Proposed TDR Accounting Relief Will Miss Most Small Banks (For Now)

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Small banks may miss out on a new proposed accounting rule that frees banks from onerous accounting and reporting requirements following a loan modification.

In November 2021, the board that sets U.S. accounting standards issued an exposure draft that will remove the reporting guidance around troubled debt restructurings, or TDRs, for banks that have adopted the new loan loss standard, called the current expected credit loss model or CECL. Under the proposal, banks that have adopted CECL could continue reporting any modifications they offer borrowers and leave TDR accounting behind, but excludes the many small banks that have yet to adopt CECL.

The move has its fans.

“I’m all for it, and good riddance. There’s not a true credit guy I know who spends much time worrying about TDRs anymore,” says David Ruffin, principal at IntelliCredit, a division of QwickRate that helps financial institutions with credit risk management and loan review. “TDRs stayed around well beyond their usefulness.”

The change from the Financial Accounting Standards Board, or FASB, stems directly from the combination of the new loan loss standard and the banking industry’s experience during the coronavirus pandemic. TDRs occur after a bank offers a concession on a credit that it wouldn’t otherwise make, because of a borrower’s financial difficulties or hardship. The bank offers a modification and it reports the value of the impaired credit using a complicated accounting approach called discounted cash flow analysis. Under the current guidance, a credit classified as a TDR could never be reclassified even when the modification ended and the borrower returned to financial health, giving rise to the phrase “Once a TDR, always a TDR.”

CECL and the coronavirus pandemic changed all that. CECL requires banks to set aside a lifetime loss estimate when they make a loan, and then periodically update that expected loss as the borrower’s financial condition or the economy changes. TDR guidance conflicted with CECL in several ways. CECL gives banks the flexibility to select what method to use to calculate loan losses, based on factors like the portfolio or borrower characteristics; the proscriptive TDR approach seemed to violate that spirit. And after the standard went into effect, banks and those who prepare financial statements told the FASB that the new approach to allowances captured most of the impacts from loan modifications that would be included in the TDR calculation.

“TDRs no longer provide decision useful information,” the board noted in the project description for this proposal.

Then the pandemic hit, and Congress took the dramatic step of dramatic step of suspending the TDR reporting requirements to encourage banks to work with borrowers facing unexpected financial hardship. Banks were free to offer loan modifications that normally would’ve triggered TDR classifications but didn’t need to engage in the accounting and formal reporting requirement.

What they did do was better. Banks voluntarily provided information on the percentage of borrowers that had received a modification, the amount of loans under modification, the type of modification and sometimes the industry. This became somewhat of an industry standard, which observers praised as more useful and actionable. Quarterly updates showed that at many banks, the percentage of secondary or continued modifications was declining, boosted by government stimulus programs and the gradual return of economic activity.

All that was slated to revert to TDRs at the end of 2021 with the sunsetting of the CARES Act provision, until the accounting board took up the mantel. If the proposal passes, CECL banks that offer a loan modification to a borrower that is facing financial difficulty in 2022 will need to provide enhanced disclosures.

But the relief would only be for some banks. CECL went into effect for most public filers — mostly large banks — at the start of 2020. But private companies and those defined as “smaller reporting companies” by the Securities and Exchange Commission received a delay until the start of 2023 and can still use the incurred accounting method, setting aside a reserve when a loss becomes probable. The argument against eliminating TDR treatment for banks using the incurred method is that because the bank doesn’t assign potential lifetime losses to its loans on a quarterly basis, the TDR guidance isn’t redundant and still applies.

Although banks large and small showed they could manage both borrower modifications and appropriate allowances during the pandemic, community banks should expect to revert to the existing TDR guidance at the beginning of 2022 until they adopt CECL.

A Fresh Look At Derivatives Under New Hedging Rules

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A new accounting standard could make hedging with derivatives a more-viable risk management strategy for banks that had previously avoided them.

The Financial Accounting Standards Board sought to remove some barriers that previously discouraged many banks from using derivatives to hedge exposure to fluctuating interest rates. Now is an appropriate time for board members at banks of all sizes to ask their executive teams about their risk management strategies, and whether derivatives should play a larger role.

The standard — Accounting Standards Update (ASU) 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” — went into effect for publicly traded institutions in the fiscal year beginning after Dec. 15, 2018. It takes effect for privately held banks in the fiscal year beginning after Dec. 15, 2020, though early adoption is permitted.

