FASB’s Current Expected Credit Loss Model for Credit Loss Accounting (CECL)
Background, Key Concepts and Implementation Challenges
On June 16, 2016, the Financial Accounting Standards Board (FASB) issued its long awaited Current Expected Credit Loss impairment standard, or CECL. The full FASB Accounting Standards Update 2016-13 can be found here. The new accounting standard changes the impairment model for most financial assets and certain other instruments covered by the new guidance. Substantially all entities will be affected; however, there may be a disproportionate impact to banks, savings associations, credit unions, and financial institution holding companies, since the standard impacts trade and other receivables, debt securities, loans and other related instruments that are customary within such entities. This article focuses on the impact to financial institutions and the allowance for loan losses. Accounting for loan losses is at the heart of financial institution financial reporting. This particular change is arguably the biggest change ever made to financial institution accounting.
CECL is effective for the financial statements of SEC registrants for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. For other public business entities that are not SEC filers, CECL is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Private financial institutions (those not considered public business entities, as defined by the FASB) will implement CECL in fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021, which alleviates those entities from filing call reports under CECL during the first year the new standard is implemented. However, there are two key points here. First, there remains some uncertainty as to whether certain banks will qualify as private businesses under CECL, and that is an area the FASB intends to clarify as it refines CECL over the next few years prior to initial implementation. And second, whether deemed a private business or not, in the initial year that CECL is implemented, a financial institution will cumulatively report the impact of CECL for the full fiscal year, meaning that a private entity with a December 31 year end will need to determine its reserves in accordance with CECL as of January 1, 2021 for purposes of its December 31, 2021 year end audited financial statements.
Summary of effective dates for calendar year institutions:
|Type of institution||Calendar year of adoption||First interim periods affected|
|Public business institutions that are not SEC registrants||2021||2021|
|All other institutions||2021||2022|
At the highest level, FASB’s Accounting Standards Update No. 2016-13, Financial Instruments- Credit Losses, “Measurement of Credit Losses on Financial Instruments” requires that “life of loan” loss estimates be recognized for loans at their origination or purchase, essentially employing a forward looking “expected loss” model that generally will result in the earlier recognition of credit losses. The FASB’s proposal previously received concern from community banks and credit unions over the new rule’s potential complexity and implementation costs. Financial service executives have argued that the new standard will significantly impact the costs to prepare and audit the allowance for loan losses and how banks and credit unions manage their capital. At the same time, regulators have indicated (most recently in FIL 39-2016) their intent to reasonably apply the new standard based on the size and nature of the respective institution, and have suggested that the new standard will allow an entity to leverage its current internal credit risk systems as a framework for estimating credit losses.
In a press release shortly after the new standard was released, FASB board member Hal Schroeder commented on the board’s new standard:
- “The objective is to better align the credit risk that’s being taken, the economics of the transaction, with the accounting for the economics. What you saw clearly in the mid-2000s was loosening of underwriting standards and rapid growth in loans, but the reserves were not keeping up, and in fact they actually decreased. In the years before the crisis, loans went up 45%, but reserves went down 10%, and that illustrates the mismatch between the economics of lending and the accounting. This standard is an effort to realign one with the other.”
While FASB’s interpretation of that data can be debated, FASB began deliberating changes to credit loss standards at the time of our last financial crisis in 2008. From the time those deliberations began, the board issued three separate documents for public comment, and received over 3,000 comment letters. Along the way, the FASB met with more than 200 users of financial statements, including preparers, regulators, auditors, banking institutions of various sizes, nonfinancial organizations and insurance companies.
As the FASB finalized CECL, some experts in the United States provided early estimates that CECL implementation would result in 30-50% increases in loan loss reserves for financial institutions. Recent independent estimates have been significantly lower; as low as 3% increases in loan loss reserves in fact for some geographic locations in the United States. It’s clear that the ultimate impact on a financial institution’s loan loss reserves will depend greatly on the historical practices and experience, current conditions and market forecasts for each respective institution. Some organizations could in fact see reductions in allowances for certain financial asset classes. The ultimate impact however may not become clear until implementation begins for SEC registrants in the first quarter of 2020.
Current accounting rules for credit losses have been in place for 40 years, and use an “incurred loss” methodology, whereby reserves are based on historical losses by instrument or pool and are generally consistent with US GAAP for all liabilities and reserves. In stark contrast, CECL will require each entity to measure all expected credit losses based on historical experience, current conditions and reasonable and supportable forecasts. With respect to historical experience, CECL requires that the evaluation be based on the life of the loan or pool, and not some recent (or selected) period. This is a significant change in approach that likely will contribute to some of the changes in loan loss balances upon adoption of CECL, and will also require entities to maintain lifetime loss information in addition to annual loss data. As to reasonable and supportable forecasts, it is clear that organizations will need to establish processes and controls to reasonably forecast future economic conditions, while also quantifying the effect of those conditions on expected losses for individual financial assets and financial asset pools.
The requirement to reasonably forecast future economic conditions certainly provides a level of complexity, as well as variability. In years since the last financial crisis, regulators have increased demands for banks and credit unions to document and justify how economic conditions, underwriting standards and related factors have affected their reserve estimates. Under CECL, management’s forecast of future economic conditions (e.g. interest rates, unemployment, etc.) will directly impact certain classes of loans based on their terms and expected life. Consider, for example, that a particular forecast for interest rates may directly impact the estimated credit loss for a variable rate loan, but that impact will depend on the expected life of the loan, and the credit quality of the underlying borrower. Those interrelated factors will add some complexity, but may also add some potential volatility inherent in any long-term forecast, which could create capital concerns for some institutions. Additionally, that complexity and volatility may add challenges for regulators and auditors when evaluating the propriety of loss reserves.
