What to expect with the new expected credit loss model

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In June 2016, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The ASU is the new impairment standard, and caps the second phase of FASB’s three-part project on financial instruments. The other two phases consisted of targeted improvements to the existing rules for classification and measurement, and hedging.

ASU No. 2016-13 is considered one of the most significant accounting changes in decades to affect entities that borrow and lend money. While banks may be most affected, FASB has made it clear that no entity is exempt from the guidance. Essentially, the new standard affects any entity that records receivables and investments, or is exposed to credit risk through guarantees, commitments, and off-balance-sheet financial instruments.

If you have reservations about the new expected credit loss model for financial instruments, let’s take a high-level look at the guidance and try to answer some immediate questions.

How Much Time Do You Have?

Like most accounting standards, ASU No. 2016-13 has different effective dates based on the type of reporting entity. Public business entities (PBEs) that file financial statements with the Securities and Exchange Commission are the first entities to adopt the standard. This group is followed by public companies that do not file with the SEC, and lastly, private companies and all other entities are the third wave of entities to adopt the standard.

This means a calendar year-end company that files periodic reports with the SEC would have to adopt the standard by Jan. 1, 2020. If the PBE does not file with the SEC, however, the mandatory adoption date would be one year later. A calendar year-end private company or not-for-profit entity would have to adopt the standard by 2021.

At Transition, What Happens with Previously Reported Allowances and Loan Losses?

FASB requires a modified retrospective transition approach (rather than a full retrospective transition) for most aspects of the ASU. This may bring a sigh of relief for many entities living through implementations of other recently issued accounting standards. A modified retrospective approach, however, still requires an adjustment to previously reported financial information. Under this transition approach, an entity must adjust beginning retained earnings for the cumulative effect of adopting a standard.

Why Change?

Financial instruments are prevalent across all industries and entities—from trade receivables, loans, securities and lease receivables, to loan commitments and guarantees.

For years, investors have reviewed U.S. GAAP-based financial statements, only to run their own numbers to predict how collectible the reported instruments really are. They wanted to know how effective these commercial entities were at managing credit and collection risk. While entities were willing to tell them, they could not do it clearly through the financial statements. Sure, the accounting standards protect investors by ensuring that the financial instruments are not overvalued in the entity’s financial statements. Unfortunately, the accounting standards prior to ASU No. 2016-13 are based on an incurred loss approach. The accounting rules prior to the ASU, therefore, prevent entities from communicating foreseeable losses to the investing public effectively.

To be more specific, under an incurred loss model an entity does not record an impairment loss until the loss is probable. For years, incurred loss models have drawn stakeholder criticism, from preparers to users of the financial statements. Overall, critics have asserted that incurred loss models delay the recognition of credit losses in an entity’s financial statements. The financial crisis in 2008 reinvigorated the criticisms about incurred loss models. Stakeholders blamed the delayed recognition of credit losses for inflating the balance sheets of financial institutions, especially those with distressed mortgage loans. It is no surprise that regulators, especially FASB, wanted to right this wrong—one viewed by many constituents as a major flaw in financial reporting.

After years of collaborating with other regulators, such as the International Accounting Standards Board (or IASB), and holding numerous roundtable discussions with a wide array of preparers, investors, and stakeholders, FASB issued its final guidance on impairment in June 2016. ASU No. 2016-13 is a direct response to the feedback they received about how the U.S. GAAP accounting and reporting for financial instruments could be improved to provide more decision-useful information.

What Do You Need to Know?

The new accounting standard fundamentally eliminates the current incurred loss models and replaces them with a forward-looking, expected loss approach. Under ASU No. 2016-13, there are two primary impairment models based on how an entity classifies a financial asset.

The first part of the ASU is an overhaul of the existing impairment guidance for financial assets measured at amortized cost. This guidance is the new current expected credit loss model, more commonly referred to by its acronym, CECL.

The second part of the ASU consists of targeted improvements to the existing impairment rules for available-for-sale (AFS) debt securities. The most significant change for AFS debt securities is that an entity no longer considers the length of time that an individual security's fair value is below amortized cost before an estimate of credit-related impairment loss is recognized.

An entity must record an allowance for expected credit losses over the contractual term of the financial asset, and a liability for expected credit losses on a receivable that has yet to be recognized (for instance, when a lender is exposed to credit risk on a guarantee or an unfunded commitment that cannot be canceled). Under the CECL model, an entity recognizes an allowance for expected credit losses at origination or acquisition. Therefore, impairment losses are often recognized sooner. Under the AFS model, an entity recognizes an allowance when the security is impaired (that is, when the individual security’s fair value is below the amortized cost). The allowance account captures both credit quality deterioration and improvements (as reversals of credit expense). The new required use of an allowance account, therefore, may create volatility in reported earnings from one period to the next.

Like current GAAP, an entity’s estimate of expected credit losses is based on historical experience and current conditions. However, unlike current GAAP, the preparer must venture into reasonable and supportable forecasts about future cash flows over the asset’s contractual life. Inherently, future projections of expected cash flows over the entire life of an asset are difficult to predict with complete accuracy and confidence. Entities will experience increased earnings volatility until they are comfortable with their ability to develop reasonable and supportable forecasts.

The standard also has extensive disclosure requirements. Although many of the disclosure requirements are similar to current GAAP, the ASU does include new or enhanced disclosures to provide better decision-useful information. For example, an entity must disclose the credit risk associated with its portfolio of assets and how management monitors this risk. Because the models also rely heavily on subjective management assumptions, particularly expectations about the future, an entity must disclose major drivers of changes in the estimate.

