New Accounting Guidance for Credit Losses Is Coming, Should I Panic?

Note: This article originally appeared in The Showroom.

Well…maybe. The allowance for credit losses is the most significant estimate on any set of BHPH financial statements. Since June 2016, when the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) amending the accounting guidance for measuring and recognizing credit losses, many industry accounting practitioners remain conflicted as to the impact this ASU will have on financial reporting practices and some dealers are wondering what this new ASU means for them.

The variety of opinion is an indication of the wide diversity that currently exists in the application of current accounting guidance for determining credit losses. The current guidance includes an “incurred loss” methodology that generally delays the recognition of the full amount of a credit loss until the loss is probable of occurring. Within the BHPH community, some accountants and dealers interpret “probable” to mean a triggering event which has occurred, such as delinquency, and develop an allowance for future credit losses based solely on accounts contractually delinquent. Or, it has also been interpreted as meaning the allowance should represent the probable losses within the next reporting period (i.e. the expected losses over the next 12 month period). On the other end of the spectrum, some accountants and dealers acknowledge that loan portfolio losses are inherent at the inception of installment contracts and therefore, the allowance for credit losses should be based on the expected losses over the entire life of the loan portfolio.

It was this diversity in practice and the global financial crisis that started the FASB down a path in 2008 which would lead to the amended guidance provided in 2016 that will require companies to utilize a Current Expected Credit Loss (CECL) model when effective. Essentially, the CECL model requires the measurement of all expected credit losses of a company’s loan portfolio throughout the contractual term of the loans. When unpacked further, the CECL model will require Companies to utilize historical credit loss experience, current conditions, and reasonable and supportable forecasts as the basis for determining the allowance for credit losses. Qualitative, in addition to quantitative, information such as changes in underwriting standards or economic conditions that exist today (or expected in the future) will be required considerations in determining the estimate for the allowance for credit losses.

For some BHPH operators, the new guidance could have a significant impact on their financial statements. Others will find that the new ASU is better aligned with their current accounting policies.

Those BHPH operators who have historically tried to minimize their allowance for credit losses, may find that the new rules will cause a significant increase in the reserve for credit losses on their balance sheets. This will negatively impact their profitability and equity which may in turn, impact their compliance with financial covenants or availability of credit from borrowing base issues. It is important to assess the impact of this ASU prior to its effective date so that BHPH operators can begin some dialogue with lenders and realign expectations.

As a reminder – the above discussion pertains to generally accepted accounting principles and financial statement reporting. For tax reporting purposes – bad debt deductions are only allowed in the year that specific loans are determined to be uncollectible and are charged off. Blanket loss reserves covering the entire loan portfolio do not give rise to tax deductions.

Now for some good news – the FASB delayed the effective date of the new ASU until 2020 for public companies and 2021 for nonpublic companies. Thus, BHPH operators have a long runway to analyze the impact on their financial statements and determine how to implement the required changes. Again, some may find that the ASU will result in business as usual, however many may find there is tough sledding ahead of them and may need this long runway to allow for a safe landing when the new rules are fully implemented. Companies can choose to adopt the new rules early but we do not foresee many electing to do so.

It is also worth mentioning that this new ASU also impacts net investments in leases for sales type and direct financing leases. BHPH dealers with lease here–pay here operations may also want to work with their accountants to determine what impact this will have on leasing operations as well.