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Impairment toolkit: Financial instruments · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:06
  SPEAKER_04: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_04: I'm Heather Horn.
• 0:11
  SPEAKER_04: Thanks for tuning in to another episode in our Toolkit series where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:25
  SPEAKER_04: This month we're all about impairment.
• 0:28
  SPEAKER_04: So with that, let's get started.
• 0:37
  SPEAKER_04: So, Brad Shannon, thanks so much for joining me today to continue our conversation about impairment.
• 0:43
  SPEAKER_04: And you know, one of the things that we've talked about in the series is this continuing high level of uncertainty about the future state of the economy, which has caused a lot of companies to think about whether the carrying value of their assets is appropriate.
• 0:58
  SPEAKER_04: And so continuing our impairment series, we heard last week from Pat Durbin, who talked about the fact that basically financial instruments are sort of the first step when you're looking at impairment from a hierarchy point of view.
• 1:11
  SPEAKER_04: So we thought, what better for our next episode than to talk about financial instruments?
• 1:16
  SPEAKER_04: But maybe, Brett, I thought we could just start things off to level set and let people know what they should be focused on, you know, sort of as a first when considering financial instrument impairment.
• 1:27
  SPEAKER_02: Sure.
• 1:29
  SPEAKER_02: I think the first thing to keep in mind, Heather, is that even though we're talking about financial instruments broadly, you need to think specifically about the type of financial asset you're dealing with, because there are different impairment models for different types.
• 1:41
  SPEAKER_02: So today I think we should talk through equity securities and debt securities and loans and receivables, because although they have some commonalities, the framework for each one of them is sort of fundamentally different.
• 1:55
  SPEAKER_02: So maybe first I touch on impairment of equity securities.
• 2:00
  SPEAKER_02: So remember, the general accounting model for equity securities is fair value through PL.
• 2:05
  SPEAKER_02: So there's no separate impairment test at all.
• 2:09
  SPEAKER_02: Where we do have an impairment test is for equity securities without a readily determinable fair value.
• 2:16
  SPEAKER_02: So think of private company investments.
• 2:19
  SPEAKER_02: We often see companies elect what we call the measurement alternative.
• 2:23
  SPEAKER_02: And if this measurement alternative is elected, they're measured at cost, less impairment, and also adjusted for prices from observable transactions.
• 2:32
  SPEAKER_02: So when we look at impairment for these for these measurement alternative assets, uh, you need to think about what would trigger an impairment.
• 2:40
  SPEAKER_02: And obviously, if you have an observed transaction in your security that that is below your cost basis, whether you engage in that observed transaction or you see it in the market, that's going to be a basis for a write down.
• 2:55
  SPEAKER_02: But the impairment model doesn't just stop there.
• 2:58
  SPEAKER_02: Impairment exists wherever there's um you start with a qualitative assessment about whether it's likely that fair value is below cost.
• 3:07
  SPEAKER_02: And so that can happen even without an observable transaction.
• 3:10
  SPEAKER_02: And in the current markets with equity prices declining in general, we'll often see companies believe that there's this qualitative trigger.
• 3:20
  SPEAKER_02: So every reporting period, companies should be going through this qualitative assessment to determine if it's if they have reason to believe that fair value is below carrying value.
• 3:30
  SPEAKER_02: And if impairment does exist, the impairment loss is recognized directly in net income as a difference between estimated fair value and the carrying amount.
• 3:39
  SPEAKER_02: So this is a one-step model now, right down to fair value.
• 3:43
  SPEAKER_02: Um sometimes companies think, well, I haven't observed a transaction, so I don't really know what the fair value is.
• 3:48
  SPEAKER_02: So do I really have an impairment?
• 3:50
  SPEAKER_02: If you meet one of those qualitative triggers, you need to go through and assess fair value.
• 3:55
  SPEAKER_02: And that may be an estimate that's very difficult to do because uh it may be a very illiquid asset, uh, but that's what the standard required.
• 4:05
  SPEAKER_02: And remember, there's no significance or time horizon.
• 4:08
  SPEAKER_02: So you don't avoid impairment anymore just because you believe that this decline in in value is temporary.
• 4:14
  SPEAKER_04: Yes, and I guess Brett's interesting.
• 4:17
  SPEAKER_04: I was just thinking overall, and maybe we'll get a little more into this later, but I do think with these sort of fair value instruments, there's always that feeling, okay, but you know, it's September 30th.
• 4:28
  SPEAKER_04: I concluded fair value is one amount, but then you know, two weeks later, maybe it's completely different.
• 4:34
  SPEAKER_04: And I feel like people sometimes don't like to record those impairments.
• 4:38
  SPEAKER_04: But to the point you made, it's at the end of the period, and you record, you know, if there is an impairment, you record it.
• 4:43
  SPEAKER_04: Right, right.
• 4:44
  SPEAKER_04: All right.
• 4:44
  SPEAKER_04: So then let's keep going because you mentioned uh equity securities, but how about then debt securities?
• 4:51
  SPEAKER_02: Sure.
• 4:52
  SPEAKER_02: Um let's talk about um investments in available for sale debt securities.
• 4:57
  SPEAKER_02: So this is where you're measuring the debt security at fair value, but changes in value generally go to OCI rather than rather than earnings.
• 5:06
  SPEAKER_02: And um, under the accounting literature, a debt security is an AFS debt security is impaired if its fair value is below its amortized cost basis.
• 5:14
  SPEAKER_02: So you start there and you know you have an impairment, you have to decide what to do with it.
• 5:19
  SPEAKER_02: From there, um, you need to consider whether the company has an intent to sell the security or whether it's more likely than not that they would be required to sell the debt security before recovery to its amortized cost basis.
• 5:33
  SPEAKER_02: If those two, if either of those two things exist, then the security should be impaired to fair value.
