This is a second in a series of blog posts about the proposed ASU for codification improvements to ASU 2106-13, better known as the CECL standard. Click here to see the initial post in the series and to read some background on the proposed ASU.
Issue 1C: Recoveries
The issue of the treatment of recoveries of previously charged off amounts has been an ongoing topic of discussion. It was discussed at the June 11 TRG meeting, discussed again at a subsequent August FASB board meeting, then discussed again in the November 1 TRG meeting.
Two main issues were brought up and deliberated around this:
Inclusion of Recoveries in the ACL Estimate
Some preparers did not feel that the standard was clear on if recoveries should be included in the estimate of expected credit losses. Many financial institutions use net charge-off rates today, that is, loss rates that include both the charge-offs as well as any subsequent recoveries, which theoretically produces an allowance that is net of those amounts today. There were also some questions about which types of recoveries should be included in the estimate, and if recoveries were required to be considered, or if that was optional. Some of these questions were based on the difficulty in obtaining data related to recoveries.
Related to the question above, if recoveries are included in the estimate of credit losses, then this could result in allowance amounts at either the loan or segment level that could at times be negative. Examples were given of banks who had very high levels of losses during the financial crisis where the subsequent recoveries of these amounts resulted in net recoveries in the years following the crisis. Preparers felt that clarification was necessary considering this definition in the ASU:
318.104.22.168 The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset. At the reporting date, an entity shall record an allowance for credit losses on financial assets within the scope of this Subtopic. An entity shall report in net income (as a credit loss expense) the amount necessary to adjust the allowance for credit losses for management’s current estimate of expected credit losses on financial asset(s).
In the definition, the allowance is defined as a valuation account that is deducted from the amortized cost basis of the asset. It wasn’t clear if that could include negative amounts that would be essentially added to the amortized cost basis rather than deducted.
Response in the Proposed ASU
Much of the clarification in the proposed ASU is around the second issue of Negative Allowances. The FASB appears to have mostly believed that there was not much clarification necessary on the inclusion of recoveries in the estimate, as the existing guidance was clear, particularly this paragraph:
326-20-30-7 When developing an estimate of expected credit losses on financial asset(s), an entity shall consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts. An entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s). When financial assets are evaluated on a collective or individual basis, an entity is not required to search all possible information that is not reasonably available without undue cost and effort. Furthermore, an entity is not required to develop a hypothetical pool of financial assets. An entity may find that using its internal information is sufficient in determining collectability.
In this paragraph, institutions are asked to “consider all available information relevant to assessing the collectability of cash flows”, which would include information on expected recoveries. It also addresses that institutions are “not required to search all possible information that is not reasonably available without undue cost and effort”, which should address the questions for recovery data that is difficult to acquire. For negative allowances, the proposed ASU states that they are acceptable in this new addition to paragraph 326-20-30-7:
Recoverable amounts included in the valuation account shall not exceed the aggregate of amounts previously written off and expected to be written off by the entity.
There is also similar language added to the collateral dependent practical expedient, that those individual loans may also carry negative allowances as long as they do not exceed amounts previously written off.
For the most part, the clarifications addressed in this portion of the proposed ASU related to recoveries should require minimal change to ongoing implementation efforts at community financial institutions. Most institutions were already planning to include recoveries in their allowance estimate and likewise include them in their modeling for developing this estimate. As for the possibility of negative allowances, we feel these situations are likely to be extremely rare at the pool level, but may become more common for some individual loans, particularly for institutions who are very conservative with their initial charge-offs. However, institutions who may wish to carry negative allowances on individual collateral dependent loans should make sure that they have all their documentation and justification prepared, as the regulatory scrutiny that will be applied to these loans will likely be quite high.