In theory, using derivatives such as interest-rate swaps should be an effective way for banks to fine-tune portfolios and offset risks that come with having a mix of fixed rate and floating rate assets and liabilities. In practice, however, many banks chose not to hedge with derivatives because of complicated accounting and financial reporting practices required by generally accepted accounting principles.

Old hedging rules required banks to separately measure and report hedge ineffectiveness, or any amounts by which a derivative did not perfectly mirror the instrument being hedged —even if the hedge was effective overall. Separately reporting ineffectiveness was confusing for investors and often conveyed a misleading impression of a bank’s derivatives-based hedging practices.

The new standard eliminates that requirement, resulting in hedge accounting that more accurately reflects a bank’s risk management activities and provides financial statement users more worthwhile information about the effect of hedging activities.

When initially establishing a hedge, banks must document how they will evaluate its effectiveness in offsetting the changes in the fair value or cash flow of the hedged instrument. This evaluation must be performed quarterly.

In the past, when a bank chose the “shortcut” method for evaluating hedge effectiveness, it was bound to that method throughout the life of the hedge. If management later determined that the more complicated “long-haul” method would be more appropriate, they could not simply start using that method prospectively. Rather, they would also have to evaluate for a possible restatement of previous financial statements, as if hedge accounting had never been applied.

The new standard changes that. Banks now may specify a long-haul method in their documentation to be used as a fallback method if they later determine that the shortcut method is no longer appropriate.

Things also have gotten simpler for banks that choose the long-haul method at inception. Previously, banks using the long-haul method were required to perform a quantitative assessment (such as a regression analysis) every quarter for the life of a hedge. The new standard still requires a quantitative assessment at inception, but now in certain circumstances banks can perform subsequent quarterly assessments using only qualitative methods, validating that the terms and conditions of the hedged transaction and hedging derivative have not changed.

The new guidance also revises how a bank may measure the change in a hedged item’s fair value due to changes in its benchmark interest rate. Instead of calculating fair value based on all the cash flows of the instrument’s coupon, banks now can calculate the change in fair value based solely on the benchmark interest rate component, which is a more targeted and appropriate measure.

Under old hedging rules, hedging the change in fair value of an instrument (such as a fixed-rate loan) generally required the life of the hedged instrument and the life of the hedging derivative (such as an interest-rate swap) to match. The new standard removes that burden and allows for partial-term fair value hedges. For example, a bank can hedge a 10-year fixed rate loan for only two years, using a two-year interest-rate swap.

Another new opportunity known as the “last-of-layer” technique lets banks hedge the change in fair value of a pool of long-term fixed rate assets such as loans or securities — a hedge that generally was not possible in the past. Upon adoption of the standard, banks are permitted to transfer eligible held-to-maturity securities to available for sale, even if the bank eventually chooses not to hedge the securities at all.

Bank directors should familiarize themselves with the ways the new standard simplifies hedge accounting and enables new hedging techniques before engaging management to decide if it’s time to introduce or expand derivatives as risk management tools.

FASB Sheds Light On CECL Delay Decision

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CECL-8-15-19.pngSmall community banks are poised to receive a delay in the new loan loss standard from the accounting board.

The Financial Accounting Standards Board is changing how it sets the effective dates for major accounting standards, including the current expected credit loss model or CECL. They hope the delay, which gives some banks an extra one or two years, provides them with more time to access scarce external resources and learn from the implementation lessons of larger banks.

Bank Director spoke with FASB member Susan Cosper ahead of the July 27 meeting discussing the change. She shed some light on the motivations behind the change and how the board wants to help community banks implement CECL, especially with its new Q&A.

BD: Why is FASB considering a delay in some banks’ CECL effective date? Where did the issue driving the delay come from?
SC: The big issue is the effective date philosophy. Generally speaking, we’ve split [the effective dates] between [Securities and Exchange Commission] filers or public business entities, and private companies and not-for-profits. Generally, the not-for-profits and private companies have gotten an extra year, just given their resource constraints and educational cycle, among other things.

We started a dialogue after the effective date of the revenue recognition standard with our small business advisory committee and private company council about whether one year was enough. They expressed a concern that one [extra] year is difficult, because they don’t necessarily have enough time to learn from what public companies have done, they have resource constraints and they have other standards that they’re dealing with.

We started to think about whether we needed to give private companies and not-for-profits extra time. And at the same time, did we need to [expand that] to small public companies as well?

