Are you ready for the new credit losses standard?

The new credit losses standard will require banks and other creditors to recognize losses on bad loans earlier than under current U.S. Generally Accepted Accounting Principles (GAAP). It goes into effect for public companies in 2020; private companies have an extra year to implement the changes. However, the AICPA is requesting that the latter deadline be extended, because some smaller financial institutions and private companies are concerned that the transition will be difficult unless they get more time.

Close-up on credit losses

The Financial Accounting Standards Board (FASB) responded to the 2008 financial crisis by issuing Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. It’s based on a current expected credit loss (CECL) model, which relies on estimates of future losses. By contrast, current GAAP relies on an incurred-loss model to recognize losses.

Specifically, the new credit losses standard requires banks and other businesses to look to the foreseeable future, consider all reasonable and supportable losses that could happen over the life of the loan, trade receivable or security in question, and book losses. Under the CECL model, the estimate isn’t supposed to cover a best-case or worst-case scenario. To record a loss provision, banks should take into account past experiences, future estimates and current trends in the economy, using their best judgment.

The loss provision, or reserve, is a much-watched figure on banks’ balance sheets and income statements. It’s designed to offer insight into how a bank is performing. Investors and bank examiners pay close attention to changes to loss reserves because, when a bank increases its loss provision, it sends a signal that trouble is coming.

More time

The FASB staggered the effective dates for large banks, small banks, and nonpublic organizations and businesses. But the AICPA and the Credit Union National Association (CUNA) say the standard’s effective date is worded in such a way that many smaller organizations will be left with less time to implement the standard than what the FASB intended. These organizations are asking the FASB to amend the standard’s effective date and give community banks and credit unions until January 1, 2022, to implement the changes.

When the FASB proposed the credit losses standard in 2014, community bankers and credit unions were among the harshest critics of the changes, saying they didn’t partake in the riskiest lending practices that led to the 2008 crash. But the FASB maintained that the new accounting rules needed to apply to all financial institutions because banks of all sizes were affected by the crisis. However, the FASB conceded that credit unions and smaller banks needed more time to comply with changes.

The FASB declined to comment on the requests from the AICPA and CUNA. But that’s not unusual; the FASB doesn’t typically respond publicly to individual comment letters.

Ready, set, implement

Banks and other creditors have a lot of changes to implement in the coming years. In addition to the new credit losses standard, they also must tackle new rules on recognizing revenue and leases. This fall, expect the FASB to issue additional guidance to help facilitate your company’s transition to the CECL model for reporting credit losses.

Sidebar: Auto lenders weigh in

Lenders who underwrite car loans to customers with poor credit fear that the new credit losses standard will make them 1) report losses long before customers stop making payments and 2) accumulate more interest income than they expect to collect in later periods. So, companies that lend to high-risk car buyers are planning to use the standard’s option to measure new loans at fair value once the new guidance goes into effect.

But balance sheets could be messy as these creditors transition to fair value, because their old loans will be on the books at amortized cost. Several subprime lenders and auto dealers have written to the FASB in recent weeks, asking for an amendment to the transition guidance. They want the FASB to allow a one-time use of the fair-value option to measure financial instruments previously recognized and measured at amortized cost.

“Most entities, they don’t want half their balance sheet at amortized cost and half at fair value,” said Graham Dyer, a member of the FASB’s Transition Resource Group for the credit losses standard. Allowing the fair-value option at transition will more closely match reported losses to expected future cash flows, rather than to contractually required cash flows.

Although the FASB hasn’t publicly addressed these requests, it plans to discuss them in the coming months at meetings of the Transition Resource Group for the credit losses standard, which addresses implementation issues.