• 5:38
  SPEAKER_02: You know, the concept is if you're gonna dispose of the security whether you have to or whether you choose to, you should record that impairment now.
• 5:46
  SPEAKER_02: And in all other cases, a company should always be assessing whether there's a credit loss, you know, an inability uh to pay.
• 5:53
  SPEAKER_02: And uh if a credit loss exists by measuring that credit loss by the present value of expected cash flows, uh that's gonna be an instrument-specific analysis, but but like that credit analysis should be done separately.
• 6:05
  SPEAKER_04: Sticking with these AFS securities, Shannon, I'm just curious.
• 6:10
  SPEAKER_04: I know you're in the market and working with a lot of companies, and you know, we've kind of framed this as a discussion of current market conditions.
• 6:17
  SPEAKER_04: So, what are you seeing in terms of the impacts um on companies dealing with investments in AFS debt securities?
• 6:25
  SPEAKER_01: Yeah, sure, Heather.
• 6:26
  SPEAKER_01: So uh generally, unrealized losses in fixed income have been growing quite a bit compared to the beginning of the year, and part of that's due to rising interest rates and in some cases widening credit spreads.
• 6:38
  SPEAKER_01: Even though like those unrealized losses have risen, um, generally we haven't seen AFS credit allowances increasing to a big degree.
• 6:48
  SPEAKER_01: Um many have a view that you know the the difference is not really due to credit and that the unrealized losses are more driven by by rates.
• 6:58
  SPEAKER_01: Um as Brett said, you know, it's an instrument-specific analysis.
• 7:03
  SPEAKER_01: And um, you know, that doesn't mean that there aren't individual cases, of course, where there where some of the loss is credit related.
• 7:10
  SPEAKER_01: Um of course, an allowance which should be recorded in in those cases, but we haven't seen you know widespread um you know increases in allowances um for AFS debt securities.
• 7:22
  SPEAKER_04: So, Shannon, thank you for that.
• 7:24
  SPEAKER_04: I just want to clarify, and I know Brett said this, but I think it definitely has kind of sailed over my head, and so for our listeners, you know, you I think sometimes it helps to repeat things.
• 7:34
  SPEAKER_04: So if I am dealing with the AFS um debt security, I look basically at my loss almost in two parts, and I look at credit loss and then market losses more broadly, and I record my credit loss.
• 7:50
  SPEAKER_04: Well, why don't you explain the model to us?
• 7:52
  SPEAKER_01: Yeah, sure.
• 7:53
  SPEAKER_01: So the the model generally is um you know changes in fair value go through other comprehensive income.
• 8:02
  SPEAKER_01: If the fair value is below the amortized cost, and it's like you know, more likely than not that uh the or or that the the company's gonna be like required to sell the security or the company intends to sell the security, then you know you impair it to its fair value.
• 8:19
  SPEAKER_01: Um, if that's not the case, as Brett Brett mentioned, then it's an instrument-specific analysis where you would impair and recognize in earnings only the credit portion of the loss.
• 8:33
  SPEAKER_04: All right.
• 8:33
  SPEAKER_04: So then, Shannon, thanks for reminding us of the model.
• 8:36
  SPEAKER_04: I like I said, I think the repeat is helpful.
• 8:39
  SPEAKER_04: So let me go back then to your point of what you were talking about with the market.
• 8:43
  SPEAKER_04: And I think what you're saying is that even if you see that the price of an AFS debt security has fallen, it that actually doesn't mean there's anything sort of security specific, but it could just be because the broader rise in interest rates may be causing its price to fall.
• 8:58
  SPEAKER_01: Yeah, that that's right, Heather.
• 9:00
  SPEAKER_01: And and so the the AFS impairment model is very borrower security specific.
• 9:05
  SPEAKER_01: Um so like even if, in addition to interest rates, even if it's like market credit spreads have widened, it doesn't necessarily mean that an individual's uh security is impaired either.
• 9:14
  SPEAKER_01: Um so a lot of companies have you know filters to determine which securities to scrutinize.
• 9:21
  SPEAKER_01: And you know, when when the fair value of the security is greater than cost, obviously there's no impairment in that case.
• 9:27
  SPEAKER_01: You know, prior prior to this year, uh, you know, a lot of fair values were fairly stable.
• 9:33
  SPEAKER_01: Companies generally weren't meeting um triggers very often because uh of uh you know low interest rates and um you know some economic stability.
• 9:43
  SPEAKER_01: So this hasn't really been like a strong focus for companies for a while.
• 9:47
  SPEAKER_01: But while it's been on the sort of the back burner for a couple of years, companies really should sharpen their pencils now in terms of their process for recognizing uh problem securities.
• 9:58
  SPEAKER_01: Um the the volume of of corporate borrowing has has decreased significantly compared to prior years.
• 10:04
  SPEAKER_01: And that um, you know, widening high yield credit spreads and and um and other, you know, even investment grade credit spreads and rising interest rates have caused yields to rise.
• 10:14
  SPEAKER_01: So now, you know, a lot of uh a lot more securities might be uh might be hitting some of those triggers that where companies will need to scrutinize them and look at those more.
• 10:25
  SPEAKER_01: Also, you you have some kind of specific things like companies in some industries, um, like insurance, have had more growth in the amounts of uh and complexity of their AFS investment portfolio as they've expanded relationships with other asset managers and and um invested in more.
• 10:42
  SPEAKER_01: Um, so that's led to a need to get more data and just have more uh robust capabilities to do credit surveillance um on the portfolio and assess impairment.
• 10:53
  SPEAKER_04: All right, so it definitely sounds like that companies need to make sure that they really do have the right controls in place, because I think to your point, this is isn't something I think we talked about briefly right when COVID started, but then you know it's kind of been off the radar, so which makes me feel a little better for getting confused about the model there.
