New accounting for expected credit losses must be applied to calendar-year companies’ first quarter financial statements. While mostly financial institutions have bandied about its potential impact, nonfinancial companies must also determine which transactions it will affect—whether as lenders or borrowers.
The Financial Accounting Standards Board’s (FASB) Current Expected Credit Losses (CECL) standard requires lenders to recognize credit losses expected over the life of a loan at the outset. It replaces the incurred loss method that recognizes losses when they become probable.
Financial institutions have expressed concerns to FASB, the Securities and Exchange Commission (SEC), legislators, and all other relevant parties about the accounting change’s potential real-world impact, and they succeeded in requiring the federal government to study the issue. Some worry that during stressful financial periods, banks will have to ramp up their loan-loss reserves, eating into their capital and reducing lending when it is needed most.
Longer term, changes may be in store for loans and other banking products impacting corporate capital structures and funding. For example, to reduce the credit losses that CECL requires banks to recognize upfront, they may determine that riskier loans should have shorter maturities or other changes.
Michael Gullette, senior vice president, accounting and tax, at the American Bankers Association, said that changes to terms will not happen at once, but many banks are now discussing the issue. He noted that banks price loans across a term and length spectrum, so the market as a whole will determine the terms.
“We had a group of bank investors and analysts in and they said they were sure that repricing and changes in terms would occur, but it would probably take a whole economic cycle to be able to see the impact,” Gullette said. “If we get into an economic downturn, then you will see that happen quicker, I think.”
Part of the reason for the delay, said Tom Barbieri, a partner in PwC’s national professional services group, is that financial institutions are still seeking to understand CECL’s broader impact and the future volatility that could result. He noted that banks’ reasonable forecasts have tended to be over the next two to three years, varying by product. “If the economy were to slow down, at least in the short-term, that could lead to higher CECL loan-loss allowances,” he said.
TIME TO ACT
More immediately, nonfinancial companies must identify their financial assets that are subject to CECL. “As people dive deeper and deeper, they’re realizing there are more balances in CECL’s scope than they would have thought,” Barbieri said.
He noted that the transactions PwC has discussed most with clients have been trade receivables and net investments in direct sales and financing leases, in which the sale of a piece of equipment or other product is accounted for as a lease. Also under scope are transactions such as credit guarantees and employee receivables. Barbieri added that a separate impairment model that was proposed alongside CECL brings in available-for-sale debt securities.
Until the arrival of the new credit-loss models, companies typically relied on historical loss rates to determine credit allowances for transactions. With trade receivables, for example, they placed receivables of different ages in buckets—60-day, 90-day, etc.—and then looked at the historical loss rates relative to those buckets. But under CECL, they will also have to consider current and reasonably supportable forecasts. “So they’ll be thinking about what will happen in the future relative to those receivables, and not just those that are late,” Barbieri said.
He added that it will require much more judgment regarding how to view historical information and adjust it for current conditions and reasonably supportable forecasts. Trade and lease receivables, for example, will require companies to anticipate the state of the economy over the period they forecast, as well as the state of the company the receivable is from and the industry it is in.
“If the receivable is from a retailer, the company may want to think about the retail marketplace, where it stands, and the nature of the retailer,” Barbieri said, noting that the longer that period is, the more judgment will be necessary.
CECL may also result in implausible results. For example, a nonfinancial corporate may provide a credit guarantee to nonconsolidated ventures or other join-venture arrangements. Under previous generally accepted accounting principles (GAAP), the company would typically record a liability the for the guarantee on day one.
“Under CECL, it will have not only that liability, the obligation to stand ready to perform under the guarantee, but it will also have to project out what it believes the credit loss could be over the life of the guarantee, as if it were a funded loan,” Barbieri said. “To record a loss on the same day you enter into that arrangement, on an arm’s length basis, is counterintuitive to ‘traditional’ treasury thinking.”
As part of the CECL project, the FASB also issued a new impairment model for debt securities that are accounted for as available-for-sale, one of three categories possible. Held-to-maturity securities are subject to CECL, and securities placed in the trading category are marked to market each period, and so already capturing credit changes in the income statement.
Today, GAAP requires companies to take a loss on an impaired available-for-sale debt security and write down the asset, but if its credit improves, the write down cannot be reversed. “Under the new accounting, the company creates an allowance that can go up and down. So there’s the ability to recoup losses,” Barbieri said.
The issue of CECL impacting the terms of bank products raised enough concern to be included in recent legislation that was signed into law Dec. 20, 2019. The H.R. 15: Further Consolidated Appropriations Act notes concerns about CECL’s potentially adverse impact during “times of recession or economic crisis.” It directs the Treasury Department in consultation with the Federal Reserve and other federal banking regulators to conduct a study within 270 days of its enactment to determine whether any changes to regulatory capital requirements are necessary.
Gullette said the ABA is emphasizing that the study focus on how CECL could impact specific financial products and banks of different sizes. “So perhaps more consideration could be given toward capital factors based on product,” Gullette said.