In Brief

In the wake of the Great Recession, FASB spent years deliberating new guidance intended to provide users with more useful information on the expected credit losses on financial instruments, the sudden recognition of which was deemed to be a contributor to the crisis. The result, ASU 2016-13—codified as ASC 326—went into effect in 2020. This article takes this opportunity to look at the past three years of reporting, examine the trends in loss recognition, and asks whether the guidance has met the goals of standards setters.

As a result of the Great Recession and the lending crisis suffered by many financial institutions in 2008, FASB took on a project to improve accounting guidance in this area. In 2016, FASB issued Accounting Standards Update (ASU) 2016-13, Financial Instruments–Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (codified as ASC 326). Under the previous guidance, financial institutions were required to determine the amount of credit losses recognized on the income statement from an “incurred loss” approach, whereby information from past events and current conditions were used to estimate losses that had already occurred. Under ASC 326, an “expected loss” approach is required whereby financial institutions must estimate and record future losses when the asset is purchased or originated and in subsequent reporting periods. This is referred to as “current expected credit losses” (CECL).

The purpose of financial statements is to provide useful information to decision makers. For some financial statement line items, recognizing an estimated amount based on future expectations is more useful than recognizing only the actual cost incurred. The objective of ASC 326 is to “provide financial statement users with more decision-useful information about the expected credit losses on financial instruments.” To achieve this end, companies must now estimate expected credit losses in the current period instead of recognizing losses when it is deemed probable that they are no longer collectible.

Background

ASC 326 was established as a result of the 2008 financial crisis and the Great Recession that began in December 2007 and ended in June 2009. The financial crisis was a result of the bursting of the U.S. housing bubble and collapse of the subprime mortgage market. However, its roots stretch further back. In response to the bursting of the “dot.com” bubble from March 2000 to October 2002, the September 11, 2001, attacks, and the economic slowdown that followed, the Federal Reserve reduced the federal funds rate down to only 1% by June 2003. The intention was to provide cheap credit to consumers and businesses to spur the economy. One such result was that home mortgages became available at historically low interest rates. Attracted by low mortgage rates and lax lending standards, even subprime borrowers with limited or poor credit histories were able to acquire loans from banks and subprime lenders. With the expanded availability of mortgages, the demand for homes increased, as did their prices.

However, some mortgages were often intentionally structured with initially low interest rates to lure prospective borrowers into mortgages. Then, after the “teaser rate” expired, the rate on the mortgage reset to a higher subprime rate or increased due to the general increases in interest rates as the Federal Reserve gradually raised the Federal Funds rate to above 5% in 2006 and 2007. Homeowners with “teaser rate” mortgages or adjustable-rate mortgages soon found their mortgage payments growing in excess of what they could afford to pay.

Fannie Mae and Freddie Mac both played a role in, and were impacted by, the 2008 financial crisis. Fannie Mae was created by Congress in 1938, restructured as a public-private hybrid entity in 1954, and privatized in 1968. Freddie Mac was created by Congress in 1970 and privatized into a publicly held company in 1989. The mission of both Fannie Mae and Freddie Mac is to increase home ownership, which is facilitated by purchasing mortgages from mortgage lenders, thereby providing mortgage lenders with the liquidity to offer additional mortgages. Both entities then packaged the mortgages into securities that were sold to investors. Prior to 2008, Fannie Mae and Freddie Mac were criticized for facilitating the issuance of subprime mortgages to borrowers who ultimately could not afford the mortgage payments. The large number of mortgages purchased by Fannie Mae and Freddie Mac might have been consistent with its mission, but it helped fuel the growth of mortgages, some of which should not have been issued in the first place. This boosted the demand for houses, which contributed to the U.S. housing price bubble that occurred from 2005 through 2007. By September 2008, Fannie Mae and Freddie Mac had suffered such severe losses on their portfolios of subprime and nonperforming mortgages that the federal government placed both entities into Federal Housing Finance Agency (FHFA) conservatorship. The intent was that under FHFA supervision, both entities would continue their mission of providing liquidity to the mortgage market and be restored to a financially stable condition.

