US companies including banks, will have to reassess how financial statements report credit risks, and expected losses in current statements and future outlooks due to changes in accounting standards which were published last week and will be effective in 2020. The changes may also have an impact of capital requirements and reporting. This is another step in the tighter regulation of the banking sector.
According to Moody’s, the US Financial Accounting Standards Board (FASB) published its Current- Expected-Credit-Loss model (CECL), a controversial and long-awaited expected-credit-loss model for financial instruments. CECL better aligns the recognition of credit losses with the economics of lending and investing. Additionally, the overall principle for CECL is easy to understand, reducing complexity in financial statements.
Although CECL applies to all companies that report under US generally accepted accounting principles (GAAP), it has the most material effect on bank financial statements because of the size of their loan portfolios. As of 31 March 2016, the loan portfolio of US commercial banks totaled $8.7 trillion. Banks will need to reassess the credit risk inherent in these loans to comply with CECL, in some cases requiring significant systems changes to incorporate forward-looking information.
When a bank first reports under CECL, provisions will significantly increase, reducing bank capital. In subsequent periods, however, provisions will only reflect changes to the bank’s estimated expected credit losses. US regulators supported CECL throughout its development, but it remains to be seen whether the new rules will affect regulatory capital requirements and nonperforming loan disclosures.
The main changes are:
Incurred versus expected credit losses. An expected-credit-loss model improves the usefulness of information in financial statements for investors. Currently, banks must wait until credit losses are probable or incurred before recognizing provisions for contractual cash flows that will not be collected on loans. On the day a loan is originated, CECL requires banks to recognize in earnings a provision that reflects management’s expectation of lifetime credit losses incorporating all reasonable and supportable information, including forward-looking information. Therefore, under CECL, the carrying value of loans measured at amortized cost on the balance sheet will reflect the net amount a bank expects to collect.
CECL has been heavily criticized because it requires a loss to be recognized upon loan origination, which many believe is counterintuitive since credit risk is typically considered in pricing. For credit analysis, however, we believe this is appropriate for banks: history has shown that in a pool of performing loans, not all contractual cash flows will be collected.
Detailed and transparent credit quality disclosures. Along with the CECL model, the FASB’s new credit loss standard published Thursday expands current credit quality disclosures by requiring banks to disaggregate their loans and receivables not only by class and credit characteristics but also by vintage.
These disclosures will be particularly helpful in understanding how credit quality has changed from period to period.
US GAAP and International Financial Reporting Standards (IFRS) have different expected credit loss models, a negative for users of financial statements. Although both CECL and the new IFRS impairment model are expected-credit-loss models, their principles are not fully aligned, which does not aid in global comparability of bank financial statements. IFRS 9, the financial instruments standard published in July 2014,4 requires recognition of lifetime expected credit losses once financial assets exhibit a significant increase in credit risk. For performing financial assets, an amount equal to 12-month expected credit losses is recognized. As such, CECL results in earlier recognition of credit losses on performing loans compared with IFRS 9. In addition, financial reporti g under CECL will be easier to understand because provisions in each reporting period will only reflect changes in the bank’s estimate of lifetime expected credit losses. Provisions under IFRS 9 will include a cliff effect for loans that exhibit credit deterioration but were previously performing.
