FASB Issues New Accounting Standard on Credit Losses
After eight years of study, hearings, deliberations, exposure drafts and re-drafts, the Financial Accounting Standards Board recently issued the much anticipated Accounting Standards Update (ASU) Financial Instruments-Credit Losses (otherwise known as CECL). This ASU has been described as “the most sweeping change to bank accounting ever” and “having a pervasive impact on all financial institutions”. The ASU runs some 285 pages and makes for an excellent read while relaxing at the beach. But if you haven’t had the opportunity to study it yet, this article will attempt to summarize a few highlights without ruining your summer vacation.
Understanding the New Standard
Perhaps the easiest way to understand CECL is to compare it to current GAAP. At present, we use the “incurred loss” method which means credit losses are recorded when they are “probable”. To measure the necessary allowance, a bank would generally only consider past events and current conditions. From a theoretical stand point, this was considered one of the largest flaws in the current methodology as losses were not permitted to be recognized until the “probable” threshold was met.
CECL will employ an “expected loss” recognition standard which will require a bank to record the full amount of expected credit losses in its loan portfolio as of the reporting date. In other words, the net carrying amount (loans less the allowance for credit losses) will represent what a bank expects to collect. To arrive at the recorded allowance under CECL, a bank would consider past events, current conditions and reasonable and supportable forecasts.
After the above contrasting of the current practices with CECL, many bankers may wonder-what is the real and practical difference? For many community banks there may not be a large difference.
CECL is a principle based accounting standard and as such, it does not prescribe the use of any specific estimation method. Both FASB and banking regulators are on record stating that it is expected that small and less complex institutions will be able to leverage their current systems and methods with changes to appropriately incorporate the use of reasonable and supportable forecasts, without the use of costly and complex models. Additionally, banks will still be allowed to use different methods for different groups of loans, and apply judgement in developing their estimate methods.
The financial impact of CECL has been the subject of much speculation with some estimates of allowances increasing by 30-50%. However, we do not believe that community banks will see such increases. FASB recognized this fact in the ASU which stated:
The amendments in this Update affect an entity to varying degrees depending on the credit quality of the assets held by the entity, their duration, and how the entity applies current GAAP. There is diversity in practice in applying the incurred loss methodology, which means that before transition some entities may be more aligned, under current GAAP than others to the new measure of expected credit losses.
What has not changed?
CECL has not changed the existing guidance on the write-off of loans or the current nonaccrual practices.
When does CECL become effective?
For the vast majority of nonpublic community banks, CECL will become effective December 31, 2021, with early application permitted after 2018. Banks should continue to calculate their allowance for credit losses under the current incurred loss standard until they apply CECL.
In the near term, bankers should became familiar with the new standard, keep an eye out for regulatory guidance and plan for what additional data might be needed to implement the new standard. To read the entire press release, please click here.