As of January 1, many public entities began to apply the current expected credit loss (CECL) model under Topic 326, Financial Instruments—Credit Losses. Due to the pandemic, stakeholders are concerned about losses.
Disclosures are critical to help stakeholders understand the effects of the coronavirus, in particular for credit losses. This post explores considerations when describing your accounting for CECL in the times of the coronavirus.
This post focuses on financial assets measured at amortized cost. Topic 326 provides separate disclosure guidance for available-for-sale debt securities (although many requirements are similar).
If you haven’t seen it, please check out our related post on accounting for expected credit losses under Topic 326.
CECL Disclosures and the Coronavirus
Providing adequate disclosures describing your accounting is critical, especially due to the uncertainty surrounding the coronavirus.
Disclosures take on heightened importance in the wake of uncertainty. The pandemic and its effects are still unfolding. Users of financial statements (such as lenders, investors, and regulators) are clamoring to understand the effects of the coronavirus on entities’ financial statements.
CECL is a principles-based standard. By nature, a principles-based standard requires reporting entities to apply more judgment. More judgment requires more disclosure. CECL provides flexibility in various areas, such as the methods used to estimate credit losses under Topic 326. As such, the approaches used by companies will differ from one entity to the next. Users need adequate disclosure to be able to compare results across entities.
Topic 326 requires numerous disclosures about credit quality, the allowance for credit losses, the status of assets (such as those on past-due or nonaccrual status), purchased financial assets with credit deterioration (PCD assets), collateral-dependent financial assets, and off-balance-sheet credit exposures. We’ll explore these items further here:
- Credit quality: A reporting entity must disclose the credit quality of its financial assets and how management monitors risk. Management may consider various credit quality indicators, such as credit ratings, internal risk ratings, debt-to-value ratios, collateral, and collection experience. Even so, evaluating creditworthiness during the pandemic is a monumental task. Conditions are changing dramatically. Businesses, even entire industries, face challenges in maintaining customer demand, supplies, and labor. It can be difficult to see inside another business and interpret the immediate and lasting effects of the pandemic. Reporting entities must do their best to consider credit quality and provide appropriate disclosures by credit quality indicator where required.
- Allowance for credit losses: Reporting entities must disclose the methods and assumptions used to estimate expected credit losses and determine the allowance for credit losses. Valuations, estimates, and assumptions can be a complex area. Make sure the disclosures are clear and understandable. An entity also must disclose how it has considered past events, current conditions, and reasonable and supportable forecasts in determining its allowance. Due to the coronavirus, users are likely to pay close attention to how reporting entities have assessed current conditions and future forecasts. A rollforward of the allowance is also required. Users may be particularly interested in the current-period provision for expected credit losses, initial allowances established for PCD assets, and any write-offs charged against the allowance. Also, be prepared to explain the reasons for those changes, including how the coronavirus has impacted your results. Reporting entities also must disclose the risks characteristics of their assets, which will require additional work behind the scenes to determine. If a reporting entity has elected not to measure an allowance for credit losses for accrued interest receivables, it must state that fact and what is considered “timely” for writing off uncollectible interest.
- Past-due status: When the economy tanks, fewer borrowers make payments on time. Users of financial statements know this and will look to your disclosure to see how this affects you. Topic 326 requires disclosure about the past-due status of financial assets, including an aging schedule. Make sure your aging schedule captures any new assets that fall into the past-due category. Also, be sure your aging schedule is disaggregated appropriately. This is one of several disclosures that must be made by class of financing receivable and major security type. It’s also important to disclose your policy for when you consider financial assets past due.
- Nonaccrual status: A reporting entity may have to stop accruing interest on a loan. Topic 326 requires numerous disclosures about the nonaccrual status of assets. This includes disclosures about a reporting entity’s accounting policies for discontinuing and resuming accrual of interest, as well as how the reporting entity determines past-due or delinquency status, recognizes write-offs within the allowance for credit losses, and records payments received on assets in nonaccrual status. US GAAP does not specify when to place an asset on (or remove it from) nonaccrual status. As such, users of financial statements rely on these disclosures to understand your policies. The coronavirus may place the collection of interest in doubt. Users of financial statements will want to know how you are monitoring this and accounting for it.
- PCD assets: Due to the coronavirus, more assets are likely to have credit deterioration. Consequently, a reporting entity may be purchasing more assets that qualify as PCD assets under Topic 326. For instance, consider a reporting entity that purchased loans this month. If those loans were made to borrowers in the travel or hospitality industries, there may have been credit deterioration as of the purchase date due to the fallout from the pandemic. Topic 326 provides disclosure requirements for PCD assets. Users of financial statements will be interested in disclosures about PCD assets as they may provide information about reporting entities deciding to take on additional levels of risk.
- Collateral-dependent assets: Topic 326 provides specific disclosures for collateral-dependent financial assets. In part, this includes describing significant changes in the ability of collateral to secure those financial assets. The value of collateral backing financial assets may be changing. Users of financial statements must have sufficient information to understand the extent to which collateral still secures a collateral-dependent financial asset.
- Off balance sheet credit exposures: Topic 326 includes specific disclosure requirements for off-balance-sheet credit exposures. Examples of off-balance-sheet credit exposures are loan commitments, standby letters of credit, and financial guarantees not accounted for as insurance. Remember the financial crisis in 2008? We were bombarded with headlines about off-balance-sheet credit exposures. Users will look to these disclosures as they try to interpret the current economic crisis. The SEC also might pay particular attention to these disclosures. After the economic collapse in 2008, the SEC issued various comment letters related to disclosures for off-balance-sheet arrangements.
Many disclosures for financing receivables are made by “portfolio segment” or “class of financing receivables”. Portfolio segments are based on the level at which the entity has separate methodologies to determine an allowance for credit losses. Classes of financing receivables depend, in part, on the risk characteristics of those assets (such as credit scores or ratings). The risk characteristics of assets may be changing due to the coronavirus. Likewise, an entity may have to adjust its portfolio segments.
Disclosures in Topic 326 often require a reporting entity to indicate the line items where the effects of CECL can be found on the balance sheet or income statement. Expected credit losses may be material. Don’t forget to let users know not only the amounts of the impacts, but also where the impacts are recorded.
Providing useful disclosures is an art, not a science. Disclosures need to reflect a reporting entity’s own facts and circumstances. A reporting entity must determine the appropriate level of detail necessary to satisfy a disclosure requirement. A fine line exists between omitting key information and excessive detail.
As a final check, take a step back and ensure you’ve satisfied the disclosure objectives in Topic 326. The objective of the disclosures is for management to give users of its financial statements an understanding of its credit risk, its monitoring of that risk, its estimate of expected credit losses, and changes in that estimate during the reporting period. In light of the current environment, disclosing how you manage risks is paramount. Also be sure to provide adequate information about your accounting for CECL in the times of the coronavirus.
Of course, subsequent events will also require disclosure under Topic 855, Subsequent Events.
The effective dates for CECL may be affected by the pandemic. Today, the President approved a coronavirus relief package. Buried within is a provision aimed at pushing back the effective dates of the CECL model for banks, at least until the pandemic ends or December 31, 2020 (whichever happens first).
COVID-19 is a rapidly evolving situation. In the coming weeks and months, we may witness additional accounting effects as the full impact of this disease manifests itself. We encourage you to stay informed on accounting and financial reporting developments.