The Future of Measuring Expected Credit Loss - Case Study Example

In purchasing high-yielding Citibank mortgage assets, the corporate controller for ABC controller should design an expected loss model to enhance the accurate disclosure of the financial assets at hand. The entity should recognize an allowance for expected credit losses on the mortgage assets acquired at low prices. The expected credit losses of the financial asset are an estimate of a number of cash flows that an entity does expect to receive. The entity should recognize this amount of funds at each reporting date. The company should not recognize the expected credit losses on the mortgage assets at fair value only if they meet some conditions. First, the mortgage assets’ fair value should be higher than or equal to its amortized cost basis. Second, expected credit losses on the assets are negligible based on the position where the mortgage asset is placed in a range of expected credit losses that the company has on the reporting date.

Based on the proposal of the FASB, the firm is required to find an estimate of the mortgage assets expected based on the relevant information obtained from external and internal sources. The implications of reasonable forecasts on the expected credit losses are also considered. The relevant information used in the estimation of the expected credit losses includes both qualitative and quantitative factors such as the evaluation of the borrower’s creditworthiness and the direction of the current and future economic cycle. The relevant information used expected credit loss would include collectability of available contractual cash flows without unnecessary effort and the entity’s operational environment. When estimating the expected credit losses of the mortgage assets, the company will have to ensure the estimates give a reflection of the explicit and implicit time value of money. If the firm decides to use a discounted cash flow method to incorporate the time value of money, then the applicable discount rate would be effective interest on the mortgage assets.

The FASB proposal prohibits the presentation of the most likely outcome in the estimation of expected credit losses. The estimates should only present the possibility that a credit loss would occur or a possibility that it will not and not the presenting the best-case scenario or the worst-case scenario. The estimates designed by the firm are required to represent how enhancements can be put in place to reduce the expected credit losses on the mortgage assets. The enhancements would be such as the assessment of a guarantor’s financial condition or if the presence of subordinate interests would help absorb a portion of the mortgage assets expected losses. If the company has a separate freestanding contract that intends to reduce its credit risk, then the firm will not be permitted to combine it with the mortgage assets during the estimation of the expected credit losses to reduce it. Similarly, the company would not be permitted to offset an excisable contract, which is legally detachable such as a credit default swap that may reduce the expected credit loss of the mortgage assets against the estimated value (Wintour, 2016).

Since the estimation of the expected credit losses requires judgment, the techniques used to carry the estimation should be relevant and practical to the particular circumstances engulfing the asset. The techniques used to make these estimations vary based on financial assets and availability of relevant information. For developing historical statistics useful in the estimation of expected future credit losses, the company can make several judgments election of policies. Examples are; the definition used in the developing of default statistics, the method used to measure the rate of loss based on the defaults, the method applicable in the adjusting of loss statistics for recoveries, and the approach applicable in the weighing of historical experiences. No specific approach or election are a requirement; the firm is left with the discretion to choose an estimation technique that it would use consistently in accordance with key principles outlined by the FASB proposal (Yuka Koshino, 2016).

Following the proposals of the FASB, the company would be required to estimate the expected credit losses to reflect the time value of money. A discounted cash flow model or loss statistics reflects the time value of money explicitly. The loss statistics is based on the ratio of the amount of written off amortized cost due to credit loss and the amount of amortized cost basis of the financial asset. The company is at liberty to use the roll rate methods, loss-rate methods, the probability of default methods, and a provision matrix method that uses loss factors in its estimation of the expected credit loss. If the purchased mortgage assets have collateral attached to it, then a method that compares the amortized cost of the asset and the fair value of the collateral should be applied as a practical expedient. If the repayments of these mortgage assets depend on the sale of the collateral, the company should adjust the collateral’s fair value to consider the selling price ("New Rules on Accounting for Credit Losses Coming Soon - Community Banking Connections", 2016). The will be no inclusion of the collateral in the estimation of the credit losses if the repayment of the mortgage assets depends on the operation of the collateral rather than its sale.

In the estimation of the expected credit losses, the company should also consider the possibility of an occurrence and no occurrence of a credit loss. If a range of more than two outcomes is present are implicit in the approach used, the firm will not have to pin point the various credit loss scenarios or estimate the weighted probability of the expected credit losses. Since some measurement methods such as the roll rate method, loss-rate method, and the probability default method use a wide-range population of historical loss data in estimating future credit losses, the requirement is met implicitly. This requirement is met in a provision that the method includes items that resulted in both losses and no losses. The entity can also incorporate the use of collateral fair value as a practical expedient in the estimation of credit losses of the mortgage assets if they are collateral dependant. This incorporation is because several potential outcomes are determined on a market-weighted basis in the collateral’s fair value. In situations that the collateral’s fair value is greater than the financial asset amortized the cost, then there will be zero expected credit losses (Financial & Financial, 2015).

