Accounting for current expected credit losses (CECL) under the Financial Accounting Standards Board’s ASU 2016-13 has found itself in the spotlight during the coronavirus crisis.
CECL was mandated to be adopted Jan. 1, 2020, for large public companies, meaning companies’ first-quarter financial results were required to include the impact of CECL methods for the first time. However, on Friday, the House approved and the President signed an emergency relief package that includes a provision giving large public banks a temporary delay in adopting ASU 2016-13 including CECL methods until Dec. 31, or when the coronavirus public health emergency ends, whichever comes first.
In addition, the Federal Reserve, in a joint statement made Friday with the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, announced it would give banking organizations the option to delay an estimate of CECL’s effect on regulatory capital in their regulatory filings for up to two years due to the pandemic. The interim final rule, which takes immediate effect but is not mandatory for banks wishing to stay the course, applies to banks required to adopt CECL by its Jan. 1 effective date this year and is in addition to a three-year transition period already in place.
The accounting challenge facing companies that choose to report CECL in the first quarter despite the reporting relief, or continue to refine their CECL models and assumptions for future reporting, in the midst of all other economic and health challenges is how to reasonably reflect the potential effects of the coronavirus in estimates of current expected credit losses.
“COVID-19 puts a lot of uncertainty into the marketplace,” says Jonathan Jacobs, managing director and global financial services industry leader at Duff & Phelps. “It has stopped the economy, resulted in record levels of unemployment, and led to an unprecedented federal government stimulus, so there is no correlation to other events.”
The U.S. economy has already been confronted with the steepest market decline since the 1980s, cuts in interest rates by the Fed, and record unemployment levels—all in a very short time. There have been market declines in all major markets and forecasts of a global recession as a result of the pandemic. Companies have experienced business interruptions and changes to their supply chain and distribution networks, and employees and customers are being forced to stay home.
To put the current accounting challenge in perspective, Jacobs suggests it is important to think about the genesis of CECL. The need for the CECL model arose during the financial crisis of 2008-2009 to address historic levels of financial instrument and accounts receivable impairments. With significant input from companies across all industries, FASB chose this new accounting model that estimates the potential expected loss over the lifetime of an instrument from its origination based on historical, current, and future economic losses. This was a major change from the existing incurred loss model that estimates losses considering a shorter period of 12 to 24 months based on historical information and the current environment. The result is a potential substantial increase in reserves.
“COVID-19 puts a lot of uncertainty into the marketplace. It has stopped the economy, resulted in record levels of unemployment, and led to an unprecedented federal government stimulus, so there is no correlation to other events.”
Jonathan Jacobs, Managing Director and Global Financial Services Industry Leader, Duff & Phelps
ASU 2016-13 requires companies to make their best estimates that incorporate forecasting of losses over time and may incorporate probabilities and weighting of expected outcomes. It requires a well-thought-out process, and assumptions are revised each period as more evidence becomes available. GAAP permits a number of acceptable models and inputs, and there is no one prescribed approach. But all require forecasting and a prospective approach about the amount, timing, and duration of market losses. “Use the best information that is known and knowable,” Jacobs says.
Know your business
Each company and financial institution must make assumptions and perform scenario analyses about how their business will trend in the short-term, intermediate, and long-term economic environments. The timing of exposure will vary depending on the terms of the financial instruments.
In the current crisis, there is much new economic data available, at various extremes. These include diverse perspectives and forecasts about recovery; even the economists have vastly different long-term estimates.
The goals and requirements under the CECL model are to think about your own business. “Impacts will be different depending on whether you are a financial institution, a real estate company with shopping malls, a utility, or an airline or cruise line,” Jacobs says. He encourages companies to look to prior historical evidence of effects on their business, including their financial instruments, supply chain, customer base, and workforce, as well as considering current and anticipated impacts on their business chain caused by company-specific, industry-specific, and external (e.g., fiscal stimulus) factors.
In implementing CECL under the current crisis, Jacobs reminds companies to include in their analysis their current expectations about the potential for and length of a recession and how quickly there will be a recovery. Corrections and mitigations over time need to be included, including the federal government’s historic stimulus plan and other recent actions by governments and the Treasury. There are also assumptions to be made about the impact of the presidential election later this year.
A new dawn
In addition, companies are faced with having to build into their CECL models assumptions about the impacts of COVID-19 as they would adjust for other catastrophic events like natural disasters such as hurricanes and earthquakes or terrorist attacks like 9/11. Because this virus is new, the length and ultimate severity are unknown, and there is no one most likely scenario right now. “Nothing fits the coronavirus,” Jacobs says.
Companies will likely not have their own historical data that correspond to an event like this one, so they may have to update their expected loss models by applying regression analysis and correlations to their data.
“Hopefully we will come out of COVID-19, but companies must still continue to look at the economy going forward and assess how long the economy will be in a recession. It will depend on how borrowers and suppliers react,” Jacobs advises. The fiscal stimulus package may help, along with future actions by the Treasury, state, and federal governments, and other regulators. None of them want markets to freeze up, and they want capital to be available to meet future demand for loans.
Assumptions must be made about what will happen to financial instruments and customers once relief measures are complete. “Extended loan terms may lapse, but what will the lending environment and customer creditworthiness be?” Jacobs asks. “Some companies may go out of business, and credit deterioration is likely to be greater than before COVID-19.”
Jacobs reminds companies that clear documentation is critical. This should include support for the appropriateness of thought processes for estimates and evidence that the best information that is known and knowable has been used. He recommends discussions about loss estimates and related assumptions with auditors and consultants.
“There is no one true right or wrong answer for assumptions, as long as there is a well-thought-out process for the assumptions being reasonable, supportable, and documented,” Jacobs reiterates. “Even with a well-thought-out process with supportable assumptions that are currently used, there will be CECL adjustments under the model each reporting period as assumptions continue to be refined and more support is obtained.” Backtesting in subsequent quarters will be performed using data about what happens in the economy in the first quarter.
While the emergency relief package provides some delay for first-time CECL adopters, Jacobs advises those companies not adopting CECL as a result of the bill, along with those not required under GAAP to adopt until 2023, not to stop their implementation process but to continue to work on their data and assumptions and document them for their auditors. Although the health crisis is definitely having an impact on financial reporting timing, Jacobs acknowledges there is really never a good time to adopt a new accounting standard of this magnitude.
He recognizes the significant uncertainties and challenges companies of all sizes are facing right now, but he believes large public banks would have been ready for CECL adoption in the current quarter.
“The financial services industry already had their CECL models and system tests and were running parallel,” he said. “Large institutions should have their methodology and documentation well underway at this point. Now they need to see how their models and assumptions are affected by the drastic changes of the past few months.”
There is no doubt, though, that many large public banks will take advantage of the relief provisions and use the extra time they have been provided.
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