CECL for Commercial Entities

Transcription

1 CECL for Commercial Entities St. Louis, MO April 12, 2018

2 With You Today: Anthony Burzinski Managing Director Accounting Advisory Services KPMG LLP Alan Kuska Director Accounting Advisory Services KPMG LLP 2

3 CECL Overview

4 Scope Not just loans! In scope Trade receivables Contract assets arising from revenue transactions Net investment in leases recognized by a lessor Debt securities classified as held-to-maturity Loans receivable Loan commitments Financial guarantee contracts Out of scope Debt securities classified as available-for-sale* Loans and receivables between entities under common control Equity investments All financial instruments measured at fair value through net income * Not within the scope of CECL, however ASC 326 makes targeted changes to impairment accounting for AFS debt securities 4

5 ASC 326 effective dates SEC filers Public business entities: Fiscal years beginning after December 15, 2019 Non-SEC filers Public business entities: Fiscal years beginning after December 15, 2020 (including interim periods within those fiscal years) All other entities: Fiscal years beginning after December 15, 2020 (and interim periods thereafter) Early adoption Fiscal years beginning after December 15,

6 CECL primary areas of change 1 Lifetime loss estimate 2 No probable loss recognition threshold 3 Allowance reduces the amortized cost to amounts expected to be collected 4 Additional Need to consider complexity future for economic prepayable conditions loans and reasonable and supportable forecast period 5 Applies to HTM debt securities 6 New credit impairment process and considerations for AFS securities 6

7 Measuring Current Expected Credit Losses Historical loss experience adjusted for differences in loan attributes Adjustments for current economic conditions Reasonable and supportable forecasts Estimate of current expected credit losses 7

8 CECL measurement considerations Pool assets with similar risk characteristics Do not consider credit losses beyond the stated contractual term Consider expected prepayments Not required to recognize loss when risk of nonpayment of the amortized cost is zero Incorporate reasonable and supportable forecast. Revert to historical loss information beyond forecast period 8

9 Reasonable and supportable forecast and reversion Reasonable and supportable forecasts Apply as a judgment, not a policy election Apply a process consistently and ensure that it is well-documented Assess ability to make or obtain forecasts of future economic conditions Determine the appropriate source for the economic data Consider whether length and support differ by economic assumption Consider other economic forecasts prepared/used Reevaluate the length of the forecast period Reversion Reversion method is an assumption that must be supported Assumptions can change - Need to have a reasonable basis for a change in the assumption - Needs to be supported - Evaluated similar to other changes in allowance methodology Must be representative of the best estimate of expected credit losses 9

10 Comparison to existing reserving practices Projection Horizon Macroeconomic Factors Current Reserving (Incurred loss) Loss emergence period (LEP) (often 1 2 years for long-term assets) Current conditions not forward looking CECL Contractual life of receivable Reasonable and supportable forecasts Aggregation Pool or loan level Pooling required where risk characteristics are similar Qualitative factors Allowed Required for any in-scope factors not incorporated quantitatively Discounting Not commonly used Optional Multiple economic scenarios Losses on unfunded Commitments No Yes, through LEP Optional Yes, through lifetime, except for unconditionally cancellable commitments 10

11 Loan commitments and financial guarantees Loan commitments Funded portion allowance for expected credit losses Unfunded portion expected credit losses recognized as liability if not unconditionally cancelable. Guarantees Liability at fair value on recognition like today Separate liability for expected credit losses 11

12 Held-to-Maturity Securities Current U.S. GAAP Other-than-temporary impairment Credit losses reduce amortized cost basis Prospectively adjust accretable yield if expectations of cash flows improve significantly subsequent to impairment recognition Generally measures HTM debt securities on an individual asset basis using a discounted cash flow methodology New standard Lifetime expected credit losses no recognition threshold Credit losses recognized using an allowance approach Recognize subsequent changes in expected credit losses (favorable and unfavorable) immediately in earnings by adjusting the allowance Does not prescribe a specific modeling methodology Requires collective assessment for financial assets with similar risk characteristics (i.e., pooling) 12

