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CECL disclosures

Connecting all the disclosure dots should aid understandability

Financial statement preparers need to identify a “Goldilocks” level of Current Expected Credit Loss (CECL) disclosures—not too much, not too little. Getting to that “just right” amount requires significant time and effort, from reviewing international research efforts to understanding the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) guidance. But it’s an investment that can pay off big if done well.

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Turning CECL obstacles into opportunities

The Financial Accounting Standards Board (FASB)’s CECL trifecta of being principles-based, involving complex models, and requiring life-of-the-loan estimates with reasonable and supportable (R&S) forecasts will challenge financial statement preparers to develop useful, transparent disclosures. Similarly, these three elements will challenge financial statement users to understand both individual company results and industry comparability.

FASB appreciated the challenges CECL disclosure requirements would present, emphasizing the need for companies to determine the right “Goldilocks” level of disclosures. Furthermore, a major investment manager has suggested that complementing the required Generally Accepted Accounting Principles (GAAP) disclosures with non-GAAP disclosures may be needed to provide investors with a more useful representation of the allowance for credit losses.

Companies that develop informative and transparent CECL disclosures may be rewarded by the investor community upon adoption and, perhaps even more so, when the economy enters its first, post-CECL adoption recessionary period. A disclosure approach that “connects all the disclosure dots” including FASB’s credit quality indicator(s), CECL allowance measurement methodology, and the period-over-period allowance change attribution with the SEC’s critical accounting estimate disclosures should be valuable to investors.

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CECL disclosures: Connecting all the disclosure dots should aid understandability

International research efforts should provide useful insights for US companies developing their CECL disclosures approach. In May 2012, the Financial Stability Board (FSB) created the “Enhanced Disclosure Task Force” (EDTF), and the EDTF issued its first report outlining seven risk disclosure principles in October 2012. Subsequently, the FSB requested the EDTF to develop disclosure guidance that may be useful to better understand the upcoming changes as a result of the new expected credit loss (ECL) approaches (IFRS 9 and CECL) and to promote consistency and comparability. The EDTF’s November 2015 report highlighted the need to present relevant, qualitative, and—importantly—quantitative information regarding those factors and risks that create variability in the measurement of ECL and why those factors and risks are the most significant.

Building on this international effort, several UK regulators concluded something more was needed and in November 2017 formed the “Task Force on Disclosures about Expected Credit Losses.” Late last year, the Task Force issued its report and identified nine areas for disclosure consideration. While the report addresses IFRS 9 disclosures specifically, two recommendations clearly are applicable to the current CECL standard:

1. Understanding the alignment between accounting for credit losses and credit risk management

2. Understanding the measurement uncertainty caused by future economic conditions and critical judgments

FASB states that CECL disclosures should enable financial statement users to understand the credit risk inherent in a portfolio, how credit quality is monitored, the methodology to estimate ECL, and period-over-period changes in the estimation of ECL.

In CECL, FASB retained the existing credit disclosure framework with its two discrete components. The credit quality component is focused on how credit is monitored and assessed and on the credit quality indicator(s) used in the monitoring and assessing of credit risk. Specifically, companies are required to describe their credit quality indicator(s) by class of financing receivable and to disclose amortized cost by credit quality indicator(s) by year of origination (that is, by vintage year).

The credit loss measurement component is focused on describing and discussing, by portfolio segment, the method and information used in developing the allowance and the circumstances that caused the allowance to change period-over-period. Furthermore, companies are required to discuss the relevant risk characteristics and the factors that influenced the current allowance estimate, including historic, current, and R&S forecasted information.

This two-component disclosure framework challenges preparers in providing easy-to-understand information in two ways:

1. The different grouping conventions of portfolio segment

2. Class of financing receivable and the lack of a defined relationship between allowance measurement factors and credit risk indicators

The SEC staff’s 2003 Interpretive Release (regarding “Management’s Discussion and Analysis [MD&A] of Financial Condition and Results of Operations”) provides useful information addressing companies’ disclosure responsibilities for critical accounting estimates.

The SEC staff notes that a company should analyze the sensitivity to change of its critical accounting estimates and should provide qualitative and quantitative information, if quantitative information is reasonably available. The SEC’s staff guidance, while more than 15 years old, is relevant to CECL readiness perhaps even more so than under the existing incurred-loss model. The potential future volatility driven by CECL’s R&S forecasts and the life-of-the-loan loss estimates warrants careful consideration of the guidance provided in 2003.

A possible disclosure approach

Heading toward a January 2020 adoption, financial statement preparers should increase their focus on defining their CECL disclosures approach. Consistent with the international and UK disclosure recommendations, a disclosure approach that connects and aligns the FASB’s credit quality indicator and allowance measurement disclosures with the SEC’s critical accounting estimate sensitivity disclosures should improve transparency and thus enhance understandability.

To connect the disclosure dots, it’s useful to start with the allowance measurement disclosures. These disclosures provide financial statement users with insight into the drivers of the allowance and current-period provision expense and useful information to estimate future CECL sensitivity, including the impact of changing economic forecasts.

In preparing these disclosures, companies also may find further disaggregation in portfolio segmentation useful from that disclosed today. Specifically, disaggregation may provide better linkage to the class of financing receivable disclosures and may better align modeling drivers with SEC accounting estimate sensitivity disclosures. For example, separating overall commercial loans into commercial/industrial and commercial real estate could better align discrete allowance measurement with specific SEC sensitivity disclosures.

Next, connecting the SEC’s MD&A critical accounting estimate sensitivity disclosures to the most significant factors that impact the allowance measurement would be important. Aligning these sensitivity disclosures with the significant allowance measurement drivers should provide financial statement users with key CECL insights needed to understand the risk in the credit portfolio and the associated allowance measurement. Given that R&S forecast changes should impact portfolio segments differently, additional sensitivity disclosure should be beneficial.

Finally, connecting the credit quality indicator(s) disclosures with the allowance measurement and sensitivity disclosures sets the foundation for a better understanding of the allowance. Recognizing the importance of selecting the right credit quality indicators, FASB emphasized that judgment should be used in their selection. Furthermore, given CECL’s new measurement requirements, it could be appropriate to change or perhaps increase the number of credit quality indicators from what was useful under an incurred-loss allowance model.

CECL brings a new level of uncertainty to the most closely analyzed number in banks’ financial statements.

Meeting the 'Goldilocks' challenge

Developing the right CECL disclosure requirements approach to meet the “Goldilocks” challenge will likely be the most difficult financial disclosure decision preparers will face during their careers.

Using a disclosure approach that connects all the dots should help bridge the GAAP disclosure framework with the SEC MD&A framework. Absent some linkage between FASB’s and SEC’s disclosures requirements, financial statement users likely will be left to go it alone.

For sure, CECL brings a new level of uncertainty to the most closely analyzed number in banks’ financial statements. The CECL implementation journey thus far has had many twists and turns, but those twists and turns may be modest compared to the post-implementation disclosure journey. Clearly, a CECL perspective that connects and aligns all the credit and allowance disclosures could pay big “transparency dividends” for companies.

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