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Credit Losses: The Godfather of Updated Accounting Standards

Credit Losses: The Godfather of Updated Accounting Standards

Banks and other asset-holders must feel more like Michael Corleone all the time. Just when they thought they were out, the global credit crisis pulls them back in.

A full decade after a credit-induced earthquake shook the financial system, aftershocks are still reverberating. The latest rumble: an update to accounting standards for the measurement of credit losses, which will impact reporting for financial entities and other public companies holding certain financial assets.

Financial institutions experienced billions of dollars’ worth of losses and write-downs when the terms “subprime mortgage,” “derivatives,” and “credit default swap” became part of our lexicon. Since then, calls for earlier reporting of expected credit losses have grown louder, prompting action from the Financial Accounting Standards Board (FASB).

The goal of FASB’s resulting Accounting Standard Update on Topic 326 is twofold: to ensure greater transparency around credit and loan losses, and to provide investors with more (and more accurate) forward-looking information. The FASB states, “The main objective of this Update is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments.”

So, what does it all mean? Those who prepare financial statements will need to report credit losses on financial instruments earlier under the new standard. There also will be a significant effect on accounting for purchases of credit-impaired assets—for instance, acquiring “underwater” real estate, where the market price has dipped below the outstanding value of its mortgage.

The updated standard for credit losses is being phased-in gradually. Early application is permitted as soon as the fiscal year beginning after December 15, 2018. For Securities and Exchange Commission (SEC) filers, the new standard will become a requirement exactly one year later; for non-SEC filers, two years later. That means if a company’s fiscal year ends by the first half of December, they may adopt the new standard as early as January 1, 2019.

The Federal Reserve, together with other government entities, issued a joint statement a day after FASB’s announcement, urging institutions to avoid increasing their credit-loss allowances before the updated standard takes effect. Some public companies, though, have reportedly been getting ready in other ways. This includes reviewing the revised standard, modifying procedures for loan-and-lease losses, and updating systems and technologies associated with credit modeling.

The greatest accounting challenge, it seems, will be to include losses that will impact a balance sheet when the risk of those losses is remote. For Intelligize #accountingweek, we’ve created a list of the assets most likely to raise that difficult scenario: purchased credit deteriorated assets, collateral-dependent financial assets, past-due or nonaccrual items, and allowances for expected credit losses. Companies should also review their policies for determining write-offs and credit quality.

For regulators, this Accounting Standard Update is a long time coming, an earnest attempt to better account for the complexities of the credit world. Or, in other words, to oversee offers the banks just couldn’t refuse.

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