Credit losses: 4 things you need to know

By Ken Tysiac

Banks and other financial institutions are on the clock as the focus in credit loss accounting shifts from incurred losses to a forward-looking, predictive approach.

Although pandemic-related effective date delays have pushed back the start of implementation to the beginning of 2023 for SEC smaller reporting companies and private companies that are calendar-year reporting entities (many public companies have already adopted), FASB's new current expected credit loss (CECL) standard places substantial demands on finance teams at financial services companies.

Here's what private company finance personnel need to know about CECL as the time for implementation approaches.

Huge change to credit losses model

The impact of the standard on credit loss accounting will be enormous.

"Many will confidently say that it's the largest accounting change we've had in banking, ever," said Jason Brodmerkel, CPA, the leader for Depository and Lending Institutions on the AICPA accounting standards team. The standard is an attempt to address issues in bank accounting that emerged during the global financial crisis that began in 2007.

The idea is to adjust the accounting so that financial statements provide investors with information on what losses are expected to occur in a loan portfolio rather than a description of past losses. At the same time, the new model is designed to lead financial institutions to adjust their loan-loss reserves to reflect the expected losses.

Not just for banks

As a primary source for lending, banks, of course, are most affected by a standard altering accounting for credit losses. But credit unions, insurance companies, and other businesses are affected by the standard as well.

CECL applies to all financial instruments carried at amortized cost, a lessor's net investment in leases, and off-balance-sheet credit exposures accounted for as insurance or derivatives. Financial instruments carried at amortized cost include loans held for reinvestment, held-to-maturity debt securities, trade receivables, reinsurance recoverables, and receivables that relate to repurchase agreements and securities lending agreements.

Off-balance-sheet credit exposures within the scope of the standard include loan commitments, standby letters of credit, and financial guarantees. Altogether, that's a long list of items that draws a lot of companies into the standard.

The standard also affects multiple areas of the balance sheet.

Reasonable and supportable is the key

The standard requires reasonable and supportable forecasts as the basis for loan-loss reporting, which requires intricate modeling on the part of preparers.

Because FASB didn't place restrictions on the methodology used, a variety of options are available to preparers. These include discounted-cash-flow analysis, the average charge-off method, vintage analysis, static pool analysis, the roll-rate method, the probability-of-default method, and regression analysis.

Merely choosing which model is right for your company is a huge task, but the key once again is that the forecast should be reasonable and supportable.

Modeling can be outsourced to experts, but even that can be a slow process.

"We've seen stops and starts when companies outsource the modeling to somebody else," Brodmerkel said. "You're going to build the models, but do I have the data that I need? What do I do if I don't?"

It's dynamic

Experts say companies should not wait to get to work on implementing this standard.

"There needs to be lead time, and it's more dynamic than you can think," Brodmerkel said.

Data gathering is a big challenge as companies consider which qualitative data they will pull from the past to build their models. They also need to store that data so auditors can make sure it's complete and accurate.

While performing this work, it's important that preparers communicate with their auditors and the audit committee to make sure there are no surprises later in the process.

"You're building a model out," Brodmerkel said. "It's not just dropping a number and being done. You really have to be able to communicate why the change is both relevant and reliable when supporting the reasonableness of the estimate."

The recently published AICPA Audit and Accounting Guide: Credit Losses provides information for preparers and auditors on CECL requirements. More information on CECL is available in an AICPA practice aid and on the AICPA website.

Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA's editorial director.

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