CECL Effective Date for Private Banks. A Discussion Paper of the AMERICAN BANKERS ASSOCIATION. ABA Contact: Michael L. Gullette

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1 CECL Effective Date for Private Banks A Discussion Paper of the AMERICAN BANKERS ASSOCIATION ABA Contact: Michael L. Gullette SVP, Tax and Accounting mgullette@aba.com the practical and ongoing issues that can be expected in estimating and managing expected credit losses.

2 Summary For calendar year-end banks that qualify as non-public business entities, the effective date for the CECL credit loss accounting standard is December 31, The requirement, however, is to report both a CECL-based beginning balance as of January 1, 2021 and an ending balance as of December 31, 2021 for these private banks. CECL credit loss estimates will be unlike other estimates used in bank accounting. CECL forecasts are meant to be subjective and entity-based (not market-based) without a threshold for recognition. They are based on management s expectation of borrower performance, in light of long-term future macroeconomic conditions foreseen at a specific point in time, and are subject to a disclosure requirement that discusses the changes in the factors making up the estimate from one period to the next. The processes around developing reasonable credit loss expectations at or near each reporting date will be critical. The integrity of reported performance during a fiscal year (on the income statement) will be, thus, dependent on governance and internal control procedures performed at or near January 1, as well as December 31. Therefore, the effective date of CECL (for audited financial statement purposes) may be considered, for practical purposes, January 1, 2021 for all non-sec registrant banks. These banks will likely need to consider implementing CECL-related internal controls and governance processes over the analysis of CECL assumptions by the beginning of From a practical perspective, banks that implement CECL-related internal controls by the beginning of 2021 will be able to gain valuable experience throughout the year, whether or not CECL is reported in the interim period Call Reports. Such banks will be able to better understand how changes in current loan performance and changes to periodic macroeconomic forecasts can affect their credit loss provisions in real world situations, compared to doing so only at year-end. It is possible that a soft implementation can be conducted, whereby a limited number of internal controls and governance processes are implemented at January 1, 2021 while incurred losses are reported for the first three quarters of Year 2021 then can possibly be used as a parallel process year. Before applying this implementation approach, bankers should discuss such an option with their auditors and their Boards of Directors, as CECL policy decisions and assumptions that are agreed upon as of January 1 could change by December 31. Changes from the Previous Version of this Discussion Paper This paper updates the version exclusively available to ABA CECL Network participants that was published in fall A reference in footnote 1 to the AICPA s Technical Q&A was added, relating to the definition of a Public Business Entity as well as a reference to CAMELS ratings in a new footnote 4. 2

3 Background Effective Dates in the CECL Standard When issuing a new Accounting Standards Update (ASU) to its Accounting Standards Codification, the standard process of the Financial Accounting Standards Board (FASB) is to consider allowing private companies more time to implement the ASU than required for publicly-held companies and to consider reducing the disclosure requirements for these entities. For ASU Measurement of Credit Losses on Financial Instruments (also known as the CECL standard, named after the current expected credit loss model that was introduced during the standard-setting process), later effective dates were granted to non-sec registrants. Per ASU : For SEC filers, CECL is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For calendar year-end banks, this generally equates to a January 1, 2020 effective date. For Public Business Entities (PBEs) 1 that are not SEC filers, CECL is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For calendar year-end banks, this generally equates to a January 1, 2021 effective date, with quarterly reporting coinciding with the first quarter of For banks that are neither SEC filers nor PBEs (hereinafter referred to as private banks ), CECL is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, For calendar year-end banks, this generally equates to a January 1, 2021 effective date a full-year income statement is presented for 2021, though any quarterly reporting requirement starts in In reaction to the schedule of CECL effective dates, the Federal banking agencies announced that quarterly Call Reports should generally be submitted by private banks during 2021 in accordance with current incurred loss standards until the fourth quarter report, when CECL is required. This is specifically addressed in Question 34 of Frequently Asked Questions on the New Accounting Standard on Financial Instruments Credit Losses. 1 For a discussion of the definition of a PBE, including a decision tree to determine whether a bank qualifies as a PBE, see ABA s discussion paper The Definition of a Public Business Entity. See (c).pdf. Further information on the Public Business Entity definition is also available at the AICPA web page: 3

