Banks and other financial institutions are getting ready to begin complying this year with the Financial Accounting Standards Board’s new credit losses standard, which means they will need to start making disclosures about their loan portfolios.
The new standard, also known as CECL for the Current Expected Credit Loss model it uses, takes effect this month for larger public companies, although FASB recently decided to delay the effective date of the standard until January 2023 for private companies and nonprofits, as well as what the Securities and Exchange Commission defines as “smaller reporting companies,” those with a public float of less than $250 million; or annual revenue of less than $100 million and either no public float or a public float of less than $700 million (see
“Certainly the smaller banks feel that they will be able to learn from the activities of the larger banks, and also perhaps with that learning develop similar approaches that are more commensurate with the risks that they face,” said Greg Norwood, a former bank CFO who is now managing director in Deloitte & Touche LLP's Risk and Financial Advisory practice. “I think that’s a benefit to them. I think for the larger banks, the ones that are adopting [this] month, we see folks that went through 2019 in a different way than maybe they thought. But by and large when we talk to clients — banks and non-banks — people will be ready for CECL in the first quarter of 2020.”
Still, he has seen some of the larger banks encountering obstacles with the new standard, and the approach taken by different clients hasn’t been the same. “For the banks that are adopting it, 2019 probably didn’t go as planned, but with some changes they’ll get over the finish line,” said Norwood. “CECL will be an evolutionary piece of accounting as both companies and investors become more versed in the benefits and challenges of a principle-based standard because everybody is doing it a little bit different. FASB had acknowledged that people are doing it different and may get different results, so that’s going to be the challenge going forward.”
Even though many banks seem to be confident about their modeling and accounting conclusions, the same doesn’t necessarily hold true when it comes to disclosing CECL’s impact to senior management, investors and financial analysts. Referred to as “describe and discuss” by Deloitte, disclosure stakeholder communications are an area that remains open to interpretation by management, even more than other recent accounting changes. Banks will need to periodically communicate changes in the allowance in a straightforward way. The risks of getting post-adoption communications wrong are weighing heavily on CFOs. If accounting teams can’t discuss the changes wrought by CECL clearly and effectively with their CFO, that could put the CFO in an uncomfortable spot with investors.
“Obviously communication is going to be critical,” said Norwood. “We’ve developed an understanding of the allowance process over decades, so it’s reasonable to expect that 2020 will be a learning process. Relative to some of the things that we encourage CFOs to think about is first to make sure your investor relations group is a big player in the communications strategy. This goes beyond disclosures in SEC documents, financial statements and/or MD&A. We need to tell the CECL story. We’ve got to lay out what is critical to determining the CECL estimate, and then from that, what are the most sensitive aspects of the CECL estimate, so that investors can look at what companies are doing and begin the process of comparing company A to company B. That’s going to be the challenge.”
If investors can’t understand the main changes, it becomes much harder to benchmark a company’s performance. In addition, if financial analysts have to resort to guesswork to model the changes, the modeling differences could lead to various challenges for buyers and sellers of stocks and place stress on companies as they work to correct the issues in the analysts’ models.
“After a short period of time, I think people will start to understand what an individual company is doing, but it will take longer to deepen that understanding where they can actually compare one bank to another bank,” said Norwood. “There are things like sensitivity analysis. There are things like understanding the economic factors that drive the period-over-period changes. There are also components of your portfolio, because components have different CECL charges. Some have a smaller charge, and some have a larger charge, so where you’re growing your loan book matters a lot more in the CECL world than it does today, where the losses tend to be more averaged than they are with CECL.”
FASB worked for a number of years with the International Accounting Standards Board on converging their financial instruments standards under U.S. GAAP and International Financial Reporting Standards, but the two standard-setting boards went their separate ways on the model used for figuring expected credit losses. Nevertheless, FASB had early on agreed with the IASB to make their standards more principles based as opposed to rules based. But the new approach will require some adjustment in how a company communicates about its credit losses to investors and analysts.
“One of the challenges with the standard is it’s principles based, so comparability between companies is going to be challenging,” said Troy Vollertsen, who leads Deloitte’s banking audit practice in the U.S. “It really is going to be coming through their disclosures. They’re going to have to tell a complicated story with complicated models and assumptions within the footnotes and within the investor calls and SEC disclosures in a succinct, clear and not overly verbose manner to allow analysts and investors to understand their approach and hopefully be able to compare and contrast that with others.”
Banks are likely to take different approaches as they begin discussing the impact of CECL in their earnings calls without getting too much into the weeds. “I would say that you’ll see folks really trying to determine the balance,” said Norwood. “FASB in the document itself said that too much data can be as confusing as too little data. We call it the Goldilocks balance. I think you’ll see some folks, beginning with earnings release calls in January, start to talk more about CECL then, and others will not. Probably you will start to see some folks describe and expand their disclosures in their 2019 10-Ks that they would file at the end of February. Some may begin to disclose information around the upcoming CECL adoption and others may not. And then you obviously will have the disclosures of the first quarter, so I think you will see a lot of different approaches. Some of that could be relative to the nature of the lending book. Some companies have fewer products, so it can be simpler and more succinct, and others may have different types of geographies and products, and they all act differently so you can see some more expanded dialogue.”