BD: What does this mean for CECL? What would change?
SC: For the credit loss standard, we had a three-tiered effective date, which is a little unusual. Changing how we set effective dates would essentially collapse that into two tiers. We will still have the SEC filers, minus the small reporting companies, with an effective date of Jan. 1, 2020.

We would take the small reporting companies and group it with the “all-other” category, and push that out until Jan. 1, 2023. It essentially gives the non-public business entities an extra year, and the small reporting companies an extra two years.

BD: How long has FASB considered changing its philosophy for effective dates? It seems sudden, but I’m sure the board was receiving an increasing amount of feedback, and identified this as a way to address much of that feedback.
SC: We’ve been thinking about this for a while. We’ve asked our advisory committees and counsels a lot of questions: “How did it go? Did you have enough time? What did you learn?” Different stakeholder groups have expressed concern about different standards, but it was really trying to get an understanding of why they needed the extra time and concerns from a resource perspective.

When you think about resources, it’s not just the internal resources. Let’s look at a community bank or credit union: Sometimes they’re using external resources as well. There are a lot of larger companies that may be using those external resources. [Smaller organizations] may not have the leverage that some of the larger organizations have to get access to those resources.

BD: For small reporting companies, their CECL effective date will move from January 2020 to January 2023. How fast do you think auditors or anyone advising these SRCs can adopt these changes for them?
SC: What we’ve learned is that the smaller companies wait longer to actually start the adoption process. There are many community banks that haven’t even begun the process of thinking about what they need to do to apply the credit loss standard.

It also affords [FASB] an opportunity to develop staff Q&As and get that information out there, and help smaller community banks and credit unions understand what they need to do and how they can leverage their existing processes.

When we’ve met with community banks and credit unions, sometimes they think they have to do something much more comprehensive than what they actually need to do. We’re planning to travel around the country and hold meetings with smaller practitioners — auditors, community banks, credit unions — to educate them on how they can leverage their existing processes to apply the standard.

BD: What kind of clarity does FASB hope to provide through its reasonable and supportable forecast Q&A that’s being missed right now? [Editor’s note: According to FASB, CECL requires banks to “consider available and relevant information, including historical experience, current conditions, and reasonable and supportable forecasts,” when calculating future lifetime losses. Banks revert to their historical loss performance when the loan duration extends beyond the forecast period.]
SC: There are so many different aspects of developing the reasonable and supportable forecast in this particular Q&A. We have heard time and time again that there are community banks that believe they need to think about econometrics that affect banks in California, when they only operate in Virginia. So, we tried to clarify: “No, you need to think about the types of qualitative factors that would impact where you are actually located.”

The Q&A tries to provide an additional layer of clarity about what the board’s intent was, to help narrow what a bank actually has to do. It also provides some information on other types of metrics that banks could use, outside of metrics like unemployment. It talks about how to do the reversion to historical information, and tries to clarify some of the misinformation that we have heard as we’ve met with banks.

BD: People have a sense about what the words “reasonable” and “supportable” mean, but maybe banks feel that they should buy a national forecast because that seems like a safe choice for a lot of community banks.
SC: Hindsight is always 20-20, but I think people get really nervous with the word “forecast.” What we try to clarify in the Q&A is that it’s really just an estimate, and what that estimate should include.

BD: Is the board concerned about the procrastination of banks? Or that at January 2022, banks might expect another delay?
SC: What we’re really hoping to accomplish is a smooth transition to the standard, and that the smaller community banks and the credit unions have the opportunity to learn from the implementation of the larger financial institutions. In our conversations with community banks, they’re thinking about it and want to understand how they can leverage their existing processes.

BD: What is FASB’s overall sense of banks’ implementation of CECL?
SC: What we have heard in meetings with the larger financial institutions is that they’re ready. We’re seeing them make public disclosure in their SEC filings about the impact of the standard. We’ve talked to them extensively about some of how they’ve accomplished implementation. After the effective date comes, we will also have conversations with them about what went well, what didn’t go well and what needs clarification, in an effort to help the smaller financial institutions with their effective date.

CECL Delayed for Small Banks

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CECL-7-18-19.pngSmall banks hoping for a delay in the new loan loss accounting standard could get their wish, following a change in how the accounting board sets the effective dates for new standards.

