Insights for BHPH Dealers From Adopters of the New Credit Loss Standard

This article originally appeared in The Showroom.

The current expected credit loss (CECL) accounting standard has had numerous amendments and delayed effective dates since the Financial Accounting Standards Board (FASB) originally issued it in 2016. The changes aimed to provide entities sufficient time and resources to transition to the CECL model. Now that the first group – those who file with the Security and Exchange Commission – has adopted the new standard, the FASB hosted a roundtable event to gather feedback on whether the accounting standard is working as intended. This commentary will likely inform the guidance for private company adopters, including buy here – pay here (BHPH) dealerships, which are expected to adopt the new CECL standard by Jan. 1, 2023.

The CECL standard requires entities to recognize a provision for estimated losses on the day of origination that reflects all losses expected to occur during the lifetime of the loan. The expected loss estimate should consider historical loss experience, current conditions, and reasonable and supportable forecast information. This shift from an incurred loss model (probable losses) under legacy guidance to expected losses under the CECL model was intended to result in more timely recognition of losses. A BHPH entity’s largest asset is generally its portfolio of subprime loans, so it goes without saying that this standard could have a significant impact on the BHPH industry.

The preparers that participated in the FASB roundtable included large banks and credit unions, investors, accounting practitioners, and regulators. The insights from the large banks and credits unions translated well to BHPH dealers’ related finance companies. Generally, most participants in the roundtable felt that despite adopting the CECL standard in the year of a global pandemic, the implementation was successful and that preparers and practitioners were well prepared and responded appropriately. Here are some specific takeaways that are applicable to the BHPH industry.

Flexibility

Investors and preparers participating in the roundtable generally responded positively to the flexibility provided in the CECL model, which allowed entities to build reserves quickly, particularly in the face of uncertainty caused by the pandemic. Because the CECL model includes requirements for entities to include reasonable and supportable forecast information when generating their expected credit loss estimates, entities were able to reflect the uncertainty created at the onset of the pandemic and quickly increase their credit loss reserves.

Comparability

While many participants praised the flexibility that the CECL model provides, there was acknowledgement that each financial institution evaluates forecasts differently, which can create many different responses, even with the same set of data. Others noted that significant judgment is required when determining credit loss estimates, regardless of what their loss models are calculating. That also affects comparability across entities. Investors at the roundtable indicated that the financial statement disclosures were helpful in adjusting for some of the comparability issues; however, some noted that the disclosures were uneven across financial institutions.

Volatility

Many participants mentioned the income volatility created when significant provision adjustments are made in one period followed by a significant release of reserves in the following periods. Some noted that the volatility of credit loss provision adjustments made it difficult for investors/users to determine the quality of earnings of an entity, particularly when reserve adjustments are contrary to net charge-offs. However, others noted that in the face of the pandemic, with rapidly changing economic expectations, government stimulus initiatives, and the rollout of testing and vaccines, the CECL model did exactly what it was intended to do. Early in the pandemic, there was tremendous uncertainty as to what would happen to the credit quality of loans, and reserves went up significantly as a result. As information became available that loss rates would not be realized as initially anticipated, credit loss reserves came back down.

Other Implementation Challenges

The accounting practitioners participating in the roundtable noted that it was a challenge determining the relevance and reliability of third-party data used in their credit loss estimates. It was especially challenging for smaller entities that were more heavily reliant on third-party data providers who had fewer resources, which placed a disproportionate burden on smaller entities – defined as financial institutions with assets in the low billions. As a result, it would be expected that a small BHPH dealer with a $15 million loan portfolio may have a heavy reliance on third-party data providers and may have significant hurdles implementing this standard – particularly as it relates to forward-looking forecasted data.

What Now?

This FASB roundtable reiterated concerns around significant cost, complexity, and lack of available and reliable data associated with implementation. However, this roundtable highlighted additional concerns on income volatility between periods, use of significant judgment when determining credit loss estimates, and a lack of comparability between entities. How – or if – the FASB will address this feedback remains to be seen. Since private companies are required to adopt the CECL standard on Jan. 1, 2023, BHPH dealers should begin assessing the impact of this standard over the next 12 months. The FASB may issue additional guidance and expedients for private companies prior to the 2023 effective date, but proactively planning for this change will help set your BHPH dealership up for accounting success.