13 Available-for-Sale Securities ASC makes targeted changes to the other-than-temporary impairment (OTTI) model Current U.S. GAAP When determining whether a credit loss exists, an entity is allowed to consider among other factors: 1) The length of time during which the fair value has been less than the amortized cost basis; 2) The historical and implied volatility of the fair value; 3) Changes in fair value after the balance sheet date. Credit losses recognized through a direct write down of the amortized cost basis Credit losses can exceed total unrealized losses Improvements in credit loss forecasts are recognized prospectively and accreted into interest income New standard When determining whether a credit loss exists, an entity is NOT allowed to consider: 1) The length of time during which the fair value has been less than the amortized cost basis; 2) The historical and implied volatility of the fair value; 3) Changes in fair value after the balance sheet date. Credit losses recognized through an allowance account Credit losses limited to the difference between the amortized cost basis and fair value of a debt security ( floor concept ) Recognize reversals of credit losses immediately, including reversals due to fair value increases 13

14 AFS Securities: Impairment identification Is the fair value of the debt security less than its amortized cost basis? No The debt security is not impaired. No allowance is recognized. Yes Does the entity intend to sell the security, or more likely than not will be required to sell the security before recovery of the amortized cost basis? Yes Write-off previously recognized allowance for credit losses, if any, and write down the security s amortized cost basis to its fair value through earnings. No Is the decline in fair value below the amortized cost basis a result of credit losses? No Record through other comprehensive income (OCI), net of applicable taxes. Yes Record the credit related impairment through an allowance for credit losses limited to the amount that fair value is less than the amortized cost basis. 14

15 Example: AFS Impairment The following three scenarios show the amount of credit losses that would be recognized based on different fair values at the date of measurement: Facts Scenario 1 Scenario 2 Scenario 3 Amortized cost $100 $100 $100 Fair value Credit loss amount Allowance amount (using floor)

16 Disclosures Rollforward of the allowance for expected credit losses for financial assets measured at amortized cost and FV-OCI A discussion of the type of collateral and extent to which collateral secures an entity s financial assets Qualitative disclosures about how an entity estimates expected losses, including changes in credit loss expectations Current credit quality indicators that are disclosed under current GAAP would be disaggregated by year of origination (vintage disclosures) Reconciliation between the purchase price and the par value of PCD financial assets at the time of purchase AFS debt securities Retain current disclosure requirements, updated for the general principles regarding disclosing credit risk 16

17 CECL quantitative disclosure requirements Disclosure requirement Credit quality information Portfolio changes Allowance for credit losses Rollforward of the allowance for credit losses Days past due Non-accrual status Description Amortized cost basis within each credit quality indicator Broken down by year of origination, class of financing receivable, and major security type for the five years preceding the current period Amount of significant purchases, sales, or reclassifications of loans held for sale by portfolio segment and major security type Amount of any significant purchases of financial assets during the reporting period Amount of any significant sales of financial assets or reclassification of loans held for sale If a discounted cash flow method is used, creditors are allowed to report the change in PV in two ways: - Entire change in PV as a credit loss expense (or reversal of credit loss expense) - Portion of the change in PV that is due to the passage of time as interest income If the latter method is used, that amount must be disclosed Includes beginning balance, current period provision for loan losses, initial allowance for purchased credit deteriorated assets, write-offs charged against the allowance, recoveries of amounts previously written off, and ending balance For each item, report by portfolio segment and major security type Aging analysis of the amortized cost basis for past-due financial assets Reported by class of financing receivable and major security type Also provide criteria for identifying past-due financial assets Beginning and ending amortized cost basis of financial assets on nonaccrual status; includes: - The amount of interest income recognized during the period on nonaccrual assets - Amortized cost basis of 90 days or more past due assets that are still on accrual status - Amortized cost basis of nonaccrual assets with no related expected credit losses Reported by class of financing receivable and major security type 17

