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Recoveries
Publication date: 22 Oct 2018
us FASB TRG credit losses memo 17
MEMO
| Memo No.
Issue Date
Meeting Date(s)
| 17
October 22, 2018
TRG Meeting November 1, 2018
|
Contact(s) | Jay Shah | Lead Author, Project Manager | Ext. 317 |
Damon Romano | Co-author, Practice Fellow | Ext. 334 | |
Chris Cryderman | Co-Author, Practice Fellow | Ext. 467 | |
Trent LaFrano | Postgraduate Technical Assistant | Ext. 239 | |
Doug Jepsen | Postgraduate Technical Assistant | Ext. 388 | |
Shayne Kuhaneck | Assistant Director | Ext. 386 | |
Project | Transition Resource Group for Credit Losses | ||
Project Stage | Post-Issuance | ||
Issue(s) | Recoveries | ||
Disclaimer: This paper has been prepared for discussion at a public meeting of the Transition Resource Group for Credit Losses. It does not purport to represent the views of any individual members of the Board or staff. Comments on the application of generally accepted accounting principles (GAAP) do not purport to set out acceptable or unacceptable application of GAAP. Stakeholders are strongly encouraged to listen to feedback about this staff paper from TRG members and Board members during the TRG meeting and to read the meeting summary, which will be prepared by the staff after the meeting.
Memo Purpose
1. The purpose of this memo is to summarize recent feedback received by the staff (solicited or otherwise)regarding the Board’s tentative decision made at the August 29, 2018 meeting related to recoveries. For the purposes of this meeting, the staff will not provide a recommendation on the first issue but rather pose questions to Transition Resource Group (TRG) members and observers to gather their views on feedback received by the staff and to highlight two alternative approaches that could be considered to expand the Board’s tentative decision on recoveries to include other sources of cash inflows, such as the sales of nonperforming financial receivables.
2. The staff also will seek input from TRG members about the staff’s analysis of the second issue, which relates to whether entities can have a negative allowance when measuring the allowance for credit losses.
Question for TRG Members
|
Issue 1: Recoveries
1. Does the TRG believe that, with the exception of deleting the last sentence of paragraph 326-20-35-8, further clarifications of the guidance are unnecessary for the accounting of recoveries in determining the estimate of expected credit losses?
2. If TRG members believe that further clarifications are necessary for the accounting of recoveries in determining the estimate of expected credit losses, what additional clarifications do TRG members propose?
Issue 2: Negative Allowance
3. Does the TRG agree with the staff’s analysis that an entity should be permitted to record a negative allowance when measuring the expected credit losses for financial asset(s), as long as the negative allowance does not exceed the aggregate amount of previous or expected writeoffs of the financial asset(s)?
|
Issue 1—Recoveries
Background and Description
3. Before the TRG meeting on June 11, 2018, stakeholders informed the staff that there was diversity in views on whether future expected cash receipts (expected recoveries) from a financial asset that had been written off, or may be written off in the future, should be included in the calculation of expected credit losses under Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments. Specifically, the TRG submission describes how the principle in paragraph 326-20-30-1 implies that recoveries of financial assets should be included in the “net amount expected to be collected” and, therefore, by extension should be included in the allowance calculation. However, because paragraph 326-20-35-8 specifically states that recoveries on written-off assets should be recorded when received, stakeholders disagree about whether an entity is permitted or required to include estimates of expected recoveries when measuring the expected credit loss for financial assets on an individual or pool basis.
4. At the June 2018 TRG meeting, the staff provided the following interpretations and recommendations.
5. The staff believes that the Board’s intent is clear that expected recoveries should be estimated and included in the calculation of the allowance if the information used to measure expected recoveries is determined to be in accordance with guidance in paragraphs 326-20-30-7 through 30-9, which is consistent with the treatment of other inputs or assumptions used in the measurement of expected credit losses.
