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Understanding the Proposed Changes to Determining the Allowance for Loan Losses

Last December the Financial Accounting Standards Board (FASB) issued an exposure draft on credit losses that would have a significant impact on the way that financial institutions compute and record their allowance for loan losses, if it is ultimately adopted. The proposed change is motivated primarily by two things:

  • The FASB and International Accounting Standards Board (IASB) are trying to jointly develop a new standard for financial instruments that are in harmony with each other;
  • And much criticism was received in the context that the existing standards resulted in an overstatement of assets for many financial institutions when the financial crisis in 2008 began.

This criticism has created a sense that the methodology must be changed. Thus far the FASB has received a significant number of negative comment letters regarding the proposal, many being from credit unions and other financial institutions.

The basic change being proposed is to go from the current methodology of recognizing the estimated loss amount when it is incurred to a new approach of estimated loss based on the total amount of cash flows not expected to be collected over the life of the loan.

The impact of the change in methodology would not change the overall losses recorded over the lives of the loans, it would however change the timing of when the losses are reflected.

To illustrate the impact of the proposal vs. the old methodology let’s look at the following data.

Year 1 Year 2 Year 3
Auto loans made 100,000 100,000 100,000
Historical default loss year 1 0 0 0
Historical default loss year 2 5,000 5,000

5,000

Historical default loss year 3 5,000 5,000

5,000

 

Under the old methodology the loan losses recorded each year would be similar to the following:

Year 1 0
Year 2 5,000
Year 3 10,000
Year 4 10,000
Year 5 5,000
Total Loss 30,000

 

Under the new proposal the loan losses would be recorded similar to the following:

 

Year 1

10,000

Year 2

10,000

Year 3

10,000

Total Loss

30,000

As is demonstrated the total loss did not change, however the timing did. Upon initial application the difference between the new and old computations would be posted as a one-time adjustment to retained earnings.

I personally am in the camp that the change is not warranted and will not lead to an improvement in the overall financial reporting process or the carrying value of loans. Since both methods are ultimately based on historical losses, trends and cash flows, it is unlikely that even if the proposed new method were in place in 2008 financial institutions would not have been able to reasonably estimate the cash flows ultimately to be received. In addition, during that time period cash to be realized on collateral dependent loans was also hard to predict due to the volatility that existed with trying to estimate the value of the underlying collateral.

The FASB has had this project in process for several years and has undergone several different versions. We will continue to provide updates as they occur.

Condit
Contact
  • Gary Condit
  • Director, Assurance & Business Advisory Services
  • (614) 947-5272
  • gcondit@gbq.com