On July 17, the Financial Accounting Standards Board (FASB) proposed pushing back the effective date of major accounting changes like revenue recognition, leases and — key to financial institutions — the current expected credit loss model (CECL). The board hopes the additional time will offer relief to smaller companies with fewer resources and provide more space to learn from the implementation efforts of larger peers. Under the proposal, community banks and credit unions now have a new effective date of Jan. 1, 2023, to implement CECL.

The board’s proposal also provided relief for a new category they call “small reporting companies,” and thus simplified the three-tiered effective dates into two groups. The proposal retains the 2020 effective date for companies that file with the U.S. Securities and Exchange Commission that are not otherwise classified as a small reporting companies.

CECL will force banks to set aside lifetime loss reserves at loan origination, rather than when a loss becomes probable. The standard has been hotly contested in the industry since its 2016 passage, and banking groups and members of Congress had unsuccessfully sought a delay in the intervening years.

But on Wednesday, some finally got what they were looking for. The proposed CECL delay for many banks comes as FASB grapples with how it sets the effective dates for different standards, said board member Susan Cosper in an interview conducted prior to the July 17 meeting.

In the past, FASB would pass a new accounting standard and set an effective date for SEC filers and public business entities in one year, then give private companies and nonprofit organizations an extra year to comply. The gap in dates recognizes the resource constraints those firms may face as well as the demand for outside services, and provide time for smaller companies to learn from the implementation lessons of large companies. However, the board’s advisory councils said this may not be enough time.

“What we’ve learned … is that the smaller companies wait longer to actually start the adoption process,” Cosper says. “There are many community banks that haven’t even begun the process of thinking about what they need to do to apply the credit loss standard.”

The extra time should allow these companies the ability to digest and implement the credit loss overhaul using existing resources. During the meeting, FASB member R. Harold Schroeder said that bankers tell him they could quickly apply the CECL standard in a “compliance approach” as a “box-checking exercise” for their banks. But, they tell him, they need more time if they want to implement CECL in a way that allows them to use it to make business decisions.

“The companies I talked to are taking these standards seriously as an opportunity to improve; ‘We want the data to flow through our systems, but it takes more time,’” he said.

The board also adopted an SEC filer category, called “small reporting companies” or SRCs. The SEC defines a small reporting company as a firm with a public float of less than $250 million, or has annual revenues of less than $100 million and no annual float or a public float of less than $700 million. For CECL, SRCs have the same implementation deadline as their private and not-for-profit peers. Companies with a 2023 effective date have the option of adopting the standard early.

The proposal to extend the CECL effective dates for small companies received unanimous support from the board. The proposal now goes out for public comment.

“The process of gathering, cleaning and validating [loan loss] data has taken longer than we expected,” says Mike Lundberg, national director of financial institutions services at accounting firm RSM US. “Having a little more time[for banks] to run parallel paths or fine-tune their models is really, really helpful.”

Lundberg points out that small banks will now have nearly six years to implement the standard, which passed in 2016. He also warns against bankers’ complacency.

“[The implementation] will take a long time and is a big project,” he says. “It’s definitely a ‘Don’t take the foot off the gas’ situation. This is the time to get it right.”

FASB also offered additional assistance to financial institutions with a newly published Q&A document around the “reasonable and supportable” forecast, and announced a multi-city roadshow to meet with small practitioners and bankers. Cosper says the Q&A looks to narrow the work banks need to do in order to create a forecast and includes additional forward-looking metrics banks can consider.

“I think that people really get nervous with the word ‘forecast,’” she says. “What we tried to clarify in the Q&A is that it’s really just an estimate, and it goes on to describe what that estimate should include.”

Five Tips on Choosing the Right CECL Solutions for Community Banks

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CECL-10-8-18.pngAny big accounting change—especially one as large as CECL (current expected credit loss)—is bound to cause some pain. But, there are ways to make sure your bank is not making the challenge bigger than it has to be. Here are five tips on selecting a calculation methodology that’s compatible with your institution.

1. Consider the complexity.
Banks can choose from several methodologies that range in complexity. The more complex the methodology, the more data needed—and the more inherent risk of error. Both the Financial Accounting Standards Board (FASB) and regulators have consistently indicated that complex CECL models aren’t required. Nevertheless, some community institutions seem to be choosing more complex methodologies over simpler solutions that can decrease cost and reduce risk.

Overall, the choice of a more complex methodology can impose additional costs and risks to a bank. If a community bank is going to use a complex methodology, it should go into it with clear understanding of the cost and risk involved.

