According to Fitch Ratings, approval of a Financial Accounting Standards Board (FASB) proposal on the treatment of credit losses for loans and other financial assets could eventually force U.S. banks to book expected losses early, putting pressure on reserve levels and reported earnings. Fitch Ratings sees the potential for use of the loss model under this new FASB proposal to drive U.S. institutions to report asset values more conservatively than international counterparts applying the proposed new IFRS credit loss standard.

The FASB loan loss proposal, released in December and open for public comment until April 30, would change the way in which banks account for expected losses on loans and other debt securities and financial assets. Unlike the current loss reserve rules that allow institutions to wait until losses are incurred before boosting provisions, the new approach would require a more timely recognition of future losses as expected cash flows change.

In contrast to the current system, in which multiple impairment models relying on an "incurred loss" approach are used, the new framework would lead to a single "expected credit loss" model, in which management would be required to incorporate more forward-looking information in reporting on credit losses. As well as using available current and historical data, they would also need to consider forecasts of future losses.

On the balance sheet, U.S. banks would be required to reflect current loss expectations in the "allowance for credit losses" account. The income statement would capture deterioration or improvement in credit loss expectations through changes in the provision for bad debt expense.

Fitch believes that the use of this model is likely to lead to quarterly adjustments in expected loss projections, possibly leading to more volatility in provision expense and reported earnings. However, banks could also conceivably take large one-time charges at first signs of distress in their loan portfolios, then look for opportunities to smooth earnings volatility over time through reserve releases or reverse provisions

If the proposal is adopted, the rule would likely take some time to go into effect. Banks will require time to improve their accounting and reporting systems to collect the type of data that will be needed to estimate prospective losses. We believe the rule would not go into effect until 2015 or later. At that time, assuming a prospective approach to loan losses leads to increased bookings of provisions, most banks will likely report one-time hits to earnings.

Like the FASB, the International Accounting Standards Board (IASB) is seeking public comment on proposed changes in credit loss treatment. The IASB exposure draft on the subject (open for comment until July) does not go as far as the FASB proposal in encouraging a move away from the levels of provisions booked under an "incurred loss" standard. This could set up a situation in which U.S. banks are ultimately required to report greater expected credit losses, leading to more conservatism in reporting and potentially larger loss provisions relative to their European, Canadian and other international competitors. This could derail the process of international accounting convergence on credit losses and lead to less clarity in comparing bank balance sheets and income statements around the world.

Ultimately the method used by banks to estimate expected losses, as well as the time horizon over which these estimates are made, will be important in providing a reasonable picture of banks' financial positions.