18 Internal control considerations for CECL Entities will likely need to design and implement new internal controls, or modify existing controls, to address risk points resulting from new processes, judgments and data New risk points, or what could go wrongs, may arise from changes to IT systems and reports that provide data inputs used to support new judgments Incremental data elements will need to be subject to processes and controls to evaluate the relevance and reliability (completeness and accuracy) of the information especially if it was not previously collected or it is sourced from systems of record that are outside the financial reporting environment Further alignment of risk, asset servicing, and financial reporting systems, including internal control considerations, will likely be needed New judgments and different analyses will require consideration of the skill level, resource capacity, and training needs of employees who will be responsible for new processes and performing the new or modified controls Processes and related internal controls should be designed and implemented to assess the impact of the application of the new standards SEC registrants may need to consider the effect of changes in internal controls on management s quarterly and annual disclosures and certifications SAB 74 disclosures prior to adoption need to be subject to internal controls, including consideration of the SEC Staff Announcement (September 2016) 18

19 Comments from the SEC Implementation will involve in many cases a fresh look at estimation processes and related policies, procedures, systems and internal controls. Investors expect companies to have internal controls in place to reasonably assure the reliability of the financial information reported by management. Therefore, transition plans for the new standard should include initiatives for identifying and implementing the necessary changes to controls. The new credit loss standard will require significantly more judgments. This highlights the importance of another element of a company s control environment setting the right tone at the top and expectations for appropriate conduct throughout the organization Management should consider whether the existing control environment is adequate to support the formation and enforcement of sound judgments that will be necessary in executing control activities or whether changes are necessary. In applying the accounting standard and meeting the existing guidance, management may need to identify and resolve as part of its application of internal control over financial reporting significant differences in views regarding collectability advanced by various business units and other functions within the company, in determining that management s best estimate is reflected in the financial statements. The new standard represents an improvement over the measurement objective for a best estimate of incurred losses by providing financial statement users with more decision-useful information about expected credit losses. The approach more closely aligns an entity s financial reporting with management s estimate of expected credit losses which, even today, are informed by and incorporated into the entity s underwriting, servicing, and collateral management practices. Wesley R. Bricker, SEC Interim Chief Accountant, 2016/

20 Comparison to IFRS 9

21 Overview: CECL vs IFRS 9 Expected credit loss model CECL Single-measurement model: lifetime expected credit losses are estimated for all originated and purchased assets regardless of credit risk. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset Expected credit loss model IFRS 9 (General Approach) Dual-measurement model 12-month expected credit losses Transfer If the credit risk on the financial asset has increased significantly since initial recognition Lifetime expected credit losses Move back if transfer condition above is no longer met Expected credit losses are the present value of expected cash shortfalls. 21

22 Simplified Approach Scope Trade receivables Contract assets arising from transactions in the scope of IFRS 15 Revenue from Contracts with Customers Lease receivables arising from transactions in the scope of IAS 17/IFRS 16 Leases Simplified Approach Single-measurement model: lifetime expected credit losses regardless of credit risk. Optional for lease receivables, and trade receivables or contract assets with a significant financing component Required for trade receivables and contract assets without a significant financing component Estimate must reflect the time value of money by discounting expected losses to the reporting date. Lifetime expected credit losses for all qualifying assets 22

23 CECL vs IFRS 9 (General Approach) Accounting requirement CECL IFRS 9 (General Approach) Effective date Scope Expected credit loss model For fiscal years beginning after December 15, 2019 for public business entities that are Securities and Exchange Commission (SEC) filers and for fiscal years beginning after December 15, 2020 for all other entities. Early adoption is permitted for fiscal years beginning after December Loans, trade receivables, debt securities classified as held-tomaturity (HTM), loan commitments, financial guarantee contracts that are not accounted for as insurance or measured at fair value through net income, receivables that relate to repurchase agreements, securities lending agreements, and a lessor's net investment in leases are all within the scope of CECL. Debt securities classified as available for sale and financial assets measured at fair value through net income are out of scope of CECL. Single-measurement: lifetime expected credit losses are estimated for all originated and purchased assets regardless of credit risk. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset January 1, All financial assets, loan commitments and financial guarantees not measured at Fair Value Through Profit or Loss (FVTPL) are in scope of the IFRS 9 Impairment Model. Dual-measurement model under which the loss allowance is measured as either: 12-month expected credit losses for Stage 1 instruments, being instruments where no significant increase in credit risk has occurred since origination. Lifetime expected credit losses for Stage 2 instruments, being instruments where a significant increase in credit risk has occurred since initial recognition, and for Stage 3 instruments, being instruments where the instrument is credit impaired. Expected credit losses are the present value of expected cash shortfalls. 23