• 11:12
  SPEAKER_04: Um so with all of that said, Brett, if we think through the other main financial instruments where impairment accounting comes into play, we obviously have the Cecil model for amortized costs.
• 11:26
  SPEAKER_04: And in particular, I know there's often questions about the purchase credit impaired assets.
• 11:33
  SPEAKER_04: And that's been something even the FASBE has been talking about.
• 11:36
  SPEAKER_02: Right.
• 11:37
  SPEAKER_02: And I I would um I'd say I don't think there's a completely separate impairment model for what we call PCD assets, purchase credit um deteriorated assets.
• 11:47
  SPEAKER_02: Um, but there's certainly a different accounting treatment uh for them.
• 11:51
  SPEAKER_02: And what you're hearing at the FASBE right now is a discussion about expanding the scope of PCD accounting to all purchased loans more generally, not just loans purchased with credit deterioration.
• 12:04
  SPEAKER_02: Um and so that's a topic that financial institutions in particular should be focused on, but maybe too complicated today.
• 12:11
  SPEAKER_02: I would just let's let's stick with uh with Cecil, which is certainly complicated enough.
• 12:16
  SPEAKER_04: Yes, I was definitely thinking that.
• 12:18
  SPEAKER_04: And probably Cecil is applicable to a broader swath of our audience, since uh I think in general that purchased impaired loans would typically be more of a financial institution issue.
• 12:33
  SPEAKER_04: Not to say it's not important.
• 12:34
  SPEAKER_04: Uh, but that said, Shannon, what are some of the highlights and reminders you would give for companies thinking about the Cecil model, whether you're just dealing with, you know, you're a consumer company with AR or you know, financial institution with a lot of assets being measured using this model.
• 12:50
  SPEAKER_01: Yeah, yeah, sure.
• 12:51
  SPEAKER_01: And I I would agree that PCD um is probably a totally separate discussion and you probably have a whole another podcast, but I I I wouldn't volunteer for that one.
• 13:00
  SPEAKER_04: Um we'll give Brett back for that one.
• 13:04
  SPEAKER_01: Yeah, so uh so so Cecil.
• 13:06
  SPEAKER_01: Um Cecil is the impairment model for you know financial assets that are held at amortized cost.
• 13:12
  SPEAKER_01: And the goal there is to recognize credit losses that are expected over the the life of the asset.
• 13:18
  SPEAKER_01: Um there's no triggers um for recognizing impairment.
• 13:21
  SPEAKER_01: It's it's basically just it's a valuation account for the amount that you expect not to collect.
• 13:28
  SPEAKER_01: Um and so then when you net that against the amortized cost basis, the idea is you then get the amount that's expected to be collected for that financial asset.
• 13:38
  SPEAKER_01: And that, you know, in terms of like the scope, it's assets that are measured to amortized cost, and then also some off-balance sheet credit exposures.
• 13:47
  SPEAKER_01: Um, for example, you have things that are obvious, like loans and finance receivables, held to mature debt securities or even trade receivables, you know, for non-financial companies, um, a net investment in a lease is a less or, as well as things like loan commitments or guarantees that are sort of more off your balance sheet, um, and many other things that are you know more speci industry specific, like a reinsurance receivable.
• 14:11
  SPEAKER_01: And and there's a few things that are pretty key to remember about how to determine expected credit losses.
• 14:18
  SPEAKER_01: So under Cecil, you're supposed to pool the assets like when similar risk characteristics exist.
• 14:24
  SPEAKER_01: So look at things on a on a collective basis.
• 14:27
  SPEAKER_01: Um, but obviously, if there's things that are unique about a particular asset, then you you might look at that individually.
• 14:34
  SPEAKER_01: Um and you're supposed to think about relevant internal and external information, um, like the company's own historical experience, um, current conditions, and then also reasonable and supportable forecasts.
• 14:46
  SPEAKER_01: So that that reasonable, supportable forecast creates some complexity because now we're trying to actually forecast out how you know conditions might impact um expected losses.
• 14:56
  SPEAKER_01: And then when the when the life of an asset actually extends into a period beyond which it's possible to come up with a reasonable and supportable forecast, you're then supposed to supposed to revert to historical loss information that's not adjusted.
• 15:12
  SPEAKER_04: All right.
• 15:13
  SPEAKER_04: And I know um so thanks for that, Shannon.
• 15:15
  SPEAKER_04: And I remember from I our podcast that we did when CSOL was first adopted that because it's introduced, you know, it's based on the life of the asset, that actually may make it harder to estimate loss now.
• 15:29
  SPEAKER_04: I know a lot of times people say they don't even estimate at the beginning, but now you know, especially if you're partway through and changing market conditions, that's definitely a lot to think about.
• 15:38
  SPEAKER_04: And so, Brett, can you just kind of walk us through how you would think about that when you kind of look at the time horizons associated with CSOL?
• 15:45
  SPEAKER_02: Sure.
• 15:45
  SPEAKER_02: I I I and I think sometimes this does make it complicated.
• 15:48
  SPEAKER_02: In other cases, it's not that big of a consideration.
• 15:51
  SPEAKER_02: If you're a company dealing with relatively short-term receivables, you know, thinking about the life of the asset over, you know, 30, 90 days, not relatively simple.
• 16:01
  SPEAKER_02: But think of it when you're dealing with like a 30-year mortgage, that becomes much more complicated.
• 16:07
  SPEAKER_02: So the life of the asset considers a few things.
• 16:11
  SPEAKER_02: It starts with the contractual term of the loan.
• 16:15
  SPEAKER_02: Um, and then you also factor in expected prepayments.