6. Because the issue of including expected recoveries is a foundational issue in the application of the expected credit loss model, the staff believes that including expected recoveries should be applied consistently on an individual and pool basis. The staff acknowledges that applying expected recoveries for an individual financial asset may yield different results than including expected recoveries on a pool basis; however, the overall framework of Topic 326 must be consistently applied regardless if an entity is measuring the allowance for credit losses on a pool or on an individual basis.
7. The staff believes that because the estimation of expected recoveries is an input to the overall calculation of the allowance for credit losses (that offsets expected losses), the input should be included as part of the valuation account and not a direct write up of the asset.
8. The staff also highlighted that if an estimate of expected recoveries is included when measuring expected credit losses, this may result in financial assets with expected recoveries that are greater than their amortized cost basis. The staff understands that many entities have historical practices in this area because this phenomenon occurs today. The staff believes that the Board’s intent in this area has always been to avoid changing practice for writeoffs as expressed in the excerpts from BC73 provided in paragraph 21 of TRG Memo 11. Moreover, the staff believes that current practices do not violate the concepts in Topic 326 but rather are a practical outcome of the overall model for calculating expected credit losses.
Feedback from the June 2018 TRG Meeting
9. Overall, TRG members supported the staff’s interpretation that expected recoveries should be included in the calculation of the allowance for credit losses. However, several TRG members questioned whether entities should be permitted or required to include an estimate of expected recoveries in the allowance calculation. These TRG members supported providing entities with an option to include expected recoveries in the calculation of the allowance for credit losses, noting that this would be a more practical outcome, especially for certain portfolios such as credit cards. In reaching this view, these TRG members highlighted difficulties with creating internal controls for calculating recoveries on loans that have been previously written off and noted that entities would need to disclose their policies for developing expected recovery inputs.
10. In response to these members, the staff clarified that the Board’s intent in this area was to require the inclusion of expected recoveries, that an entity should use judgment when estimating the allowance for credit losses, and that inputs and assumptions used in the measurement of the allowance should be consistent with all other inputs and assumptions used to measure the allowance in accordance with Subtopic 326-20. Therefore, an estimate of expected recoveries should not be included in the allowance for credit losses if that expected recovery input or assumption does not meet the requirements in paragraphs 326-20-30-7 through 30-9, as follows:
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 collectibility 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 collectibility.
326-20-30-8 Historical credit loss experience of financial assets with similar risk characteristics generally provides a basis for an entity’s assessment of expected credit losses. Historical loss information can be internal or external historical loss information (or a combination of both). An entity shall consider adjustments to historical loss information for differences in current asset specific risk characteristics, such as differences in underwriting standards, portfolio mix, or asset term within a pool at the reporting date or when an entity’s historical loss information is not reflective of the contractual term of the financial asset or group of financial assets.
326-20-30-9 An entity shall not rely solely on past events to estimate expected credit losses. When an entity uses historical loss information, it shall consider the need to adjust historical information to reflect the extent to which management expects current conditions and reasonable and supportable forecasts to differ from the conditions that existed for the period over which historical information was evaluated. The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors that are associated with credit losses on the financial asset or in the group of financial assets). Some entities may be able to develop reasonable and supportable forecasts over the contractual term of the financial asset or a group of financial assets. However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information determined in accordance with paragraph 326-20-30- 8 that is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period. An entity may revert to historical loss information at the input level or based on the entire estimate. An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis.
11. Some TRG observers noted that it may be difficult to justify having expected recoveries on an individual asset without any incremental performance. The staff clarified that any estimate of expected recoveries, on either a pool or individual asset level, would need to meet the conditions as required.
12. Some TRG members suggested that the staff consider separately presenting a negative allowance balance as an asset, instead of netting down the allowance for credit losses.
Feedback Received After both the June 2018 TRG Meeting and the August 2018 Board Meeting
13. After the June 2018 TRG meeting, the staff was informed by certain stakeholders, including financial statement preparers and regulators, that some entities were interpreting the term recoveries to include amounts recoverable from the sale of the underlying collateral in the event of a default or foreclosure. In addition, some entities interpreted the term recoveries to include amounts received from a third party upon the sale of a nonperforming loan or credit card balance. An example may include the amounts a credit card company would receive when selling off a nonperforming line of credit to a debt collector.
