Are You Ready?
By: Nirmitee Shah, Managing Director, Insurance Investor Services
After the 2008 global financial crisis, the question of how to measure and manage systemic risk dominated the worldwide regulatory agenda.
In the aftermath of the crisis, financial industry participants began to isolate the causes and propose solutions to deter another market-shattering event. Regulators also quickly began to dig into specific financial instruments and areas of the market that they believed needed stronger — not just more — regulation.
The Financial Accounting Standards Board (FASB) was no exception. In response to concerns that the credit losses identified and recorded leading up to the crisis were “too little, too late,” FASB announced a new set of accounting standards in 2016. Replacing the other-than-temporary impairment model, the Current Expected Credit Loss (CECL) accounting guidelines for loans and held-to-maturity debt securities will apply to any institution that issues or purchases credit. This includes banks, savings institutions, credit unions, insurance firms and holding companies filing under generally accepted accounting principles (GAAP).
Public business entities that file with the U.S Securities and Exchange Commission (SEC), except for small reporting companies, must begin applying the standard in 2020. For all other entities, the effective date will begin in 2023. FASB’s new accounting guidance includes targeted changes to the impairment model for available-for-sale (AFS) securities to recognize an allowance for credit losses rather than a reduction to the carrying value of the asset.
Why it’s important
CECL implementation could be one of the most challenging accounting standards change in decades.
Financial institutions affected by the revised guidelines will likely need to change their business processes around impairing securities. This can range from collecting new data to assess securities for impairment all the way to forecasting economic conditions, which is not an easy task. Financial institutions will need to spend significant time and effort on purchasing or building new models, and will want to make sound judgement.
For securities following the AFS model, calculating an impairment allowance means that financial institutions will limit credit losses to a fair value floor. For both the AFS and CECL models, institutions will change interest-income yield when the impairment allowance is limited for beneficial interests. A positive change in cash flows will reduce the allowance. When the allowance is exhausted, institutions will adjust interest income prospectively. Organizations will also need to convert to a purchased credit deteriorated model. This means grossing up the book value and establishing an allowance on the conversion date for impaired assets. This must occur while maintaining the current yield and not recording an impairment expense.
Another important change will be how organizations respond to financial reporting, including the presentation of impairment and the related footnote disclosures. Institutions impacted by the new standards may need to adjust their internal controls, and may want to consider modifying or upgrading their IT systems.
How we are helping clients
Many of FASB’s changes are complex and introduce new concepts that are generating significant discussion around the industry. As part of our commitment to understand the nuances of CECL’s new standards, we’ve been closely following the developments that result from FASB’s standard-setting activity and their Transition Resource Group’s ongoing discussions.
Since FASB first proposed the new accounting guidelines, our client advisory and working groups have been closely collaborating with clients to design new models and solicit their feedback. Clients have also had the opportunity to participate in regular demos and to test the models’ functionality.
In response to the updated standards, we’ve implemented a new process to estimate an impairment allowance using a discounted cash flow method based on two different sets of cash flows: one that includes losses and the other that does not. Our new impairment structure allows transaction for debt securities and loans to record the impairment expense. We have also established a new transaction method to record collateral-dependent allowances on loans.
Among the multiple adjustments we’ve made to support our clients, new general ledger accounts help track impairment allowance balances. Clients have the option to choose how the impairment allowance is presented in their financial statements to allow for differences between GAAP and International Financial Reporting Standards. They will also have access to a suite of reports to help them meet CECL’s new footnote disclosure requirements.
Organizations that hold financial instruments in scope should be well along in their implementation plan. We encourage smaller companies filing with the SEC and private firms with a delayed effective date to identify assets subject to the GAAP credit loss standard, and to develop a strategy with key milestones, impairment models and data collection needs. Firms working toward the 2023 date will also want to run use-case scenarios, design and implement internal controls, and begin drafting disclosures.
We recommend that all affected institutions evaluate their readiness for this major market change and consult with trusted partners to achieve a smooth transition. Please reach out to your State Street representative with any questions.