• 16:18
  SPEAKER_02: And also you should factor in extensions of renewals that are contractually provided and outside the lender's control.
• 16:26
  SPEAKER_02: So all of those things, um, you know, they could, like prepayments, shorten the life of the of the asset beyond uh uh shorter than its contractual term, or it could extend.
• 16:36
  SPEAKER_02: What you don't consider in the life of the asset are modifications or extensions not not outside of what I just um what I just described.
• 16:46
  SPEAKER_02: And when we think about off-balance sheet exposures like loan commitments, uh you consider the period over which the commitment is legally binding, um, and but you don't consider obligations that are unconditionally cancelable at the lender's discretion.
• 17:00
  SPEAKER_02: So if you have the if the lender has the right um to immediately cancel or not not fund that exposure, um you you wouldn't you wouldn't estimate a loss beyond that time period.
• 17:10
  SPEAKER_04: So, Brad, I have a follow-up question on one of the things you said there, but I have a broader follow-up because you um piqued my interest with your 30-year mortgage.
• 17:19
  SPEAKER_04: Because just thinking, you know, if it's a 30-year mortgage, there's a lot of economic cycles that can happen in 30 years.
• 17:26
  SPEAKER_04: Not to mention, I'm assuming most mortgages or many mortgages don't last for their full year 30 years.
• 17:33
  SPEAKER_04: So it just generally, and obviously someone who's recording Cecil on a mortgage do not follow what Brett's about to tell us, but just to help our listeners kind of visualize this, how do you think about the fact that there's kind of ups and downs in an economic cycle in thinking about that type of a long lived asset?
• 17:51
  SPEAKER_02: Yeah, so it starts with estimating the life of the asset.
• 17:54
  SPEAKER_02: Like what period of time am I trying to do this forecast?
• 17:58
  SPEAKER_02: And then how I do the forecast is gonna be a separate question.
• 18:02
  SPEAKER_02: So I may determine that I have um I can I can use an actual economic forecast for some reasonable period of time.
• 18:12
  SPEAKER_02: Maybe I might conclude I can't do that economic, that specific economic forecast over eight years because there's gonna be ups and downs and it's too uncertain.
• 18:20
  SPEAKER_02: So I may do a specific economic forecast and run a model for a shorter period of time.
• 18:26
  SPEAKER_02: And then beyond that, for the in my example, the remaining part of the eight years, uh, you revert to a more just historical norm of losses.
• 18:35
  SPEAKER_02: So you're not actually trying to estimate economic conditions very specifically for that longer tail period.
• 18:43
  SPEAKER_04: All right, very helpful.
• 18:44
  SPEAKER_04: And I do think it is a uh good example for companies that don't like doing C SL even on their short-term assets, that things could be much more complicated than what they're dealing with.
• 18:54
  SPEAKER_04: So, okay, so Brett, that's very helpful.
• 18:57
  SPEAKER_04: So let me go back then to the other question I had from what you uh mentioned earlier.
• 19:02
  SPEAKER_04: And you had mentioned that in this process you aren't thinking about any forecast and modifications.
• 19:09
  SPEAKER_04: And I know that the FASBE recently made some changes to how a comp company should be considering troubled debt restructurings in their allowance.
• 19:18
  SPEAKER_04: So, how how is does that work now?
• 19:20
  SPEAKER_02: Um under current literature, uh reasonably expected troubled debt restructurings should be considered in determining the life of the assets.
• 19:28
  SPEAKER_02: Uh, but in March, the the FASBE issued new guidance that will eliminate TDR accounting guidance more generally.
• 19:35
  SPEAKER_02: Um that's not no longer going to be a direct consideration in the life of the asset.
• 19:40
  SPEAKER_02: You've stopped forecasting these uh reasonably expected uh troubled debt restructurings.
• 19:45
  SPEAKER_02: But the loss mitigation impact of those restructurings may be may be still relevant in the measurement of the allowance.
• 19:52
  SPEAKER_02: For example, you know, a company does a restructuring because they think it's going to reduce the losses that they would ultimately have if they went to full contractual term or tried to enforce the uh the original contractual terms of the arrangement.
• 20:05
  SPEAKER_02: So that loss mitigation impact on the loss rate should still be included.
• 20:10
  SPEAKER_02: Um this TDR project, I think, is something that companies should be focused on, like before, uh particularly financial institutions, because there's some disclosure changes that will require some work, but that's probably another good topic for another day.
• 20:25
  SPEAKER_04: All right.
• 20:25
  SPEAKER_04: So Brett, sounds like I'm gonna have you back for two podcasts.
• 20:28
  SPEAKER_04: So um looking forward to that.
• 20:31
  SPEAKER_04: All right, so let's kind of shift then.
• 20:34
  SPEAKER_04: I want to loop back to something that I had talked to Pat Durbin about um in our last podcast.
• 20:39
  SPEAKER_04: And we were focused on how macroeconomic trends are impacting impairment considerations for non-financial assets from a big picture point of view.
• 20:48
  SPEAKER_04: And Shannon, you had mentioned earlier that companies should be considering forecast information and determining the allowance under Cecil, and Brett gave us that example.
• 20:58
  SPEAKER_04: Um, but that, you know, again, I alluded to this earlier.
• 21:03
  SPEAKER_04: That requirement was a big change from the previous impairment guidance.
• 21:07
  SPEAKER_04: So can you explain a bit more about that?
• 21:09
  SPEAKER_01: Yeah.
• 21:10
  SPEAKER_01: Um, so under Cecil, um you need to be like, or companies need to be able to respond to changing conditions and then incorporate that information into their credit losses.
• 21:22
  SPEAKER_01: Um so even though the impairment guidance doesn't require like a specific approach, it does require the companies incorporate reasonable, supportable forecast information.