14. One stakeholder asked if an entity could analogize to the recovery decision by considering increases in the fair value of collateral as a negative allowance, to the extent that the increase in fair value exceeds the amortized cost of the asset as of the reporting date. This would be in a situation in which the financial asset was partially or fully charged off in a prior period but subsequently the fair value of the underlying collateral increased. This stakeholder noted that the negative allowance would be limited to the previously charged off amount.
15. After the August 2018 meeting, the staff developed a questionnaire to solicit feedback from stakeholders regarding the Board’s decision on recoveries. The staff provided the questionnaire to three preparers, seven accounting firms, and three other stakeholders.
16. The following summarizes the feedback shared by stakeholders who participated in the questionnaire.
Preparer Feedback
17. Each of the preparers noted that all recoveries should be considered when measuring the allowance for credit losses. Each of the preparers noted that the reference to “all recoveries” should not be intended to include freestanding contracts. Generally, each preparer believes that, at a minimum, recoveries should include the following forms: (a) cash from the borrower (principal and interest payments), (b) collateral (such as, homes or vehicles), and (c) the sale proceeds of a financial asset to a third party (such as, the sale of defaulted credit card balances to a debt collector). One preparer noted that recoveries also should include private mortgage insurance proceeds and other embedded credit enhancements. These preparers noted the following benefits of including all recoveries when measuring the allowance for credit losses:
(a) Largely consistent with existing practice and historical loss data
(b) Supports arriving at an entity’s best estimate of the net amount expected to be collected
(c) Alignment of expected losses with expected recoveries
(d) Conceptually consistent as a sale of a receivable to a third party should not be treated differently than cash collections from the borrower because the third party is willing to purchase the receivable only based on its expectations of future cash collections from the borrower. Therefore, the sale of a receivable acts as a proxy for the amount that the entity could recover if it had retained possession of the receivable and pursued its own collection efforts instead.
(e) Economically, there is no difference in the various sources of a recovery. The various sources of recoveries are how the industry balances the costs and benefits of workouts directly with the borrower versus collecting recoveries externally. That is, the accounting for recoveries should be consistent regardless of the methods of monetizing the financial asset, that is, the lender pursing collections directly from the borrower or the lender selling a receivable to a third-party debt collector.
18. These preparers identified certain expected proceeds that should be excluded or adjusted in determining recoverable amounts:
(a) Recoveries should include proceeds from the expected sale of financial assets that have experienced credit deterioration, including prior charge offs, delinquency, or other defaults. This would mean sales proceeds from expected sales of financial assets that are currently performing could not be considered a recovery.
(b) Expected proceeds from the sale of underlying collateral or sales of financial assets to a third party should be offset by the selling costs that are expected to be incurred.
19. As a follow-up to stakeholders who supported the view that all recoveries should be considered when measuring the allowance, the staff asked the following questions:
(a) Do you believe that Subtopic 326-20 is clear as currently written, that is, that all recoveries can be included when measuring the allowance for credit losses? Answer: All preparers stated that striking out the sentence that reads “Recoveries of financial assets and trade receivables previously written off shall be recorded when received” from paragraph 326-20-35-8 would clarify that all recoveries can be included when measuring the allowance for credit losses.
(b) If sales to third parties are considered recoveries, does that mean freestanding contracts can be included as recoveries? Answer: No, freestanding contracts have their own measurement guidance and are outside the scope of the guidance related to the measurement of credit losses.
(c) Paragraph 326-20-30-4 refers to principal and interest as those cash flows that would be considered when measuring the allowance for credit losses when using a discounted cash flow method. In contrast, paragraph 326-20-30-5 refers to cash and other considerations when measuring expected credit losses. Do you believe that the reference to “other considerations” in paragraph 326-20-30-5 should be added to paragraph 326-20-30-4? Answer: All preparers stated that they would not object to that clarification; however, they noted that the guidance is clear as written and that the reference to cash flows includes collateral and other forms of recoveries.
