Revenue recognition may be the biggest accounting change many companies are facing in the near term, but new rules for recognizing expected credit losses are causing just as many headaches in certain places.
Banks are the first to feel the pangs of this particular accounting standard, given the enormity of the credit instruments they carry on their balance sheets. “This is their revenue recognition,” says Jonathan Prejean, managing director at Deloitte & Touche.
While the requirements don’t kick in until 2020, companies outside of financial services would be wise to tune in. “Don’t ignore it,” says Prejean. “Think about who has large receivables, like trade receivables.” Companies in healthcare and telecommunications, for example, often carry large receivable balances, he says, so they will likely be affected as well.
The Financial Accounting Standards Board adopted Accounting Standards Update No. 2016-13 to require companies that carry debt instruments to change the way they recognize losses on those balances. Current accounting prohibits entities from reflecting losses in financial statements until they are more likely to occur, giving investors little forewarning.
The catastrophic effects of that approach played out in the financial crisis, prompting FASB and the International Accounting Standards Board to require a more forward-looking approach. Now both rulebooks require entities to do some forecasting, apply their historic experience, then estimate and report how much they expect to lose on their loan portfolios.
The IFRS standard, called IFRS 9, takes effect in 2018, but it requires a somewhat different approach to estimating expected losses. FASB’s model, commonly known as the current expected credit loss (CECL) model, requires companies to book an expected loss from the day an instrument is added to the books. IFRS 9 looks a little further into the future.
Financial institutions, which will experience the biggest changes under the new requirements, should tune in to the implementation activity taking place at companies adopting IFRS 9, says Anshu Agarwal, executive director in EY’s financial services advisory practice. Banks have struggled with underestimating the significance of the accounting change, with a lack of data as well as the quality of data, and with reconciling their different systems for finance and risk, she says.
“it is of utmost importance that banks develop a detailed implementation plan assessing current data availability, models, and impairment methodologies all the way through designing, building and deploying their implementation plan.”
Anshu Agarwal, Executive Director, Financial Services Advisory Practice, EY
In the U.S. “it is of utmost importance that banks develop a detailed implementation plan assessing current data availability, models, and impairment methodologies all the way through designing, building, and deploying their implementation plan,” says Agarwal.
The largest banks are making some progress, says Prejean. Given the effective date of 2020, they want to be prepared to run parallel systems in 2019 so they can have “dress rehearsals” in 2018 to test out their new approaches, he says.
“A lot of banks are either finalizing what they are going to do with their models or are in that model design phase,” he says. “Once they decide what model to use, that drives other aspects of implementation. What data do you need? What processes do you set up? The majority if not all have a plan in place.”
Smaller banks are further behind, says Brad Bird, national assurance director at BDO USA. “They’re more keenly aware of the composition of their portfolios at the end of the most current year, and they’re getting a sense of whether they should look at categories of loans more granularly,” he says. “They’re getting an understanding of what’s in their loan portfolio, the types of risks, and how they are going to use that to populate the model, whatever that’s going to be when they move forward.”
DELOITTE SUMS UP IFRS 9
Below, Deloitte offers a summary of the International Accounting Standards Board’s IFRS 9:
FRS 9 Financial Instruments is the IASB’s replacement of IAS 39 Financial Instruments: Recognition and Measurement. The Standard includes requirements for recognition and measurement, impairment, derecognition and general hedge accounting.
Overview of IFRS 9
Classification and measurement of financial instrumentsInitial measurement of financial instruments
Under IFRS 9 all financial instruments are initially measured at fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs. This requirement is consistent with IAS 39.
Financial assets: subsequent measurement
Financial asset classification and measurement is an area where many changes have been introduced by IFRS 9. Consistent with IAS 39, the classification of a financial asset is determined at initial recognition, however, if certain conditions are met, an asset may subsequently need to be reclassified.
Subsequent to initial recognition, all assets within the scope of IFRS 9 are measured at:
• amortised cost;
• fair value through other comprehensive income (FVTOCI); or
• fair value through profit or loss (FVTPL).
The FVTOCI classification is mandatory for certain debt instrument assets unless the option to FVTPL (‘the fair value option’) is taken. Whilst for equity investments, the FVTOCI classification is an election. The requirements for reclassifying gains or losses recognised in other comprehensive income (OCI) are different for debt and equity investments. For debt instruments measured at FVTOCI, interest income (calculated using the effective interest rate method), foreign currency gains or losses and impairment gains or losses are recognised directly in profit or loss. The difference between cumulative fair value gains or losses and the cumulative amounts recognised in profit or loss is recognised in OCI until derecognition, when the amounts in OCI are reclassified to profit or loss. This contrasts with the accounting treatment for investments in equity instruments designated at FVTOCI under which only dividend income is recognised in profit or loss with all other gains and losses recognised in OCI and there is no reclassification on derecognition.
To some extent, all banks, especially smaller ones, are troubled by a kind of “chicken and egg problem,” says Graham Dyer, a partner in Grant Thornton’s accounting principles consulting group. Banks need historical data on which to base a model, but they need a model to know what historical data to gather to plug into it. Banks may have annualized loss data, for example, but not necessarily full life-of-loan loss data on certain instruments.
Even bigger banks are going forward with their models with some trepidation about how they will be accepted by auditors and regulators, says Deloitte’s Prejean. “There’s a lot of room for interpretation,” he says. “There are some questions out there as to what the expectations are. What’s going to be acceptable? What’s acceptable for one bank may not be acceptable for another.”
Questions are still circulating, says Dyer, around how to estimate expected losses over the life of loans. The FASB standard says estimates should focus on expected credit losses over the life of the loan unless the entity can expect a loan to be restructured in a troubled debt restructuring. The standard also tells entities to pool similar loans.
“People have asked how those concepts fit together,” says Dyer. “Should you project troubled debt restructurings on a pool basis or individual loan basis? I don’t think the profession has reached a consensus on that question at all.”
FASB has formed a Transition Resource Group to take and vet implementation questions, but the group has so far received no submissions, a spokesman said, although the board understands some entities may be in the process of drafting or preparing questions for submission.
The key principle entities should embrace as they move forward, says Prejean, is to assure forecasting for accounting purposes is consistent with forecasting used elsewhere in the business, including for risk, finance, and other compliance purposes. CECL results will be reported more frequently than, say, the comprehensive capital analysis and review required by the Federal Reserve or stress testing required under Dodd-Frank. “But forecasting in the CECL model should not be inconsistent with that forecasting,” he says.
It’s too soon for entities to be able to say in quantitative detail how the standard will affect their loan loss allowances, although the general expectation is that losses will go up given the forward-looking nature of the new requirement. A recent Deloitte survey found most banks are expecting loan impairments to rise at least 10 percent, and most expect volatility in the income statement. But it’s nearly three years until the standard takes effect, says Rahul Gupta, a partner at Grant Thornton. “Right now your expectations are going to be different than they are going to be on Jan. 1, 2020,” he says.
Barry Pelagatti, assurance partner at BDO USA, cautions entities to scrutinize sales pitches for models that are sold as plug-and-go to comply with the new standard. “You can’t lose in translation that while the model may mathematically work, you have to be able to support the inputs,” he says. “Some of the salesmanship out there is all you have to do is give us the raw data, put it in the machine, and you’re done. Companies may be hearing only what they want to hear.”