24 CECL vs IFRS 9 (continued) Accounting requirement CECL IFRS 9 (General Approach) Stage transfer criteria Not applicable Stage transfer criteria: Transfer to lifetime expected credit losses when there has been a significant increase in credit risk since initial recognition unless credit risk is low. Transfer back to 12-month expected credit losses when the transfer to stage 2 criteria are no longer satisfied. Effective Interest Rate (EIR) Time value of money Future periods beyond reasonable and supportable forecasts Discounted cash flow method The Effective Interest Rate (EIR) is based on the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term. unless estimated on a pool of homogenous assets. Optional CECL does not require expected credit losses to be discounted for the time value of money, but does require discounting by the EIR when a discounted cash flow method is used. For periods beyond which the entity is able to make or obtain a reasonable and supportable forecast, CECL requires entities to revert to historical credit losses immediately, on a straight-line basis, or using another rational and systematic basis. CECL permits use of a discounted cash flow method, requiring that expected cash flows be discounted at the financial asset s effective interest rate. Where a security s interest rate fluctuates due to changes in an independent variable such as the Prime Rate or LIBOR, the effective interest rate needs to be calculated based on the variable input as it varies over the life of the security. The EIR is based on the contractual cash flows but does not include any future credit losses except for purchased or originated credit impaired assets. IFRS generally requires expected prepayments to be considered when calculating the EIR unless in rare circumstances the cash flows and expected life of the financial instrument cannot be reliably estimated. Mandatory under IFRS 9. For fixed rate assets, expected credit losses are discounted by the asset s original EIR. For floating rate assets, expected credit losses are discounted by the current EIR. For periods beyond which the entity is able to project a reasonable and supportable forecast, IFRS 9 allows extrapolation of projections from available, detailed information. For Stage 1 and Stage 2 assets, expected credit loss is the difference between contractual and expected cash flows discounted at the EIR. For Stage 3 assets, expected credit loss is the difference between the asset's gross carrying amount and the present value of estimated future cash flows. 24

25 CECL vs IFRS 9 (continued) Accounting requirement CECL IFRS 9 (General Approach) Alternative methods/nondiscounted cash flow methods Range of possible outcomes Collective assessment Expected loss amount Renewals and extensions In addition to a discounted cash flow method, CECL refers to other permissible methods such as loss rate methods, roll-rate methods, probability of default methods, or a methods that utilize an ageing schedule. If an entity estimates expected credit losses using a method other than a discounted cash flow method, an entity may develop its estimates by separately measuring the following components of the amortized cost basis, including both of the following: (a) Amortized cost, excluding premiums (included net deferred fees and costs), foreign exchange, and fair value hedge accounting adjustments; (b) Premiums or discounts, included net deferred fees and costs, foreign exchange, and fair value hedge accounting adjustments. CECL does not require expected credit losses to be based on multiple probability-weighted outcomes. An entity is required to do a collective assessment for assets that share similar risk characteristics. An entity is not required to measure expected credit losses on a financial asset (or group of financial assets) in which historical credit loss experience adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. When determining the contractual term of financial assets entities should consider expected prepayments but will exclude expected renewal, extensions and modifications unless a Troubled Debt Restructuring ("TDR") modification is reasonably expected. IFRS 9 does not prescribe a single method to measure expected credit losses, although application of discounting is always required. The methods used to measure expected credit losses may vary based on the type of financial asset and the information available. IFRS 9 requires the expected credit losses to reflect multiple probability weighted outcomes. IFRS does not have a requirement to do a collective assessment for assets that share similar risk characteristics. However, an entity may do a collective assessment. An entity is always required to conduct an estimation of expected credit loss, even when the risk of a credit loss occurring is very low. A significant increase in credit risk should always be monitored under IFRS 9 even if the expected loss is zero in situations where an asset is fully covered by collateral for disclosure purposes. An entity shall estimate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument. 25

