Private equity and venture capital firms that have or are looking to invest in financial services portfolio companies should be aware of the coming changes in the way financial service entities calculate credit loss reserves. Starting in the calendar year 2020, private equity and venture capital firms that invest in certain types of portfolio companies will have to be aware of new accounting rules that affect the timing of credit loss recognition. The new credit loss impairment rules under the Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13, Financial Instruments (Topic 326) – Measurement of Credit Losses on Financial Instruments (ASU 2016-13) apply to financial instruments and loans measured at amortized cost. Due to the change in the recognition of credit losses, the credit loss impairment standard will affect financial statements and potentially business valuations of companies in the financial services sector.
Financial services organizations will be among the hardest hit by the changes, which establish a Current Expected Credit Loss (CECL) impairment model for loans measured at amortized cost. Public business entities will adopt the new accounting standard for fiscal years beginning after Dec. 15, 2019 (generally calendar year 2020) and all other entities will adopt for fiscal years beginning after Dec. 15, 2020 (generally calendar year 2021) and interim periods beginning after Dec. 15, 2021 (generally calendar year 2022).
Brief Primer on the Standard
Organizations currently record credit losses on their financial instruments measured at amortized cost using an incurred loss model. Credit loss is recognized when the loss occurs or when a triggering event occurs that makes credit loss impairment likely.
Following the financial crisis of 2008, the financial services sector was asked to bring more transparency to its financial instrument risks. ASU 2016-13 addresses some of those concerns and simplifies the instrument-specific approach to credit loss impairment in current U.S. generally accepted accounting principles (GAAP).
The CECL impairment model in the new credit loss standard requires organizations to record an estimate of lifetime expected losses at the acquisition date. The standard was designed to provide entities with significant flexibility in order to develop a reserve approach that can be consistently applied over time. As a result of this flexibility, the standard does not prescribe a method of calculating reserves but common approaches such as discounted cash flow, loss rate, roll rate, and the probability-of-default method will likely continue to be used under the new standard. It is likely that each of these models will need to be adjusted in order to account for the differences between an incurred loss model and CECL.
No matter the valuation method selected, entities will need to evaluate data to span the life of the contract, including the risk characteristics, collectability of cash flows, past performance, and projected future economic conditions. It is not likely that any instrument will have zero expected credit losses; the estimated loss will need to be recorded even if the risk of credit loss impairment is low.
The New Credit Loss Standard’s Impact on Financial Statements
Financial services groups will be recognizing credit loss earlier under the new credit loss impairment standard than they would under current U.S. GAAP. The accelerated credit loss recognition will affect multiple parts of organizations’ financial statements, which will in turn affect profitability and solvency measures.
Loan loss reserves and related deferred tax assets and overall capital levels will be affected. Financial services groups may have higher reserves, even in periods of strong economic performance, and lower overall capital levels as a result of the higher loan loss reserves. It’s important to note that the higher loan loss reserve levels may be a good thing for investors and management companies. High reserves may result in less dramatic swings in reserve levels if economic performance worsens.
On the other hand, there still may be volatility in earnings from reporting period to reporting period, especially in reporting that relies on forward-looking modeling. Although credit losses will be recognized up front, loan-related income will continue to be recognized periodically under the effective interest method. A financial statement period that includes the start of several new loans may reduce the loan-related income from that period because of the new credit loss impairment standard’s requirement to recognize credit loss at loan origination. Periods that do not have as many new loans will look more profitable than they would have under legacy U.S. GAAP.
The New Credit Loss Standard’s Impact on Business Valuation
How significantly the new credit loss standard’s changes to profitability and solvency measures will be to the overall valuation of a financial services company remains to be seen. There are a couple of ways it could go. One way would be that a private equity and venture capital firm’s valuation of a financial services company target may not differ that much from current U.S. GAAP because the changes to the timing of the credit loss recognition will not dramatically affect cash flows or overall financial performance of a company. Another view would be that any decrease to earnings or book values as something that would lower the business’s value.
One point that is certain to be affected is comparability between pre-accounting change periods and post-implementation periods. If a private equity and venture capital firm is planning an acquisition of a financial services company during the CECL standard adoption years, it may want to consider requesting a non-GAAP analysis to increase insight into the company’s financial performance over time.
If a private equity and venture capital firm is concerned about the impact that the CECL change will have on its target, it may also want to analyze the accounting standard’s expected impact on the target during the pre-deal due diligence process. As part of the analysis, it should consider:
- The adoption costs for the financial services company, including the updates it may need to make to its internal reporting processes, and
- Which valuation method it plans to pursue to recognize the CECL allowance
Enlisting the help of a valuation professional may help private equity and venture capital firms further understand the potential business valuation impact that the CECL model will have on a financial services target.
For More Information
For specific comments, questions, or concerns about the role the new credit loss impairment standard may play in your complex transaction, please contact us.
Published on May 16, 2019