Non-banks still have plenty of work ahead to adopt CECL

The new rules require all companies with debt-like financial instruments on their balance sheet to transition to a more forward-looking approach to recognizing the value of those instruments. Accounting Standards Codification Topic 326 tells companies they must develop a “current expected credit losses” model using a combination of their own historic information and market data to arrive at those values.

The CECL model is the brainchild of the Financial Accounting Standards Board, which conducted a great deal of research and outreach over several years to establish the requirements as an alternative to the current “incurred loss” model. Under the current model, entities are prohibited from recognizing losses until they are virtually assured, which delays warning to investors.

While most operating companies have been busy the past few years adopting big changes to revenue recognition and leases, entities in financial services have had their eye on the transition to CECL, which has a far more significant effect on their balance sheet. Citigroup recently disclosed its reserve for bad debt will rise some 20 percent to 30 percent when it adopts the CECL model beginning Jan. 1, 2020, the standard’s effective date for all calendar-year public companies.

Many companies outside financial services are viewing CECL to be a standard that applies primarily or only to banks, said Alex Fredericks, a partner in financial accounting advisory services at EY. “We’re trying to raise awareness and light a fire to say you can’t bury your head in the sand over this,” he says. “You’ve got to do something, even if you think it’s not going to be a material change to your balance sheet or your income statement.”

While banks hold plenty of loans that will be subject to the CECL model, companies outside financial services also typically hold similar assets. The standard applies to items like trade receivables, loans, debt securities that are being held to maturity and that are available for sale, financial guarantees, and lease receivables.

“We’re trying to raise awareness and light a fire to say you can’t bury your head in the sand over this. You’ve got to do something, even if you think it’s not going to be a material change to your balance sheet or your income statement.” 

Alex Fredericks, Partner, Financial Accounting Advisory Services, EY

Troy Vollertsen, a partner and U.S. banking audit leader at Deloitte & Touche, says he sees more activity in the current quarter than in the first quarter. “But I do still think that companies need to continue to raise the level of awareness,” he says. “It really depends on the company. Some have started scoping, and some are further along. But some are still waiting to engage and haven’t started the CECL process in as much depth as they need to.”

The more assets a company has on its books that are affected by the standard, the more work they will need to do to prepare, says Vollertsen. “The first step is scoping the impact,” he says. “What assets do you have that may be in the scope of CECL? Do a gap analysis of your current processes and what CECL will require.”

Early on, companies should determine if the standard will have a material effect, says Vollertsen, and then develop appropriate processes, procedures, and internal controls to transition. If the standard will not be material, companies still need to document that conclusion for auditors, he says.

Reza van Roosmalen, a principal at KPMG and leader for financial instruments accounting change, says companies that are closely related to financial services will also be heavily affected by the standard. That includes companies in specialty finance, finance technology, nonregulated lenders, debt collection companies, and those with captive finance operations, like car companies that lend to customers. Mortgage real estate investment trusts will also be heavily affected, he says.

Those companies that do a fair amount of lending but are not regulated by banking regulators may have an especially steep climb, says Roosmalen. “Nonregulated institutions don’t have the stress-testing machinery that banks have to leverage for the lifetime loss modeling required by CECL,” he says.

Insurers may also have some challenges, as they have been busy lately adapting to new rules from FASB on accounting for long-duration insurance contracts, which is more core to their business than lending, says Roosmalen. Casinos that lend to gamblers may also have a heavy lift, he says. “Any company with debt securities, other debt investments, contract assets, or trade receivables of any kind needs to be aware of this,” he says.

Members of Congress and groups of banks have appealed to FASB, along with the Securities and Exchange Commission, the U.S. Treasury, and various banking regulators, to delay CECL so its effects on the economy can be studied. A new appeal to the Federal Reserve and the Federal Deposit Insurance Corp. was signed by a bipartisan group of 15 senators. Roosmalen is advising companies to stay the course, regardless of calls for delay. “I would not count on it,” he says.

One of the difficulties companies outside financial services may face is determining what kind of model is appropriate for establishing their CECL reserve. The accounting standard is not prescriptive, so it does not tell companies exactly how to calculate the expected loss. Instead, it gives them guidance on using both historic and market information as they see fit, depending on what’s important to any particular business.

For companies with longer-duration instruments, that will mean potentially more complex modeling and forecasting, says Joseph Soviero, executive director at EY. “It depends on what type of financial assets you have,” he says.

Companies will need to understand how their collectability has worked historically, especially through various types of economic cycles, said Fredericks. They’ll also need to understand their customer base and how instruments can be segregated based on risk characteristics to determine appropriate models.

Depending on the nature of the instruments, it’s possible companies may already be doing “CECL-esque” reserving, says Brandon Vaughn, managing director in audit methodology and standards at Grant Thornton. Especially for receivables of 30 to 45 days, entities may already be using lifetime loss rates, he says, and they may already be segmenting or pooling instruments by geography or by past-due status.

“Even if there’s maybe limited impact, you still have to go through the exercise,” says Vaughn. “You have to adopt the standard, adjust your policies and procedures, and your internal controls, even though you may believe the impact will not be significant.”