26 CECL vs IFRS 9 (continued) Accounting requirement CECL IFRS 9 (General Approach) Unfunded commitments Modifications The period over which unfunded loan commitments are considered for credit losses is the contractual period over which the entity has a present contractual obligation to extend credit unless unconditionally cancellable. Estimate of expected credit losses should consider both the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded. Unconditionally cancellable loan commitments are not considered when estimating expected credit losses. TDRs are considered to be a continuation of the original contract. EIR used for measuring expected credit losses would be the original (pre-modification) EIR. The cost basis would not need to be adjusted but the concession will be reflected through the allowance account. The main difference to current US GAAP will be a discounted cash flow technique will not be required (other approaches may be used). TDRs should be treated like other unmodified assets and assessed on a pooled basis. Expected credit losses for financial instruments with a loan and undrawn commitment component should be considered over the time period the entity is exposed to credit risk, which may be longer than the maximum contractual period. Expected credit losses are estimated on unfunded loan commitments (i.e., revolving lines) even when unconditionally cancellable if not enforced in the normal day-to-day management. IFRS 9 explains that such instruments generally have the following characteristics: (1) they do not have a fixed term or repayment structure, and usually have a short contractual cancellation period e.g., one day (2) the contractual ability to cancel the contract is not enforced in the entity's normal day-to-day management activities, but only when the entity becomes aware of an increase in the credit risk at the facility level; and (3) they are managed on a collective basis. IFRS does not address TDRs explicitly. 26

27 CECL vs IFRS 9 (continued) Accounting requirement CECL IFRS 9 (General Approach) Financial assets secured by collateral (required only if foreclosure is probable) Assets acquired with deteriorated credit quality (PCD) and purchased credit impaired assets (PCI) For collateral-dependent financial assets, CECL requires that expected credit losses be calculated based on the fair value of the collateral when the creditor entity determines that foreclosure is probable. When an entity determines that foreclosure is probable, the entity shall remeasure the financial asset loan at the fair value of the collateral so that the reporting of a credit loss is not delayed until actual foreclosure. An entity may use, as a practical expedient, the fair value of the collateral at the reporting date when recording the net carrying amount of the asset and determining the allowance for credit losses for a financial asset for which the repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the entity s assessment as of the reporting date. If repayment depends on the sale of the collateral, the fair value is adjusted for the estimated costs to sell. PCD assets will be grossed up for the CECL allowance on initial recognition. The allowance at acquisition is equal to the lifetime expected credit losses. The amortized cost basis will be grossed up by the allowance at the acquisition date. Interest income recognition will be based on the grossed-up basis (gross carrying value). If DCF is used for CECL, the discount rate will be the rate that discounts the expected cash flows to the purchase price. Once that rate is determined, CECL is calculated as the PV of cash flows not expected to be collected at that rate. The difference between par and the amortized cost basis will be the accretable discount which will be accreted into interest income. If DCF is not used for CECL, the estimated expected credit losses will be based on the unpaid principal balance. For collateral-dependent financial assets, under IFRS 9 the timing of the sales proceeds, net of costs, would need to be considered, and expected credit losses would be discounted. PCI assets are recorded at fair value at acquisition without any allowance. The expected credit loss for PCI assets is based on the cumulative change (from the original expectation at acquisition) in lifetime expected credit losses using the credit adjusted effective interest rate and would be recognized as an allowance. Interest income recognition is based on applying the creditadjusted effective interest rate to the net carrying value of the financial asset. For PCI assets, the EIR will be the rate that discounts the expected cash flows to the purchase price. 27

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