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Registered Broker-Dealer: Measurement of Credit Losses on Financial Instruments

November 19, 2020
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Accounting for Current Expected Credit Loss

During June 2016 the Financial Accounting Standards Board (“FASB”) issued its Accounting Standards Update (“ASU”) 2016-13, Measurement of Credit Losses on Financial Instruments. Within the codification of accounting principles, including the ASU and several amendments, FASB has identified this rule as Accounting Standards Codification Topic 326 (“ASC 326”). The rule is often referred to as “Current Expected Credit Loss,” or “CECL.” For brokers and dealers (“brokers” or “broker-dealers”) that file or furnish their financial statements with the Securities and Exchange Commission (“SEC”), ASC 326 is effective in 2020. Throughout this article, we will explain the main provisions that affect broker-dealers and how they impact their accounting. The focus of this article is for receivables with maturities of one year or less.

The Need for Change

After the global financial crisis of 2008, financial statements users expressed concern that current US GAAP did not reflect bad debts that were expected by management at the financial statement date, since some of the “expected losses” had yet to be incurred. After taking in the feedback from financial statement readers, FASB published its guidance under ASC 326. FASB writes that during the global financial crisis users of financial statements analyzed credit losses by using forward-looking information to assess a broker-dealer’s allowance for credit losses on the basis of their own expectations. Consequently, in the lead-up to the financial crisis, users were making estimates of expected credit losses and devaluing financial institutions before accounting losses were recognized, highlighting the different information needs of users from what was required by US GAAP.

What is the Change About?

ASC 326 brings an end to the existing methodology, known as the incurred loss methodology. In its place, CECL changes the components of the estimate that should be used to determine the allowance for doubtful accounts. FASB allows a broker-dealer to use data and apply methods that reasonably reflect its expectations of the bad debt estimate. FASB prescribes methods that include, but are not limited to discounted cash flow methods, loss-rate methods, probability-of-default methods and methods that utilize an aging schedule.

ASC 326 requires that a financial asset (or a group of financial assets), such as trade receivables, commissions receivable, or loans receivable be measured at amortized cost to be presented at the net amount expected to be collected. These financial assets should be grouped in pools on the basis of similar risk characteristics, such as effective interest rates, size, collateral, financial asset type, etc. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net carrying value at the amount expected to be collected on the financial asset. No longer would a broker-dealer use the incurred loss methodology in which an entity will study individual receivables for collectability. Now a broker-dealer will review pools of receivables and apply judgment to historical loss rates recovery statistics, and other factors that impact estimates of future cash flows from receivables.

Also, credit enhancements should be considered in developing estimated credit losses under ASC 326. However, when estimating expected credit losses, an entity shall not combine a financial asset with a separate freestanding contract that serves to mitigate credit loss. As a result, the estimate of expected credit losses on a financial asset (or group of financial assets) shall not be offset by a freestanding contract (for example, a purchased credit-default swap) that may mitigate expected credit losses on the financial asset (or group of financial assets).

With respect to amounts expected to be collected ASC 326 provides practical expedients, described below, relating to securities borrowed and failed to deliver assets. The practical expedients relate to collateral dependent financial assets and financial assets secured by collateral maintenance provisions. These practical expedients take into account the unique risk characteristics of these financial assets.

Proprietary trading securities recorded at fair value through the income statement are outside the scope of ASC 326.

A broker-dealer will apply the ASU and its amendments through a cumulative effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (that is, a modified-retrospective approach). During 2020 broker-dealers will be required to disclose information about the change in accounting principle and its effects with each interim financial statement.

Practical Expedients

CECL provides for the following practical expedients:

  • Collateral dependent financial asset:
    Broker-dealers may determine the allowance for credit losses by comparing the fair value of the collateral to the amortized cost basis of the related financial asset. Additionally, there is a practical expedient for financial assets where the borrower is experiencing financial difficulty and a broker-dealer expects the loan to be satisfied through operation or sale of collateral. The fair value of the collateral shall be adjusted for estimated costs to sell when sale of the collateral is used to repay the receivable.
  • Financial assets secured by collateral maintenance provisions:
    For certain financial assets, the borrower may be required to continually adjust the amount of the collateral securing the financial asset(s) as a result of fair value changes in the collateral. In those situations, a broker-dealer may compare the amortized cost basis with the fair value of collateral at the reporting date to measure the estimate of expected credit losses. If the borrower continually replenishes the collateral securing the financial asset such that the fair value of the collateral is equal to or exceeds the amortized cost basis of the financial asset and the borrower has the intent and ability to continue to replenish the collateral as necessary, a broker-dealer may determine that the expectation of nonpayment of the amortized cost basis is zero.

Considerations and Business Risks for Certain Receivables

A broker-dealer’s estimate of expected credit losses should consider the expected risk of credit loss even if that risk is remote, regardless of the method applied to estimate credit losses.

A broker-dealer, however, is not required to measure expected credit losses on a financial asset (or group of financial assets) in which historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data. Management would be expected to document its considerations regarding the impact of CECL and why it would be immaterial with respect to certain financial assets. Refer to the appendix for comments about selected categories of broker-dealer financial assets.

Click here to refer to the appendix for comments about selected categories of broker-dealer financial statements.

Relevant Selected Disclosures for Broker-Dealers

The presentation and disclosures required by CECL are intended to provide information that helps users analyze a broker-dealer’s exposure to credit risk and understand how management of the broker-dealer estimates the allowance for credit losses. Broker-dealers should use judgment in determining the appropriate level of detail to provide financial statement users with sufficient information to understand credit risk related to the in scope assets.

In general, a broker-dealer should provide the following information to enable its users to:

  • Understand management’s method for developing its allowance for credit losses
  • Understand the information that management used in developing its current estimate of expected credit losses
  • Understand the circumstances that caused changes to the allowance for credit losses, thereby affecting the related credit loss expense (or reversal) reported for the period

When FASB describes disclosure objectives, it describes the objectives in terms of “portfolio segments.” Portfolio segments are defined, for all businesses, as the level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses. To fulfill the above objectives of CECL, a broker-dealer shall disclose all of the following by portfolio segment and, if applicable, major security type: 

  • A description of how expected loss estimates are developed
  • A description of the broker-dealer’s accounting policies and methodology to estimate the allowance for credit losses, as well as a discussion of the factors that influenced management’s current estimate of expected credit losses, including:
    • Past events
    • Current conditions
    • Reasonable and supportable forecasts about the future
  • Additional disclosures including quantitative and qualitative disclosures about the portfolio segments, their risk characteristics, and major changes during the period in financial assets

When is the Change Effective?

The new accounting should be implemented not later than the dates indicated below:

  • Broker-dealers that file with the SEC and therefore meet the definition of public business entities, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years; and
  • Broker-dealers that file with the Commodity Futures Trading Commission and do not meet the definition of public business entities, for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years

While FASB has delayed implementation for smaller reporting companies (“SRCs”), it is important to note that the SEC defines SRCs as issuers that may not exceed established levels of public float, annual revenue, or both as defined by the SEC. Most broker-dealers are not issuers and would therefore not be eligible to qualify as SRCs as defined in Item 10(f)(1) of Regulation S-K. Those broker-dealers that believe they are SRCs should confirm with their legal counsel that they satisfy the definition of an SRC.

View the appendix here.