Financial and non-financial institutions alike are nearing adoption of the Financial Accounting Standards Board’s new Current Expected Credit Loss (CECL) standard, which will take effect at the beginning of the next fiscal year for most public companies.
Considered to be one of the most impactful accounting changes for U.S. financial institutions in decades, the new guidance — which applies to any company that extends credit — requires companies to measure expected losses over the estimated life of a loan using reasonable and supportable economic forecasts. That’s a substantial departure from current allowance for loan and lease losses (ALLL) practices.
While many entities are confident about their modeling and accounting conclusions, the same may not hold true for another crucial aspect of compliance: disclosing the standard’s impacts to investors and analysts.
Specifically, FASB requires that CECL disclosures enable financial statement users to understand the credit risk inherent in a portfolio, how credit quality is monitored, the methodology used to determine loss estimates, and period-over-period changes in the estimation of CECL.
The difficulty, however, is that disclosures are an area that remains open to interpretation by management — more so than other recent accounting changes. So, even though affected entities must find a way to effectively disclose their CECL methodology and changes to their CECL estimates, every company could ultimately have a unique way of communicating its new credit loss estimate to the market.
The onus for developing these high-stakes disclosures weighs particularly heavily on CFOs. If investors can’t understand key components of CECL, it becomes significantly more difficult to understand individual company results and industry comparability. And, if analysts are left to model CECL estimates through guesswork, it could result in a variety of challenges for investors and put operational stress on companies as they work to enhance their disclosures.
Ultimately, it will be crucial for CFOs to develop the right disclosure approach to help communicate effectively with each stakeholder group. Even with less than three months left until the first reporting period for public companies, there are several ways CFOs can better prepare themselves to help deliver their organization’s disclosure story effectively next spring.
Grab Hold of the Disclosure Reins
To date, most CFOs have led their organization’s CECL implementation processes using traditional change-management techniques. Now is the time for finance chiefs to take the reins and drive the disclosure phase from the top down.
Running parallel-run disclosure preparation and review processes like you would for a large merger or balance sheet restructuring will likely drive a laser-like focus that should benefit a company’s disclosure development. Further, active CFO engagement can help surface key strategic issues as well as some important “in the weeds” issues sooner rather than later.
Drive the in-depth conversation with probing questions, including the following:
- “What goldilocks level of disclosure will best communicate the critical aspects of CECL?” Create an internal disclosure control group to provide independent feedback from an investor’s perspective.
- “What linkage should exist between credit quality indicators and portfolio allowance calculations?” Consider whether linking these two FASB disclosures would help provide transparency to CECL results.
- “Do we have the right information available to support the required period over period change disclosures?” Review the information the company will use to support the describe-and-discuss narrative disclosures.
- “Do any qualitative adjustments impact disclosures to our investors?” Review the qualitative adjustments to the CECL model results, including any adjustment for forecast variability. Would additional disclosures enhance an investor’s understanding of the current CECL estimate and future impacts of a changing economic outlook?
Assess Critical Accounting Estimate Sensitivity Disclosure Requirements
Sensitivity analyses can help provide a better understanding of CECL among investors and analysts. While CECL sensitivity disclosures could be complicated, disclosures that provide insights to the impact of future changes in CECL estimates could be very useful to investors.
For example, disclosing sensitivity information around changing economic forecasts and credit quality indicators should provide investors useful information to demystify the CECL estimate.
Engage Your Investor Relations Group
IR needs to have a big seat at the disclosure table. Their job is to build upon the fundamental GAAP and SEC disclosures to create a clear and simple investor message.
Investor questions will likely fall into two categories: How does your CECL process work? How do I project your future CECL provision expense? A few ways your IR group can help include (although more may be found here):
- Develop the investor “tough questions” list for CECL. Like quarterly earnings release preparation, identifying the questions and the company’s responses can be valuable.
- Conduct mock earnings release calls focused on CECL methodology and results. There is no substitute for mock investor dialogue. Given CECL’s complexity, lack of comparability due to the principles-based nature of the standard, and volatility due to the incorporation of forward-looking estimates, investor communications will likely be challenging.
- Draft a mock sell-side review of your CECL GAAP/SEC disclosures. Using an independent internal control group to review the disclosures and predict future CECL provision can help assess whether investors “heard” the message. This could also be done by “bringing an analyst over the wall” to provide feedback.
Developing an effective CECL disclosure approach will likely be one of the most difficult financial disclosure decisions that CFOs will face. CECL’s required credit loss forecasting will bring a new level of uncertainty to the most closely analyzed number in bank and non-bank financial statements.
Clearly laying out and aligning all the credit and allowance disclosures could pay big transparency dividends for companies and investors — something that could be invaluable whenever the current credit cycle ends.
Gregory Norwood is managing director in Deloitte & Touche LLP’s risk and financial advisory practice and serves on Deloitte’s CECL implementation leadership team. Troy Vollertsen is an audit and assurance partner and leader of Deloitte & Touche’s audit and assurance business for U.S. banking, and also serves as co-leader of Deloitte’s offerings related to FASB’s CECL model.
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