Banks are hoping there won’t be as much volatility this year in the economy and the financial markets, and that could ease concerns about the impact of CECL on their quarterly results.
“2020 is probably not going to be as volatile,” Norwood predicted. “The numbers will be higher, of course, but probably not as high as some people thought. There’s not a lot of expected economic uncertainty in 2020, so I think that will allow investors and financial statement preparers to try to come up with the right balance. Some might end up disclosing more by the end of 2020 than they start, and that will help set the pace and the context for what could happen in 2021, 2022 and 2023. That’s when it’s really going to be important for the industry to develop a communication paradigm that helps investors understand the volatility of CECL’s forecasted economic environments.”
CECL is likely to have a much more serious impact on banks’ financial results in the event of an economic downturn. “CECL is designed to increase reserves and theoretically to have institutions record those extra reserves earlier, but that’s pivoting off a view of when we’ve actually begun to turn into a recessionary environment,” said Norwood. “No one can predict that, but very few people are predicting much of a probability in 2020. That will allow institutions to perfect their communication around CECL, most likely prior to any real volatility due to economic uncertainties. If a particular loan portfolio starts to have issues before an economic turn, that will show up in CECL under the life of loan, but the real uncertainty that people are expecting and trying to become educated about is when we actually start to move into a recessionary environment.”
Those impacts could be seen especially acutely if problems develop with mortgages and student loans, as the ballooning level of student loan debt is already considered to be a threat, and banks are starting to return to some of the risky lending practices they engaged in before the 2008 financial crisis.
“Most CEOs that have spoken about CECL over the last year or so will basically reaffirm that the company is making lending decisions based on economics and not on accounting measurement, and therefore you don’t see a lot of people spending a lot of time revisiting their lending economics,” said Norwood. “Having said that, longer-based loans like a residential mortgage or a student loan, in particular a student loan where payments are deferred, you could see where the impacts to those portfolios on a go-forward basis could be more significant.”
Besides delaying the effective date of the standard for smaller banks, FASB has made a few tweaks in the standard in response to some of the complaints it has heard. Some trade groups representing banks and credit unions would like to see further adjustments. One lawmaker in Congress, Rep. Blaine Luetkemeyer, R-Mo., introduced a bill last September known as the Responsible Accounting Standards Act, which would require FASB to make a formal study of new accounting standards like CECL before they’re finalized. But most banks seem resigned to implementing CECL even if they’re dissatisfied with the standard.
“I would say it hasn’t been satisfying, but they’re not hoping for more changes,” said Norwood. “The reality of it is there will be a big debate, and we probably won’t know until after we go through a full cycle as to whether or not this will result in reserves earlier. I think there still continues to be a strong theoretical difference between what FASB versus some of the practitioners believe, but I don’t think anybody is holding out hope that there are going to be any wholesale changes in the near term. And the reality of it is the adjustment on day one is going to be noteworthy, but most people have said that it’s not overly material, particularly as they have refined their models. It really comes down to when we move into that first recessionary environment, when people will really start to figure out how we estimate the CECL losses for 2022, for example. I think that’s when you’ll start seeing a renewed interest in the disclosures.”
Officials at the Securities and Exchange Commission and its Office of the Chief Accountant are likely to comment on how the banks are making their initial CECL disclosures and may recommend some changes in their public speeches and letters to CFOs, as they’ve done with the recent revenue recognition standard.
“The SEC tends to look at the disclosures and they start to ask questions about why haven’t you disclosed this type of question,” said Norwood. “I think we’ll start to see that, maybe at the end of 2020 or maybe in 2021, when people file their Form 10-Ks for 2020. I think it will be a while before they weigh in in any meaningful way. They may start to show preferences in their speeches and things of that nature. But it could be the end of next year before they really start to weigh in.”
Banks and other financial institutions that deal with CECL are focusing on making sure their internal controls are up to handling the new standard, and that’s one area where their accountants can help. “People are focused on really making sure the internal controls over the process are as good as they can be,” said Norwood. “It’s a very complicated process, starting with data and modeling and new production. When you think about how long banks have honed their current processes and focused on the controls around those current processes, I would say most of the fall and early winter have been spent on internal controls along with communications, because you’ve got to tell the story, but you’ve got to make sure you’re doing it right. That’s where we see a lot of folks finishing out the year of double- and triple-checking the internal controls from an end-to-end process point of view because that’s the critical aspect. You’ve got to make sure that you’re exercising the judgments right, but you’re also calculating them and determining the disclosures in a controlled, repeatable and well-documented method.”
