The method used in determining the appropriateness of an allowance for credit losses (ACL) has been a challenging financial reporting issue for decades. The 2008 financial crisis evidenced a need for reforms, particularly in accounting for credit losses, which had stirred deep controversy with its “incurred-loss” accounting model (John Page and Paul Hooper, “The Fundamentals of Bank Accounting: Its Effect on Current Financial System Uncertainty,” The CPA Journal, March 2013, In June 2016, FASB issued Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326). This ASU represents a significant change in the ACL accounting model by requiring immediate recognition of management’s estimates of current expected credit losses (CECL). Under the prior model, losses were recognized only as they were incurred, which FASB has noted delayed recognition of expected losses that might not yet have met the threshold of being probable.

The new model is applicable to all financial instruments that are not accounted for at fair value through net income, thereby bringing consistency in accounting treatment across different types of financial instruments and requiring consideration of a broader range of variables when forming loss estimates. Although this change affects any entity holding financial instruments, the financial services industry by its nature bears the most exposure. How these entities are responding to the new ASU can provide insights for other affected entities.

Although the standard is effective for fiscal years beginning after December 15, 2019, for public entities (with early application permitted), SEC registrants must present disclosures regarding the implications of new accounting pronouncements within their Form 10-K and other filings, as prescribed by SEC Staff Accounting Bulletin (SAB) 74, Disclosure of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period. SAB 74 disclosures provide the first official discussion of how management views the implications of the ASU. The authors have sampled this first round of disclosures to provide insight into the anticipated impact of the new ASU and the potential disclosure trends. These disclosures can inform financial statement preparers who will be required to implement the new ASU and must discuss the ASU’s anticipated impact between now and eventual adoption.

Requirements of ASU 2016-13 and SAB 74

Exhibit 1 lists the key provisions of the ASU, which will affect many areas and require management to make challenging estimates that must be reassessed each reporting period. As FASB has noted, the ASU will “broaden the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually.” A CECL analysis must reflect the nature of the credit portfolio and the economic environment—two variables that are moving targets—as they exist at the specific reporting date. In such a scenario, changes in CECL are likely to arise at each reporting period.

Exhibit 1

Key Attributes of ASU 2016-13

▪ Changes the accounting approach from an “incurred loss” to a “current expected credit loss” (CECL) model for all financial instruments. ▪ Expected to require an increase to the allowance for credit losses (ACL), most obviously for loans, but also establishing new allowances for certain other financial instruments, including purchased financial instruments. ▪ Expected to generate a charge to retained earnings when initially implemented. Subsequently, the income statement will reflect the measurement of expected credit losses for newly recognized financial assets as well as the expected changes in CECL during the reporting period. ▪ Will require applying various loss estimation models to different credit portfolios, such as commercial and industrial loans, installment loans, mortgage loans, credit card loans, purchased loans, debt securities, and trade receivables, including within the context of macroeconomic models. ▪ Actual implementation calculations will reflect two key variables, the particular financial instrument portfolios and the macroeconomic environment, as they exist at the time of adoption. ▪ For SEC registrants, effective for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020), with early adoption permitted for fiscal years beginning after December 15, 2018 (i.e., January 1, 2019). For non-SEC registrants, effective one year later.

The first cumulative adjustment required is a charge to retained earnings, with subsequent changes in CECL reported in the income statement. One would therefore expect that management would wish not to adopt the ASU early. First, entities would likely prefer to avoid having to record a charge through retained earnings sooner than required. In addition, entities that adopt early might encounter a CECL adjustment in the following year that is also a charge for a deterioration in the portfolio, but would then be considered operating in nature. Thus, one would expect entities to wait until the last moment to adopt so that any charge is fully reflected in the adoption charge to retained earnings, which is not part of operating results.

Exhibit 2 presents a summary of the requirements of SAB 74. One is that management disclose if it plans to adopt earlier than required. Therefore, silence on this topic would indicate that management has no intention to adopt early. SAB 74 also requires management to disclose its choice of implementation method; however, since ASU 2016-13 permits only a modified retrospective approach without restatement (and a prospective transition approach for certain securities), this requirement is inapplicable. Finally, the absence of discussion or disclosure leads the reader to infer that a matter is not considered material. Conversely, discussion of recent pronouncements not yet effective implies that the matter is considered potentially material.