• 21:34
  SPEAKER_01: Um and while uh you know, due to the nature of the receivables of of certain uh companies and and who their customers are, I mean, there there are some companies that have found that like their losses are not very sensitive to to broad macroeconomic conditions and and factors.
• 21:52
  SPEAKER_01: Um, but there are a lot that are.
• 21:55
  SPEAKER_01: Um so there's a a number of other companies that have found that their their losses can be explained.
• 22:00
  SPEAKER_01: At least in part due to economic variables like GDP or unemployment rates.
• 22:07
  SPEAKER_01: So many companies will utilize a credit loss estimation model that incorporates forecasts of those macroeconomic variables that they found are related to losses.
• 22:21
  SPEAKER_01: So an example like Cecil became effective for public companies in 2020.
• 22:28
  SPEAKER_01: So right after it became effective, you have the impacts of COVID-19 starting to show up, great timing, right?
• 22:35
  SPEAKER_01: Lots of uncertainty, right, that um that the companies had to deal with.
• 22:40
  SPEAKER_01: And then since the beginning of the COVID pandemic, right, we we observed that just a lot of breakdowns in some of the relationships that traditionally were predictive of credit losses, like the relationship between delinquencies and charge-offs.
• 22:55
  SPEAKER_01: And you also had new phenomena like very large uh stimulus and deferral programs.
• 23:02
  SPEAKER_01: Um so so many like of the purely quantitative credit loss estimation models, they didn't perform as well during during that time period.
• 23:11
  SPEAKER_01: Um so in addition to sort of the quantitative um uh you know analysis and estimates, companies also had to increase uh their use of more qualitative uh adjustments to create their estimates and had to apply some judgment because it was, you know, there were sort of unprecedented conditions.
• 23:29
  SPEAKER_04: So, Shannon, it's interesting because we dealt with that then, and then you know, the past couple of years have actually been challenging for companies in developing these losses because we have had some ups and downs.
• 23:41
  SPEAKER_04: But let's fast forward.
• 23:43
  SPEAKER_04: So now you know we're in the fall of 2022, and how are companies thinking about our current economic conditions?
• 23:52
  SPEAKER_04: Because again, there's a lot of uncertainty.
• 23:54
  SPEAKER_04: Um, has it gotten easier to take into account those factors, or you know, how are they thinking about it?
• 24:00
  SPEAKER_01: Um so I would say most people would probably say no, it not really.
• 24:04
  SPEAKER_01: Um never get easier.
• 24:07
  SPEAKER_01: Right, right.
• 24:08
  SPEAKER_01: Um so yeah, I mean, even though we've we've mostly recovered from you know the the 2020 COVID induced recession, um, companies are still facing lots of challenges in forecasting and then relating those forecast conditions to their expected credit losses.
• 24:23
  SPEAKER_01: Um a lot of those traditional relationships I mentioned that they had they had somewhat broken down.
• 24:28
  SPEAKER_01: Maybe now, you know, I wouldn't say they've broken down, but they've changed.
• 24:32
  SPEAKER_01: Um and and so right now, for example, you've got you know relatively low unemployment, right?
• 24:38
  SPEAKER_01: The the rate was 3.7% in August, up very slightly from a uh of a very low uh rate in July.
• 24:46
  SPEAKER_01: And you know, the the number of job openings is up, uh, you know, hiring is slowing a little bit, but um, but at the same time, you also have some measures of you know lower economic output, like real GDP contracted for the for the first six months of the year.
• 25:01
  SPEAKER_01: But then you also have other measures like gross domestic income, um, where if you look at that measurement, the economy is still growing.
• 25:09
  SPEAKER_01: So there's just there's a lot of um a lot of relationships that that are that are that have become a little bit more hazy.
• 25:16
  SPEAKER_01: Um you know, you've got low consumer confidence um levels, like you know, in in August and July, it's it's it was pretty low, but you know consumer spending has actually been been fairly stable.
• 25:29
  SPEAKER_01: Um and you you also have, you know, uh and I know Pat mentioned this, right?
• 25:33
  SPEAKER_01: That lots of um supply chain disruptions and supply shocks from COVID.
• 25:38
  SPEAKER_01: There's just all these things that are going on.
• 25:40
  SPEAKER_01: Um inflation, right, uh especially for food and energy, that that's putting pressure on consumers.
• 25:46
  SPEAKER_01: And we have you know very large increases in interest rates as the Fed looks to fight inflation.
• 25:51
  SPEAKER_01: So there's a lot of these things um that that kind of make it challenging.
• 25:57
  SPEAKER_01: Um and then many of the models they don't explicitly consider the impacts of some of these other effects.
• 26:04
  SPEAKER_01: So that need for companies to you know use judgment, make qualitative adjustments certainly hasn't gone away.
• 26:11
  SPEAKER_01: Um it it's it's become more focused in some cases, like on you know particular industries or products.
• 26:17
  SPEAKER_01: Um but there, you know, there's still a need to do that.
• 26:21
  SPEAKER_01: Um and that's also of course led to more companies having more robust uh oversight and and increased um scrutiny over their the output of their models.
• 26:32
  SPEAKER_04: Well, definitely with two and a half years of experience, they've had time to put in place um more controls over that.
• 26:39
  SPEAKER_04: But it you know, as I was listening to you talk, and as we think about the breakdown of all these traditional relationships, you know, when you can kind of predict how things would move in tandem with each other.
• 26:49
  SPEAKER_04: And then now we have some conflicting data, different things happening in the global economy.
• 26:55
  SPEAKER_04: Um, it definitely is a case that even with those additional controls, companies should be carefully reviewing the results of their models and making sure that they do make sense and they reflect the best information uh that's in place, including what management's own forecast is saying.
• 27:14
  SPEAKER_04: So, all of that said, how are companies taking all of this different information and turning it into a forecast or into an expected credit loss?
