FASB Proposes Major Revisions to Accounting for Credit Losses On Financial Assets: FASB Proposes to Replace the “Probable” or “Incurred” Thresholds for the Allowance for Loan and Lease Losses Under U.S. GAAP With an “Expected Credit Loss” Standard: Potential Impact on Bank Reported Earnings and Capital and on Regulatory Capital Ratios

Sullivan & Cromwell LLP - December 27, 2012
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On December 20, 2012, the Financial Accounting Standards Board (the “FASB”) issued for public comment a Proposed Accounting Standards Update, Financial InstrumentsCredit Losses (Subtopic 825-15) (the “Credit Loss Proposal”), that would substantially change the accounting for credit losses under U.S. generally accepted accounting principles (“U.S. GAAP”). Under U.S. GAAP’s current standards, credit losses are not reflected in financial statements until the credit loss is probable or has been incurred. Under the Credit Loss Proposal, however, an entity would reflect in its financial statements its current estimate of credit losses on financial assets over the life of each financial asset. Comments on the Credit Loss Proposal are due by April 30, 2013.

The Credit Loss Proposal, if adopted as proposed, is likely to have a negative impact on U.S. banks’ reported earnings and capital and on regulatory capital ratios, as well as on regulatory limitations based on capital (e.g., loans to affiliates). This is a result of larger loan loss reserves being required at an earlier date. It could also have a procyclical impact on lending because higher reserves would seemingly be required at the inception of a loan if recent loan loss experience on a portfolio basis had increased and conversely lower initial reserves if recent loan loss experience had declined.