Nothing like a financial crisis to show the rough spots in estimation of losses.
“Credit losses weren’t being recognized on a timely basis,” and the impairment accounting models were complex and varied widely, according to Kevin Guckian, Partner, National Professional Practice at Ernst &Young. He was the first of three panellists at the webinar “The Long Road to CECL” sponsored by the Global Association of Risk Professionals on September 8, 2016.
“FASB’s final standard should accelerate recognition of credit losses,” Guckian noted, referring to the current expected credit losses (CECL) standard newly adopted by the Financial Accounting Standards Board. He summarized the key changes [compared to the expected loss estimates in use].
“An event no longer needs to have occurred in order to recognize an impairment,” he said. “Under the new standard, credit losses will be recognized based on management’s expectations.” He also pointed out that “the estimate of expected credit loss must reflect the risk of loss, even when the risk is remote.” Guckian pointed out that this means that, even when the risk of loss is very remote, there will likely be some amount of credit loss recognized. “Every asset will likely have some level of credit loss recognized.”
Expect to see a lot more use of forecasts. Firms should “use forecasted information” that is “reasonable and supportable” when determining CECL.
Guckian warned, “a lot more disclosure will be required.” He also noted that available-for-sale debt securities will now have losses recognized as allowances. Currently, those impairments are recognized as direct write downs to the cost basis of the asset.
There will be many new challenges for audit. For example, data may be coming from systems that are currently not subject to audit or from third parties.
“Credit models will be more complex, incorporating forecasted assumptions,” he said. Therefore, “the auditor must determine the reasonableness of the assumptions, and will check to see if those assumptions are consistent with similar assumptions used in other places within the entity, such as stress testing scenarios and capital adequacy.”
Auditors will also look for directional consistency; for example, an improving economy generally should result in lower provisions.
Controls are central to auditing, and “higher levels of management will be responsible for approval.”
Not just any estimate of expected credit loss will do. Ignoring economic forecasts could result in a misleading estimate of CECL. Guckian elaborated on the inclusion of “reasonable and supportable” forecasts. Banks are already required to prepare forecasts for capital modelling.
He reassured the audience that the use of forecasted information used to calculate CECL “falls under the umbrella of undue cost and effort.” An entity is not required to search all information that is not reasonably available without undue cost and effort. If the cost and effort to obtain the information exceed the benefits of having it then the firm is allowed to revert to historical loss estimates.
In response to an audience member’s question, Guckian said that financial institutions are most affected by the new CECL standard. However, non-financial firms will also be affected, most likely in the area of accounts receivable. ª
The Long Road Ahead photo is by Wolfgang Staudt