2. Select your methodology first.
Regulatory agencies — including the Securities and Exchange Commission and the FASB — have continually discussed how Excel is an acceptable tool for fulfilling CECL requirements. As a general rule, the more complex the methodology, the more likely you’ll need new software. Industry participants are becoming aware that they can use, with some adapting, methodologies similar to those they use today. That means they can continue to use Excel.

CECL software does have its advantages. For example, there’s functionality for quickly disaggregating the portfolio to a finer degree and the ability to explore various methodologies, which could be beneficial. But, new software won’t eliminate all of the hard work of making estimates requiring a managerial decision.

3. Don’t panic about the reasonable and supportable forecast requirements.
The accounting standard provides a framework for incorporating a reasonable and supportable forecast. The standard doesn’t require fancy and sophisticated forecasting techniques with regression equations. Using charts with historical economic information compared to long-term trend lines can be a way to reasonably support a forecast. This framework is illustrated within the accounting standard and consists of comparing the general direction of two economic indicators (unemployment and real estate values) and using historical loss periods with similar directional trends as a basis for qualitative adjustments.

4. Start with what makes sense and add complexity as needed.
The more complex the methodology, the more historical, loan-level data will be required. Many institutions won’t have accurate and complete data from several years ago readily available. They could do a tremendous amount of work right now to obtain that historical data. A better solution might be for those institutions to start changing their processes for the current year, so that going forward, they’ll have the correct data. In the meantime, they can use a less complex methodology that’s acceptable to regulators, such as the weighted average remaining maturity that doesn’t require loan-level information.

5. Ignore the hype and do what’s right for your institution.
Much of the focus in the industry now is on the big banks that are closest to adoption. A big, complex institution will require a complex CECL solution, so much of the dialogue in the industry relates to those complex methodologies. But, what’s good for your bank? Much of the industry buzz around advanced methodologies and CECL software has little to do with the needs of community institutions. The adoption deadline for community banks, which is still a couple of years away and simpler than that for large banks, is not an argument for procrastination. Rather, it’s a reminder that community institutions can craft solutions appropriate to their own needs that are efficient, effective, and economical.

Some community banks are still not working on CECL with necessary diligence and speed. Others are introducing complexity that makes the process more difficult than it has to be. An approach that recognizes there’s work to do—but understanding it can be minimized—is the right CECL strategy for the large majority of banks.

FASB Update Removes Roadblock to Hedging With Derivatives

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derivatives-11-13-17.pngComplex hedge accounting rules are high on the list of reasons that community banks have chosen to avoid derivatives as risk management tools. But the Financial Accounting Standards Board (FASB) created a stir a little over a year ago, when it promised to improve accounting for hedging activities. That stir turned into a wave of fanfare from community banks in August 2017, when the final Accounting Standards Update (ASU 2017-12) was issued for ASC 815 – Derivatives and Hedging, the standard formerly known as FAS 133. In order to appreciate the excitement surrounding the new hedging guidance from FASB, it helps to take a quick look at the history behind the accounting standard that is widely considered to be the most complex the accounting organization has ever issued.

When derivatives were introduced in the mid-1980s, they were known as “off-balance sheet” instruments because there was not a neat way to fit them onto a firm’s financial statements. Derivatives were instead relegated to the footnotes. As derivative structures became more complex and began to be used more aggressively by treasurers who often viewed derivatives as profit centers, a sharp unexpected rate hike in 1994 led to large derivative losses at Procter & Gamble and others. With speculative trades buried deep in the footnotes, demands for transparency from the investor community led to FAS 133 which, starting in 2000, required for the first time that derivatives be carried at fair value on the balance sheet.

In order to prevent having on-balance sheet derivative values lead to wild swings in earnings, hedge accounting rules were created as a shock absorber. But while the original intent of hedge accounting was to be helpful, in practice it was difficult to apply and unforgiving when applied incorrectly. It also lacked viable solutions for some of the most common challenges facing community banks.

With that as a backdrop, here are three changes included in ASU 2017-12 that will make hedging with derivatives much more practical and worry-free for community banks.

1. Portfolio Hedging of Fixed-Rate Assets
What made hedging a portfolio of fixed-rate mortgages impractical under the original standard was the caveat that almost every loan in the pool needed to be homogeneous with regard to origination date, maturity date and prepayment characteristics. Some banks would occasionally hedge larger commercial loans one at a time, but this very common source of interest rate risk was either hedged in a different manner or ignored in the past. The newly introduced “last-of-layer” designation eliminates this unattainable caveat and will enable liability-sensitive banks to hedge a portion of an identified closed portfolio of prepayable assets. As a result of this new strategy, banks will have a one-time opportunity to reclassify held-to-maturity securities as available for sale if they are eligible for the last-of-layer designation. Mitigating interest rate risk in both the loan and securities portfolios will now be squarely on the table for community banks’ consideration.