• 27:24
  SPEAKER_01: Right.
• 27:25
  SPEAKER_01: So, so yeah, so companies need to be pretty agile, um, I would say, in their process.
• 27:31
  SPEAKER_01: So there's a lot of views on what all this means for you know our economic future and credit losses.
• 27:37
  SPEAKER_01: You know, if you listen to financial, you know, media and press, you get a lot of a lot of different um perspectives out there.
• 27:46
  SPEAKER_01: Um and because there's more economic uncertainty, um, some companies are really looking harder at multiple economic scenarios and then potentially adjusting their weightings to determine kind of the sensitivity of their allowance uh for losses.
• 28:03
  SPEAKER_01: Um so they're they're trying to determine kind of what are the downside risks that may not be in their base case.
• 28:10
  SPEAKER_01: Um and so some companies have have developed sort of alternative scenarios that are specific to like stagflation or long-term conflict scenarios and and have sort of said, all right, what's the what what's the sensitivity of my allowance to those?
• 28:26
  SPEAKER_01: And then potentially are assigning some higher probability weightings to those now than they would ever have done in the past in the past few years.
• 28:34
  SPEAKER_01: Um thinking about it as high as like 10 or 20 percent.
• 28:38
  SPEAKER_01: Um but at the same time, you know, again, it's it's hard for a quantitative model to pick up some of these factors that may impact uh you know a company's receivables like supply chain disruptions and others.
• 28:50
  SPEAKER_01: So again, you you've had also kind of an increase in specific calculations to measure some of those unique events.
• 28:59
  SPEAKER_04: All right, that's helpful.
• 29:00
  SPEAKER_04: And so, Brett, maybe looping back in, I know that obviously there's, you know, from what you and and Shannon have both said, there's a lot of judgment involved.
• 29:09
  SPEAKER_04: And anytime there's judgment, I think that leads to a lot more questions, even in your own company's control process and review cycle, and then especially then you know, you layer on auditors, some companies have regulators, like lots of people are gonna be asking questions of the people putting together those initial um calculations.
• 29:30
  SPEAKER_04: So, how do you see companies kind of respond to dealing with different types of risks in the estimation process?
• 29:37
  SPEAKER_02: Yeah, I th I think there's a couple things to think about there.
• 29:40
  SPEAKER_02: Um, first, from maybe from a governance and control perspective, um, you know, with all of this increased judgment under Cecil, as well as the increased uncertainty in the economic environment, um, I think there's increased caution and scrutiny in the allowance review process itself.
• 30:00
  SPEAKER_02: Um you know, companies need to have a robust governance structure to determine who is going to make these decisions.
• 30:08
  SPEAKER_02: What information do they need to be able to make the decisions and have that to be an organized process?
• 30:15
  SPEAKER_02: Um otherwise you can find yourself running around at quarter end on a very judgmental item, scrambling for information, scrambling to get decision makers in a room.
• 30:25
  SPEAKER_02: So we found you know, companies put in um, you know, probably generally more formal governance processes and and control meetings and things like that to make these decisions.
• 30:36
  SPEAKER_02: Um, you know, and the second thing to mention, as Shannon mentioned, the the need for qualitative adjustments has come down a little bit since the COVID-19 pandemic has subsided.
• 30:46
  SPEAKER_02: Um, but qualitative adjustment adjustments haven't gone away for sure.
• 30:51
  SPEAKER_02: Um in some cases, they've um become more specific rather than broader broader base portfolio concerns early in the pandemic.
• 30:59
  SPEAKER_02: You have a specific geographical concern, you have a specific industry concern rather than concerns just generally about your loss estimation models.
• 31:09
  SPEAKER_02: Um companies have found that they've um used in in enhanced documentation to support material specific qualitative adjustments of you know for sub-segments of the portfolio, and also documenting, thinking through why that adjustment for that sub segment isn't relevant for other sub-segments too, you know, um thinking why it's why it's specific.
• 31:33
  SPEAKER_02: Um and then I I think uh there's been a lot of work done to develop stronger governance around this, around the qualitative adjustments in general, to make um as as direct of a link as they can to perceived model shortcomings.
• 31:50
  SPEAKER_02: Um, you know, companies I I think are increasingly not thinking about these qualitative adjustments as very broad qualitative adjustments, if they don't have to, um, but thinking about them about what specifically is my model not picking up that's exists that I think exists in the economic environment that I need to adjust it for.
• 32:09
  SPEAKER_02: You know, a good example is is our current inflation rates.
• 32:13
  SPEAKER_02: You know, your your loss estimation data in the past may not have ever contemplated inflation rates in the US like we're seeing now.
• 32:21
  SPEAKER_02: So, can how can I think about specifically that shortcoming and what qualitative adjustments might I be able to make for that specific shortcoming rather than just broadly saying, I think my loss estimation models in general are falling short.
• 32:36
  SPEAKER_04: All right.
• 32:36
  SPEAKER_04: Well, definitely good reminders there.
• 32:37
  SPEAKER_04: And I think in particular, the reminders about documentation and oversight probably apply to everything in our conversation, you know, not just the CESOL estimates and probably actually to everything pretty much we talk about on this podcast more broadly.
• 32:52
  SPEAKER_04: But with all that said, Shannon, we keep alluding to different macroeconomic impacts, but I know that your team actually spends time analyzing the impacts of those changes or of those impacts on the allowance for um credit losses for many banks.
• 33:11
  SPEAKER_04: So obviously, big picture and and not dealing with any specifics, but what types of trends are you seeing that might be helpful for our listeners just to think about in dealing with their own reserves?
• 33:23
  SPEAKER_01: Yeah, so relative to the to the beginning of the year, we we've certainly seen some increases to the level of reserves.