(d) As noted, you recommended no changes to Subtopic 326-20 other than striking out a single sentence in paragraph 326-20-35-8. However, you have also suggested that the sale of performing financial assets should be excluded from the treatment of a recovery. Do you have any recommended wording changes for this carve out? Answer: All preparers stated that they do not view securitizations or sales of performing financial assets as a way to mitigate credit losses. They also noted that recoveries should be limited to nonperforming financial assets but did not have suggested wording changes.
(e) If no changes are made to Subtopic 326-20, what would preclude an entity from considering any expected cash flow as a recovery, such as sales of performing financial assets or expected proceeds from a lawsuit? Answer: Wording could be added to the guidance that would curtail activities such as these from being considered a recovery.
Accounting Firms Feedback
20. Most accounting firms stated that all recoveries (except for freestanding instruments and the sale of performing financial assets) should be considered when measuring the allowance for credit losses, including (a) cash from the borrower (principal and interest payments), (b) collateral (such as, homes or vehicles), and (c) the sale proceeds of a financial asset to a third party (such as, the sale of defaulted credit card balances to a debt collector). These accounting firms noted that freestanding contracts would not be included as expected recoveries. These accounting firms noted similar benefits as the preparers who responded to the questionnaire. However, these accounting firms highlighted the following concerns about including all recoveries when measuring the allowance:
(a) It would be inappropriate to treat the sales proceeds of performing financial assets as a recovery. The risk characteristics of a performing and nonperforming financial asset are substantially different in that an entity expects to monetize a performing financial asset through principal and interest cash receipts while the monetization of a nonperforming loan tends to come from recovery of amounts previously written off.
(b) Recoveries should be limited to the fair value or expected value at the foreclosure date, less estimated costs to sell (on a discounted basis). That is, entities should not consider liquidation proceeds when measuring recoveries. This would ensure that the guidance for owned real estate would be separate from the measurement of the credit loss.
(c) By including all types of recoveries, the allowance for credit losses may essentially be limited to the fair value of the underlying collateral. (d) One accounting firm recommended that rather than requiring entities to consider recoveries, an option be provided instead. This firm noted that smaller institutions may not have the data necessary to estimate recoveries if it were required.
(d) One accounting firm recommended that rather than requiring entities to consider recoveries, an option be provided instead. This firm noted that smaller institutions may not have the data necessary to estimate recoveries if it were required.
(e) One accounting firm recommended that expected recoveries be presented as a separate asset instead of creating a negative allowance associated with the charged-off financial assets. This stakeholder expressed discomfort with having a “contra-contra” account via a negative allowance for credit losses.
21. One accounting firm stated that recoveries should be limited to cash flows from the borrower (that is, principal and interest) and stated underlying collateral. Under this alternative, entities would be precluded from considering sales of financial assets as a recovery. This accounting firm stated that there was no conceptual basis for including sales of financial assets in the measurement of expected credit losses. This accounting firm noted that most of the concerns raised on recoveries have more to do with the regulatory treatment of charge offs than the accounting guidance.
22. One accounting firm stated that they agreed with the majority of other firms that all recoveries should be considered when measuring the allowance. However, this firm stated that recoveries also should include freestanding contracts. This firm noted that there should not be a distinction between collateral and freestanding contracts because both instruments are meant to mitigate credit losses. Unlike most stakeholders who participated in the questionnaire, this firm noted that the guidance is not clear on recoveries and that the Board should consider making certain clarifications to Subtopic 326-20.
23. One of the accounting firms also expressed support for further clarification in the guidance with respect to the accounting treatment of recoveries.