2. Impact of Hedging on NIM
Most banks undertaking a derivative strategy are looking to protect or enhance the bank’s net interest margin (NIM). The original standard required that hedge ineffectiveness be measured, which sometimes created unwanted accounting surprises. By eliminating the concept of ineffectiveness from the hedging framework, FASB will reduce complexity associated with interpreting hedging results. Hedge mismatches will no longer need to be separately measured and reported in financial statements. The economic impact from mismatches between the hedge and the hedged item will be reported in the same income statement line item when the hedged item affects earnings. For banks, this will enable typical hedging activities to impact NIM as intended.

3. Reduced Restatement Risk
In the past, some banks attempted to reduce the burden of hedging through the use of the “shortcut method,” where the assumption of a perfectly effective hedge was permitted by FASB when specific conditions were met. But the breach of any shortcut criterion, due to a minor missed detail or an unexpected change in business conditions, led to a loss of hedge accounting privileges and sometimes an embarrassing accounting restatement. The new ASU introduces an improvement to the shortcut method of assessing effectiveness by allowing for a fallback, long-haul method to be documented at the time of designation. This change will significantly reduce the risk of a restatement, and banks will be able to pursue prudent hedging activities with less fear of an accounting misstep.

By reducing complexity and making more hedging strategies viable, the new guidance is expected to be adopted prior to the mandatory 2019 deadline by most banks who actively hedge. In addition, more community banks are likely to consider installing hedging capabilities for the first time thanks to FASB clearing this long-time roadblock.

How the New FASB Standard on Revenue Recognition May Impact Banks

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revenue-maze.jpgThe Financial Accounting Standards Board (FASB) recently released its long-awaited standard addressing revenue recognition. Existing U.S. generally accepted accounting principles (GAAP) were largely developed on a piecemeal basis and are industry- or transactional-focused. Consequently, economically similar transactions sometimes resulted in different revenue recognition. Accounting Standards Update (ASU) 2014-09, “Revenue From Contracts With Customers (Topic 606),” adopts a standardized approach for revenue recognition. This was a joint effort with the International Accounting Standards Board (IASB), resulting in converged guidance under both GAAP and International Financial Reporting Standards (IFRS). Of course, companies will report the same total amount of revenue over time, but the timing of the recognition could be accelerated or delayed when compared with current practices. 

A Core Principle and a Five-Step Approach

The new ASU is based on a core principle: “Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” To achieve this principle, the guidance spells out several steps that a company must take when determining when to recognize revenue on its financial statements.

  1. Identify the contract with a customer.
  2. Identify the separate performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the separate performance obligations.
  5. Recognize revenue when (or as) performance obligations are satisfied.

Is This a Big Deal for Banks? 

The new ASU could be a challenge from two perspectives. First, there are certain industries for which there will be wholesale changes, including the software, telecommunication and real estate industries. For the banking industry, wholesale changes are not expected—largely because much of a bank’s revenue comes from financial instruments (including debt securities, loans and derivatives), and many of those are scoped out. That is not to say that banks won’t be affected, because most will. But for most banks, the effect is not likely to be significant.

Second, the challenge for banks (as well as other industries) will be taking the core principle and accompanying steps and figuring out how the guidance applies. In other words, the five steps provided are not written with a specific industry in mind, so a shift in thinking will be necessary to evaluate how the accounting will change for those transactions that will apply to banks. A few areas of potential application for banks include:

  • Loyalty point programs
  • Asset management fees
  • Credit card interchange fees
  • Deposit account fees

Effective Dates

The boards provided a lengthy implementation time for the new rules, giving companies time to develop and put in place new controls and processes. The ASU is effective for public companies for annual reporting periods (including interim reporting periods within) beginning after Dec. 15, 2016; early implementation is not allowed. For nonpublic companies, the guidance is effective for annual reporting periods beginning after Dec. 15, 2017, and interim and annual reporting periods thereafter. Early adoption is permitted for nonpublic companies with certain caveats.

