prohibited. Estimates would be required to represent how credit enhancements would reduce expected credit losses on financial
assets, such as consideration of a guarantor’s financial condition or whether subordinated interests could absorb credit losses on underlying financial assets. However,
an entity would not be permitted to combine a financial asset with a separate freestanding contract intended to reduce a credit risk loss in its estimate of expected
© 2013 CCH. All Rights Reserved.
3
credit losses. Consequently, an entity would not be permitted to offset a legally
detachable and separately exercisable contract (e.g., a credit default swap) that
may reduce expected credit losses on a financial asset or a group of financial assets
against estimated expected credit losses on the related financial asset or group of
financial assets.
Recognition of changes in the allowance for expected credit losses. The amount
of a credit loss or a reversal of previous amounts recognized in the allowance for
expected credit losses required to adjust the allowance in the balance sheet for
the current period would be recognized in the income statement as a provision for
credit losses.
Interest income. Except for the guidance in this section, the proposed guidance
in ASC 825-15 would not address how a creditor should recognize interest income.
An entity that recognizes interest income on purchased credit-impaired financial
assets, which are defined in the ASC Glossary as “[a]cquired individual financial
assets…that have experienced a significant deterioration in credit quality since
origination, based on the assessment of the acquirer…” would not be permitted to
recognize interest income on the discount embedded in the purchase price as a result
of the acquirer’s assessment of expected credit losses at the acquisition date. An
entity would be required to discontinue the accrual of interest income when it is not
probable that the entity will receive substantially all of the principal or substantially
all of the interest and would be required to account for payments as follows:
1. Payment of substantially all of the principal is not probable. An entity would be
required to recognize all cash receipts from a debt instrument as a reduction in
the asset’s carrying amount. Payments received after the carrying amount has
been reduced to zero would be recognized in the allowance for expected credit
losses as recoveries of amounts written off in previous periods. Payment in excess
of amounts written off would be recognized as interest income.
2. Payment of substantially all of the principle is probable but payment of substantially all
of the interest is not probable. An entity would be required to recognize interest
income on a debt instrument when cash payments are received. Cash receipts
in excess of interest income that would be recognized in the period if the asset
had not been placed on nonaccrual status would be recognized as a reduction of
the asset’s carrying amount.
If the conditions in (1) and (2) no longer exist, interest income would be recognized in the manner it had been recognized before those conditions occurred.
Subsequent Measurement
Writeoffs. When an entity determines that it has no reasonable expectation of
future recovery of the carrying amount of a financial asset, it would directly reduce
its cost basis in the financial asset or portion thereof in the period in which that
determination is made. The entity also would reduce the balance of the allowance
for expected credit losses by the amount of the financial asset’s balance that was
written off. A recovery of a financial asset that had been written off in a previous
period would be recognized as an adjustment of the allowance for expected credit
losses only if consideration is received to satisfy some or all of the contractually
required payments.
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© 2013 CCH. All Rights Reserved.
Other Presentation Matters
The financial statement presentation of estimates of expected credit losses for
recognized financial assets under the scope of ASC 825-15 would be as follows:
Financial assets measured at amortized cost. The estimate of expected credit losses
would be presented in the balance sheet as an allowance reducing the assets’
amortized cost.
Financial assets measured at fair value with changes in fair value recognized in comprehensive income. The estimate of expected credit losses would be deducted from the
assets’ amortized cost, which is presented on the balance sheet as a net amount.
Recognized purchased credit-impaired assets not measured at fair value with all changes
in fair value recognized in current income. The estimate of expected credit losses
would be presented on the balance sheet as an allowance reducing the sum of the
assets’ purchase price and the expected credit losses on the assets at acquisition.
Loan commitments. The estimate of expected credit losses would be presented on
the balance sheet as a liability.
Disclosure
The purpose of the proposed disclosures is to help financial statement users to
understand the following:
The portfolio’s underlying credit risk and how management monitors the portfolio’s credit quality;
Management’s estimate of expected credit losses; and
Changes in the estimates of expected credit losses that occurred during the period.
Information about credit quality. The information disclosed would have to
enable users of financial statements to do both of the following:
Understand how management manages the credit quality of its debt instruments; and
Evaluate the quantitative and qualitative risks resulting from its debt instruments’ credit quality.
An entity would be required to provide quantitative and qualitative information
by class of financial asset about its credit quality, including the following:
A description of the of the credit-quality-indicator;
The amortized cost, by credit-quality indicator; and
For each credit-quality indicator, the date or range of dates in which the information was last updated for that credit-quality indicator.
An entity that discloses information about internal risk ratings would be required
to provide qualitative information on how the internal risk ratings are related to
the possibility of loss.
The above proposed disclosures requirements would not apply to short-term
trade receivables related to revenue transactions under ASC 605.
© 2013 CCH. All Rights Reserved.
