CECL and the New AICPA Practice Aid (Part 2): Financial Statement Presentation and Enhanced Financial Statement Disclosures

Charles Soranno, Managing Director Internal Audit and Financial Advisory
Ariste Reno, Managing Director Risk and Compliance

New accounting standards that fundamentally change the way financial services organizations calculate current expected credit losses (CECL) took effect for large institutions on January 1, 2020. The new standards are part of a broader effort to increase the accuracy of financial statements and provide more transparency for stakeholders. Smaller financial organizations and private institutions have been granted an extension until January 1, 2023, due to the complexity of the CECL transition and the cumulative resource burden of multiple accounting changes, including revenue recognition and lease accounting, being implemented in relatively rapid succession.

CECL changes the way financial institutions estimate their loss reserves from an “incurred loss” to an “expected loss” model. So, instead of establishing a reserve based primarily on previous losses and historical data, financial institutions will now be required to factor in other quantitative and qualitative factors, including current market conditions, and “reasonable and supportable” forecasts of future losses based on the attributes of the assets in their portfolios. The standard also requires new enhanced and detailed disclosures to help financial statement users better understand the risks of the business, and how management determines the amount of reserves to be set aside upon asset acquisition.

The AICPA has published a CECL Practice Aid to help managers, internal auditors and audit committees prepare for the transition. We are offering our perspective on some of the sections in the Practice Aid that we think warrant additional attention, in a series of blog posts here on The Protiviti View. In Part I, we highlighted areas that board and audit committee members should be particularly attentive to. In this post, we drill down into requirements intended to ensure that financial statement presentation and related disclosures are relevant, reliable and transparent.

New Required Disclosures

During the financial crisis of 2008, it became apparent that the standards by which financial institutions evaluated the quality of their portfolios did not reflect the true risk of loss. As a result, many institutions did not set aside large enough reserves to protect investors. In the aftermath of the crisis, many experts declared the loss reverses posted at that time “too little and too late.” The rules embedded in the new CECL standard require specific financial statement disclosures to be included in reported financial statements, to help financial statement users understand an organization’s risk management practices, loss calculation methodologies and key modeling assumptions. By making institutions show their methodologies and assumptions, the Financial Accounting Standards Board (FASB) has said it hopes to provide relevant, reliable and current data to investors to eliminate future unpleasant end even catastrophic surprises.

More specifically, in regard to accounting methodologies, accounting changes and risk characteristics relevant to each portfolio segment, institutions will now be required to disclose:

  • A description of how loss estimates were calculated
  • An explanation of any period-over-period changes in the calculation, including the reasons why the changes were necessary
  • Reasons for any significant increase or decrease in write-offs
  • A discussion of the estimation models applied for periods beyond the “reasonable and supportable” forecast period

Our Point of View: The new disclosures require management to evaluate and discuss both quantitative and qualitative information used to calculate the allowance for credit losses (ACL), including not only the estimation methodologies but also any historical loss information and assumptions made to adjust historical loss data for forecasting purposes. The importance of these discussions and disclosures increases with the complexity and uncertainty of the estimate. It is important that this discussion is accompanied by the relevant data points necessary to explain and support the qualitative and quantitative assumptions. Further, as noted, management must provide explanations for periods beyond a reasonable and supportable timeframe. The reasonable and supportable forecast period should reflect management’s estimate on the balance sheet date based on all relevant data that is reasonably available without undue cost and effort. For a detailed comparison of the differences between the new CECL requirements and the legacy disclosures used for assets by type, see our publication “CECL Financial Statement Disclosures – What’s Changing?”  

Audit Readiness

Disclosures are supposed to make it clear that the process used to estimate the ACL is in accordance with GAAP, reasonable, and consistently applied. Auditors are going to test any underlying data and evaluate the business and system processes used to prepare the disclosures. Expect auditors to pay especially close attention to any new information, methodologies and assumptions used in calculating the ACL, as well as to how management used that information as the basis for significant assumptions. They are also going to be looking for potential material misstatements, information evaluation bias, and incomplete or inaccurate disclosures.

Our Point of View: It is key for institutions to provide stakeholders with sufficient information to understand the change to the reserve estimate as well as the methodology and assumptions utilized to calculate the reserve estimate, and to ensure that the process and the results can stand up to external audit scrutiny. Internal auditors and those charged with governance can add value to their organizations by anticipating the questions that could be raised by auditors and work with management to ensure that the company’s estimation processes are ready for audit. It is essential to review disclosures and the source data prior to an audit to verify that the underlying data reconciles with both the ACL model and the original source, and that the systems generating that data are protected with the appropriate controls.

Critical Audit Matters

Critical audit matters (CAMs), as defined by the Public Company Accounting Oversight Board (PCAOB), include any concerns raised by external auditors related to financial statement disclosures or items requiring significant auditor judgment. Of course, CAMs are not limited to CECL, but the types of disclosures we’ve been discussing here would typically fall under this heading due to their judgmental nature and complexity. Questions an auditor might ask when evaluating the adequacy of CECL disclosures include whether portfolio groupings are appropriate for the loss calculation used, whether disclosures provide users with enough information to get an accurate picture of management’s assumptions and loan loss calculation methodologies, and whether governance was sufficient to ensure disclosures are unbiased.

Our Point of View: Based on the first round of financial reports filed under the new PCAOB rule in 2019, CAMs so far seem to be primarily related to goodwill, revenue recognition and income tax, although some involved valuations, estimates and assumptions that required auditors to use their judgment. These are general observations not limited to financial institutions, but they do offer some insight into the areas presenting the greatest challenge to auditors. That said, financial institutions with significant portfolios can be sure that their CAMs in 2020 will include detailed auditor CAM disclosures regarding CECL, so management should expect robust dialog with their auditor in the run-up to the CAM disclosure date. As the CAMs shake out, we would expect CECL to be a CAM common to the financial services industry when significant lending activities are involved.  

Additional SEC Considerations

Staff Accounting Bulletin (SAB) 74 requires public companies to include a prospective disclosure on the effects of recent accounting changes (including CECL) on their financial statements. SEC guidelines state that this disclosure should include a description of the new standard, the anticipated adoption date, methodologies, anticipated hurdles, a comparison to current accounting practices, and an estimate of both quantitative and qualitative impacts.

Our Point of View: Although these public-facing disclosures are formally required only for companies registered with the SEC, non-public companies should leverage publicly available information that may be useful in developing their own disclosures when the new CECL standard becomes effective for them. What we have seen to date is a fair number of public filers who have provided a comprehensive update covering all the requirements noted above, including a quantitative estimate of additional loss reserves; however, many public filers have not been as specific or detailed in describing the impacts and have disclosed only a relatively general ultimate financial statement impact expected to be booked in the first quarter of 2020.

Conclusion

Although CECL’s enhanced disclosure requirements are intended primarily to provide investors with a better understanding of risks and risk management, it is the thoughtful consideration of the quantitative and qualitative models and the discussions inherent in the process that will ultimately reduce those risks and improve credit quality.

Therefore, a robust assessment of an institution’s existing credit loss-related financial statement footnote disclosures compared to the requirements of CECL is imperative to identify required changes to disclosures, or new disclosures. 

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