2021 is bringing important changes to accounting and regulatory reporting for financial institutions. Here are the top four areas your financial institution should focus on now.
Current Expected Credit Losses (CECL): Changes to the measurement of loan losses
Perspectives on those that adopted in 2020
Calendar year 2020 was an adventure for many financial institutions, not only due to the COVID-19 pandemic but also because of the adoption of CECL. The bad news for adopters? Implementation turned out to be more time-consuming and costly than originally anticipated. But there was also some good news. First, institutions yet to adopt CECL are not required to have the same complex models as institutions that were already required to adopt CECL. And second, institutions that adopted last year encountered few issues with the level of their reserves.
The common issues experienced were mainly focused on the documentation supporting the calculation, and include:
- The “journey memo”: In the years leading up to adoption, many checks and balances were performed and decisions made along the way that may or may not have been documented. This documentation provides the roadmap for the institution’s adoption of this new accounting standard.
- Assumptions used as a result of historical data that did not include a full economic cycle.
- The determination of assumptions for the forecast period.
- The methodology for reversion.
The path for those yet to adopt CECL
In November 2019, the Financial Accounting Standards Board (FASB) approved the delay of several major accounting standards, including a delay of CECL implementation to January 2023 for calendar-year entities. This change was the first indication of the board’s shift in mindset to an environment where large, public companies adopt new standards multiple years before smaller institutions. However, in the wake of the COVID-19 pandemic, some institutions haven’t made as much progress toward CECL adoption as they would have liked. Accordingly, many are looking to make up ground in 2021 by taking next steps such as selecting a model, evaluating historical data, performing dry runs, and calibrating their calculations for implementation.
To assist your institution in working toward CECL adoption, here’s a suggested timeline to consider:
Calendar year 2021
- Assess and understand available methodologies
- Identify available data
- Assess data limitations against available methods
- Select your methodology
- Organize and validate data
- Finalize segmentation
- Establish processes and controls
Calendar year 2022
- Verify new data activity
- Perform shadow calculations
- Calibrate model accordingly
- Finalize controls
- Test controls
- Have model validation performed
- Measure impact of as Dec. 31, 2022, and record variance to equity
Remaining modified loans: Classification and accrual status
While Congress and regulatory agencies have granted relief from the application of the highly subjective and challenging topic of troubled debt restructures (TDRs), institutions are reminded they’re not exempt from properly classifying and evaluating accrual status.
Overall, financial institutions have provided a wide range of loan modification programs with varying degrees of success. And while it appears that the majority of modified loans have returned to making regular payments under the contractual terms of the obligation prior to the modification, numerous institutions continue to have a material amount of loans that have not. In these instances, it’s important for an institution to first identify affected credits, effectively quantify the change in cash flows and, lastly, ensure their bases are covered from an accrual status perspective. As part of this assessment, institutions should ask and answer the following questions for loans that remain on modified terms.
- What is the nature of the borrower’s business?
- How much disruption has the borrower’s business experienced due to the pandemic?
- Does the current debt service coverage ratio support the collection of both principal and interest payments that existed prior to the first modification?
- Is there a valuation of collateral that accounts for the post-COVID-19 environment?
- How much equity (deficiency) exists with the collateral?
- Are there other mitigating factors that might remove doubt of collectability of both principal and interest (e.g. substantial guarantor net worth and verified liquidity)?
The ultimate purpose of these questions is to gather and weigh both positive and negative evidence associated with collecting both principal and interest, collectively and individually. While the ultimate determination of accrual status can be one of judgment, institutions should be prepared to defend and support those conclusions with appropriate documentation.
Guide 3 disclosure changes
The Securities and Exchange Commission (SEC) has adopted updates to statistical disclosure requirements for banking registrants to clarify the scope and amended current reporting periods and disclosure requirements. The updates clarify that these disclosures are required for all banking registrants and generally streamline the required disclosures in an effort to improve the quality of information provided to investors. For example, the amended rules remove the five-year historical disclosure period and align with the periods and information presented in the financial statements. Bank holding companies are required to comply with the updates for fiscal years ending on or after Dec. 15, 2021, and early adoption is permitted.
Reference rate reform
The countdown is on: the industry now has less than a year until the sunset of LIBOR at the end of 2021. Many financial institutions are still in the early phases of determining their exposure to this index and developing a transition plan. Here are some key action items to consider as your institution prepares for the transition:
- Review existing contracts and agreements for the use of LIBOR to identify areas of exposure and any fallback language that may already exist. Common areas include loan, securities, interest rate swaps, debt, and leases.
- Identify a new reference rate (many institutions are looking to the Secured Overnight Funding Rate (SOFR), Ameribor, or Bank Yield Index), educate the lending team and others within the organization on key differences between the indices, and establish a date for the transition from LIBOR for new agreements during 2021.
- Develop and execute a plan to transition existing contracts and agreements to a new reference rate.
2021 is set to be another challenging year for financial institutions as the industry continues to face uncertainties from COVID-19, challenges with CECL adoption, and the implementation other significant financial reporting measures. If you have questions, give us a call.