4 Key Disclosure Requirements in the CECL Standard In addition to the later effective date, private banks also do not have to provide amortized cost information of their assets subject to CECL by vintage year. 2 Paragraph in the CECL standard, however, provides certain disclosure requirements applicable to all companies. Among other disclosures, a company must discuss "changes in the factors that influenced management's current estimate of expected losses, and the reason for those changes (for example...significant events or conditions that affect the current estimate but were not contemplated or relevant during a previous period). Normal Implementation Timelines As CECL implementation efforts have begun over the past year, many commenters have stated that private banks have (as is often the case for new accounting standards) received an extra year implementation time over PBEs because their effective date is December 31, 2021, rather than January 1, These statements have been generally understood by bankers to mean that, as opposed to PBEs that must implement governance and internal controls at the beginning of the period, private banks may collect data throughout the initial year (2021), and estimates are made at year-end for both the beginning and end of period allowance for loan and lease losses (ALLL). Discussion Timing of the CECL estimate The nature of the CECL credit loss estimate is fundamentally different from other estimates made by bankers. The CECL estimate requires an entity-unique, long-term forecast of the future that will include macroeconomic factors applied to pools of unimpaired assets without a probable threshold of likelihood. In contrast, Fair value estimates should not include entity-unique knowledge or bias. Fair value estimates are also often based on open market quotes that are publicly available years after the measurement date. Current credit loss estimates under ASC are meant to exclude a forecast of the future. ASC also refers to a probability threshold for loss recognition that, until recently, has tended to limit the use of qualitative judgments and emphasized the role of recent historical loss experience within the estimate. 2 Non-SEC registrants that are PBEs have a laddered time schedule in disclosing certain vintage information, whereas SEC registrants must provide full vintage disclosure information upon implementation. 4

5 Current credit loss estimates under ASC 310 relate to impaired assets, so that the remaining term is normally less than long-term and the special servicing performed on such assets reduces the impact of future macroeconomic factors. Such estimates are also generally more detailed, in general compliance with discounted cash flow methods. None of these other estimates are subject to a disclosure that discusses qualitative changes in the factors that influenced management s current estimate. Per ASC c, examples of such a discussion will include changes in portfolio composition, underwriting practices, and significant events or conditions that affect the current estimate but were not contemplated or relevant during a previous period. Recent discussions with bank analysts and investors have indicated significant concern to understand individual macroeconomic forecasts of the future and their effect on credit loss estimates. Such concerns appear to be consistent with those of auditing standard-setters, as sensitivity testing and governance over assumptions are prominent points of focus within the current proposals by both the Public Company Accounting Oversight Board (PCAOB) and the International Auditing and Assurance Standards Board (IAASB) to revise standards related to auditing estimates and fair value measurements. In short, a bank s ability to forecast long-term macroeconomic conditions and then to quantify the impact of the assumptions used in those forecasts will be critical aspects of CECL practice. Given the dynamic nature of the economy and of borrower performance, a realistic forecast of credit losses as of January 1, 2021 (the beginning of the initial effective year) will likely require controlled processes that analyze the relevant risk factors on or soon after January 1, Likewise, a credible discussion of the changes in the factors that influenced management s estimate at December 31, 2021 would need such an analysis performed at both the beginning and end of the year. Any analysis performed one or more quarters after January 1 could inappropriately integrate the most current experience and expectation into the January 1 estimate. Therefore, estimates of the January 1 and December 31 ALLL balances that forecast similar economic conditions at both the beginning and end of the year would likely lack credulity if both were completed at the year-end. Even in the event that a forecast of long-term macroeconomic conditions did remain consistent, changes in risk factors would still be expected because portfolio performance would need to be assessed and evaluated compared to the previous expectations. 3 An analysis of the risk factors would include not only qualitative assumptions, but also the quantitative sensitivity to various other reasonable assumptions. 5

