New Phase-In Option for Credit Losses Standard

Bank regulators have completed a rule that will allow banks to phase in the capital effect of the new credit losses accounting standard over a three-year period. The relief comes amid growing banker angst about the impact of the sweeping new accounting standard.

FASB responds to financial crisis

Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, goes into effect in 2020 for publicly traded financial institutions. Published in June 2016, the standard replaces existing requirements under U.S. Generally Accepted Accounting Principles (GAAP) that allow banks to estimate losses only after they’re “probable.”

In practice, the existing guidance has often meant that loan losses are accounted for only once borrowers default. During the financial crisis, investors, regulators and banks said loan loss provisions were recognized “too little, too late.”

The updated credit losses standard, often referred to as the current expected credit losses (CECL) standard, is considered the Financial Accounting Standards Board’s (FASB’s) signature response to the 2008 financial crisis. The standard applies to all businesses. But it mostly affects banks, particularly how they account for souring loans.

In a nutshell, the CECL standard erases current restrictions on using forward-looking information to calculate loan losses. Instead, banks and other creditors must look to the foreseeable future, assess current conditions, take historical experience into account and come up with a reasonable estimate of expected losses.

The new standard requires banks to estimate and book losses on the day they issue a loan instead of waiting for customers to miss payments to set aside loan loss reserves. The increase in loan loss reserves means banks will have to shore up the capital they hold for regulatory purposes.

In turn, when banks increase their capital levels, they have less money available to lend to customers. The standard also may force banks to curtail lending to riskier customers. So, banks have been pressuring the FASB, regulators and lawmakers to either change parts of the CECL standard or stall its implementation.

Standard sparks controversy

The drumbeat against the CECL standard has intensified as banks prepare to follow the sweeping new rules. Recently, the American Bankers Association (ABA), several individual banks and some lawmakers have appealed to the FASB and the Financial Stability Oversight Council (FSOC). In December, a group of congressional leaders sent a letter to Treasury Secretary Steven Mnuchin, who chairs the FSOC, to delay the compliance date.

“Banks have long been concerned about CECL’s cost and impact on our ability to serve our customers and communities, particularly in times of economic stress,” ABA president Rob Nichols said in a statement. “That’s why ABA believes CECL must be delayed until a quantitative impact study can be conducted and the economic consequences of the accounting standard are fully understood.”

Regulators offer partial relief

In response to these appeals, banking regulators have finalized a rule that aims to help banks deal with the regulatory capital impact of the CECL standard. It offers banks the option to phase in over three years the “adverse effects” on regulatory capital that banks expect to feel when they adopt the standard.

“We’re very appreciative the agencies have moved forward by finalizing the rule,” said James Kendrick, vice president of accounting and capital policy at the Independent Community Bankers of America. “We would have rather seen five years. But we think three years would be welcomed by most, if not all, community banks.”

The regulatory rule was a joint effort between the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Office of the Comptroller of the Currency (OCC). The final rule largely follows a proposal issued by the regulators in April 2018.

When the regulators issued the proposal, Regulatory Capital Rules: Implementation and Transition of the Current Expected Credit Losses Methodology for Allowances and Related Adjustments to the Regulatory Capital Rules and Conforming Amendments to Other Regulations, for public comment, many banks applauded the move to offer relief.

However, several banks and professional groups asked to be allowed to phase in the capital hit over five years instead of three. Others took the opportunity to air grievances about the standard in general, calling on the regulators to force the FASB to make changes to the standard or conduct a formal cost-benefit analysis of the impact of the standard before allowing it to be implemented.

Are you ready?

The option to phase in the CECL standard over three years is an important step toward easing its adoption. The phase-in is also expected to give regulators time to understand how the new accounting rule could affect banks’ day-to-day operations. For more information on how this standard affects your organization, contact an accounting professional.

©2019 THOMSON REUTERS

Identifying CAMs: The New-and-Improved Auditor’s Report

Public company auditors have been conducting test runs to help them add critical audit matters (CAMs) to the auditor’s report. To comply with this new Public Company Accounting Oversight Board (PCAOB) requirement, the Center for Audit Quality (CAQ) has found that auditors must apply significant judgment and communicate effectively with management and audit committees.

What are CAMs?

PCAOB Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, was published in 2017 to make the report more useful to investors.

The main provision of the rule requires auditors to describe CAMs, which are the most complicated issues that arose during the audit of the company’s financial statements. CAMs are defined as matters that:

• Have been communicated to the audit committee,
• Are related to accounts or disclosures that are material to the financial statements, and
• Require an auditor to make a subjective decision or use complex judgment.

Although auditors may currently report CAMs on a voluntary basis, it will be required for audits of large accelerated filers for fiscal years ending on or after June 30, 2019. Large accelerated filers are public companies with market values of $700 million or more.

