Financial reporting

January 1, 2013

FASB’s new model for impairment of financial instruments has cleared hurdles as the board pursues a different path than that of its international counterpart on expected credit loss.

The revised credit impairment model FASB is developing will be re-exposed separately from tentative proposals on the classification and measurement of financial instruments, according to a summary of tentative board decisions posted on FASB’s website and available at tinyurl.com/9blvjsm.

FASB directed its staff to move forward with the drafting of a financial instruments impairment standard containing the “Current Expected Credit Loss” (CECL) model it has been developing separately from the International Accounting Standards Board (IASB) since July.

In a project that has been pursued jointly with the IASB, FASB in July decided to take a step back from the “three-bucket” impairment model the boards had been developing for financial instruments.

Addressing concerns from stakeholders, FASB has been working separately from the IASB to develop the CECL model for impairment. Stakeholders had been concerned about the understandability, operability, and auditability of the three-bucket model, as well as whether it would measure risk appropriately.

The CECL model retains the three-bucket model’s main concept of expected credit loss, and the current recognition of the effects of credit deterioration on collectibility expectations.

But the CECL model uses a single measurement objective—current estimate of expected credit losses—rather than the dual-measurement approach used in the three-bucket model. The dual-measurement approach requires a “transfer notion” to differentiate between financial assets that are required to use a credit impairment measurement objective of “12 months of expected credit losses” and those that are required to use a credit impairment measurement objective of “lifetime expected credit losses.”

The CECL model would require that at each reporting date, an entity would reflect a credit impairment allowance for its current estimate of the expected credit losses on financial assets held. The estimate of expected credit losses would reflect management’s estimate of the contractual cash flows that the entity does not expect to collect and is neither a best-case nor a worst-case scenario.

FASB tentatively decided to move forward with the CECL model without broadly considering the accounting for modifications. The CECL model would apply to all modified instruments where expected credit losses are based on the expected shortfall in contractual cash flows and discounted using the effective interest rate post-modification.

To accomplish this, the guidance in ASC Subtopic 310-40, Troubled Debt Restructurings by Creditors, would be amended. The amendment would require that when a troubled debt restructuring is executed, the cost basis of the asset should be adjusted so that the effective interest rate after modification is the same as the original effective interest rate, given the new series of contractual cash flows.

The basis adjustment would be calculated as the amortized cost basis before modification less the present value of the modified contractual cash flows, discounted at the original effective interest rate.

FASB tentatively decided that a cumulative-effect approach would be used as a transition method for the CECL model. A cumulative-effect adjustment would be recorded on an entity’s statement of financial position as of the beginning of the first reporting period in which the guidance is effective.

The IASB has been monitoring FASB’s credit loss model discussions but has not pulled back from its commitment to the three-bucket model. Both boards targeted the fourth quarter of 2012 for exposure drafts on impairment of financial instruments.

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