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Allowance for expected credit losses. The purpose of the proposed disclosures
would be to enable financial statement users to understand:
How management developed its allowance for expected credit losses;
The information management used to develop its current estimate of expected
credit losses; and
Economic circumstances causing changes in the allowance for expected credit
losses, which results in a related credit loss expense or reversal recognized during
the period.
To meet the objectives discussed above, the following information about an entity’s accounting policies and method used to estimate the allowance for expected
credit losses would be disclosed by portfolio segment:
How expected estimates are developed;
Factors influencing management’s current estimate of expected credit losses,
including past events, current conditions, and reasonable and supportable forecasts about the future;
Risk characteristics relevant to each portfolio segment;
Changes in the factors influencing management’s current estimate of expected
credit losses and reasons for those changes (e.g., change in portfolio composition, change in volume of purchased or originated assets, or significant events
or conditions affecting the current estimate that were not considered during the
previous period);
Changes, if any, to the entity’s accounting policies or methods from the prior
period and the entity’s rationale for the change, if applicable;
Significant changes, if any, in techniques used to make estimates and reasons for
the changes, if applicable; and
Reasons for significant changes in the amount of writeoffs, if applicable.
To help financial statement users to understand activity in the allowance for
expected credit losses for each period by portfolio segment, an entity would be
required to separately provide the following quantitative disclosures for financial
assets classified at amortized cost and financial assets classified at fair value with
qualifying changes in fair value recognized in other comprehensive income:
Beginning balance in the allowance for expected credit losses;
Provision for credit losses in the current period;
Writeoffs charged against the allowance;
Recoveries of amounts previously written off; and
Ending balance in the allowance for expected credit losses.
An entity that used the practical expedient discussed above and did not measure
expected credit losses for certain financial assets classified at fair value with qualifying
changes in fair value recognized in other comprehensive income would be required to
disclose the amortized cost balance of those assets at the portfolio segment level. The
amortized cost for purchased credit-impaired assets would be the sum of the assets’
purchase price plus the expected credit losses on the assets at acquisition.
Roll forward for certain debt instruments. A roll forward of an entity’s portfolio
of debt instruments classified at amortized cost would be required from the begin6
© 2013 CCH. All Rights Reserved.
ning of the period to the end of the period, separated at the portfolio segment level.
It would include the following information:
Beginning amortized cost;
Originations;
Purchases;
Sales;
Repayments;
Writeoffs; and
Ending amortized cost.
A roll forward of a portfolio of debt instruments classified at fair value with
qualifying changes in fair value recognized in other comprehensive income would
be required from the beginning of the period to the end of the period separated at
the portfolio segment level. Disclosure of the information listed above would be
required, at a minimum.
The above disclosures would not apply to the following:
Receivables as a result of revenue transactions under the scope of ASC 605;
Reinsurance receivables as a result of insurance transactions under the scope of
ASC 944; and
Loan commitments not measured at fair value with changes in fair value recognized at net income.
Reconciliation between fair value and amortized cost for debt instruments
classified at fair value with qualifying changes in fair value recognized in other
comprehensive income. If an entity has not already presented all of the following
items on the balance sheet, it would be required to disclose a reconciliation of the
difference between the fair value and amortized cost for assets measured at fair value
with qualifying changes in fair value recognized in other comprehensive income:
Amortized cost;
Allowance for expected credit losses;
Accumulated amount needed to reconcile amortized cost less the allowance for
expected credit losses to fair value; and
Fair value.
Past due status. To help users understand the extent that an entity’s financial
assets are past due, an entity would be required to provide an aging analysis of the
amortized cost for debt instruments that are past due as of the reporting date, separated at the portfolio segment level. An entity would also be required to disclose
when a debt instrument is considered to be past due.
Nonaccrual items. To help users to understand the credit risk and interest income
recognized on financial assets on nonaccrual status, an entity would be required to
disclose the following information separated at the portfolio segment level:
Amortized cost of debt instruments on nonaccrual level as of the beginning of
the reporting period and the end of the reporting period;
Amount of interest income recognized during the period on nonaccrual instruments;
© 2013 CCH. All Rights Reserved.
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Amortized cost of debt instruments that are 90 days or more past due, but not on
nonaccrual status as of the reporting date; and
Amortized cost of debt instruments on nonaccrual status for which there are no
related expected credit losses at the reporting date because the debt is a fully
collateralized financial asset.
Purchased credit-impaired financial assets. An entity that has purchased
credit-impaired financial assets during a reporting period would be required to provide a reconciliation of the difference between the assets’ purchase price and their
par value, including:
Purchase price;
Discount because of expected credit losses based on the acquirer’s evaluation;
Discount or premium because of other factors; and
Par value.
Collateralized financial assets. An entity would be required to describe the type
of collateral by class of financial assets. In addition, a qualitative description would
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