Meanwhile, U.S. home ownership peaked at 69.2% in 2004. Two years later, home prices began to fall. The prices of homes soon fell to the point where the market value of many homes was less than the amount of the mortgage obligation still owed on the homes. Therefore, if homeowners attempted to sell their homes to pay off the mortgages they no longer could afford, they would find that that the sale proceeds were less than the mortgages, and they would still end up owing thousands of dollars to the mortgage lender. So, many homeowners simply abandoned their homes and let the owners of the mortgages foreclose on the housing units. The cash mortgage payments on the mortgages or foreclosed homes stopped and the owners of the repossessed homes could only resell them at less than the balance on the mortgage, thus experiencing a loss. The holders of these mortgaged-backed securities stopped receiving payments from nonperforming mortgages and that could only be sold at a loss. The combined effect was that the prices of mortgage-backed securities dropped precipitously. The losses experienced by investors in mortgage-backed securities further exacerbated the 2008 financial crisis and the resulting recession. Homeownership then shrank to only 67.5% during 2008 and eventually fell to a low of 63.7% in 2016.

Between the recession and collapse of the housing market, the effect on the financial institutions was enormous. In March 2008, investment banking giant Bear Stearns collapsed due to its investments in subprime mortgages; its assets were acquired by JPMorgan Chase at a discounted price. Several months later, the largest bankruptcy in U.S. history occurred when Lehman Brothers filed for bankruptcy.

Because of the crisis and recession, banks and financial institutions had to recognize losses on substantial amounts of loans during this time period. Exhibit 1 shows the amounts reported in a separate line item on the income statement as “provision for credit losses” (PCL) for ten of the largest banks in the U.S. beginning in 2007, the year before the crisis, and the next three years, 2008 through 2010, encompassing the Great Recession and the following year. These were ten of the largest financial institutions based on asset size per the Federal Deposit Insurance Company (FDIC) in 2020, and all reported PCL as a separate line on the income statement. The ten entities also use a December 31 fiscal year-end and thus all adopted ASC 326 in the first quarter of 2020.

Exhibit 1

Amount Reported as Provision for Credit Losses (PCL), 2007–2010&

2007; 2008; 2009; 2010 Citigroup; $17,917; $34,714; $40,262; $26,042 Bank of America; 8,385; 26,825; 48,570; 28,438 JPMorgan Chase; 6,864; 20,979; 32,015; 16,639 Wells Fargo; 4,939; 15,979; 21,668; 15,753 Capital One; 2,636; 5,101; 4,230; 3,907 Fifth Third Bancorp; 628; 4,560; 3,543; 1,538 US Bancorp; 792; 3,096; 5,557; 4,356 State Street Bank & Tr.; 0; 0; 149; 25 PNC Financial Corp.; 315; 1,517; 3,930; 2,502 Bank of NY Mellon; (11); 104; 332; 11 &All dollar amounts in millions; obtained from financial institutions' annual report or 10-K.

The extraordinary increase in PCL for nine of the ten financial institutions between 2007 and 2008 is readily apparent. State Street Bank & Trust, however, reported zero PCL for both years. PCL for Citigroup and Capital One nearly doubled between 2007 and 2008. For the remaining seven, the increase was more than twice the 2007 amount and in some cases was four to five times the 2007 reported amount. For eight of the ten companies, including State Street Bank & Trust, the PCL amount increased from 2008 to 2009; only Fifth Third Bancorp and Capital One reported lower amounts in 2009. In 2010, after the end of the Great Recession, the remaining eight all reported a lower PCL than the previous year.

The accounting guidance in place at that time (pre-2020) required an “incurred loss” methodology for reporting credit losses. For the financial institutions, the losses were recognized when it was probable that specific mortgages were impaired and most likely uncollectible.

ASC 326

In 2008, FASB and the International Accounting Standards Board (IASB) created the Financial Crisis Advisory Group (FCAG). Its goal was to provide advice on ways to improve the reporting of PCL. The FCAG identified a weakness in GAAP at the time of the crisis due to the delayed recognition of PCL, which also resulted in the overstatement of assets. The recommendation of the FCAG was development of a more forward-looking method, as opposed to the “incurred loss” methodology being used during the financial crisis.