Other Stakeholder Feedback
24. Several other stakeholders stated that the guidance in Update 2016-13 should be clarified with respect to expected recoveries. These stakeholders noted that recoveries should be clearly defined, so entities understand which recovery amounts are included and excluded. In addition, they continued that the expected recoveries should be limited to the amount an entity expects to charge off. That is, an entity should not record expected recoveries without having previously partially or fully charged off the financial asset or without considering future charge offs. One stakeholder presented the fact pattern wherein expected recoveries on a loan issued at a steep discount could result in entities effectively recognizing a gain if allowed to consider recoveries up to the amount of the unpaid principal balance.
Staff Analysis
25. After the June 2018 TRG meeting, the staff received numerous questions from stakeholders asking for clarification on what was meant by recoveries. Specifically, stakeholders asked the staff if the Board was going to clarify (a) what types of recoveries could be included when measuring the allowance and (b) if entities could record a negative allowance when applying the collateral-dependent guidance in paragraphs 326-20-35-4 through 35-5.
26. At the June 2018 TRG meeting, the staff clarified that entities should be required to consider recoveries when estimating the allowance for credit losses. If an entity expects to record a charge off or has previously charged off a financial asset, the staff stated that allowing entities to record a recovery would be in line with the intent of the guidance that requires entities to report the net amount expected to be collected with regards to financial assets within the scope of Subtopic 326-20. After initial outreach on the subject of recoveries, the staff believed, at a minimum, recoveries should be included when measuring the allowance for credit losses, but those recoveries should be limited to amounts received from the borrower. The staff asked stakeholders what types of recoveries should be included when measuring the allowance and nearly all stakeholders supported allowing all types of recoveries in the measurement of the allowance, including (a) cash from the borrower (principal and interest payments),
(b) collateral (such as, homes or vehicles), and (c) the sale proceeds of a financial asset to a third party (such as, the sale of defaulted credit card balances to a debt collector), subject to the exclusions of freestanding instruments and sales of performing financial assets. These stakeholders also noted that entities should not consider freestanding contracts as recoveries.
27. The staff had numerous follow-up questions for stakeholders, most importantly the staff asked stakeholders what changes should be made to Update 2016-13 to clarify that all types of recoveries should be included in the measurement of the allowance. Stakeholders generally maintained that the guidance is clear as written, and that no additional changes need to be made to Update 2016-13, other than striking out the language in paragraph 326-20-35-8 that states “[r]ecoveries of financial assets and trade receivables previously written off shall be recorded when received.”
28. In consideration of the feedback received, the staff identified two alternatives that could be considered in deciding whether the Board’s tentative decision on recoveries should be expanded. The alternatives below would be incremental to deleting the language in paragraph 326-20-35-8 (as referenced in paragraph 14 of this memo):
(a) Alternative 1: Allow for All Types of Recoveries to Be Considered Except Sales of Performing Financial Assets—Most stakeholders noted that the guidance is already clear that all types of recoveries can be included when measuring the allowance for credit losses. This alternative would require some limited standard setting. This alternative would have to amend the guidance to limit recoveries to only those amounts expected to be received on nonperforming financial assets.
(b) Alternative 2: Allow for All Types of Recoveries to Be Considered—Under this alternative, an entity would be able to consider all forms of recoveries when measuring the allowance for credit losses. Because stakeholders noted that the guidance is already clear that all types of recoveries can be included when measuring the allowance for credit losses, no further amendments are recommended for Update 2016-13.
Alternative 1: Allow for All Types of Recoveries to Be Considered Except Sales of Performing Financial Assets
29. As noted above, stakeholders generally agreed that all recoveries should be considered when measuring the allowance for credit losses. As stated above, stakeholders noted that the reference to “all recoveries” should not be intended to include freestanding contracts. Generally, stakeholders maintained that recoveries come in the form of cash from the borrower (principal and interest payments), collateral (such as, homes or vehicles), and the sale proceeds of a financial asset to a third party (such as, the sale of defaulted credit card balances to a debt collector). However, stakeholders noted their apprehension about including sales of performing financial assets as a recovery. Stakeholders noted that including the expected sales of performing financial assets in the allowance for credit losses would essentially allow entities to frontload all or portions of future revenues.
