In the world of accounting pronouncements, it can sometimes take years from the time a pronouncement is made until it becomes effective. This is to give accountants and businesses plenty of time to prepare for the resulting changes to accounting practices.
There are several accounting pronouncements from recent years that will become effective soon. This makes now a good time to assess how these pronouncements could affect your borrowers and your bank.
New Lease Accounting Standard
ASU No. 2016-02, commonly referred to as the new lease accounting standard, has been called one of the most drastic changes ever made to public accounting standards. It will require businesses that lease assets (including vehicles, equipment, and real estate) for more than one year to report lease obligations as liabilities on the balance sheet.
The deadline for private companies to begin adopting the new lease accounting standard is annual reporting periods beginning after December 15, 2019. Public companies are required to adopt the new standard for annual reporting periods beginning after December 15, 2018.
Businesses that prepare GAAP-compliant financial statements will have to recognize assets and liabilities for both capital and operating leases on their balance sheet if the leases exceed one year in duration. More specifically, they must report a right-to-use asset and corresponding liability, discounted to present value, for lease payment obligations.
Because the new standard will result in new liabilities being listed on the balance sheet, it is likely to have an adverse effect on business’ liquidity, leverage, and debt service coverage ratios. This, in turn, could make it more difficult for businesses to qualify for new commercial loans and comply with covenants in loan agreements for existing loans.
Fundamental changes could be in store for loan underwriting and structuring of debt covenants once the new lease accounting standard becomes effective. This makes it critical to be proactive in addressing these changes with borrowers well in advance of the effective date.
New Revenue Recognition Standard
ASU 2014-09, commonly referred to as the new revenue recognition standard, creates a new principles-based revenue recognition model. It is based on the core accounting principle that revenue should be recognized in an amount that reflects the compensation a business expects to receive as it transfers goods or services to customers.
The deadline for private companies to begin adopting the new revenue recognition standard is annual reporting periods beginning after December 15, 2018. Public companies were required to adopt the new standard for annual reporting periods beginning after December 15, 2017.
Contractors and construction firms are among the businesses that will be most impacted by the new revenue recognition standard. These businesses must determine the likelihood of collecting revenue before applying the standard to contracts, which will require evaluating customer credit risk.
First, businesses should identify the performance obligations in each contract and determine the transaction price. The next step is to allocate the transaction price to the performance obligations. Revenue should then be recognized at the time when goods or services are transferred to the customer.
Contractors will still usually be able to use the percentage of completion accounting method. And they won’t have to recalculate completed contracts once the new standard becomes effective. Plan to sit down soon with borrowers impacted by the new revenue recognition standard to discuss its implications.
New Current Expected Credit Loss Standard (CECL)
This new standard, which will change how banks calculate credit loss reserves, represents a drastic shift for the financial services industry. Once CECL becomes effective, banks will no longer calculate reserves based on losses incurred in the past, but rather on expected future losses.
In the run-up to the financial crisis, banks’ loan loss reserves shrank by 10 percent, while loan volume rose by 44 percent. The FASB adopted CECL in an effort to reduce credit risk by improving accounting for loan losses and better matching the cost of risk (losses) with the revenue recognized on the loan (interest and fees). Banks will have to assess potential losses when putting financial assets on the books instead of setting aside reserves on loans where losses appear probable.
The deadline for CECL implementation is annual reporting periods beginning after December 15, 2019 for banks that file with the SEC and annual reporting periods, including interim periods, beginning after December 15, 2021 for non-SEC filing banks.
Contact us to schedule an appointment if you have questions about these accounting pronouncements 417-881-0145.