A new accounting rule for reporting credit losses became effective January 1, 2023, for small public companies, private companies and not-for-profits that extend credit. Although the changes primarily affect banks and other financial institutions, any company that has trade receivables, notes receivable, investments in held-to-maturity debt securities or contract assets could be affected.
Large public companies were required to adopt the current expected credit loss (CECL) accounting policy by January 1, 2021 (after an available one-year deferral in 2020 under the CARES Act). Under the new CECL model, it has caused the country’s largest financial institutions, such as, JPMorgan Chase, Bank of America, Wells Fargo and Citigroup to reserve billions more for potential loan losses in 2022, due to bleak economic conditions and rising credit card debt. Here’s a look at what smaller entities can expect as they implement the new model in 2023.
A perfect storm is brewing
In light of ongoing economic malaise, credit losses were listed as a top concern for the year ahead by 84% of small financial institutions that participated in the Tenth Annual Community Bank Survey conducted by Risk Management Association. Another major concern was regulatory compliance. Community banks have now started implementing the updated guidance which will require earlier reporting of credit losses than under the previous incurred-loss model.
Due to the adoption of CECL and combined with the possibility of a recession, there is the potential that this could lead to a surge in credit losses among smaller financial institutions in 2023. In turn, a buildup of credit loss reserves is likely to impair earnings.
New model calls for earlier recognition
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires banks and other entities that extend credit to forecast into the foreseeable future to predict losses over the life of a loan and then immediately book those losses. The updated guidance was designed to provide more-timely reporting of credit losses, but measuring losses is challenging in today’s uncertain marketplace.
In a nutshell, the updated guidance relies on estimates of probable future losses. These estimates are based on historical expenses and current conditions. By contrast, the previous rules called for an incurred-loss model to recognize losses.
The loss provision, or reserve, is a much-watched figure on banks’ balance sheets and income statements. It’s designed to offer insight into how a bank is performing. Investors and bank examiners pay close attention to changes in loss reserves as well as the assumptions and estimates used to calculate the reserve. Loss reserves are “built up” when past-due accounts and impaired loans are expected to increase; an increase in the loss reserve lowers earnings on the income statement. Conversely, loss reserves may be “released” when the economic outlook brightens; this situation boosts earnings.
CECL is a major change from the previous model for reporting credit losses and requires more forecasting. The uncertain economic environment the United States is in should be considered in calculating the loan loss reserves upon implementation of CECL and going forward. Shareholder, Scott Deters of CSH said, “there are many other factors to be considered stemming from the economic forecast. Loan concentrations, rising interest rates, and local economic changes, just to name a few. Community banks have had these factors in their calculation of reserves for many years. The difficulty is now the factors are to be supportable with economic forecasts verses what has happened historically.” For questions about this topic, reach out to CSH experts, Eric Hanson and David Klopfer for help updating your procedures and systems to implement the changes for 2023.