Credit unions can expect new and complex requirements governing the Allowance for Loan Losses.
Just when most credit unions think they’ve mastered the accounting for the allowance for loan losses -- the rules are going to change. The calculations will become much more complex, much more subjective, and, frankly, they could result in additional allowance reserves to the tune of many times current levels.
What’s going on? Well, the Generally Accepted Accounting Principles (GAAP) in the U.S. is based on the “incurred loss” model. This framework requires that before an allowance is established, it must be probable, based on events that have already occurred, that a lender will not be able to collect principal and interest payments that are required under the contractual terms of the loan. If the impairment event has not already occurred, or if it is less than probable that a loss will be incurred, then at least in theory, no allowance is established.
Much discussion has occurred between FASB (Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) on allowance for loan loss theory. Many models have been proposed over the course of the past year.
However, at a joint FASB-IASB meeting on December 14, 2011, the two boards agreed to change from the incurred loss model described above to the expected loss model. Under this new accounting model, the allowance for loan loss will be based on expected losses to be incurred over the life of the loan. The impairment event giving rise to the loss does not need to have already occurred. Rather, such events need only be reasonable possible over the life of the loan to be recognized at the measurement date.
The ramifications of the proposed new standards are huge, and you can expect significant confusion in the early years of implementation. Expect significantly higher allowance for loan loss balances, and as a result, lower levels of capital for all banking institutions. At this time, the new standards are set to go into effect in January 2015. For more details on the change, see the IASB’s update.