By: Kenneth Shilson, CPA

       President, Subprime Analytics

 

                As BHPH operators begin 2022, probably the last thing on their minds is CECL, the new AICPA credit loss measurement standard required for financial statements prepared under generally accepted accounting principles, which becomes effective January 1, 2023.  Unfortunately, it’s later than it appears and preparation should begin now.

                As discussed in this article, many think that implementing CECL can be deferred until 2023.  However, nothing could be further from the truth!

                The AICPA passed a new credit loss measurement standard which requires implementation starting in 2023 by private companies who carry financial instruments (receivables).  The new requirement was issued in Accounting Standards Update 2016 – 13 – Financial Instruments – Credit Losses (Topic 326) and its initial implementation was deferred until 2023.  This new standard applies whether the financial instruments (like buy here, pay here contracts) and lease contracts are carried on or off the balance sheet.  Under current generally accepted accounting standards (GAAP), credit losses must be recognized when it is probable a loss has been incurred.  The new standard requires credit losses on receivables to include expected credit losses in the future, which changes the approach under which they are recognized and measured.  Another significant change under the new standard is that future loss estimates must be based upon reasonable and supportable forecasts over the entire life of the receivables (including expected repayments).  In the deep subprime auto finance industry this requires historical metrics like static pool, loss to liquidation, CRR, and default related data to support such estimates.

                It is also important for BHPH operators to realize they need metrics to make more informed underwriting decisions, validate portfolio performance and to borrow money from capital providers.  Without metrics, it is analogous to “buying a used vehicle without first looking under the hood!”

                I have participated in training hosted by the international CPA firm of PWC which discussed all the challenges in applying this new credit loss standard.  The training emphasized companies should proactively start compliance by developing a strategic approach which requires them to identify their own data sources and technology, and compile current portfolio data to support the estimate requirements under the new standard.  The PWC recommendation – “To implement the new accounting standard companies should collect data to support estimates of expected credit losses in a way that aligns with the method that will be used to estimate their allowance for credit losses.  Depending on the method selected, companies may need to accumulate additional data.  Companies also may need to retain data longer than they have in the past for loans that have been paid off or charged off.”

BHPH operators should begin immediately to develop the data needed to comply.  It will impact their future borrowing relationships, loan covenants, and financial results when GAAP financials are presented.  Any increase in their allowance for credit losses from adopting the new standard will initially result in a reduction of equity which is not deductible for income tax purposes.  In comparative financial statements, the prior year impact must also be disclosed requiring the need for retroactive computations in 2022.  For companies who do not prepare or use GAAP basis financials, you still need metric data to validate portfolio performance and to value your auto installment portfolio.

Companies who do not currently have historical metrics, like static pool, loss to liquidation, CRR, and default rate calculations, should initially determine if such underlying data is available from their DMS provider and if it is credible.  A variety of modeling approaches are possible but discounted cash flow, receivable roll rates, and portfolio vintage models are the most commonly used in the BHPH industry.  Regardless of the chosen method, a range of data will be required including contract term length, interest collectability, amortization schedules, recovery rates, together with portfolio risk attributes and collateral information.  Contractual data and underlying risk attributes are the primary data requirements.  In addition, the aforementioned attributes must be supplemented with economic forecasting information.  The historical data which is needed will have to be sourced externally if it can’t be compiled internally in support of your own modeling approach.

In summary, companies are urged to coordinate with their financial advisors or CPA, and their DMS provider to begin the process immediately.  Companies are advised to estimate the expected financial impact of the new standard on financial loan covenants and discuss it with their lender to avoid future surprises!

Here are six suggested steps to do now in order to comply:

1.       Consult with your financial advisor and DMS provider about the requirements.

2.       Calculate the impact of adopting the new standard in your own financial statements.

3.       Determine the best way to implement the new standard with the least detrimental impact.

4.       Obtain or create historical data and loss metrics for the required calculations.  You may want to contact me if you do not have any!

5.       Determine how the new standard will impact your loan covenants and current borrowing relationship.

6.       Proactively comply to get the most favorable results.

Implementation of the new standard will be particularly burdensome for those who do not have the knowledge and portfolio data required.  However, the information you gather will help you make better operating and risk management decisions in the future.  You should start now and not procrastinate to minimize the adverse financial impact from this new measurement standard.  Your future results will depend on it.  Good luck!

 

Kenneth Shilson is President of Subprime Analytics (www.subanalytics.com) which provides computerized subprime auto portfolio metrics analysis using proprietary data mining technology.  To date, the company has analyzed over 2 million subprime auto deals aggregating $25 billion.  The company provides portfolio analysis, profit and cash flow enhancement and other consulting services to operators and capital providers nationwide.  You may contact Ken Shilson by phone at 281-723-9508 or email at ken@kenshilson.com.