Help Is on the Way

In addition to establishing a revenue recognition working group to own the guidance, the American Institute of Certified Public Accountants (AICPA) created 16 different industry task forces charged with providing industry-specific guidance. One of those 16 task forces is the depository institutions revenue recognition task force. With the issuance of the standard, the work now can begin.

In addition, the FASB and the IASB are forming a joint transition resource group, which will consist of 15 to 20 specialists representing preparers, auditors, regulators, users, and other stakeholders. Its objective will be to promote effective implementation and transition.

At just more than 700 pages, the new standard is the longest the FASB has ever issued. This was a major undertaking by the boards, and given the girth of the standard and the fact that it is not industry specific, it’s safe to say it’s just going to take time to digest. 

The FASB’s Proposal on Credit Losses: What’s the Status?

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8-30-13-Crowe.pngTrying to make improvements to the accounting for the allowance for loan and lease losses (ALLL) has been an endeavor for standard-setters for many years.

Because ALLL is the most significant estimate on the balance sheet for most, if not all banks, any changes to the accounting for credit losses is particularly important to the financial institutions industry.

Before the most recent proposals, the American Institute of Certified Public Accountants (AICPA) had taken up the cause and issued a proposal in June 2003, but based on the feedback received, that project did not move forward.

Motivated by the credit crisis, the Financial Accounting Standards Board (FASB) formally took on the project and issued a comprehensive proposal in May 2010. The proposal would apply to all banks, both public and private, and introduces a new model that is widely thought to result in an increase the amount of the ALLL.

The proposal was largely thought of as the “fair value proposal,” but it also addressed credit losses. At the same time, the International Accounting Standards Board (IASB) also was seeking to make improvements to its credit losses guidance. After hearing from their constituencies a desire to have a converged solution, the two boards sought to work together to require more timely recognition of credit losses and additional transparency about exposure to credit risk.

The first attempt was a proposal issued in January 2011. The proposal received mixed reviews, so the boards decided to explore alternative models. The boards jointly developed a “three-bucket” approach in which an allowance would be established by capturing three different phases of deterioration in credit quality. After hearing numerous concerns about how understandable, operable, and auditable the model would be, the FASB chose an alternative model known as the “current expected credit loss” (CECL) model, which was issued as a proposal, “Financial Instruments – Credit Losses (Subtopic 825-15),” on Dec. 20, 2012.

The CECL model considers more forward-looking information than is permitted under current U.S. generally accepted accounting principles (GAAP). Under the CECL model, the estimate for credit losses would be based on relevant information about past events, current conditions, and reasonable and supportable forecasts. Simply stated, this requires “life of the loan” estimates and recording of day one losses. Under GAAP, losses are not recorded until it is probable that an asset is impaired or a loss has been incurred. In addition to covering loans, the proposal also addresses debt securities, so the current other than temporary impairment (OTTI) model would be replaced.

Comments on the CECL model were due April 30, 2013, and the FASB received more than 360 letters. The FASB also performed additional outreach to approximately 70 analysts to understand whether the proposal would improve financial reporting for users and conducted 17 field visits with preparers to understand the cost of application and operational considerations.

The FASB found that users’ views differ significantly from preparers’ views. By a margin of nearly three to one, users prefer a model that recognizes all expected credit losses. In contrast, most preparers prefer a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses can be recognized. Not surprisingly, financial institutions raised significant concerns about the potential impact of the model on regulatory capital.

The FASB learned that many preparers are under the impression that management would be expected to forecast economic conditions over the remaining life of the assets – which was not the FASB’s intent. Upon comprehending the FASB’s expectations about estimating expected credit losses, nearly all preparers indicated that the measurement of lifetime expected credit losses would be operational. However, the preparers cited the incremental costs and effort of moving to a “life of loan” expected credit loss model and reiterated a preference for a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses are recognized.

Meanwhile, the IASB proceeded with issuing its proposal, “Financial Instruments: Expected Credit Losses,” on March 7. The proposal retains the tenets of the “three-bucket approach” but now refers to it as the “three-stage approach.” The comment period ended July 5.

On July 23, the two boards discussed feedback received on their respective proposals. The meeting was informational, and no decisions were made. Based on the outreach performed, each board found support for its respective models: the IASB from both users and preparers and the FASB from users. Russell Golden, the chair of the FASB, suggested a next step to convene the users that both boards engaged in order to try to reconcile the competing views. Stay tuned – it will be interesting to see if the boards can come together with a converged solution.