One of the most notable changes to the disclosures for assets that are subject to the CECL model is a new requirement for public business entities. A public business entity must disclose credit quality information for assets by vintage (year of origination). FASB thinks this disclosure provides users of the financial statements with better information about an entity’s underwriting standards. For instance, this disclosure may provide insight into how strictly an entity looks at credit quality before transacting with another party and whether the entity has tightened or loosened its underwriting policies over time.

Similar to current GAAP, the disclosures in ASU No. 2016-13 generally must be provided by portfolio segment, class of financial assets, or major security type.

Have You Recorded Enough?

As banks and other entities prepare for this major accounting change, officials from FASB and the SEC are calming fears that the standard will result in a double digit increase in any given entity’s reported allowances for loan and lease losses (ALLL).

Indeed, loan reserves will increase. That, however, is primarily because the allowance is based on future projected cash flows and expected credit losses over the financial instrument’s estimated life. It is a rumor (or at the very least, an outdated estimate that regulators are saying is inaccurate) that the increase could be anywhere between 30 and 50 percent. In fact, regulators continue to stress that there is no benchmark, target or range of allowance that an entity can turn to when assessing the effect of adopting the expected credit loss model. When stripped down to its core, the standard as written is a management estimate—albeit a very significant management estimate. By nature, the facts and judgment applied to a significant management estimate are entity-specific. Therefore, the effects of adoption and implementation will vary widely from one entity to another. The standard is intended to provide investors with a more accurate estimate of total collectibility. The standard, however, is also designed to be operational for preparers of all sizes and available resources. An entity should be able to leverage its existing policies and practices because the ASU is aligned with how many businesses manage the risks associated with its financial asset portfolios.

Still Skeptical about CECL?

Take comfort in knowing that FASB developed ASU No. 2016-13 based on discussions with various constituents. FASB believes the rules under the CECL model are consistent with the current management practices (such a collective assessment of loss for assets that share similar risk characteristics, or pooling), as well as economic decisions that are made in the underwriting process.

Those in the financial services industry are familiar with the regulatory requirements and reporting for ALLL. The SEC has advised banks repeatedly to leverage the existing market regulatory guidance on ALLL. Until further notice, the guidance remains relevant and still applies during this implementation phase.

What if you are not in the financial services industry? Alas, you are still required to comply with the impairment model, but it may be a matter of tweaking or refining current practice.

Does estimating expected credit losses over longer term assets or using discounted cash flow models seem a bit impractical or unnecessary? What if the company only has trade receivables? Is there any relief? The guidance is flexible—an entity can choose to roll up its sleeves and use a discounted cash flow method, or the entity can select another technique that it believes is not only accurate, but more practical for its given facts and circumstances. Although the guidance is flexible, an entity must still comply with the guiding principles of the measurement rules, including an earnest attempt at developing reasonable and supportable forecasts. To help an entity apply many of the new accounting concepts, FASB includes several illustrative examples of how to apply the principles of ASU No. 2016-13 using a variety of methods, including how to apply the standard to trade receivables.

Are You Ready to Move Forward?

You have accepted that no entity is exempt from CECL. The team is prepared to dissect the new accounting standard and gather the data needed to provide the necessary disclosures. A special team is tasked with vintage disclosures. It’s easy to get lost in the details. Here are some guideposts to help in the journey.

First, keep the primary objective of ASU No. 2016-13 top of mind. The objective is to give users of the financial statements more helpful information about the expected credit losses on financial instruments. When FASB developed the standard, it focused on the following six key areas of improvement to achieve this objective:

  • Eliminating the probability threshold that exists in current GAAP;
  • Expanding the information considered to estimate expected credit losses;
  • Requiring the consideration of forecasts;
  • Improving the accounting for purchased financial assets with credit deterioration;
  • Enhancing disclosures; and
  • Requiring credit losses on available-for-sale debt securities to be recorded through an allowance.

Second, follow the principles-based framework. The selected estimation method and inputs that management uses will drive different estimates of expected credit loss. An entity can apply the following general framework, which touches on the measurement principles for financial asset that are measured at amortized cost:

  • Step 1: Determine whether pooled assets continue to share similar risk characteristics.
  • Step 2: Determine the historical loss rate and adjust, as necessary, for current conditions affecting the existing pool of assets.
  • Step 3: Consider significant factors that may affect the expected collectibility of the amortized cost basis.
  • Step 4: Develop reasonable and supportable forecasts.

Be prepared for some earnings volatility, which comes with the use of an allowance method (e.g., increases and reversals of credit loss expense). In all cases, stick with a consistent method of estimation or be well-prepared to explain a switch in the track.

Third, use sound judgment and document management’s assumption and conclusions concurrently. FASB believes an entity already has the historical data. Therefore, from the board’s perspective, the most subjective aspect of the standard is determining how to adjust the historical data. Tone at the top is important, and an effective control environment will help with the documentation requirements.

Fourth, develop a reasonable and supportable forecast. The standard relies on it. Have a lump in the throat? How is it remotely possible to forecast collectibility for certain assets trailing off 20 or 30 years from now? Again, no need to worry. FASB has specific guidance for entities that, in earnest, are not able to develop a reasonable and supportable forecast past a certain point in time.

In the end, your team will survive the transition to the current expected credit loss model. Hopefully, it will not be long before you can convince other skeptics in the organization they were already halfway there.

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