Following hard on the heels of the new revenue recognition and leasing standards, FASB’s Current Expected Credit Losses model (CECL) for financial assets presented another challenging accounting change for companies. As companies consider strategic transactions, they should not lose sight of CECL.
CECL requires estimating credit losses over the life of certain financial assets measured at amortized cost and various other instruments within its scope and recording this estimate generally in earnings upon initial recognition. Financial services companies saw the broadest impact, but non-financial services companies were also affected. Importantly, the new standard applies well beyond loans and trade receivables — it covers financial assets carried at amortized cost, net investment in leases, reinsurance recoverables, and off-balance sheet credit exposures.
This standard became effective for public business entities (PBEs) that meet the definition of an SEC Filer, excluding small reporting companies (SRCs) as defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Companies generally saw their existing processes affected upon adoption, regardless of the financial statement impact.
Certain entities have a delayed timeline for adoption (fiscal years beginning after December 15, 2022, including interim periods within those fiscal years), which can further complicate the due diligence and integration process for acquirers. As companies pursue new acquisitions, it is critical to consider early in the diligence process the potential impact that a target's financial asset portfolio will have on financial metrics and the overall deal. This results in companies needing to perform a CECL assessment for a target company to consider how it will fit into their existing process.
The CECL standard requires more timely recognition of expected credit losses than the previous model, which may impact some key metrics used by analysts and companies when assessing the attractiveness of a business. Early understanding and assessing the target’s CECL impact for these financial metrics below has been an area of interest amongst the C-suite.
CECL may result in a higher allowance applied to receivables and other current assets in-scope, which would reduce the current ratio.
If a financial guarantee results in recording or increasing an already existing liability for an off-balance-sheet credit exposure, this may increase the company’s perceived leverage – particularly when this ratio is based on total liabilities.
More timely recognition of expected credit losses may result in higher expenses, which will flow through various income statement metrics, including operating profit, EBITDA, profit-before taxes, net income and EPS.
The standard also has an impact on the QOE performed during the due diligence process, which is used to assess the financial position of the business and overall attractiveness of the target.
While the quantitative impact of adoption varied across industries, the new CECL standard generally required a process transformation for all companies. New processes established during adoption should be flexible enough to allow for changing economic and business conditions including incorporating changes to the underlying assumptions. Certain components of executing a deal come with complexities that should not be underestimated, such as:
Carving out, spinning off or divesting a portion of your business may also come along with challenges specifically if that portion of their business is below the level at which they pool their assets, including:
Isolating the data specific to that portion of the business in order to determine the portion of the CECL allowance relevant to the standalone GAAP compliant carve-out financial statements.
Considering the impact of removing the portion of the business from the allowance process: How will this impact the overall CECL estimate for the remaining portfolios?
If executing a cross-border deal, companies will need to continue to consider the differences between the IFRS 9 and US GAAP impairment models which may add another layer of complexity to the transaction.
PwC has deep expertise with a range of accounting standard changes, the implications these have on executing a deal, and how to help companies to overcome the various challenges that come along with this. Examples of how we can help include:
Performing due diligence over the transaction to help assess if the transaction is the right strategic move for your business.
Determining the impact that CECL adoption has on a target, including what financial assets and other instruments may fall within scope of the standard and what analysis is required for adoption.
Assisting in alignment of accounting standards, specifically in the case of a US-based GAAP acquiring a company reporting under IFRS.
Advising on your post-integration controls process to enhance efficiency and help optimize your process.
Contact one of our professionals to have a deeper conversation about your organization’s challenges with recent accounting changes and how we can be of assistance.
“Observations from the front lines” provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.
Deals Partner, PwC US
Brandon Campbell Jr.
Managing Director, PwC Deals Practice, PwC US