FASB s Proposed Standards on Accounting for Financial Instruments

Transcription

1 FASB s Proposed Standards on Accounting for Financial Instruments Kevin Chiu Accounting Policy Analyst Board of Governors of the Federal Reserve System

2 The Disclaimer.. The views expressed today are my own and do not necessarily represent the views of colleagues or members of the Board of Governors. 3 Agenda FASB Proposed Accounting Standards Update: Recognition and Measurement of Financial Assets and Liabilities FASB Proposed Accounting Standards Update: Financial Instruments Credit Losses 4

3 Background on Both Proposals April 2009 G20 request that standard setters strengthen accounting recognition of loan loss provisions by incorporating a broader range of credit information and improve accounting standards for provisioning The FASB and the IASB have been working to address those concerns including: Simplifying the rules around the use of FV, and Developing standards that result in quicker recognition of losses Proposed standards were issued earlier this year 5 FASB Proposed Accounting Standards Update: Recognition and Measurement of Financial Assets and Liabilities 6

4 Current Model for Securities Category Trading or Fair Value Option Available-for-sale (debt and marketable equity securities) Measurement Approach Fair value on the balance sheet with changes in net income Fair value on the balance sheet with changes in other comprehensive income Other than temporary impairments recognized in earnings Held-to-maturity (debt securities only) Amortized cost on the balance sheet Other than temporary impairments recognized in earnings Subject to tainting rules 7 Current Model for Loans Category Trading or Fair Value Option Held-for-sale Held-for-investment Measurement Approach Fair value on the balance sheet with changes in net income Lower of cost or fair value on the balance sheet with changes in net income Amortized cost on the balance sheet Allowance for loan losses established for incurred losses inherent in the portfolio. 8

5 FASB Proposal Recognition and Measurement of Financial Assets and Liabilities Would change the model for how assets are recognized and measured Under the FASB s tentative model: Classification and measurement of a financial asset based on: Instrument s cash flow characteristics An entity s business model for which it is held Equity securities (except those accounted for under the equity method of accounting) must be measured at fair value with changes in net income: Practical expedient for investments in nonmarketable securities Liabilities generally measured at amortized cost All derivatives will continue to be marked-to-market (not in scope) 9 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not solely principal and interest Business Model N/A Not in line with other business models or FVO Category FV-NI Solely principal and interest (SPPI) Held for both collection and for sale FV-OCI Held for collection Amortized Cost 10

6 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not solely principal and interest (SPPI) Business Model N/A Not in line with other business models or FVO Category FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 11 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not SPPI Business Model N/A Category Not in line with other business models or FVO FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 12

7 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not SPPI Business Model N/A Category Not in line with other business models or FVO FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 13 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not SPPI Business Model N/A Category Not in line with other business models or FVO FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 14

8 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not SPPI Business Model N/A Category Not in line with other business models or FVO FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 15 Proposed Model for Securities and Loans (Cont d) Cash Flow Characteristics Not SPPI Business Model N/A Category Not in line with other business models or FVO FV-NI SPPI Held for both collection and for sale FV-OCI Held for collection Amortized Cost 16

9 Comparison to IFRS The FASB s proposal on recognition and measurement of financial assets generally aligns with the IASB s proposal Differences in some wording within the two proposals and the illustrative examples could result in differences in implementation for the same financial instruments across institutions 17 Proposed Model Impact Equity securities must be measured at FV-NI (excl. equity method investments) more volatility in earnings Also, investments in hybrid instruments that do not comprise solely principal and interest must be measured at FV-NI Bifurcation of embedded derivatives no longer permitted This could require certain structured finance investments and investments in securitized financial assets to be measured at FV-NI 18

10 Proposed Model Impact (Cont d) Hold to collect criteria are less strict than held-tomaturity Definition of FV-NI category raises questions as to where the line of demarcation is between the business models that underpin the FV-OCI and FV-NI categories since both business models involve selling Could increase complexity in financial reporting and impact supervisory processes and measures that are dependent on an instrument s classification and measurement 19 Proposed Model Regulatory Impact Potential changes to regulatory reporting The removal of OCI filters within Basel III will invariably impact banks with financial assets measured at FV-OCI under the proposed classification model: However, there is a one time opt-out of AOCI treatment for banks not subject to the advanced approaches rule Consideration of regulatory liquidity standards under Basel III will be necessary for banks to determine the appropriate classification of debt instruments under the proposed model 20

11 Regulatory Agency Views The Agencies generally supported the proposal as aligning classification and measurement with an instrument s cash flow characteristics and the entity s business model has sound conceptual merit However, the implementation guidance could require loans generally held for collection to be measured at fair value thru net income The Agencies recommended various changes to ensure that the model does not result in unintended consequences; a key to our recommendations was international convergence If the FASB can not achieve full convergence with the IASB, the Agencies recommend that only limited changes to current GAAP in this area be made (e.g., own credit) 21 FASB Proposed Accounting Standards Update: Financial Instruments Credit Losses 22

12 Incurred Loss Model Current U.S. GAAP A loan is impaired when it is probable that a loss has been incurred based on events and conditions existing at the balance sheet date: This does not consider possible or expected future trends that may lead to additional losses Weaknesses: Delayed recognition of credit losses: Losses recognized only when probable that a loss had been incurred Inability to consider forward-looking information Too complex: Five different models for securities and loans 23 Proposed Current Expected Credit Loss (CECL) Model - Recognition Credit losses recognized using an expected loss model Expected credit losses = current estimate of all contractual cash flows not expected to be collected Will likely lead to earlier recognition of credit losses: No longer have to wait for incurred losses to be probable (no triggering event ) Virtually any credit deterioration would affect a bank s earnings performance Incorporates reasonable and supportable forecasts of the future Requires significant use of judgment 24

