Every bank’s financial reporting requirements include an amount that reflects the outstanding loans that are anticipated not to be paid back. Currently, the standard established by the Financial Accounting Standards Board (FASB) is based on the Allowance for Loan and Lease Losses (ALLL). It is primarily based on historical experience and does not look forward to existing or projected downturns in the economy. The ALLL did not accurately nor timely report loan losses during the financial crisis of 10 years ago, so FASB has developed a new model that is called Current Expected Credit Losses (CECL) that requires lending institutions to book the costs of loan losses based on an estimation of expected losses over the life of the loan.
As an investor, your knowledge of this change will help you understand financial reports from lending institutions, help you compare institutions, and once the reporting change is in place, analyze current statements with historical ones.
Impacted Institutions
Banks are probably the first institutions that come to mind when you think of loan loss estimating and reporting, but other financial and non-financial companies will also be affected. These include credit unions and insurance companies. But the ramifications are even broader than the financial world. Just about every business has financial assets in the form of trade receivables. Currently, a reserve for bad receivables is estimated based on a company’s historical success with collections. With CECL, the reserve calculation for any company that carries receivables will have to be given a forward-looking analysis.
Types of Investments It Impacts
As an investor, you want to know the types of investments that the new requirement impacts. Equity investments in financial institutions and any company in an industry that carries financial assets will be affected. Part of the impact is due to variability in calculation methods used for revolving loan loss periods. There are also different CECL models for organizations to use for reporting loss calculations.
Eliminating Surprises for Investors
FASB has the responsibility for setting standards for accounting and reporting that are adhered to by all traded companies. This helps to assure that reporting is accurate, timely, and complete. It also helps to create a level playing field for all investors. Full and accurate disclosure can help investors make the best decisions for their portfolios. In the few years leading up to the 2008 financial crisis, loans in the United States commercial banking system increased by 85%, but the reserves associated with those loans only rose by 21%. With the adoption of CECL, FASB hopes to eliminate surprises like those in 2008 to investors with more accurate and timely financial asset loss reporting.
FASB Votes to Delay CECL for Some Institutions
On October 16, 2019, FASB unanimously approved delaying the implementation of CECL for most financial institutions. Nonprofits and private companies are required to implement the new hedging and leasing standards for fiscal years that start after December 15, 2020. Private, nonprofit, and small public lenders are required to implement CECL for fiscal periods that begin after December 15, 2022. During the delay period, FASB plans to continue with workshops to teach smaller lenders. Also, FASB plans on the industry to learn from the larger establishments on how to incorporate the new booking and reporting requirements. In the interest of creating and supporting informed investors, FASB has taken a major step to document accurate and timely losses on financial assets for companies across many industries.
We create investment portfolios that are tailored specifically for you. Get the details here!
