The arrival and implementation of ASC 326, the Current Expected Credit Loss (CECL) model, has stirred a philosophical discussion about the nature of accounting and the goals of those who shape accounting standards. For lenders, ASC 326 has not only brought about a change in the way they calculate and disclose loan loss reserves, it has prompted a reflection on the purpose of accounting itself. ASC 326 presents us with another subtle shift in accounting philosophy. Traditionally, losses were recognized only when they were deemed probable and reasonably estimable. In the new world brought about these accounting standards, from the moment a loan is originated, lenders are asked to anticipate and provision for potential losses over the entire life of the loan. This continual sprawl of forward-looking approaches with respect to GAAP accounting has been an additional catalyst of philosophical debate within the accounting community.
Proponents of accounting standards in this paradigm of enhanced conservatism, within which standards like ASC 326 fall, claim this standard aligns accounting more closely with economic reality. By recognizing expected credit losses early on, it is believed that financial statements provide a more accurate reflection of a company’s true financial position and overall health. The goal here is not merely to report historical events but to provide stakeholders with forward-looking information that enables better decision-making. This position certainly has its merits. The essence of ASC 326 lies in its departure from the status quo and its aim to improve transparency. Lenders are encouraged to invest in risk assessment models and data analytics tools to estimate credit losses accurately. Historical loss data, once the sole data required to be considered, is now accompanied by additional data for the estimation of loan loss reserves. These include:
· Past Losses
· Current Conditions
· Future Forecasts
Assets should also be segmented based on characteristics for collective evaluation. Where possible, lenders should avoid blanket assumptions being applied to all loans in favor of a more granular creation of segments. While no specific requirements on how to define such segments is provided, private lenders must embrace stress testing scenarios and categorizing the loans that will respond similarly into tranches, an exercise that forces them to confront the uncertainties of an ever-changing economic landscape. Our clients have implemented a variety of approaches. The best firms involve their audit partners with expertise in this guidance as early as possible.
However, critics question whether this shift towards expected credit losses may create a self-fulfilling prophecy. Nothing exists in a vacuum, and changing the way in which actions or results of actions are measured will always have an impact on the actions themselves when human incentives and motivations are in play. This paradox of measurement is baked into our reality and has long been observed from the social sciences to quantum mechanics measurement problem.
With a sudden shift in how quickly the recognition of losses with respect to bad loans occurs, will this lead to a more cautious lending approach and potentially stifle economic growth? ASC 326 does not set out to disincentive lending to borrowers with riskier characteristics, it just sets out to increase transparency, but that doesn’t mean it is the only effect. Unintended consequences are the result of every change in policy, and this accounting policy. Lenders already have enough reason to not make loans to risky borrowers, a sudden acceleration in the recognition of losses that are recorded with respect to these loans is a further disincentive. With another disincentive, it follows that lenders will make fewer loans to such borrowers. Policies that cause for a tightening credit does not always have the best results. This philosophical discussion delves into the fine balance between prudence and progress, as lenders navigate the new landscape of accounting under ASC 326.
If you have any concerns or questions, we’re here at Duner and Foote to assist you. Feel free to reach out to us.