Read the Crowe Horwath LLP article, “Is the Third Time the Charm? The FASB Proposes Major Changes for Credit Losses,” for a more in-depth discussion of the proposal.

Fair Value and the Allowance for Credit Losses: What Does the Future Hold?

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These two topics, near and dear to bankers, are in the process of being addressed by the Financial Accounting Standards Board’s (FASB) financial instruments project. The financial instruments proposal, issued in May 2010, was a monster–fair value, impairment and hedging all rolled into one.

Adding to the complexity, remember that FASB is trying to converge with the International Accounting Standards Board (IASB)–but IASB is using timetables that differ from FASB’s. In this post, I’m setting aside hedging to focus on the two areas that affect everyone: fair value and the allowance for credit losses.

Fair Value

red-pin-finances.jpgFASB’s past proposal to carry most financial instruments (loans, securities and deposits) on the balance sheet at fair value was received with little enthusiasm, for two primary reasons. First, robust market data doesn’t exist for many of those instruments, raising concerns about the reliability of the fair values that would be used. Second, the proposal did not take into account management’s intent–when management does not intend to ever sell most of those instruments, what is the point in recording them at fair value?
 
The good news is that FASB has reconsidered its initial proposal. The board has moved away from broadly requiring fair value for most financial instruments. Instead, the determination of whether an instrument is carried at fair value will depend on (1) the characteristics of the financial asset and (2) the business strategy. The result is three categories:


Fair Value–Net Income: Measured at fair value with all changes in fair value recognized in net income. It includes items held in trading or for sale.

  1. Fair Value–Other Comprehensive Income: Measured at fair value with qualifying changes in fair value recognized in other comprehensive income. It includes financial assets for which the business objective is investing with a focus on managing risk exposures and maximizing total return, typically characteristics of an investment portfolio category.
  2. Amortized Cost: Measured at historical cost and for assets, evaluated for impairment. It includes financial instruments for which the business strategy is managing the instruments through a lending, borrowing or customer financing activity, typically characteristics of a loan portfolio category. This category would also include those liabilities (deposits) that the bank intends to hold.

If you think this overall model looks similar to what we have today, you are correct. However, there is an important shift. Today, the accounting model is driven primarily by the form of the instrument. That is, we follow one model if the asset is deemed to be a loan and another model if the asset is deemed to be a security. The shift is really toward one model, but then drivers are the marketability of the instrument (Is there a readily available market for the asset?) and management’s intent (What is the plan for the asset? Is the intent to hold the asset and collect the cash flows the typical intent for a loan? Or is the intent to manage interest rate risk and liquidity, which is typical for an investment portfolio?).
 
While there are many nuances with this area of the project, the key point is that FASB has moved away from essentially requiring fair value for the majority of the balance sheet. Stay tuned–FASB plans to make its final decisions in the third quarter of 2011.

Allowance for Credit Losses

Near and dear to bankers is the allowance for loan and leases losses (ALLL), an area in which FASB’s financial instruments project seeks to make some changes. For decades, we have struggled with the accounting in this area in large measure because of the confusion about what the allowance does and doesn’t represent. Today, losses cannot be recorded until they are probable and incurred. Those are words of art meaning that a loss has indeed happened and that a future event will likely confirm the loss. In other words, the allowance does not represent all possible or expected losses in the portfolio.

However, these concepts are being reevaluated. In late January, FASB and the IASB published a joint proposal for comment that is focused primarily on loans evaluated on a pool basis. Think about that in the context of loans that are not individually flagged being problematic. The proposal seeks to change the allowance from a probable and incurred loss model to a more forward-looking model–that is, closer to an expected loss model.

However, the two boards differ. FASB favors an approach that looks to the foreseeable future but not one that includes losses over the life of the portfolio. IASB favors an approach that takes expected losses over the portfolio and records those losses over time. The new proposal is really a hybrid of the two approaches. Essentially, bankers would have to determine the outcome of both approaches and record the lesser of the two amounts. So, for pools, the allowance for credit losses would be calculated based on the lower of a time-proportional amount (the IASB model) or losses expected to occur in the foreseeable future, which can’t be less than 12 months (the FASB model).

Unsurprisingly, the comment letters did not yield a consensus of opinion. So, with a goal of reaching a consensus by late June, the boards are back to the drawing board. Depending on the outcome, we may see yet another exposure draft. Stay tuned–more fun to come!

Can You See ThiS????