The FASB may need to study the credit loss accounting standard for better tailoring in relation to acquisitions because it causes buyers of other banks or loans to initially book an earnings loss, practitioners said.
The current expected credit losses (CECL) standard takes effect in less than six months for private companies and small public companies.
“It’s a massive undertaking. It really is, particularly for lenders,” Michael Lundberg, RSM US LLP’s Industry Audit Policy Leader and National Director Financial Institutions, said on Aug. 25, 2022.
“It also can have a direct impact on reported earnings,” he said. “If you buy a portfolio or another bank, then you record loss reserves on all those loans that you buy all at once. Depending on the size of the transaction, you can actually wipe out earnings for the quarter. So if Bank A buys Bank B and it’s a large transaction, the loss reserves that get recorded as part of that transaction have an enormous impact on earnings and could drive it to a loss.”
RSM is an audit, tax, consulting firm focused on the middle market.
Lundberg said questions that keep surfacing relative to CECL have been around how to handle acquired loans. “No decisions have been made at the FASB but that’s the biggest thing coming out of the standard.”
The FASB issued the guidance as Accounting Standards Update (ASU) No. 2016-13, Topic 326, Financial Instruments – Credit Losses, in June 2016, in response to the 2007-2008 global financial crisis which was blamed in part on accounting rules that did not allow banks to report loan losses in a timely manner. The old rules were aimed at capturing all loss events that are probable of occurring and that have already occurred. Under the new CECL model, all loss events are captured, including those that have a remote chance of occurring.
CECL Holding up Amid Current Economic Uncertainty
The adoption of the standard comes amid a significant amount of global turmoil: economic uncertainty, the COVID-19 pandemic, war, among other issues. The guidance first took effect in 2020 for large public companies, many of which adopted the changes on time though they were granted a legislative deferral.
“The rules are holding up under today’s economic climate,” Lundberg said in context of his clients. “Early on there was a lot of concern about the economic impacts of the pandemic and so we saw loss expectations rise dramatically,” he said. “With a little bit more time, a little bit more information, the support from the Federal stimulus package, lenders realized that this is going to be more manageable than they thought initially, and so at a macro level they pulled back on those reserves. I do think the standard is generally achieving the objectives that FASB set out to do.”
Currently, the standard is under the FASB’s post-implementation review (PIR), its process to determine whether the rules worked as intended. The provisions were designed to be scalable and flexible to fit entities of all sizes and does not require complex statistical models to be operationalized, the board has stressed.
“FASB still gets peppered with questions regularly,” a board spokesperson said via email.
Two Main Adoption Challenges
Private companies – “at least what we have seen so far” – are on track to adopt the rules on time, with some choosing to outsource or get third-party support in their implementation efforts, accounting practitioners also said.
Generally, companies are faced with two main adoption challenges: compiling data so that it is usable and reliable; and model validation.
“If you were a smaller bank, a credit union, that’s acquisitive in nature in acquiring portfolios, you may have acquired the loan but you might not have acquired the data behind it,” said Charles Soranno, a managing director in the Business Performance Improvement Practice at Protiviti Inc., a global consulting firm. “So the identification of historical trends based on the data that you may not have access to, we’ve seen that being a challenge,” he said on Aug. 25.
The model for CECL for some is a new concept, Soranno explained. “So the challenge we’re seeing in modeling is basically the model selection, specifically determining the methodology you’re going to use in the model selection and then determining if they’re going to build the model in-house or rely on a third-party vendor to do that understanding the control implications that need to be followed.”
Soranno stressed that companies that have not yet adopted the rules need to start collecting the data they might use now. “Even if they are not subject to a robust public company audit process, or internal audit process, management is going to want to be comfortable that the models are performing as designed,” he said. “It just means enough time to feed that into the model, evaluate the results to see if they came close to a material threshold and that takes time – and we are less than six months to the effective date.”
For those private companies that do not have to report until the end of next year, though they have more time they too should “start now both on data, back testing,” Soranno said. “If there are not resources in-house available to maybe secure those resources from the outside,” he said. “And then finally making sure that the external auditors have the experienced resources to be efficient and also to ensure the auditor’s not learning on the job, auditing CECL for the first time for the entity.”
For in-depth analysis of the FASB’s guidance for credit losses, please see Catalyst: US GAAP—Financial Instruments-Impairment, also on Checkpoint.
This article originally appeared in the August 30, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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