6 This is important, not only because of the disclosure guidance in the CECL standard, but because users of bank financial statements often compare bank performance through review of Call Reports. Banks that report stable earnings performance, for example, may be rated more favorably than their peers by certain key users of financial statements, including deposit brokers. 4 The risk of inappropriate bias that smooths out initial year performance (2021) is, therefore, significant for those banks that evaluate credit risk factors only at year-end. Bankers and auditors will need to weigh that in their risk analyses. Benefits of Targeting a January 1, 2021 Effective Date Most private banks that target full CECL implementation on January 1, 2021 will likely face little practical risk. Regulators have indicated informally to bankers that analysis of quarterly CECL estimates will be flexible, understanding that early CECL estimation processes will often need significant adjustment. Unless the bank has core deposit brokers that may use quarterly information for investment purposes, a full adoption on January 1 will likely allow it to effectively experiment and test out different CECL models and related assumptions without also performing redundant quarterly close processes under the incurred loss model. This can be a significant time saver for many smaller banks. A January 1 Soft Adoption Approach It has been suggested that it may be possible for bankers to implement CECL-based internal controls over data entry and maintenance, as well as certain governance processes over the forecast assumptions as of January 1, 2021 without implementing CECL throughout the entire year. Since the U.S. banking agencies will not require quarterly Call Reports to be completed based on CECL, bankers would then use the remaining part of 2021 as the parallel year that irons out the new controls and tests various assumptions in the forecasting process. In such a scenario, at January 1, bankers would conduct governance processes to approve one or all assumptions related to future macroeconomic conditions and ensure that the life of loan-based credit loss data underlying those assumptions are complete and accurate. Internal controls at that point may not necessarily be reliable as to the ongoing input and management of such data. Further, testing of models and the sensitivity of the risk factors to different assumptions may need significant refinement. It is during the first three quarters in which such essential processes can be addressed. Under soft adoption, 2021 essentially becomes a parallel process year. This approach should be considered with caution because, practically speaking, a bank will likely consider this if it is 4 The C (Capital Adequacy) and E in a bank s CAMELS rating can also be affected by the policy decisions made for CECL during

7 behind its implementation schedule. Bankers, regulators, and auditors will need to agree upon an approach that preserves the integrity of the January 1 balance if this is selected by the bank. While ongoing periodic adjustments to modeling and policy decisions are to be expected, those made by banks that are behind in their implementation plans could be considered of less integrity. With this in mind, it may often be easier to merely fully implement CECL as of January 1 and avoid the parallel processes during Conclusion Banks that qualify as Private Banks (those banks that do not qualify as Public Business Entities according to the FASB definition) will need to consider how the timing of the process to develop credit loss assumptions used at the beginning of the period (January 1, 2021) can affect the credibility of reported performance during the initial effective year. The timing may also affect how they disclose changes in the factors that influenced management s estimate of expected credit losses during the period. Auditors will need to consider whether (and how) bank credit loss assumptions used at January 1, 2021 can be tested in late 2021 or in 2022, including the timing of relevant CECL internal controls and governance. Regulators, private bank investors, and other bank performance analysts will need to consider the potential lack of comparability in full-year operating performance of privately held banks to those of non-sec public business entities. Bankers are advised to discuss with their auditors and regulators whether to target an effective CECL implementation of specific governance and internal control processes as of January 1, Based on these discussions, Private Banks may also want to consider early adoption of CECL and report CECL estimates throughout each quarter of Early adoption may provide these banks especially those that will be subject to FDICIA-based internal control audits the opportunity to avoid performing governance and internal control procedures over both incurred loss and CECL estimates during the interim periods. 7