In 2016, FASB issued ASU 2016-13, enacting ASC 326. The new standard went into effect for fiscal years beginning after December 15, 2019. With this effective date, 2020 was the first full year when the updated accounting standard was applied. Because most financial institutions use a calendar year-end, three years of reported amounts, 2020, 2021, and 2022, are available to evaluate the effect the standard has had on accounting for PCL.

Exhibit 2 presents the same ten large companies’ PCL for the six-year period of 2013 through 2018. The losses reported by the ten large financial institutions for the most part stabilized from 2013 through 2018. A review of the amounts shows relatively low volatility of PCL reported by each bank.

Exhibit 2

Amount Reported as Provision for Credit Losses (PCL), 2013–2018&

2013; 2014; 2015; 2016; 2017; 2018 Citigroup; $8,514; $7,467; $7,913; $6,982; $7,451; $7,568 Bank of America; 3,556; 2,275; 3,161; 3,597; 3,396; 3,282 JPMorgan Chase; 225; 3,139; 3,827; 5,361; 5,290; 4,871 Wells Fargo; 2,309; 1,395; 2,442; 3,770; 2,528; 1,744 Capital One; 3,453; 3,541; 4,536; 6,459; 7,551; 5,856 Fifth Third Bancorp; 229; 315; 396; 343; 261; 237 US Bancorp; 1,340; 1,229; 1,132; 1,324; 1,390; 1,379 State Str. Bank & Tr.; 6; 10; 12; 10; 2; 15 PNC Financial Corp.; 643; 273; 255; 433; 441; 408 Bank of NY Mellon; (35); (48); 160; (11); (24); (11) &All dollar amounts in millions; obtained from financial institutions' annual report or 10-K.

ASC 326 became effective for SEC filers for fiscal years beginning after December 15, 2019; therefore, banks with calendar year-ends were required to report PCL under the new standard beginning with the 2020 calendar year. Exhibit 3 presents PCL of the ten banks for the two years prior to ASC 326 becoming effective (2018 and 2019) and the first year it was required (2020).

Exhibit 3

Amount Reported as Provision for Credit Losses (PCL), 2018–2020 (ASC 326 First Required in 2020)&

2018; 2019; 2020 Citigroup; $7,568; $8,218; $15,922 Bank of America; 3,282; 3,590; 11,320 JPMorgan Chase; 4,871; 5,585; 17,480 Wells Fargo; 1,744; 2,687; 14,129 Capital One; 5,856; 6,236; 10,264 Fifth Third Bancorp; 237; 471; 1,097 US Bancorp; 1,379; 1,504; 3,806 State Str. Bank & Tr.; 15; 10; 88 PNC Financial Corp.; 408; 773; 3,175 Bank of NY Mellon; (11); (25); 336 &All dollar amounts in millions; obtained from financial institutions' annual report or 10-K.

The amount reported for PCL by all ten financial institutions increased substantially from 2019, when the “incurred losses” method was employed, to 2020, the first year the “expected losses” method was required. For the two years leading up to ASC 326, there are no large variations or changes in PCL among the ten financial institutions. Fifth Third Bank did almost double the amount of its PCL from 2018 to 2019. PNC Financial Corporation also increased its PCL by almost 100% between the two years. Other than these two, which were two of the three smallest amounts reported among the companies, the changes for the other institutions from 2018 to 2019 do not appear to be out of the ordinary.

With ASC 326 in place and banks using a new method for recognizing PCL, a user of the financial information would anticipate the 2020 amounts to be a reasonable estimate of the loan losses. Because 2020 was the first year of estimating the amount of PCL, there may have been a learning curve for preparers. In addition, the U.S. economy was at the start of the COVID-19 pandemic, which could account for the large increase in PCL in 2020. For an analysis of the challenges the pandemic-created economic crisis caused financial institutions implementing ASC 326, see Pinello and Puschaver, “Implementing CECL During the Pandemic: Unexpected Consequences Revealed,” The CPA Journal, March 2022.

For all ten of the financial institutions, the amount reported for PCL in the second year ASC 326 was in place (2021), a negative expense or gain on PCL was reported. Exhibit 4 presents the PCL amounts reported for the first year of implementation (2020), and the next two years after (2021 and 2022).