Audits of smaller public companies must follow the new rule for fiscal years ending on or after December 15, 2020. In both cases, auditors must identify each CAM, detail the reasons why it was selected and back up their assertions using relevant financial information.

The PCAOB doesn’t provide a list of possible CAMs or prescribe a specific number of CAMs that must be stated in an auditor’s report. In fact, in some audits, it’s possible that an auditor will determine that there are no CAMs to report.

How are CAMs identified and reported?

The new PCAOB rule represents a major change to the brief pass-fail auditor’s report that has prevailed since the 1940s. To get a head start on revising their reports, auditors of some public companies have conducted test runs of the CAM requirement. This has allowed them to practice how to identify and draft CAMs, as well as how to engage with management and audit committees about CAMs, prior to the effective date.

In December 2018, the CAQ, an affiliate of the AICPA, published Critical Audit Matters: Lessons Learned, Questions to Consider, and an Illustrative Example. The CAQ report presents early lessons from auditors’ test runs. It also provides an illustrative example of a CAM (goodwill impairment) and a set of questions to foster an understanding of the impact that CAMs will have on the audit process.

The CAQ says, “It can be difficult to strike the right balance between the CAM description in the auditor’s report and information in the company’s disclosures, to convey concisely the essence of why a matter is a CAM, and to describe how the CAM was addressed in the audit in a manner that is informative, but not overly technical.”

Among other things, the CAQ advises auditors to communicate with company management and audit committees “early and often” in the process of identifying CAMs. This communication can help management consider the need for modifications to the company’s disclosures in relation to areas likely to be CAMs.

Any modifications to a company’s disclosures should be based on management’s reporting requirements. Modifications also should be independent of the auditor’s identification of CAMs.

Prepare for questions

Once the new auditor’s report goes into effect, investors and other stakeholders are likely to ask questions about CAMs. Companies should be ready to answer these questions. Management can prepare by openly discussing these matters with auditors. In addition to fully understanding why those matters involved especially challenging, subjective or complex auditor judgment, public companies should consider choosing a liaison who can communicate with outside stakeholders to ensure clear, consistent messaging.

©2019 THOMSON REUTERS

AICPA to Align its Auditing Standards With Public Company Standards

The AICPA’s Auditing Standards Board (ASB) is taking steps to enhance the consistency of financial reporting between public and private companies. A new omnibus auditing standard will cover standards on related parties, communications with audit committees, and consideration of fraud in a financial statement audit.

Syncing the standards

Auditors of public companies are required to follow the standards set by the Public Company Accounting Oversight Board (PCAOB). But auditors of private companies generally adhere to the ASB guidance. In some cases, the existing auditing standards may differ.

In January, the ASB voted to issue a final standard to more closely align its guidance with the PCAOB’s standards. Statement on Auditing Standards (SAS) Omnibus Statement on Auditing Standards — 2019 will primarily amend:

• AU-C Section 550, Related Parties,
• Clarified Statement on Auditing Standards (AU-C) Section 260, The Auditor’s Communication With Those Charged With Governance, and
• AU-C Section 240, Consideration of Fraud in a Financial Statement Audit.

The final standard is based on Proposed SAS Omnibus Statement on Auditing Standards — 2018, which the AICPA published in November 2017. The proposal was issued after the AICPA completed its Clarity Project in 2012. The Clarity Project was carried out to make the AICPA’s audit guidance easier to understand and use.

Promoting audit consistency

The ASB believes that the amendments will improve the quality of private company audits. The PCAOB originally based its standards on ASB guidance. However, in recent years, the PCAOB has enhanced its rules to help prevent and detect accounting scandals like Enron and WorldCom.

Specifically, the PCAOB’s Auditing Standard (AS) 2410, Related Parties, toughened the requirements for auditors when they review the business deals of a company’s officers and directors for conflicts of interest. And AS 1301, Communications with Audit Committees, strengthened communications that auditors have with audit committees.

The ASB’s omnibus standard adds communication requirements regarding the auditor’s views about a company’s significant unusual transactions. The changes will require auditors to communicate the potential effect of uncorrected misstatements on future financial statements.

In addition, the new ASB standard adds a requirement to look for previously unidentified or undisclosed related parties or significant related-party transactions. The requirement is intended to enhance the auditor’s response to the risks of material misstatement associated with related-party transactions, taking into account the information gathered during an audit.

Coming soon

A final standard will be issued early in the year in conjunction with an updated standard on auditor reporting. The ASB wants the standards to have the same effective dates to improve their implementation. That date is expected to be no earlier than for financial statement audits of periods ending on or after December 15, 2020.

©2019 THOMSON REUTERS

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