13 Proposed CECL Model Recognition (Cont d) Periodic estimates of the life of loan expected credit losses for all financial assets within the proposal s scope would be recognized as allowances for expected credit losses Changes from one period s estimate of the allowance for expected credit losses to the next (after considering charge offs and recoveries) would be reported in earnings 25 Proposed CECL Model Recognition (Cont d) Original proposal: Past events and current conditions Reasonable and supportable forecasts Estimate of expected credit losses 26

14 Proposed CECL Model Recognition (Cont d) September 2013 tentative decision: Past events and current conditions Reasonable and supportable forecasts Unadjusted historical average loss experience Estimate of expected credit losses Expected prepayments should be considered 27 Measurement A current estimate of all contractual cash flows not expected to be collected would incorporate Internally and externally available information Information about past events, current conditions, and reasonable and supportable forecasts Quantitative and qualitative factors specific to borrowers and the economic environments 28

15 Measurement (Cont d) The proposed model does not prescribe a method for measuring credit losses: One or more of the following types of methods may be used at the discretion of the entity: Discounted cash flow (DCF) methods Loss-rate methods Roll-rate methods Probability of default methods Provision matrix method using loss factors The model allows any reasonable approach provided it reflects both the possibility that a credit loss results and the possibility that no credit loss results: Cumulative loss rates and Probability of Default metrics already incorporate this notion A probability-weighted calculation that considers the likelihood of more than two outcomes is not required An entity is prohibited from estimating expected credit losses based solely on the most likely outcome (i.e. the statistical mode) 29 Scope The proposal would apply to financial assets measured at: amortized cost and FV-OCI Generally, this means: loans and debt securities that are held to maturity, and debt securities that are designated as available for sale The CECL model would replace five discrete impairment models that currently apply to certain financial instruments depending on legal form and, for securities, the degree of credit risk 30

16 Scope (Cont d) Expedient for collateral dependent financial assets: Entities could estimate expected credit losses for a collateral dependent asset by comparing the asset s amortized cost basis to fair value, less any costs to sell Definition of collateral dependent is different in the proposed ASU than under current GAAP and regulatory reporting instructions: Applies to all financial assets not just loans Repayment expected primarily or substantially through the operation of the collateral by the lender or sale of the collateral 31 Scope (Cont d) Debt Securities: Securities could be pooled as well as evaluated individually Other-than-temporary impairment (OTTI) would be superseded Allowance rather than adjustment to amortized cost for OTTI loss recognized in earnings A practical expedient could be used for qualifying securities: No allowance if: Fair value cost, and Credit losses are insignificant Significant change in how interest income is recognized (nonaccrual status) Consider forward-looking information when estimating credit losses: Potential allowance for even highly-rated debt securities 32

17 Scope (Cont d) Troubled Debt Restructurings: Retains the designation: No change in identification of TDR Impairment model changes: Basis adjustment at time of modification Effective interest rate following a TDR will be the debt instrument s original (pre-modification) effective interest rate Disclosure challenges remain 33 Scope (Cont d) Purchased Credit Impaired Loans: Operational complexity expected to decrease Creates a Day-One allowance for impairment, unlike current practice Interest income would be based on expected cash flows at the date of acquisition (yield held constant) Permits estimated increases in expected cash flow to be reflected in earnings immediately as a provision for credit losses Measurement of credit impairment would follow the same approach as originated assets 34

18 Supervisory Views on the Impairment Proposal Overall view is positive: Supportive of FASB s efforts to improve the accounting for credit losses Consistent with other reforms prompted by the financial crisis, including enhancements to regulatory capital requirements Detailed views on: Transition impact Day-One loss Application to debt securities Convergence 35 Views on Proposed Changes: Transition Impact Calculation of lifetime expected losses will require significant implementation effort: Changes to systems for data collection and analysis Initial estimates indicate an impact of 25-50% for large, welldiversified portfolios: However, the impact on individual portfolios across banks varies widely depending on the current ALLL balance, portfolio attributes and assumptions used to arrive at expected lifetime losses Recent pace and magnitude of ALLL releases will likely worsen the impact at transition 36

19 Views on Proposed Changes: Day-One Loss Interest income will be earned over time, while expected credit loss will be front loaded (recognized on Day One) Loan portfolio growth increases losses, contraction decreases losses Potential for restricted lending to higher credit risk groups? 37 Views on Proposed Changes: Day-One Loss (Cont d) Ongoing Day-One recognition of credit losses for stable, open portfolios should not significantly affect earnings: Question the role of historical loss rates experienced during highly stressed economic environments in estimation of expected credit losses on new, high-quality loans during periods of tight underwriting standards 38

20 Views on Proposed Changes: Application to Debt Securities Generally support use of one model for loans and debt securities: However, current OTTI model for debt securities appears to be working Need additional guidance on application to debt securities 39 Views on Proposed Changes: Convergence FASB and IASB differ on timing of recognition of expected credit loss The Agencies believe there is potentially meaningful common ground between the two proposals and encourage the two boards to jointly deliberate to explore whether such common ground can be reached while still achieving earlier loss recognition in all jurisdictions Efforts to narrow the gap between the FASB and IASB models may lead to revisions 40

21 Questions? 41