The Financial Accounting Standards Board (FASB) recently released a proposal that would change the way financial institutions set aside funds to cover losses on loans, debt securities and other assets. Under current accounting rules, the allowance for loan and lease losses (ALLL) is based on incurred losses; the new model, if adopted, would require the allowance to be established for losses expected over the life of the loan based on current and future economic conditions, historical losses, and other factors. The change was prompted by the global financial crisis, when stakeholders were blindsided by the tremendous credit risk that had built up in many institutions’ loan portfolios.
Financial institutions follow generally accepted accounting principles (GAAP) when reporting financial information. Under GAAP, funding for the ALLL is determined by what an institution thinks it will lose on loans based on events that have already occurred; this method is referred to as the “incurred loss” method. There are a number of problems with this method, the most significant of which is that it is not forward-looking.
See full Article: http://www.stlouisfed.org/publications/cb/articles/?id=2345
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