How the New FASB Credit Loss Standard will Affect Your Business
By: Michael Head, CPA, CGMA – Senior Manager, Finance & Accounting Services
Last month, the Financial Accounting Standards Board (FASB) approved a new accounting standard that will initially impact Public Companies, followed by all other companies beginning in 2019. This rule will be affecting a variety of areas including but not limited to accounting, finance, tax, reporting, information systems, and technology. How prepared is your company to adopt the new credit loss standard? Provided below is a tool to help determine when this guidance will go into effect, as well as the key differentiators and tips to help prepare for the transition.
Why the new standard?
The FASB States “The global financial crisis highlighted the need for more timely reporting of credit losses on loans and other financial assets held by banks, lending institutions, and public and private organizations. Current Generally Accepted Accounting Principles (GAAP) accounts for credit impairment using an ‘incurred loss’ approach, which requires recognition of the credit loss to be deferred until the loss is probable (or has been incurred). Many have argued that the incurred loss approach fails to alert investors about credit losses in a timely manner.”
The new standards will take effect in the following manner:
All entities that hold financial assets that are not accounted for at fair value through net income and are exposed to potential credit risk would be affected by the proposed amendments.
The Current Expected Credit Loss (CECL) model provides that “An estimate of expected credit losses shall be based on internally and externally available information considered relevant in making the estimate. That information includes information about past events, including:
- Historical loss experience with similar assets
- Current conditions
- Reasonable and supportable forecasts and their implications for expected credit losses
The information used shall include quantitative and qualitative factors specific to borrowers and the economic environment in which the reporting entity operates. Those factors include the current evaluation of borrowers’ creditworthiness and an evaluation of both the current point in, and the forecasted direction of, the economic cycle (for example, as evidenced by changes in lender-specific or industry-wide underwriting standards).
Therefore, a further adjustment should be made, as necessary, to reflect current information that may indicate current expectations about loss that is not reflected in the historical experience. Although an entity is required to estimate credit losses over the entire contractual term of the financial assets, as the forecast horizon increases, the degree of judgment involved in estimating expected credit losses increases because the availability of detailed estimates for periods far in the future decreases. An entity shall consider information that is available without undue cost and effort that is relevant to the estimated collectability of contractual cash flows.”
While the concept of the CECL model is relatively straightforward, implementation may be much more difficult than expected. Obtaining historical lifetime credit loss data and developing models to use the data in may be beyond some organizations capabilities. In addition, supportable forecast methodologies that use the data will require analytical sophistication. Large banks that have been participating in stress testing may have that capability but smaller organizations will find that combining data from many different systems a difficult task.
The disclosures required by the financial statements will be far more complex than just credit quality. A careful explanation of how the reserves were generated will be required. More importantly, tabular vintage disclosure information will cause “pains” for smaller institutions.
It’s clear that banks and other lending institutions will be the most affected by this new standard. However, even companies with only reserves for bad debts on accounts receivable will need to at least consider if their process meets the new standard.
The state of the economy at the time the standard becomes effective will affect the size of the new reserves. However, the projected big jump and impact on earnings should be a one-time event. Subsequent periods should only reflect the changes in the period.
Organizations other than lenders who hold these type of securities as investments on their balance sheets may find the newly required reserves affecting their compliance with contractual covenants.
Things You Can Do Now
- Begin to collect the historical data you will need to analyze your holdings.
- Examine your investments so that similar risks can be aggregated into pools for analysis.
- Develop a strategy to combine your data from multiple systems.
- Develop a team internally to address the implementation of this standard comprised of accounting/finance, lending, internal audit and credit/risk management team members.