In the continued onslaught of major new accounting changes on the horizon, companies have yet another new standard to prepare to adopt, this one focused on how to reflect credit losses in financial statements.
The Financial Accounting Standards Board has finalized Accounting Standards Update No. 2016-13 requiring all entities to reflect in financial statements their expected credit losses on financial assets. The new standard tells companies they must calculate a “current expected credit loss” based on their historical experience, current conditions, and reasonable and supportable forecasts.
That means companies will use more forward-looking information to give investors some insight into losses that are possible but have not yet occurred, even when a particular instrument is showing no signs of trouble. “On day one, for most assets originated, you’re going to set up an allowance for losses,” says Jonathan Howard, a partner at Deloitte & Touche. “We’re going to see losses sooner; and because they are lifetime losses, it will be a large number from the get go.”
Companies can thank the financial crisis for inspiring the new standard. When financial institutions faltered in 2007 and 2008 on a ripple of sub-prime mortgage failures, investors had little warning. “Under GAAP today, to recognize a loss, it has to be probable that a loss is occurring,” says Howard. “Now there’s no more probability threshold at all. It’s not just looking at events that have already occurred.”
While it was trouble in the financial sector that gave birth to the new rules, the effect is not limited to companies in the financial services business. Companies with captive financing businesses will be heavily affected, says Reza Van Roosmalen, managing director in accounting advisory services for KPMG. That might include, for example, car manufacturers or other companies that offer their own financing to customers.
“The thought process needs to start now on what additional data points you’re going to need to collect.”
Mike Gullette, Vice President, American Bankers Association
Companies that carry trade receivables will be affected, says Van Roosmalen, especially if they carry receivables for a year or longer. Companies with investment portfolios also need to look at how they are affected. “If you have an investment or liquidity portfolio with debt-type securities in there, you will be impacted,” he says. “The model applies not to just loans. Debt carried at fair value through other comprehensive income is affected.”
The good news for companies is they have a long lead time to prepare for the standard. For public companies the new requirements take effect in 2020. In the big picture, however, companies both inside and outside of the financial services sector will need all that time to properly prepare.
All public companies are facing adoption of major new rules on revenue recognition in 2018 and leasing in 2019. New requirements for measuring and classifying financial instruments also take effect in 2018, and all this is rolling out as companies are in the midst of adopting new requirements for consolidation in 2016.
Some of those changes are more monumental than others, depending on the company adopting them, but all of them come before the new standard on credit losses. That might tempt companies to put credit losses on the back burner, but Jonathan Prejean, managing director at Deloitte, cautions against that approach. “It seems like a long runway, but for any entity impacted, they really need to start now assessing where they are,” he says. “It’s a significant change in the way things are done today.”
As with other major accounting changes that are occurring, the changes that are in store under the new credit losses standard are not limited to the accounting or finance department. To reflect the kind of forward-looking information required under the new standard, the accounting office will need input from credit risk and treasury personnel.
The new standard does not prescribe a specific method for arriving at an expected loss amount. In fact, after some significant pushback from smaller banks, FASB went out of its way to assure that companies will have some flexibility in how they arrive at the numbers. Banking regulators issued a joint statement affirming that view as well.
RECOGNITION OF EXPECTED CREDIT LOSSES
Below Deloitte summarizes FASB’s latest attempt at clarifying how companies recognize expected credit loss.
Unlike the incurred loss models in existing U.S. GAAP, the CECL model does not specify a threshold for the recognition of an impairment allowance. Rather, an entity will recognize its estimate of expected credit losses for financial assets as of the end of the reporting period. Credit impairment will be recognized as an allowance — or contra-asset — rather than as a direct write-down of the amortized cost basis of a financial asset. However, the carrying amount of a financial asset that is deemed uncollectible will be written off in a manner consistent with existing U.S. GAAP
Because the CECL model does not have a minimum threshold for recognition of impairment losses, entities will need to measure expected credit losses on assets that have a low risk of loss (e.g., investment-grade held-to-maturity (HTM) debt securities). However, the ASU states that “an entity is not required to measure expected credit losses on a financial asset . . . in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the [financial asset’s] amortized cost basis is zero.” U.S. Treasury securities and certain highly rated debt securities may be assets the FASB contemplated when it decided to allow an entity to recognize zero credit losses on an asset, but the ASU does not so indicate. Regardless, there are likely to be challenges associated with measuring expected credit losses on financial assets whose risk of loss is low.
Banks are familiar with the kind of forecasting and budgeting activities that will be involved in complying with the new accounting requirements, says Howard. They’re just not accustomed to having all of them work together so closely, he says.
“This could really change the way you do business,” says Mike Gullette, vice president at the American Bankers Association. “The thought process needs to start now on what additional data points you’re going to need to collect.” Gullette adds that there are questions you will need to walk through, such as: “Should it be in a spreadsheet or a database?” or “Should you outsource it to another party?”
FASB formed a Transition Resource Group specifically for the credit losses standard to air and help work through implementation questions that might arise. Gullette says he anticipates banks in particular are likely to raise questions on how to apply the new model to revolving credit lines, where draws and payments can fluctuate significantly. “In order to do that, you probably need to have a forecast for specific cash flows,” he says. “Some think that’s something only bigger banks can do, so that’s something the TRG might speak to.”
The standard might also have some interplay with the new revenue recognition standard that companies are working to adopt, says Van Roosmalen. Under the new revenue recognition model, companies need to identify separate performance obligations in their contracts with customers. To the extent an arrangement involves a financing aspect, that should be accounted for following the model for recognizing credit losses, he says.
With revenue recognition taking effect in 2018 and credit losses in 2020, that means the accounting for that financing aspect will change when the new approach to credit losses kicks in. That’s an area where implementation teams will need to coordinate activities, says Van Roosmalen, or they may get caught off guard. “I don’t think that will be easy,” he says.
To get started, Van Roosmalen is suggesting companies study the standard to assure they know how they will be affected and perform a gap analysis to determine what data they will need. For companies reporting under both U.S. GAAP and International Financial Reporting Standards, that means an added layer of analysis because international rules for credit losses are not the same as the new U.S. standard.
“Our main message is don’t be tempted to minimize this thing,” says Gullette. “Some banks are going to be tempted to use this as a compliance exercise because that’s kind of what the allowance really is now. That changes under this new standard.”
Banking regulators issued the same warning in their joint statement. “Institutions should use judgment to develop estimation methods that are well documented, applied consistently over time, and faithfully estimate the collectibility of financial assets by applying the principles in the new accounting standard,” they wrote.