We are more than a decade removed from the financial crisis—a time when many factors converged to threaten the viability of our financial system. Since then, numerous reforms have been implemented. Today, our banking system is substantially stronger and more resilient.1
Financial regulators have introduced many of those reforms. But other groups have acted as well, including the accounting community through the Financial Accounting Standards Board (FASB). The FASB has recognized the need for change in how firms account for losses in assets held at amortized cost on the balance sheet. The result is a new accounting standard: the current expected credit loss (CECL) model.
What Went Wrong
At the time of the financial crisis (and even today), accounting standards called for losses on many assets to be recognized when it became “probable” that the loss would occur. The accounting community called this method the “incurred loss” model. Importantly, this model relied heavily on historical trends and performance to predict potential asset losses.
If financial and economic conditions are good and do not change, this model works adequately. Unfortunately, going into the financial crisis, this was not the case. Reserves for asset losses—in particular, assets in the loan portfolio—were too low relative to the quality of loans being extended and the probability that economic conditions could change.
As the financial crisis unfolded, loans on the balance sheets of many banks performed so poorly that investors and analysts began questioning the accuracy of balance sheets—balance sheets that had been prepared in accordance with Generally Accepted Accounting Principles (GAAP). Moreover, inadequate reserves for losses meant massive charges to earnings in a short period of time to reflect the pending losses in loans. This left many banks with inadequate capital to sustain normal operations. The U.S. faced emergency mergers, government intervention and more than 500 bank failures.
The FASB set out to address those weaknesses by introducing a more flexible accounting standard: CECL. Importantly, CECL calls for measuring expected losses over the life of an asset, not just when the loss becomes probable. Those expected losses are recognized the day the asset is booked.
Institutions will rely on historical experience, current conditions and “reasonable and supportable forecasts” in their assessment.2 In other words, they will now use forward-looking information to better inform their credit loss estimates.
Finally—and significantly for many firms—CECL can be implemented in a way appropriate to the size and complexity of the firm.
The FASB issued the accounting standard in 2016 with a delayed start date to allow companies time to adjust. Larger public firms will implement the standard in 2020, with smaller firms switching over at a later date.
Despite the extended rollout, implementation has proven difficult for some banking organizations because of data and personnel limitations. Next month, I’ll describe some of those challenges and the steps being taken by regulators to promote a smooth transition.
Notes and References
1 For an overview, see “Did the Dodd-Frank Act Make the Financial System Safer?”
2 For additional information, see “FASB Issues New Guidance on Accounting for Credit Losses,” FASB news release, June 16, 2016.