The entity should recognize the changes in the allowance for expected credit losses. The expected credit loss or a reversal of the previous amounts that are recognized as an allowance in the balance sheet for the current period needs to be recognized in the income statement as a credit losses provision. Under the FASB proposal on credit losses, the entity would write off the mortgage asset if the firm ascertains that it has no realistic expectation of future recovery. The entity might consider recognizing the write-off later than under the requirements of the current practice would suggest due to the concerns of the stakeholders. The new proposal of the FASB allows the company to retain the write-offs that existed in the US GAAP. This retention implies that the company can write off the carrying amount of the mortgage asset once it ascertains that the financial asset is uncollectible.

The new credit loss model will apply to AFS debt securities. In some instances, the proposals may tentatively make a decision not to include AFS debt securities despite it being in the scope of the credit losses model. This situation leads to the impairment of AFS debt securities to be accounted in ASC 320, which the FASB decided to revise it. The revision required an entity to use an allowance approach. The revision also led to the removal of the requirement that a firm must consider the duration the fair value of its financial asset has been less than its amortized cost. This consideration is made during the assessment of whether the security is of another kind apart from being temporarily impaired. The revision also removed the requirement that a firm must have considerations in the fair value after the balance sheet date during the assessments of the existence of credit loss existence ("FASB's Current Expected Credit Loss Model | ALLL Regulations", 2016).

In the situation that the mortgage assets purchased by the firm are classified as PCI assets, then they would measure expected credit losses in a similar manner as how it does for purchased and originated non-credit impaired assets. After the acquisition of a PCI asset, the firm is entitled to recognize the amount of contractual cash flows not expected to be as its allowance for expected credit losses. This recognition would act as an adjustment to increase the cost basis of the asset. After the firm recognizes the PCI assets and any allowances related to it, it can proceed the new CECL model to the mortgage assets. This trend will ensure that any changes that arise in the estimation of the entity’s cash flows would be recognized in the income statement whether they are favorable or not. Interest income recognition of a financial asset is based on the price it is purchased plus the initial allowance that is connected to the contractual cash flows.

The new proposal of the model provides a guideline in dealing with modified financial assets. The entity should measure expected credit losses because of the cash flows expected when dealing with non-TDR modifications since they do not result in derecognition. This measurement of these cash flows is done at the post modification effective interest rate (Prejean, Pfeffer, & Bisnov, 2016). Following the proposals of the ASU, the cost basis of the financial asset should be adjusted when the firm executes a TDR modification. The adjustment takes place to ensure that the original effective interest rate of the asset under modification is maintained despite the new series of the contractual cash flows. The adjustment would include the calculation-amortized cost of the assets before modification less the present value of the new series of the contractual cash flows. What the present value of the cash flows in this situation is discounted at the original effective interest rate. The adjustment that reflects a reduction in cash flows after modification would be recognized as a credit loss. The credit loss is also recognized with a corresponding decrease in the amortized cost basis of the instrument. If the adjustment reflects a rise in the cash flows after the modification, the entity should recognize it as an increase in the asset’s amortized cost. The recognition would have a correspondence increase in the allowance for the expected credit losses. The new scope of the CECL model has a provision for loan commitments. The off-balance sheet arrangements such as the extension of credits, standby letters of credit, and guarantees are within the scope of the new credit loss model since they have credit risk.

The entity should disclose the expected credit loss of the mortgage assets it purchased to enable users of the financial statements understand various things. Some of these things include the portfolio of the underlying credit risk and the manner in which the management monitors it, management’s estimations of the expected credit losses, and changes that may occur to the estimations of the expected credit losses. The disclosed information of expected credit losses would help financial statement users get an understanding of the management’s efficiency in credit management of financial assets. The stakeholders of the company would use the disclosed information to evaluate the risk attached to the mortgage assets the company has purchased.

The allowance for doubtful accounts for accounts receivables safeguards the company in the event that the company has bad debts, which are to be written off in the income statements. The allowance for doubtful accounts only operates on current assets such as the account receivables. The CECL model would save the ABC Corporation since it provides an allowance for the credit loss that may be incurred by its financial assets such as the mortgage assets it purchased.