How will the new CECL affect financial reporting?
- March 16, 2020
- Posted by: Hood & Strong
- Category: FASB
The new current expected credit loss (CECL) standard goes into effect this year for large public companies. However, a recent study by Moody’s Investors Service reports that bank-to-bank comparisons will be muddled, because the new rules don’t prescribe a specific model for measuring losses. But the study also found that new rules are unlikely to have a significant effect on banks’ loss reserves or credit ratings.
FASB changes the rules
In response to the financial crisis of 2007–2008, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The updated guidance relies on estimates of probable future losses. By contrast, current GAAP relies on 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 to loss reserves because, when a bank increases its loss provision, it sends a signal that trouble is coming.
The new credit losses standard will require banks and other companies to recognize losses on bad loans earlier than under current U.S. Generally Accepted Accounting Principles (GAAP). It goes into effect for most public companies in 2020. In October 2019, the deadline for smaller reporting companies, private entities and nonprofits was extended until 2023.
New rules muddle peer comparisons
The FASB’s new CECL standard isn’t prescriptive about the models that must be used to estimate credit losses under GAAP. While this flexibility helps accountants implement the changes, it frustrates stakeholders because the resulting information isn’t necessarily comparable across companies.
In January, credit-rating agency Moody’s Investors Service published “CECL Impact will be Limited for Most Large Banks.” The report is based on a study of banks’ preliminary credit loss estimates in third quarter 2019 SEC filings. It’s common for the marketplace to look to large public companies for best practices when applying large new accounting standards.
Moody’s report says that the new rules make it “difficult for creditors to compare peer banks because estimating expected losses under CECL requires more complex internal models that will differ among banks.” The findings also indicate that the rules will have only a limited impact on the loan loss reserves of most publicly traded banks. CECL adoption will cause most banks to increase loan loss reserves and reduce capital slightly. But the report states, “Their overall loss-absorption capacity will be essentially unchanged under our solvency analysis, which considers both capital and reserves as loan-loss mitigants.”
Need for comprehensive disclosures
It’s important to remember that the new rules for measuring credit losses also require expanded financial statement disclosures. Those disclosures should be clear and quantitative. Moody’s reports that this is an area that banks need to improve on.
Moody’s report states, “Except for a range of potential overall increases in reserve balances on day one, banks have provided little insight into the methodologies and assumptions used. A small number of banks have disclosed the length of the reasonable and supportable forecast period, the period over which they plan to revert to historical data for portfolios with a life exceeding the forecast period and the number of macroeconomic scenarios they plan to use.”
A gray area in financial reporting
The new CECL 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. To record a loss provision, companies must take into account past experiences, future estimates and current trends in the economy, using their best judgment. Contact your accountant for help implementing the updated guidance.