Exhibit 2

Key Attributes of SAB 74

▪ Requires a brief description of the new standard, the date of mandatory adoption, and the date the registrant plans to adopt, if earlier. ▪ Calls for a discussion of the methods of adoption allowed by the standard and the implementation method the registrant expects to use. ▪ Requires a discussion of the impact that adoption of the standard is expected to have on the registrant's financial statements, unless not known or reasonably estimable. ▪ Encourages disclosure of the potential impact of other significant matters that the registrant believes might result from adoption (e.g., technical violations of debt covenant agreements, planned or intended changes in business practices).

Preparers face pressures from not only the expectations of stakeholders and SAB 74’s guidance, but also from the inherent peer pressure that develops as the disclosure process evolves.

Preparer Pressures

Initial disclosures by SEC registrants are leading indicators of how the ASU is likely to impact all affected entities, and these disclosures are carefully scrutinized by interested parties. Preparers face pressures from not only the expectations of stakeholders and SAB 74’s guidance, but also from the inherent peer pressure that develops as the disclosure process evolves. SEC representatives have been actively making comments, pointing out the SAB 74 requirements and noting that the ASU’s significance will likely evoke significant disclosures and that registrants may need to comment on the implications for their internal financial reporting controls.

At a September 22, 2017, meeting of the Emerging Issues Task Force (EITF), it was stressed that “a registrant should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed.” Entities of course seek to comply with SAB 74, but one would also expect a natural hesitancy to disclose more than is necessary, especially at first. The implication is that entities which disclose more judge that doing so is necessary; if a material situation is thought to be evolving, then management would make some form of disclosure about it in this initial filing under SAB 74’s requirements.

Peer pressure and the recurring nature of SAB 74 disclosures will contract the time available for management to substantially complete the implementation analysis, and such pressure will persist for all SEC reporting going forward from the 2016 Form 10-Ks. If an entity decides to adopt early in 2019, its management will need to disclose this intent in its 2018 Form 10-K, and possibly even earlier in its 2017 Form 10-K. If this occurs, other entities will likely be queried by interested parties about the potential magnitude of their forthcoming implementation. Even if entities choose not to adopt until required, SAB 74 disclosures discussing the forthcoming adoption’s consequences will need to be made in the 2019 Form 10-K. Thus, management has to be prepared to discuss the impact of the ASU prior to adoption.

Research Methodology

The authors reviewed 2016 Form 10-K disclosures for 15 of the largest and 15 of the smallest domestic SEC regis-trants in the financial services industry, selected from iBanknet Financial Reports Center’s ranking of the 100 largest entities. Exhibit 3 lists the 30 entities included in the sample. In compliance with SAB 74, all of the selected Form 10-Ks included comments regarding the pending ASU; however, there was fairly wide diversity in terms of disclosure content and trends.

Exhibit 3

Entities Included in Sample

Largest Entities; Smallest Entities JP Morgan Chase; Bank of the Ozarks Bank of America; Fulton Financial Wells Fargo; Chemical Financial Citigroup; Western Alliance Goldman Sachs Group; Bank of Hawaii Morgan Stanley; Washington Federal US Bancorp; Old National PNC Financial; BancorpSouth Capital One; Astoria Financial Bank of NY Mellon; Cathay General State Street; United Bankshares Charles Schwab; Sterling Bancorp BB&T; Flagstar Bancorp SunTrust; Trustmark Ally Financial; TFS Financial Corporation

Disclosure Content

The uncertainties of establishing CECL at a particular point in time would seem to give little incentive for management to adopt early. Not surprisingly, of the 30 entities sampled, no entity disclosed an intent to adopt early, while three (Wells Fargo, Fulton Financial, and Trustmark) specifically indicated that they would adopt in 2020, and one (Sterling Bancorp) commented that it “has not yet concluded whether it will early adopt.” Hence, the general trend is not to adopt early.

The review of disclosures revealed that entities are exerting significant compliance effort. In 14 instances, management disclosed that cross-functional steering committees had been formed and models were being reviewed. BancorpSouth pointed out that its effort was designed “to ensure an easy transition” and that “management feels prepared to move forward with the current documentation to provide the necessary information for the new methods.” One could infer from such comments that management is well along in the process. Sterling Bancorp stated that it “has engaged a nationally recognized accounting firm to advise and assist management in performing an implementation readiness assessment.” Obviously, this management team takes the effort seriously and feels that it needs outside expertise and resources. State Street stated bluntly: “We expect a significant effort to develop new or modified credit loss models and that the timing of the recognition of credit losses will accelerate under the new standard.” Exhibit 4 contains additional excerpted disclosure comments.