Exhibit 4

Amount Reported as Provision for Credit Losses (PCL) 2020–2022 (First Three Years ASC 326 Required)&

2020–2021; 2021–2022 2020; 2021; 2022; $ Change; % Change; $ Change; % Change Citigroup; $15,922; $(3,103); $4,745; 19,025; 119.5; 7,848; 252.9 Bank of America; 11,320; (4,594); 2,543; 15,914; 140.6; 7,137; 155.4 JPMorgan Chase; 17,480; (9,256); 6,389; 26,736; 153.0; 15,645; 169.0 Wells Fargo; 14,129; (4,155); 1,534; 18,284; 129.4; 5,689; 136.9 Capital One; 10,264; (1,944); 5,847; 12,208; 118.9; 7,791; 400.8 Fifth Third Bancorp; 1,097; (377); 563; 1,474; 134.4; 940; 249.3 US Bancorp; 3,806; (1,173); 1,977; 4,979; 130.8; 3,150; 268.5 State Str. Bank & Tr.; 88; (33); 20; 121; 137.5; 53; 160.6 PNC Financial Corp.; 3,175; (779); 477; 3,954; 124.5; 1,256; 161.2 Bank of NY Mellon; 336; (231); 39; 567; 168.8; 270; 116.9 &All dollar amounts in millions; obtained from financial institutions' annual report or 10-K.

The largest change was at JPMorgan Chase, which reported a PCL of $17.5 billion in 2020 and a PCL gain or negative expense of $9.3 billion in 2021, representing a difference of $26.8 billion and a 153% decrease. Because all companies’ PCLs decreased from a reported expense in 2020 to a negative expense or gain in 2021, in each case the percentage decrease was more than 100%. A review of the financial statement notes provides some explanation. Wells Fargo explained the decrease as “better credit quality and continued improvements in current and forecasted conditions.” JPMorgan Chase perhaps described the decrease best: “Determining the appropriateness of the allowance for credit losses is complex and requires significant judgment by management about the effect of matters that are inherently uncertain.” The big change from the large PCLs of 2020 to the PCL gains of 2021 may partially be explained by the change in economic conditions. In 2020, the economy was feeling the full effects of the COVID-19 pandemic; in 2021, it was starting to recover. In any case, companies are still determining how best to apply ASC 326, especially in turbulent economic times.

All of the companies analyzed returned to a loss in 2022 from the gain in 2021. Again, JPMorgan Chase had the largest change in dollar amounts between 2021 and 2022 of $15.6 billion. The largest percentage change was reported by Capital One, which went from a $1.944 billion gain in 2021 to a $5.847 billion loss in 2022, or a 400.8% change.

Although Exhibit 4 presents annual amounts, companies were required to estimate credit losses under the new standard beginning with the first quarter in 2020. In addition, a cumulative effect adjustment to retained earnings and the loan loss reserve account was required for the period leading up to the first quarter of 2020. For example, Citigroup had a $3.08 billion cumulative adjustment to decrease its 2020 beginning retained earnings, while JPMorgan Chase and Bank of America had adjustments of $2.65 and $2.41 billion respectively.

Exhibit 5 presents the amounts reported by the ten financial institutions for each of the four quarters of 2020, 2021, and 2022 along with the total for each year. A look at the first two quarters of 2020 shows that, for most of the companies, the PCL for the year was recognized during these two periods. The first quarter of 2020 marked the start of the pandemic, which added to the uncertainty of the economy and carried over into the second quarter. By the third quarter, all but one of the banks, Fifth Third Bancorp, were still reporting additional PCL. By the fourth quarter of 2020, however, more than half of the companies were decreasing their PCL for the year by reporting a “benefit” or “recapture” from the reversal of the PCL such that it acted as a gain on the income statement.

