Credit Losses: Changes to Credit Loss Guidance
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What are some of the ASC 326 changes from the standard from previous guidance?
I think it was in response to the credit crisis. There were concerns that credit losses were recognized too little, too late. So the major differences in the new standard is we don’t any longer have a probability assessment as far as to when you recognize a loss. You know, prior to this it had to be probable that you already incurred a loss. Now from the minute you become involved in an asset, you’re estimating the expected losses over the life of that asset. So it’s really ultimately over time you should recognize the same amount, but it’s kind of getting it on the balance sheet sooner. And recognizing it on your income statement sooner.
There’s a common perception that this standard is specifically or only for banks. Is that true?
It’s not; I would say it’s certainly impacting them the most. And you can tell they’re the ones that are probably having the larger implementation efforts. It does apply to all assets at any entity if your assets are at amortized cost. So whether it’s loans, securities, or receivables, the impact will be bigger for entities that have longer dated assets like loans or longer dated, you know, held to maturity securities.
There’s an international standard IFRS 9, that went into effect January 1, 2018. What have companies learned from this so far that you can apply to the FASB guidance?
There has been a group that has sent in a letter to the FASB of some of the mid-tier U.S. banks asking them to reconsider ASC 326 and maybe do a hybrid of the IFRS 9 model. IFRS 9, generally speaking, is for when you have a new asset, unless it’s really troubled when you become involved with it. When you have a new asset, you only recognize the losses you think are going to happen over the next year. It’s only when it deteriorates that now you look at the lifetime losses. So it’s maybe a little bit delayed recognition. It’s maybe a smaller number on day one. And so I think the U.S. banks are thinking, if we have to recognize lifetime losses on day one, that could be a big hit to capital. And so they’ve actually sent in a letter and the FASB is going to discuss whether they want to go to kind of a hybrid model where maybe the allowance would be the same. But the amount that goes to earnings is kind of consistent with an IFRS 9 model of what would be lost in the next year. Everything else would go to equity.
Another new standard that affects financial instruments is on derivatives and hedging ASC 815. Can you talk a little bit about that? It’s a voluntary standard.
Well, hedge accounting itself is voluntary. I would say, this is kind of the flip side of CECL. So with ASC 326, people have been wringing their hands and asking the FASB to reconsider, and think of other models and we’ve got a transition resource group that’s trying to work through issues. Even though it’s not effective until 2020, you do have entities that are going through a lot of efforts and trying to make sure they can get ready with hedge accounting. It was issued in August of last year and you had companies adopting even in Q3. As soon as it got issued, people decided these are improvements to an existing standard to really make hedge accounting a lot easier to implement, a lot easier to just on a day to day basis, track and report.
It put a lot of new hedging strategies on the table, so this is one that people were actually excited about. To the extent they weren’t all tied up dealing with revenue recognition, leasing and other things like if they had the resources, they were jumping on board and trying to adopt this as early as possible.
In a recent conference address, FASB chairman Russell Golden talked about a phase two of derivative hedging. Can you talk more about that?
There are a few issues. When they were doing these targeted improvements there were a few issues that I think people felt like, well, we like where you’re going, we’d like you to maybe go a little bit farther. And so like in the area of hedging nonfinancial assets, right now you can hedge forecasted purchases and sales.
Let’s say you have a supply contract, and you can hedge contractually specified components as opposed to the whole price. I think they would like them to maybe go a little bit farther or consider an IFRS 9 hedging model where you just have separately identifiable and reliably measurable components, which would really help for, even if you don’t have supply contracts, just buying things on the spot market. And because a lot of times you’ll buy at different locations, but the derivatives market is all based on a central location. So, is there always a NYMEX component to the purchases in Oklahoma and purchases in Kansas? And so that’s one area they’re pushing. Another area where they’re asking for maybe a little bit more: banks will be applying what we call last of layer hedge and allows them to hedge portfolios of pre-payable fixed rate assets.
And you really can just hedge, like let’s say you have $100 million of fixed rate mortgages and you know that $60 million of them will be around or you have a pretty good idea, $60 million of them will be around for three years. You can hedge for three years, just $60 million of that with an interest rate swap and any prepayments or defaults come out of the $40 million you weren’t hedging. The way it’s written, you can do that with one derivative in one pool. Now they’re saying, well, maybe we feel like there will be $40 million outstanding at least by the end of year five. So can I do different derivatives on the same pool and kind of have a stacking process. And so I think as Sue even talked about after Russ, they are talking about those issues. The board did direct the staff to pursue a few more things where maybe they’ll make some further improvements.
Any other thoughts on financial instruments in general?
I would say with CECL, the FASB has been done a great job as far as to when questions come in. We’ve got the transition resource group, they’ve been willing to amend the standard. They’ve been trying to be as timely as they can in addressing the issues as quickly as they can because on that one, it’s going to take a lot of time for people to implement. And so I think people want to do kind of a parallel run. We may see some more things come out as they’re starting to work through this in 2019 and do what I’ll call the dry run, the parallel run before they have to flip the switch. As you know, with anything, once you actually start in and try to apply it, new questions come up.
So I’m sure we’ll still have more activity on that. We’ll have to probably watch and see what happens with the fads with hedge accounting. And then Sue briefly talked about how they’re trying to finish a balance sheet classification of debt with current and noncurrent and simplifying that model too. But the only other big thing on the horizon, and this is a big ticket item, is liabilities and equity and trying to decide what’s the equity, what’s the liability. Seems like it should be easy, but when you talk about things like convertible debt, is it going to end up as equity? Is it going to end up with them paying it off? Right now we have a lot of different models or convertible preferred stock, but maybe it’s redeemable. And so that’s something that they’ve said they want to address. They’ve tried to address that several times. It could take a while because there are some people on different sides of the fence as far as to how much or how little belongs in equity.