Exhibit 4

Excerpted Disclosure Comments Regarding Effort

▪ “Management created a formal working group to govern the implementation of these amendments consisting of key stakeholders from finance, risk, and accounting.” (Ally Financial) ▪ “The Company has begun its implementation efforts by establishing a Company-wide implementation team. This team has assigned roles and responsibilities, key tasks to complete, and a general timeline to be followed. The implementation team meets periodically to discuss the latest developments and ensure progress is being made.” (Bank of Hawaii) ▪ “We have formed a cross-functional committee that is assessing our data and system needs and evaluating the impact of adopting the new guidance.” (Old National) ▪ “The Company has designated a management team to evaluate ASU 2016-13 and develop an implementation strategy.” (Cathay General) ▪ “We have established an internal steering committee to lead the implementation efforts. The steering committee is in the process of evaluating control and process framework, data, model, and resource requirements and areas where modifications will be required.” (Flagstar Bancorp) ▪ “Trustmark has established a steering committee which includes the appropriate members of Management to evaluate the impact this ASU will have.” (Trustmark)

The uncertainties of establishing CECL at a particular point in time would seem to give little incentive for management to adopt early.

One cannot infer, however, that those entities which made no mention of such efforts do not have a process in place or at least an implementation plan outlined. All 30 entities’ disclosures concluded with the equivalent of, “the implications of the ASU are being evaluated.” In no instance did an entity state that its current processes and procedures were inadequate to address the new guidance.

Another discussion point within the disclosures regarded the expected materiality of the ASU’s impact. This was only the first round of disclosures and, as discussed above, management would be very selective in choosing its wording regarding materiality, since silence is often the chosen preference. Furthermore, there would be a natural reluctance to avoid disclosing too much too soon. Therefore, it is noteworthy that nine entities already chose to make some form of commentary that the ASU is likely going to be a “material” matter. Wells Fargo’s disclosure noted “an anticipated material impact from longer duration portfolios,” which highlights the subtlety of CECL calculations in certain situations. See Exhibit 5 for other comments.

Exhibit 5

Excerpted Disclosure Comments Regarding Financial Statement Impact

▪ “We expect the Update will result in an increase in the allowance for credit losses given the change to estimated losses over the contractual life adjusted for expected prepayments with an anticipated material impact from longer duration portfolios, as well as the addition of an allowance for debt securities.” (Wells Fargo) ▪ “The CECL model may result in material changes to the Company's accounting for financial instruments.” (Citigroup) ▪ “The implementation of this guidance may result in material changes in our accounting for credit losses on financial instruments.” (Capital One) ▪ “Upon adoption, the Company expects that the ACL will likely be materially higher.” (BB&T) ▪ “The new accounting model for credit losses represents a significant departure from existing GAAP, and will likely materially increase the allowance for credit losses with a resulting negative adjustment to retained earnings.” (Ally Financial) ▪ “We expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance.” (Astoria Financial) ▪ “ASU 2016-13 will significantly change the accounting for credit impairment.” (Sterling Bancorp) ▪ “May require us to increase our allowance for loan losses, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for loan losses. Any increase in our allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on our financial condition and results of operations.” (TFS Financial Corporation)

If disclosed in the financial statements, the disclosure of what is essentially forward-looking information is subject to audit testing.

As one would expect at this early juncture, none of the disclosures indicated any expected range of adjustment; however, the degree of disclosure already observed reinforces the idea that management has less time than one might expect to formulate its thinking and judgment regarding the impact of ASU 2016-13.

Disclosure Trends

SEC registrants file their annual reports within a lengthy Form 10-K and are required to make disclosures in either the forepart sections, such as the management discussion and analysis (MD&A) section, or in the financial statements themselves. Other preparers are only required to present the information within the financial statements as required by GAAP. The authors’ analysis of current disclosure practice reveals a trend to disclose the consequences of ASU 2016-13 within the financial statements. The SEC’s Interpretive Response within SAB 74 begins with a discussion of MD&A guidance and concludes that “disclosure of impending accounting changes … should be disclosed in accordance with the existing MD&A requirements.” The auditor’s relationship with such a disclosure in the MD&A would only be one of affiliation with the requirement to “read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements” [Auditing Standard (AS) 2710.04].

