Loan Losses: It’s Time to Sync the FASB and SEC Guidance

In August, Securities and Exchange Commission (SEC) officials announced plans to update the interpretive guidance for estimating loan loss allowances to reflect the updated credit loss standard. The accounting standard goes into effect in 2020 for public financial institutions. 

Changes under U.S. GAAP

Under U.S. Generally Accepted Accounting Principles (GAAP), banks currently measure their loan losses when they become “probable.” In practice, “probable” has meant that the loss has already happened.

In the aftermath of the 2008 financial crisis, investors, regulators and banks said the so-called “incurred loss” accounting caused banks to delay their decisions to book reserves. As the mortgage market deteriorated, bank balance sheets showed inflated values.

So, the Financial Accounting Standards Board (FASB) created the credit loss standard in June 2016 to overhaul how banks and other financial businesses estimate the losses they expect to feel on souring loans and other financial products. Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, requires them to look to the future, make reasonable and supportable estimates that take macroeconomic factors like the housing market or unemployment rates into account, and set aside loan loss reserves based on these estimates.

The standard requires banks to use a current expected credit loss (CECL) model. The model isn’t supposed to estimate a best-case or worst-case scenario. Rather, it takes into account management’s past experiences, future estimates and current trends in the economy, using “best judgment” to record a loss provision. Bank loss reserves are closely followed by investors and regulators because they are an early indicator of trouble brewing in a bank’s financial condition or the broader economy.

Need to update SEC rules

Now it’s the SEC’s turn to modify the loan loss guidance. The SEC is in the early stages of examining the changes it may need to make to Staff Accounting Bulletin (SAB) No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues (SAB Topic 6-L).

The SAB from 2001 expresses the SEC’s views on the development, documentation and application of a systematic method for determining the allowances that are set aside to cover losses on bad leases, securities and other instruments. “Loan loss estimates developed without a disciplined methodology or adequate documentation (of both a disciplined methodology and the resulting amounts of loan loss provisions and allowances) can undermine the credibility of an institution’s financial statements,” the SAB states.

“There’ll be an update to the SAB,” said Sagar Teotia, an SEC deputy chief accountant, at the American Accounting Association’s annual meeting in National Harbor, Md. Teotia provided no further details, but he indicated that some of the “core elements” continue to be relevant. 

Stay tuned

The FASB’s credit loss standard goes into effect in 2020 and 2021, depending on the size of the financial institution. So, the SEC has more than a year to review its guidance and decide on the necessary changes to better align it with U.S. GAAP.

Small banks given extra time to comply

The new financial accounting standard on credit losses is a substantial change from existing practice. So, the Financial Accounting Standards Board (FASB) called for financial institutions to comply with the standard on a staggered basis, depending on size. The credit loss standard groups them into public business entities, non-SEC filer public business entities and nonpublic business entities.

SEC filers — typically larger financial institutions — must comply with the updated credit loss standard for fiscal years beginning after December 15, 2019. For calendar year-end banks, this generally means a January 1, 2020, effective date.

For public business entities that aren’t SEC filers, the new standard is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For calendar year-end banks, this means a January 1, 2021, effective date, with quarterly reporting coinciding with the first quarter of 2021.

For banks that are neither SEC filers nor public business entities — typically, credit unions and community banks — the standard is effective for fiscal years beginning after December 15, 2020. But these smaller institutions don’t have to comply with quarterly filing requirements until periods beginning after December 15, 2021.

However, the transition and effective date requirements of the standard require both non-SEC filer public business entities and nonpublic business entities to adjust retained earnings for the cumulative effect of the accounting changes as of January 1, 2021, for calendar year-end entities. This effectively would have negated the benefit of providing nonpublic business entities with an extra year before implementing the guidance. That wasn’t the FASB’s original intent.

So, the FASB recently issued a proposal to amend the transition guidance for the nonpublic business entities. The amendment would allow them to follow the accounting standard for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Under the amended transition guidance, community banks and credit unions would adopt the standard and adjust their opening retained earnings balance as of January 1, 2022, assuming they report on a calendar-year basis.

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