Community Banks: It’s Time to Adopt Updated Credit Loss Rules

A new accounting rule for reporting credit losses goes into effect this year for small public companies, private companies and not-for-profits that extend credit. Although the changes primarily affect banks and other financial institutions, any company that has trade receivables, notes receivable, investments in held-to-maturity debt securities or contract assets could be affected.

Large public companies were required to adopt the updated credit loss rules by 2021 (after a one-year deferral under the CARES Act). Switching over to the current expected credit loss (CECL) model caused the largest financial institutions — including JPMorgan Chase, Bank of America, Wells Fargo and Citigroup — to write off billions of dollars of losses in 2022 as economic conditions faltered and credit card debt grew. Here’s a look at what smaller entities can expect as they implement the new model in 2023.

A perfect storm is brewing

In light of ongoing economic malaise, credit losses were listed as a top concern for the year ahead by 84% of small financial institutions that participated in the Tenth Annual Community Bank Survey conducted by Risk Management Association. Another major concern was regulatory compliance — in particular, community banks must now start implementing updated guidance that will require earlier reporting of credit losses than under the previous incurred-loss model.

The looming implementation deadline for the credit loss rules, combined with the possibility of a recession, is expected to lead to a surge in credit losses among smaller financial institutions in 2023. In turn, a buildup of credit loss reserves is likely to impair earnings.

New model calls for earlier recognition

Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires banks and other entities that extend credit to forecast into the foreseeable future to predict losses over the life of a loan and then immediately book those losses. The updated guidance was designed to provide more-timely reporting of credit losses, but measuring losses is challenging in today’s uncertain marketplace.

In a nutshell, the updated guidance relies on estimates of probable future losses. These estimates are based on historical expenses and current conditions. By contrast, the previous rules called for an incurred-loss model to recognize losses.

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 in loss reserves because, when a bank increases its loss provision, it sends a signal that trouble is coming. Loss reserves are “built up” when past-due accounts and write-offs are expected to increase; an increase in the loss reserve lowers earnings on the income statement. Conversely, loss reserves may be “released” when the economic outlook brightens; this situation boosts earnings.

Ready, set, implement

The new CECL is a major change from the previous model for reporting credit losses. So smaller financial institutions may be unsure how to proceed, especially as concerns over a possible recession mount. Contact your CPA for help updating your procedures and systems to implement the changes for 2023.