Accounting for loan losses is at the heart of credit union accounting. Setting aside reserves for loan losses is an important accounting component, but an increase in allowances reduces a credit union’s capital. Under current accounting standards, a credit union recognizes losses when they reach a probable threshold of loss. This is called an incurred loss accounting model. In practical terms, incurred loss accounting is a backwards-looking model, measuring a pool of loans against historic annualized write-offs. This method can drastically underrepresent potential future losses when a loan portfolio is exposed to a financial crisis, especially after a run of several years with lower losses. And this is exactly what happened following the financial crisis of 2008 in which some credit unions found themselves under reserved and unprepared for losses in their loan and mortgage portfolios while losses to their investments, and in many cases, shares declined. In the rising economy of the early 2000’s, losses were not being accounted for as “probable”.
In response (and in hindsight) the Financial Accounting Standards Board (FASB) approved a new standard in 2016, which becomes mandatory for all U.S. financial institutions in 2021. Instead of the “incurred loss” model which looked at losses in terms of “probable”, and is open to interpretation, the new standard is based on “expected loss”. In this model credit unions need to estimate lifetime credit losses on day one, and those losses don’t have to be “probable”. This change has the potential to increase allowances for losses to increase. This increase was estimated to be as high as 30-50% when first discussed in 2015, but as forecasts of future economic conditions brighten, most analysts have lowered that number. Although it is not required until 2021, early adoption of the new standard is permitted beginning in 2019, allowing for credit unions to phase in the changes in a more orderly manner.
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