• 33:29
  SPEAKER_01: I mean, again, it's it's not universal as there's there's a lot of mixed views out there, as we've as we've talked about.
• 33:35
  SPEAKER_01: Um and and there's been you know, of course, more volatility in the allowance um at banks since since the adoption of Cecil.
• 33:43
  SPEAKER_01: Um so most you know, public companies adopted in Q1 of 2020.
• 33:49
  SPEAKER_01: So with the with the forecast economic conditions as they were back then, many companies recognized an increase in their reserves, and then you know, they in they've trended down right since then over the course of 2020 through 2021 due to recovering economic conditions, government stimulus, other economic factors, right?
• 34:07
  SPEAKER_01: Um but can now compare to the end of 2021, reserves have generally either have flat or have they begun to increase um in the first half of 2022, just due to the economic uncertainty, the increasing likelihood of a recession and slowdown.
• 34:22
  SPEAKER_01: Um but as I mentioned, my you know, market sentiment is is mixed.
• 34:27
  SPEAKER_01: So there's not um it's not a universal uh thing that we're seeing across all financial institutions.
• 34:33
  SPEAKER_04: All right, but then given what we were talking about earlier in terms of sort of the data that's maybe moving in untraditional directions from what we see in terms of relationships, do you think we are going to see things just continue to be volatile or even potentially to get more volatile?
• 34:51
  SPEAKER_01: Yeah, I think it's likely that there's going to be more kind of volatility and also just dispersion um in terms of what people are thinking and um because there's so many different views.
• 35:02
  SPEAKER_01: Um you have different views about you know likelihood of a of a soft economic landing.
• 35:07
  SPEAKER_01: Um and you you also have just a lot of a lot of data.
• 35:10
  SPEAKER_01: So like if you think about you know consumer credit, for example, like credit card balances increased by$46 billion in Q2 of 2022 over the past year.
• 35:20
  SPEAKER_01: Um over the past years it's increased like by uh around$100 billion, the 13% increase, which is the largest increase in 20 years.
• 35:30
  SPEAKER_01: Um and delinquency transition rates for credit cards and auto loans is also increasing, especially for lower lower income borrowers.
• 35:37
  SPEAKER_01: Um and you've also seen like an increase in delinquencies and like subprime auto lending.
• 35:43
  SPEAKER_01: Um so you know, there's there's those things that are happening.
• 35:48
  SPEAKER_01: You also have like inflation that's been affecting consumers and and you know, car repossessions have been up.
• 35:53
  SPEAKER_01: Um, but at the same time, some of those factors are are could could help, right?
• 35:58
  SPEAKER_01: Obviously, um, you know, anyone who's tried to buy a car in the past you know year or so uh knows that you know used price used car prices as well as new are you know are kind of uh they're high, right?
• 36:08
  SPEAKER_01: Um so you know that being said though, like except for you know some specific segments like subprime, like credit quality has been generally stable, relatively stable even in the face of inflation.
• 36:22
  SPEAKER_01: Um and while inflation is you know is has started to slow down a little bit, it it's still pretty high.
• 36:29
  SPEAKER_01: Um and the the you know, the Fed has emphasized they're focusing on reducing inflation, they're continuing to raise interest rates to try to slow the economy, reduce demand, and and you also have other central banks globally that are also raising interest rates to try to reduce inflation.
• 36:44
  SPEAKER_01: Um so it there's you know, with that with all that backdrop, you know, you've got a decline in consumer confidence, um, although there have been some some improvements from some lows earlier in the summer.
• 36:59
  SPEAKER_01: Um and the the savings rate of consumers has dropped um quite a bit, likely due again to inflation.
• 37:08
  SPEAKER_01: But at the same time, you know, consumer balances or consumer balance sheets uh on the whole are are reasonably strong.
• 37:14
  SPEAKER_01: Um so you've got uh you know some people that will that with that backdrop with all those those factors believe that those conditions, you know, economic conditions are gonna deteriorate and have therefore kind of changed their credit outlook, they've increased their reserves, um, whereas others have uh kind of look at some of the positives, right, uh that that I mentioned and and haven't um haven't done the same thing.
• 37:41
  SPEAKER_01: They they they feel that um their the reserves that they have are adequate and that they don't need to significantly increase them.
• 37:48
  SPEAKER_04: All right.
• 37:49
  SPEAKER_04: Well, I think that's a good reminder.
• 37:50
  SPEAKER_04: I'm gonna put another pitch in for good documentation because particularly when there's obviously so many different points of view, I think making sure it's particularly important to make sure that your company's point of view is documented clearly at the time you made those judgments.
• 38:08
  SPEAKER_04: So you know you're not trying to figure out later why you you did what you did.
• 38:11
  SPEAKER_04: So, Shannon, Brett, very, very helpful.
• 38:14
  SPEAKER_04: Definitely a lot to think about in this area.
• 38:17
  SPEAKER_04: I know you both spent a lot of time talking to clients about financial instruments and financial instrument impairment.
• 38:25
  SPEAKER_04: Any sort of last words of wisdom in terms of recommendations you'd give?
• 38:31
  SPEAKER_04: Um, and Brett, I'll ask you that question.
• 38:34
  SPEAKER_02: I guess I would just go back to where we started this conversation and remember that different types of financial assets have different uh impairment frameworks, and so they're gonna be impacted differently by what we've what we're seeing in the macroeconomic uh environment and geopolitical events.
• 38:50
  SPEAKER_02: Um, for equity investments under the measurement alternative, make sure you're looking for those qualitative impairment triggers and coming up with your best estimates of fair value if you hit a trigger.
• 39:02
  SPEAKER_02: Uh, for AFS debt securities where the the um you've been hit by maybe rising interest rates or for whatever reason the fair value is declined below a cost basis.