Exhibit 5

Quarterly and Total Amount Reported as Provision for Credit Losses (PCL), 2020–2022 (First Three Years ASC 326 Required)&

2020 Q1; Q2; Q3; Q4; TOTAL Citigroup; $6,960; $7,990; $1,931; $ (959); $15,922 Bank of America; 4,761; 5,117; 1,389; 53; 11,320 JPMorgan Chase; 8,285; 10,473; 611; (1,889); 17,480 Wells Fargo; 4,005; 9,534; 769; (179); 14,129 Capital One; 5,423; 4,246; 331; 264; 10,264 Fifth Third Bancorp; 640; 485; (15); (13); 1,097 US Bancorp; 993; 1,737; 635; 441; 3,806 State St. Bank and Tr.; 36; 52; 2; (2); 88 PNC Financial Corp.; 914; 2,463; 52; (254); 3,175 Bank of NY Mellon; 169; 143; 9; 15; 336 2021 Q1; Q2; Q3; Q4; TOTAL Citigroup; $ (2,055); $(1,126); $ (188); $ 266; $ (3,103) Bank of America; (1,860); (1,621); (624); (489); (4,594) JPMorgan Chase; (4,156); (2,285); (1,527); (1,288); (9,256) Wells Fargo; (1,048); (1,260); (1,395); (452); (4,155) Capital One; (823); (1,160); (342); 381; (1,944) Fifth Third Bancorp; (173); (115); (42); (47); (377) US Bancorp; (827); (170); (163); (13); (1,173) State St. Bank and Tr.; (9); (15); 0; (9); (33) PNC Financial Corp.; (551); 302; (203); (327); (779) Bank of NY Mellon; (83); (86); (45); (17); (231) 2022 Q1; Q2; Q3; Q4; TOTAL Citigroup; $ 755; $1,274; $1,365; $ 1,351; $4,745 Bank of America; 30; 523; 898; 1,092; 2,543 JPMorgan Chase; 1,463; 1,101; 1,537; 2,288; 6,389 Wells Fargo; (787); 580; 784; 957; 1,534 Capital One; 677; 1,085; 1,669; 2,416; 5,847 Fifth Third Bancorp; 45; 179; 158; 181; 563 US Bancorp; 112; 311; 362; 1,192; 1,977 State St. Bank and Tr.; 0; 10; 0; 10; 20 PNC Financial Corp.; (208); 36; 241; 408; 477 Bank of NY Mellon; 2; 47; (30); 20; 39 &All dollar amounts in millions; obtained from financial institutions' annual report, quarterly report, 10-Q, or 10-K.

In the first quarter of 2021, all ten of the companies reported a PCL gain. By this time, the effects of the pandemic were beginning to recede. All ten companies reported a PCL gain for the full year, whereas six of the ten reported a gain in all four quarters of 2021. In 2022, the amounts reported finally returned to what might be considered normal. All ten banks reported a loss for the year; in the quarterly results, only three of the ten reported a gain in one of the quarters. Finally, for all ten entities, the amount reported for PCL in 2022 was substantially less that the amount reported in the first year the new standard was required (2020); for example, Citigroup reported $15.9 billion in 2020 and only $4.7 billion in 2022.

Recalibrating Expectations?

Under ASC 326, which became effective in 2020, financial institutions are required to use an “expected loss” approach when estimating PCL. The results discussed here show a large reversal in the amount of PCL reported in the second year after the standard went into effect, causing all ten large banks to report a PCL gain. The volatility of PCL has raised concerns in the financial community as to the usefulness of the information provided. The Wall Street Journal reported on the reaction to banks reporting gains in 2021 from reversals of 2020 PCL (“How a New Accounting Rule Is Making Bank Earnings Go Wild,” June 3, 2022). In 2022, the reported PCL amounts were all losses, and the amounts substantially less than 2020.

The primary goal of financial reporting is to provide useful information to users and decision makers. The large increase in PCL during the first two quarters of 2020 when ASC 326 went into effect is not completely unexpected, because the amounts reported were based on “expected losses” projected into the future, as opposed to the previous method of “incurred losses” only during the current year. What might not have been expected, however, was that all ten of the financial institutions reported a “gain” on PCL in the second year after the standard was in place. In the third year, all ten entities reported a loss. An expectation of financial reporting by banks in future years is that this provision will be reported as a loss in most years and not a gain on the income statement, and the amount would be less volatile across reporting periods.

Mark McCarthy, PhD, CPA is a professor in the College of Business, East Carolina University, Greenville, N.C.
Douglas K. Schneider, PhD, CPA is the Edwin B. Jones Family Distinguished Professor in the College of Business, East Carolina University, Greenville, N.C.