Theoretical and political debates aside, the long-awaited new accounting for credit losses is moving forward in 2019 unless someone takes definitive action to delay or alter it.
Accounting Standards Codification Topic 326 on credit losses is slated to take effect Jan. 1, 2020, more than three years after the Financial Accounting Standards Board finalized the standard. Described by some as the most significant change to ever occur in bank accounting, the standard affects all companies by taking a more futuristic approach to reporting credit losses.
“This is not a standard just for banks,” said Jonathan Howard, a partner at Deloitte, at a year-end accounting conference on regulatory matters. “It applies to all entities, although it is certainly a bigger deal for banks.” Banks have massive amounts of long-lived instruments on their balance sheets, but even operating companies outside of financial services have receivables, lease agreements, and debt securities they plan to hold to maturity that are affected by the new accounting.
The new rule traces its roots to the global financial crisis in 2008, when banks recognized losses following the present-day incurred loss model. Under today’s rules, companies recognize losses only when they were deemed probable. That gives investors little or no opportunity to see signs of trouble in lending portfolios before losses begin occurring.
In the aftermath of the crisis, FASB and the International Accounting Standards Board took a hard look at the accounting rules that may have contributed to the crisis and determined they should take a different approach. The IASB adopted its model under International Financial Reporting Standard 9, which took effect in January 2018.
FASB chose a somewhat different approach to the current expected credit losses model, requiring companies to record a day-one loss on instruments even on the day of inception. It also set the effective date well into the future to allow a longer lead time, in part because the accounting was so different but also to allow for equally monumental changes in revenue recognition in 2018 and in leases in 2019.
CECL requires entities to take a more forward-looking view of their risks when calculating loan losses, giving investors more forewarning when debtors are having trouble meeting their obligations. The new standard under ASC 326 doesn’t prescribe a precise formula for how to calculate the allowance for loan losses, instead leaving individual entities some latitude to use historic data and market information to develop models that reflect how they do business.
“This is not a standard just for banks. It applies to all entities, although it is certainly a bigger deal for banks.”
Jonathan Howard, Partner, Deloitte
The implications are most significant for financial institutions, whose balance sheets are steeped in debt-based financial instruments and whose capital reserves under banking regulators are based on the accounting calculations. The day-one recognition of a possible loss as required under the CECL model will drive reserves upward.
Financial services entities turned to banking regulators like the Federal Reserve and the Federal Deposit Insurance Corporation to ask how they planned to modify capital requirements to reflect the higher levels that would be required under the new Generally Accepted Accounting Principles rule. Regulators indicated recently they didn’t plan to alter reserve requirements, but they would give banks three years to phase in the effects.
Now the debate rages over whether CECL will be harmful to the economy, whether it will dry up lending as banks take a more conservative view of borrowers, whether the complexity is too much for smaller institutions, and even whether the model should be modified to at least take the sting out of the effect on the income statement.
The American Bankers Association and the Bank Policy Institute have appealed to the U.S. Treasury to put the brakes on ASC 326 until its effects can be further studied and better understood. The recently departed chairman of a House sub-committee even introduced a bill as Congress wrapped up the end of 2018 to prevent banking regulators from enforcing CECL and to compel the SEC to study it more carefully. Given the newly seated Congress and its bigger concerns these days about finalizing a budget, the prospects for the bill are subject to question.
The Securities and Exchange Commission and FASB have acknowledged the pressure, but so far have not budged on the effective date or the essential requirements of CECL. FASB is working on some amendments to address periphery implementation issues, but it would not alter the core requirements. FASB has said it will hold a roundtable in January to air the various concerns, making no promises about whether the roundtable process will lead to any change in the model or its effective date.
At a House sub-committee hearing in December, CECL opponents told members of Congress that CECL is “procyclical,” meaning it will magnify any movement in the economy further in the direction it is headed. When things are turning south, reserving and reporting losses under CECL will drive it there faster, said Scott Blackley, CFO at Capital One.
“While the FASB’s efforts in developing CECL were laudable, it is likely to create significant unintended consequences that could be harmful to the availability, accessibility, and affordability of credit for consumers and small businesses,” said Blackley. The concepts developed in CECL predate the Dodd-Frank Act, which produced numerous other regulatory measures, especially new stress testing for banks, that would be at odds with CECL, he said.
CECL requires banks to predict losses based on their views of the economy into the future, said Blackley, which many believe will exacerbate the procyclicality of CECL. Missed forecasts will drive volatility in allowances for loan losses, he says. Increased reserves will reduce the availability of capital to lend, and ultimately it will drive up the cost of borrowing.
Mark Zandi, chief economist at Moody’s Analytics, says those who criticize CECL and call for its delay are relying on “severely limited” analysis. CECL is not countercyclical, but it will be less procyclical than the current accounting model, he says.
“I think CECL adoption will lead to a stronger, safer financial system and economy,” said Zandi in his testimony at the hearing. Companies following International Financial Reporting Standards have already adopted a standard similar to CECL and have not observed the dire consequences that CECL opponents predict.
Zandi says that based on an analysis by Moody’s using historic figures, CECL would not have prevented the bubble that led to crisis in 2008. The bubble, however, would have been smaller. It would have incentivized banks to pay closer attention to indicators of problems in their loan portfolios and use more caution in lending, he said.
Wherever the debate may lead, companies in the meantime in all sectors should be preparing to comply by the Jan. 1, 2020, effective date, says Mike Lundberg, a partner at audit firm RSM. Talk of delay or possible changes to the standard has caused some companies to contemplate whether they should proceed with implementation, he says.
“It generates the question of: ‘Do I really need to do this?’ ” says Lundberg. “The consequences of being wrong are really big. It’s been said over and over again. Just get started. Go, go, go.”