By Joseph Neu
God forbid you should wait for credit losses to actually happen!
Banks have long bemoaned FASB’s Financial Instruments-Credit Losses standard (Topic 326) for an obvious reason: The standard’s “current expected credit loss” (CECL) guidance impairs assets and requires banks to set aside more capital as a buffer.
Beyond banks. Nonbanks have been slower to realize the impact but are waking up to it quickly. Indeed, CECL affects all entities making or holding loans and loan commitments, financial guarantees, debt securities (especially held-to-maturity debt securities), trade receivables and off-balance-sheet credit exposures. FASB wants most SEC filers to adopt it for reporting periods beginning after Dec. 15 of this year.
No more waiting for losses. The principle behind CECL is that companies should acknowledge losses as soon as there is an expectation that they will occur—which may mean always. FASB tells businesses to measure all expected credit losses for financial assets held at the reporting date “based on historical experience, current conditions, and reasonable and supportable forecasts with the objective of presenting an entity’s estimate of the net amount expected to be collected on the financial assets.” So if you have experienced credit losses, or haven’t but think that you might based on current conditions, or have reason to forecast losses, then the loan or trade credit you record on your balance sheet should reflect that potential loss even as you first extend credit.
No more expectation of recovery. In the good old days, recognition of losses on financial instruments could be waited out in hopes that the situation would improve. Various impairment rules then came into effect, forcing firms to recognize the loss positions rather than carrying them with the expectation that they would recover. Now, with CECL, the rose-colored glasses must come off entirely—there is no such thing as temporary and other-than-temporary impairment anymore.
Use your judgment. In classic principles-based accounting fashion, the CECL standard does not require a specific credit loss method; instead, it allows “entities to use judgment in determining the relevant information and estimation methods that are appropriate in their circumstances.”
What’s reasonable and supportable? By not giving preparers or users of financial statements rules to follow, the FASB has everyone scrambling, and accounting firms and consultants are more than happy to charge for their services in defining reasonable and supportable forecasts, judgment calls, relevant data and estimation methods. FASB, when asked about acceptable approaches, points back to its standard:
“When developing an estimate of expected credit losses on financial asset(s), an entity shall consider available information relevant to assessing the collectibility of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts. An entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s). When financial assets are evaluated on a collective or individual basis, an entity is not required to search all possible information that is not reasonably available without undue cost and effort. Furthermore, an entity is not required to develop a hypothetical pool of financial assets. An entity may find that using its internal information is sufficient in determining collectibility. [Emphasis added.]”
Don’t make too big a deal of it. To say the least, this leaves a lot of leeway for auditors to determine what is acceptable—and they are calling it the biggest change to accounting standards since standards were established. Companies should push back on this by working with what is reasonably available to them without undue cost and effort.
Bad things come to pessimists. What’s worse is that recognizing credit losses before they happen, regardless of how reasonable or how much cost and effort are put into the determinations, forces more capital to be set aside by banks, less revenue to be recognized by all, and for all the bad things that come at the end of a credit cycle to be recognized with acyclicality, since everyone extending credit will need to account for bad stuff at the beginning of the credit cycle. Should we really make businesses live under the negative, oppressive cloud of expected losses, rather than be lifted by the positive, propelling winds of growth and expected returns?
For this reason and others, banks have asked Congress for help. Bills to delay CECL’s implementation for smaller banks, at least, have succeeded in causing FASB to propose delaying implementation for them. Don’t hold your breath for a wider delay or even a repeal, but it’s possible. Optimists try to look on the bright side of life.