Are You Ready for Changes to the Allowance for Loan Loss Methodology?

In the aftermath of the most severe economic downturn since the Great Depression, accounting professionals have been trying to understand why the loss allowances in loan portfolios did not predict the losses that were ultimately incurred in a more timely manner.

As far back as 2008, the Financial Accounting Standards Board (FASB) began to discuss changes to the allowance for loan loss (ALLL) model used by financial institutions to measure potential losses in their loan portfolios.  In its attempt to revise the methodology, the proposed standard has gone through many transformations over the years.  One objective was to converge with international standards (IASB).

In December 2012, the FASB issued Proposed Accounting Standards Update No. 2012-260, Financial Instruments – Credit Losses (Subtopic 825-15).  The proposed model changes the approach to measuring loan losses from the “incurred loss” model currently in place to the “current expected credit loss model,” also referred to as the expected loss model.

The incurred loss model attempted to measure losses in loan portfolios based upon probable losses inherent in the portfolio at the measurement date.  These losses were measured by analyzing historical results as adjusted for current qualitative factors.   The expected loss model eliminates the probable threshold and requires institutions to estimate cash flows they don’t expect to collect over the life of each loan. Along with historical loss rates, the estimates should utilize probabilities of default, changes in portfolio risk and forecasting measures that are supportable. Institutions should be prepared to obtain more granular data to implement the expected loss model.

Most observers agree that the change in methodology will occur, although the final form may be subject to change.  Most also agree that the currently proposed methodology will ultimately result in larger allowances that are recognized sooner.