• 39:14
  SPEAKER_02: So you have a negative amount sitting there in OCI, you need to think about your intent uh to sell those securities or potential requirements to sell those securities before recovery.
• 39:24
  SPEAKER_02: And in all cases, be be looking at credit losses.
• 39:27
  SPEAKER_02: Um and then in for other assets evaluated under Cecil, um, you know, make sure you've got the right governance structure to think about um making revisions to your economic outlook, whether that's through forecast adjustments, probability weighting if you use multiple different macroeconomic scenarios, or these qualitative adjustments.
• 39:49
  SPEAKER_02: And then you know, you brought it back to documentation and controls.
• 39:53
  SPEAKER_02: Those are those are always important, especially when you're dealing with significant judgments like this.
• 39:58
  SPEAKER_04: All right, very helpful.
• 39:59
  SPEAKER_04: And then, Shannon, more maybe looking sort of bigger picture as you're dealing with companies, any piece of advice you would give them?
• 40:08
  SPEAKER_01: Uh I I think it's I think we we've hit on a lot of it, but I would say it's make sure that your um you know allowance estimate reflects your uh best judgment and and estimate, and that it's reasonable, uh, reflects you know historical and you know forecast conditions, and that you've you've it's it's well supported and well documented.
• 40:30
  SPEAKER_04: All right, very good way to summarize that.
• 40:32
  SPEAKER_04: So, uh Shannon, this is your first time with this, but now we're to my favorite part of the podcast.
• 40:38
  SPEAKER_04: Promise I have some good questions uh for you guys today, for me to try to stump you.
• 40:42
  SPEAKER_04: But I I think these are some good ones that you're gonna like.
• 40:44
  SPEAKER_04: So let me get my list.
• 40:47
  SPEAKER_04: All right, I have two questions for you and a couple hints too.
• 40:52
  SPEAKER_04: So, first question, um, just as a reminder, and I know you too know this, but just a reminder for our listeners that right at the time of COVID, uh, there was in the CARES Act the ability for SEC financial institutions with less than 50 billion in assets to delay implementation of CESOL.
• 41:14
  SPEAKER_04: So they would have had to adopt CESOL, or or if they would have anyway, they did have an opportunity to delay because of the CARES Act and the subsequent consolidated approach appropriations act.
• 41:27
  SPEAKER_04: So my question for Shannon and Brett is what percent actually took that delay?
• 41:35
  SPEAKER_04: And if you need a hint, I have a few a few data percentages I can give you to pick from.
• 41:44
  SPEAKER_02: I think we'll take the hint.
• 41:45
  SPEAKER_02: And I'm gonna make Shannon guess and then I'm gonna go lower.
• 41:49
  SPEAKER_04: Okay, perfect.
• 41:50
  SPEAKER_04: All right, so here's the hint.
• 41:52
  SPEAKER_04: I thought you may want it.
• 41:53
  SPEAKER_04: 5%, 25%, 40%, or 65%.
• 41:59
  SPEAKER_01: I'm gonna go five percent so that Brett can't go lower.
• 42:03
  SPEAKER_04: Very good guess.
• 42:05
  SPEAKER_01: You got it.
• 42:07
  SPEAKER_04: So you want to go five.
• 42:08
  SPEAKER_02: I want to go five, too.
• 42:10
  SPEAKER_04: All right.
• 42:10
  SPEAKER_04: So I was hoping you were gonna go higher, the next higher, because it's actually 25%.
• 42:15
  SPEAKER_04: And so it says, well, calendar year ends as you see filers that are not um smaller reporting companies or emerging growth companies were set to implement the standard at the beginning of 2020.
• 42:25
  SPEAKER_04: As I said earlier, there was a delay.
• 42:28
  SPEAKER_04: And of publicly traded institutions that were um, you know, would have been otherwise required, we did see about 25% elect to take the delay.
• 42:38
  SPEAKER_04: So I think higher actually than I expected as well.
• 42:41
  SPEAKER_04: I would have gone with five, too.
• 42:42
  SPEAKER_04: So all right.
• 42:44
  SPEAKER_04: So the second one, and I will give it, I will just give the hint for this one.
• 42:48
  SPEAKER_04: In the year that Cecil was issued by the FASB, where were the Olympics held?
• 42:53
  SPEAKER_04: And my hint here is it's not the year it was effective.
• 42:57
  SPEAKER_04: It was the year it was issued.
• 42:59
  SPEAKER_04: So you can I'll just give you that.
• 43:00
  SPEAKER_04: That was 2016.
• 43:02
  SPEAKER_04: So it was effective in 2020, issued in 2016.
• 43:05
  SPEAKER_04: Any guesses where the Summer Olympics were?
• 43:10
  SPEAKER_04: It's a test of your memory.
• 43:11
  SPEAKER_01: I think it was Brazil.
• 43:14
  SPEAKER_04: It was in Brazil.
• 43:15
  SPEAKER_04: Any cities, or should we just go with Brazil for the win?
• 43:19
  SPEAKER_04: Yes, very good.
• 43:20
  SPEAKER_04: So that was actually the first time the Olympics were held in South America.
• 43:23
  SPEAKER_04: So good job, guys.
• 43:25
  SPEAKER_04: And as always, thanks so much for joining me.
• 43:27
  SPEAKER_04: I really appreciate all your insight.
• 43:30
  SPEAKER_04: That's our show for today.
• 43:31
  SPEAKER_04: Tune in next Tuesday for the continuation of our impairment toolkit for the month of September.
• 43:37
  SPEAKER_04: And we're back on Thursday with more ESG information.
• 43:41
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• 43:48
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• 43:57
  SPEAKER_04: From Thought Leadership at PWC, I'm Heather Horn.
• 44:01
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