The SEC also states, however, that “the staff believes that recently issued accounting standards may constitute material matters, and, therefore, disclosure in the financial statements should also be considered.” If disclosed in the financial statements, the disclosure of what is essentially forward-looking information is subject to audit testing. In AS 1301.13.f, the PCAOB specifically identifies new accounting pronouncements that are not yet in effect as a situation to be communicated with the audit committee if the auditor’s procedures identified a concern regarding management’s anticipated adoption and the new pronouncement might have a significant effect on future financial reporting. If the SAB 74 disclosures are not in the MD&A (where the reader would first expect them to be located), a cross-reference should be included redirecting the reader to their presentation in a different location within the notes to the financial statements. Preferably, there should be a separate header within the MD&A, similar to “Recent Accounting Pronouncements,” containing the redirection.

A substantial majority of the entities reviewed (24 our of 30) presented the disclosure in a note to the financial statements; the authors observed such disclosure for 10 of the 15 largest entities and for 14 of the 15 smaller entities. Of those 24 entities using note disclosure, 14 had a specific direct cross-reference from the MD&A and 12 used a specific header such as “Recent Accounting Pronouncements.” Two entities (BancorpSouth and Astoria Financial) presented the information in both the MD&A and a note, so a cross-reference would not be expected. One entity (Cathay General) split the discussion of “Recent Accounting Pronouncements” between the MD&A and a note and included a cross-reference. Furthermore, seven entities (US Bancorp, Capital One, Bank of the Ozarks, Fulton Financial, Washington Federal, TFS Financial, and Astoria Financial) had comments about the ASU in the early part of the Form 10-K that discusses “Risk Factors.” In fact, Astoria Financial discussed the ASU’s potential impact in three locations: under “Risk Factors” in the early part of the Form 10-K, where mention was made that the ASU “could require us to significantly increase our allowance,” which “could adversely affect our business,” and in the MD&A and notes, where comparable wording about a possible increase in the allowance was not included. Similarly, Washington Federal and TFS Financial respectively commented in “Risk Factors” that the ASU “could have a material impact” and “may have a material adverse effect,” but neither entity included such wording in the note discussing “New Accounting Pronouncements.” Finally, while there is always an underlying presumption that efforts to change accounting standards represent an improvement, it is noteworthy that more than half of the sampled entities (16 out of 30) highlighted exposure to “changes in accounting standards” when discussing the cautionary “Risk Factors” for investors to consider.

Although it is difficult for entities to project future losses based on contractual values of loans, the new model requires such estimates.

Note disclosures were most often presented within an early note discussing “accounting policies,” but in two instances (Sterling Bancorp and TFS Financial Corporation) they were presented separately as nearly the last note. Similarly, in six instances (Bank of NY Mellon, BancorpSouth, Astoria Financial, Bank of the Ozarks, Bank of Hawaii, and Cathay General) the disclosure discussion or the cross-reference to a note was in the MD&A but located separately from “Critical Accounting Policies.” The Big Four were the auditors in 26 of the 30 Form 10-Ks reviewed, but there did not appear to be any auditor-related pattern to the format, wording, or location of the disclosures.

A Major Undertaking

ASU 2016-13 represents a fundamental change in the credit loss accounting model, from the incurred loss model to an expected loss model. Although it is difficult for entities to project future losses based on contractual values of loans, the new model requires such estimates. The authors’ analysis reveals a concern that the materiality of this change may lead to risks in the adequacy of the allowance and appropriate disclosures. For current disclosures, there is fairly wide diversity in terms of disclosure content and location. Disclosures indicate that implementation of ASU 2016-13 is anticipated to be a major undertaking with material implications. While most entities do not plan to adopt early, they must be prepared to discuss the expected impact between now and when ASU 2016-13 becomes effective. The forthcoming next round of disclosures will likely increase the amount of detail provided as entities refine their implementation plans.

Ariana Pinello, PhD, CPA, CIA is an associate professor of accounting at the Lutgert College of Business, Florida Gulf Coast University, Fort Myers, Fla.
Ernest Lee Puschaver, CPA is a retired partner of PricewaterhouseCoopers who lives in Estero, Fla.