30. The staff agrees with stakeholders that treating the sales of performing financial assets as a recovery would result in entities essentially frontloading future revenues. However, the staff also notes that because an entity could not record a recovery without having an expectation for future charge offs or had previously charged off all or a portion of a financial asset it is unlikely that an entity would be able to include sales of performing financial assets in the measurement of the allowance credit losses.
31. Lastly, under this alternative, an entity would be required to offset sales proceeds by expected selling costs
Alternative 2: Consider All Expected Recoveries (Including Sales of Performing Financial Assets)
32. Under this alternative, an entity would be permitted to include all types of recoveries when estimating the allowance for credit losses, including the sales of performing financial assets. In addition, entities would be required to offset sales proceeds by expected selling costs. This alternative would provide entities with a principle that would permit all forms of recoveries, excluding freestanding contracts, as long as those inputs meet the guidance requirement in paragraph 326-20-30-7 (see paragraph 5). This alternative would include the fair value of the collateral at the date of foreclosure or expected proceeds from the sale of defaulted financial assets. Based on feedback from stakeholders who participated in the questionnaire, this alternative would not require any standard setting because stakeholders believe Update 2016-13 would not require further clarification beyond that described in paragraph 14 that all types of recoveries can be considered when measuring the allowing for credit losses.
Issue 2—Negative Allowance
Background
33. At the June 2018 TRG meeting, the staff clarified that an entity could record a negative allowance when measuring expected credit losses. After the TRG meeting, stakeholders highlighted the guidance for collateral-dependent financial assets in paragraphs 326-20-35-4 through 35-5 and asked whether entities could have a negative allowance when an entity measures the allowance for credit losses using the fair value of the underlying collateral. Stakeholders noted that when a borrower experiences financial difficulty and the entity elects to apply the practical expedient guidance for collateral- dependent financial assets, the fair value of the underlying collateral may increase in a subsequent period. Therefore, if the entity had to previously write down the financial asset, these stakeholders noted that entities should be able to reverse that writedown by recording a negative allowance as long as the negative allowance does not exceed amounts previously charged off.
Feedback Received After both the June 2018 TRG Meeting and the August 2018 Board Meeting
34. The feedback on allowing entities to record a negative allowance when measuring the allowance for credit losses was mixed. Some preparers and accounting firms supported allowing for negative allowances. Those who supported a negative allowance stated that the Board should clarify the guidance by stating that an entity can record a negative allowance in all circumstances, including when measuring the allowance for collateral-dependent financial assets or when foreclosure is probable. In contrast, some preparers and accounting firms disagreed and noted that entities should not be allowed to record a negative allowance. One preparer who disagreed noted that if the fair value of collateral exceeds the amortized cost basis of the financial asset, any expected amounts in excess of previously recorded charge offs should be recorded as a gain in other income when realized.
Staff Analysis
35. The staff believes that entities should be permitted to record a negative allowance, which would be consistent with the nature of a valuation account and the intent of the guidance in Update 2016-13. That is, entities should be permitted to increase or decrease a valuation account so that the net amount expected to be collected is reported on the balance sheet when measuring a financial asset. The staff believes that entities may record a negative allowance subject to a cap. The staff believes the cap would preclude an entity from recording a negative allowance that exceeds the aggregate amount of previous or expected writeoffs of the financial asset.
36. The staff acknowledges that the guidance in Update 2016-13 would have to be amended in order to clarify that negative allowances are permitted when measuring the allowance for credit losses regardless if the financial asset is unsecured or a collateral-dependent financial asset.
Next Steps
37. The staff will collect feedback from TRG members and observers with regards to recoveries. The staff will either ask the Board to reconsider its previous decision on recoveries made at the August 29, 2018 Board meeting or will include a question in the Exposure Draft to solicit feedback on these questions regarding recoveries.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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