While the majority of public companies are dealing with revenue recognition and lease accounting changes coming in the next year or more, the banking sector is trying to tame an even bigger beast.
A new standard on credit impairment doesn’t take effect until 2020, but banks believe it to be a far bigger accounting change for them, commanding even more attention ahead of other big accounting changes that will happen sooner. The new standard requires banks to take a more forward-looking approach to their debt instruments and calculate a “current expected credit loss” to reflect in financial statements. The American Bankers Association characterizes it as the most sweeping change to bank accounting — ever.
The standard, Accounting Standards Update No. 2016-13 published by the Financial Accounting Standards Board, doesn’t tell companies how to calculate what they expect to loose on any given pool of loans. In fact, it gives them plenty of latitude to decide how to calculate their expected losses.
And that’s the part of the standard that’s perhaps most daunting to bank executives — how to arrive at black-and-white numbers to report in financial statements that have potentially enormous consequences for earnings and capital requirements with no black-and-white instructions on how to do so.
“CECL does not tell you that you have to use this model,” says Jon Howard, senior consultation partner at Deloitte & Touche. “It lays out a concept. So the data you’re going to have to collect in part depends on what model you’re going to use, and you can use different models for different types of loans.”
While the standard is most relevant to the banking sector because they’re in the business of loaning money, and therefore have massive portfolios affected by the new accounting, it will apply to any business entity that carries any kind of debt instrument on the balance sheet. Operating companies that carry credit accounts for their customers, for example, will have to comply eventually as well.
As summer slips away, however, those companies are fully consumed away with getting their revenue recognition plans pinned down. That standard takes effect Jan. 1, 2018 for calendar-year companies. And close on the heels of revenue recognition, companies across virtually all sectors will need to comply with the new lease accounting standard in 2019.
“There are elements you can take from IFRS 9 into CECL,” says . “The lifetime loss modeling can be useful.”
Jonathan Prejean, Managing Director, Advisory Pracitce, Deloitte & Touche
It’s not as if the revenue recognition and leasing standards are not important to the banking sector. Like many companies, many in the financial services sector initially believed the revenue recognition standard in particular would not present such a big challenge, says Steven O’Donnell, an assurance partner in BDO USA’s banking group.
“Now they’re playing catchup (on revenue recognition) to assure their analysis is complete,” says O’Donnell. “With CECL, they knew it was a big deal, so they put a heavy focus on it when it was issued.”
Among the handful of big banks in the United States, the analysis to comply with CECL is well underway. Companies are deciding how they will perform their calculations, building their models, and gathering the data they will need. To some extent, companies that also report under International Financial Reporting Standards are leading the pack in deciding on how to comply with CECL under GAAP.
IFRS also contains a new standard on credit impairment, IFRS 9, and it takes effect even earlier, in 2018. While the standards do not require the same considerations for establishing the estimated forward-looking loss, the exercise of getting compliant with IFRS 9 can be leveraged to some degree for global banks that now must also prepare for the GAAP standard.
The biggest difference between the requirements under IFRS compared with GAAP is what to report in the first year of a new instrument. IFRS allows companies to assume a promising loan in the first year it is issued will not suffer a loss, so companies are not required to reflect any kind of loss unless or until the loan actually starts to go bad. GAAP requires a calculation of a lifetime loss estimate from the day a loan is issued.
“There are elements you can take from IFRS 9 into CECL,” says Jonathan Prejean, a managing director in the advisory practice at Deloitte & Touche. “The lifetime loss modeling can be useful.”
CREDIT LOSS OVERVIEW
Below FASB summarizes the scope of the Credit Loss standard.
On June 16, 2016, the FASB completed its Financial Instruments—Credit Losses project by issuing ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts.
To that end, the new guidance:
Eliminates the probable initial recognition threshold in current GAAP and, instead, reflects an organization’s current estimate of all expected credit losses over the contractual term of its financial assets
Broadens the information an entity can consider when measuring credit losses to include forward-looking information
Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses
Increases comparability of purchased financial assets with credit deterioration (PCD assets) with other purchased assets that do not have credit deterioration as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses for all assets
Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage)
For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write down
The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income.
The new guidance affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.
Those big banks are well down the path of deciding what kind of model they will use to reflect lifetime loss expectations and gathering the data they will need to perform those calculations. To some extent the data and capabilities they’ve amassed to comply with capital requirements under various banking regulators gives them the right resources to prepare for CECL.
But for most entities in the financial services sector and virtually everyone outside the sector, the task of developing a CECL compliance methodology still awaits. “It’s bit of a chicken-and-egg situation,” says Mike Lundberg, a partner at audit firm RSM. “Do you pick a model and figure out what data you need to run the methodology? Or do you look at the data you have and can reasonably recreate and then pick a model that will work with the data? It’s a little bit iterative.”
Smaller banks that don’t have the resources or the data repository of larger institutions are somewhat stuck in that feedback loop, says Lundberg. “They’ve got some level of understanding of the words of the standard, but they’re still struggling with how do we implement,” he says. “How do we get started?”
Those smaller banks raised a large fuss over CECL as FASB wrote the rules, convinced it would lead to complex, oppressive requirements that would drive them out of business. FASB responded by writing in language to indicate it meant for the standard to be scalable to the different circumstances and resources of smaller institutions. Banking regulators have piped up in support of that concept as well.
Big banks are zeroing in on some key methods they will use to reflect their expected losses, says Peter Barbera, a director at Navigant Consulting focused on financial services. Some will use a percentage-of-loss or dollar loss rate, applying historic loss rates to new loans and applying those rates to calculate the CECL provision.
Some models will focus more on probability of default to arrive at the CECL number, says Barbera, and some plan to rely on discounted cash flow models, applying a series of default-related assumptions or projections and calculating the cash flow of instruments accordingly.
Some of those models require more data than others, Barbera says, and entities need to consider not only the availability of data but also the quality. If historic data happens to be available for some reason but has never been subject to the rigor of a financial statement audit, how reliable is it?
Where companies have gaps in their own data, they’ll have to turn to industry data produced by entities like Fannie Mae, Moody’s, or Bloomberg, says Barbera. They may also have to pay for data through more proprietary research services, he says.
In terms of understanding the cascading effects of the new standard, that’s still very much to be determined, says Prejean. Experts predict all sorts of possible fallout from the new standard, including income statement volatility, increased capital needs, and possibly even changes to the way banks price loans and bring them to the market.
Some entities are considering asking FASB to change or defer the standard, which is not likely says Prejean. And some are already appealing to banking regulators to consider regulatory relief with respect to capital requirements. Prejean believes that may be premature. “People are not far enough down the road to know what the impact is,” he says, and that’s a prerequisite to determining whether changes to capital regulation or capital planning are in order.
Jose Molina, a financial services advisory principal at Grant Thornton, says companies need to be sure they’re putting a cross-functional team together to plan their CECL compliance. “It requires collaboration of finance, accounting, risk, compliance, and technology,” he says. “It really is a team effort, and in some places that will be a challenge. Sometimes they are not used to working together.”