It has been nearly four years since FASB began issuing its revised financial instruments guidance (see the sidebar, "Topic 326 Changes"). The guidance impacts all industries, not just financial institutions in the financial services industry, and applies to a broad range of financial assets.
The underlying principle of FASB ASC Topic 326, Financial Instrument--Credit Losses, is that a reporting entity holding financial assets is exposed to credit risk throughout the holding period. Thus, a credit loss may exist at financial asset purchase or origination, as well as until the financial asset is settled or disposed of. Financial instrument guidance specific to credit losses in Topic 326 changes the recognition, measurement, and presentation of estimated credit losses on existing debt assets involving contractual future cash flows and on off-balance-sheet commitments to extend credit.
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments--Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, applies to all financial instruments carried at amortized cost (including loans held for investment (HFI) and held-to-maturity (HTM) debt securities, as well as trade receivables, reinsurance recoverables, and receivables that relate to repurchase agreements and securities lending agreements), a lessor's net investments in leases, and off-balance-sheet credit exposures not accounted for as insurance or as derivatives, including loan commitments, standby letters of credit, and financial guarantees.
The new accounting standard does not apply to trading assets, loans held for sale, financial assets for which the fair value option has been elected, or loans and receivables between entities under common control.
In addition to significant changes in accounting, the new guidance implementation will require major changes to the debt asset holder's operations processes and internal controls over financial reporting. Implementation will also impact information technology and data management because its forward-looking approach means amassing internal and external data to analyze credit losses and forecast future economic expectations.
The effective date for SEC filers is years beginning after Dec. 15,2019. For all other public entities, the effective date is years beginning after Dec. 15,2020. Private companies have until years beginning after Dec. 15,2021. In August 2019, FASB proposed extending the effective dates for SEC smaller reporting companies and for private companies to years beginning after Dec. 15,2022. The soonest early-adoption date was for years beginning after Dec. 15,2018. Interim period adoption has the same dates as annual adoption.
If historical experience and future expectations suggest that some debt asset cash flows will not be collected, the debt asset holder must immediately recognize an allowance for credit losses, which reduces the debt asset's net carrying value with a corresponding impact on earnings.
The biggest change from current guidance is the way to estimate credit losses (uncollectible future cash flows). The magnitude of that change will depend on the debt asset credit quality and terms, The expectation is that uncollectible future cash flow amounts, financial debt asset impairment, and off-balance-sheet losses will now be reflected sooner in the financial statements under the current expected credit loss, or CECL, model.
IN-SCOPE AND OUT-OF-SCOPE DEBT ASSETS
Topic 326 applies to all entities holding debt assets that are not currently measured at fair value with holding gains and losses reflected in earnings. Inscope debt assets include the following:
Financial assets measured at amortized cost
* HTM debt securities exist when the holder has both the intent and ability to hold the debt security to maturity. This is typically the first amortized-cost example that comes to mind.
* Financing receivables, which represent a contractual right to receive cash on demand or at determinable future dates.
* Receivables that meet the definition of a security (which means they are debt securities) that result from revenue transactions within the scope of both revenue recognition standards (Topic 605 or Topic 606) or Topic 610, Other Income.
* Reinsurance receivables that result from insurance transactions within the scope of Topic 944...