Under current guidance, organizations generally estimate their loan loss reserves on a loan-by-loan basis for impaired loans, and on a pool basis for other loans. Under CECL, the concept of individual versus impaired loss analysis disappears, and the loan loss reserve is evaluated under the expected loss concept. That is not to say that loans with unique credit characteristics cannot be identified as “impaired” for purposes of individual credit loss evaluation, but rather that there is no distinction between measuring credit losses on impaired and unimpaired loans under CECL. Still, some guidance may still be required from the FASB to determine exactly when collective evaluation or individual evaluation is appropriate.
CECL effectively transforms the allowance for credit losses to a “valuation account”, and that valuation account is measured as the difference between the amortized cost basis of the underlying financial asset and the net amount expected to be collected on that financial asset. Although some loss estimation approaches used today may still be permitted, you can expect that your regulators will require you to utilize forward-looking information to better inform your credit loss estimates. Although not defined in the new standard, the FASB indicates that “expected credit loss” should:
- Be based on an asset’s amortized cost (including premiums or discounts, net deferred fees and costs, foreign exchange impact, and fair value hedge accounting adjustments);
- Reflect losses expected over the remaining contractual life of an asset, considering the effect of voluntary payments;
- Consider available relevant information about the collectibility of cash flows, including information about past events, current conditions, and reasonable and supportable forecast; and
- Reflect the risk of loss, even when that risk is remote, meaning that an estimate of zero credit loss would seldom be appropriate.
Ultimately, CECL does not prescribe the use of any specific estimation methods, and organizations may apply different estimation methods to different groups of financial assets. In fact, organizations may very well continue to segment their portfolios for purposes of credit loss evaluation as they have in the past, or with only modest refinements. The ability to utilize judgement that is appropriate and practical for an entity’s particular needs and circumstances was one of the concessions the FASB made as it finalized the provisions of CECL. As such, it is not expected that the smaller and less complex credit unions and community banks, for example, would need to implement estimation processes and methodology utilized by the nation’s largest financial institutions. Smaller and less complex institutions will be able to adjust their existing allowance methods to meet the requirements of CECL without the use of costly and complex models.
The flexibility afforded to management’s evaluation of the loss reserve under CECL is one of the benefits of the standard, since under CECL, losses are recorded when management perceives a risk to be evident. That flexibility, however, requires forecasts and analysis that will demand some effort, as well as demonstration of appropriate support that is far more pervasive than what is typically maintained today.
In the years leading up to these new standards, third-party service providers have encouraged many community banks to purchase software and systems to help comply with the requirements of CECL. However, in a joint statement issued on June 17, 2016, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the National Credit Union Administration indicated that they will not require institutions to engage third-party service providers to calculate their allowances for credit losses, and that those institutions should instead discuss the availability of historical loss data with their core loan service providers. Some system changes related to the collection and retention of data may be warranted, but the extent of those modifications will be entity-specific. In the final paragraph to that joint statement, the agencies concluded that, “The move to an expected credit loss methodology represents a change to current allowance practices for eligible agencies and institutions. The agencies support an implementation of the FASB’s new accounting standard that is both reasonable and practical, taking into consideration the size, complexity, and risk profile of each institution.”
So, exactly how much data does an organization need in order to comply with the requirements of CECL? An appropriate response to that question might be, “how much data do you have?” Certainly, organizations will need an abundance of data and history, since the standard requires unadjusted life cycle loss history. That concept means you’ll need loan history that is greater than the average term of each class of loans by one year (e.g. if the average term of a loan class is seven years, you might need to gather eight years of data). The more data you have, the more reliable the estimate, and the better correlated your result to the external and internal factors required for consideration under CECL.
Additionally, an abundance of data will prove necessary when calculating prepayments over the life of a financial asset, which is one more factor an organization will consider when developing an estimated credit loss reserve. This particular area is one that is likely to garner additional discussion, and ultimately additional guidance from the FASB board. Because credit losses expected over the life of a financial asset are recorded upon that financial asset’s origination, the life of that financial asset needs to be considered. The FASB has excluded expected extensions, renewals or modifications from that consideration, unless the organization expects a troubled debt restructuring. Although this “life” concept provides some complexity to the implementation of and continuing compliance with CECL, it is a manageable requirement that will require enhanced data collection and analysis by some organizations.
Upon implementation of CECL, and for all financial assets carried at amortized cost, changes in loss reserves (up or down) will be recorded within retained earnings in the year CECL is adopted. As such, a cumulative-effect adjustment will be recognized on the balance sheet as of the beginning of the first reporting period in which CECL becomes effective. As relief, the existing loss contingency model codified in ASC 450-20 will continue to apply to instruments outside the scope of the new standards, including for example: receivables between entities under common control, participant loans made by a defined contribution plan, pledges receivable of a not-for-profit entity, and policy loan receivables of an insurance entity.
With the changes in approach to loss reserves, financial statement disclosures will be revised and significantly expanded. The more significant disclosures that CECL will require include:
- Information about how the entity develops its allowance, including changes in the factors (e.g., portfolio mix, economic conditions, credit trends) that influenced management’s estimate of expected credit losses and the reasons for those changes; and
- Information to further disaggregate the information an entity currently discloses about the credit quality of loans receivable (i.e. credit quality indicators) by year of a loan’s origination for as many as five annual periods. The FASB provides an example in which an entity that uses delinquencies to monitor the credit quality of its consumer loans will need to disclose, by category of days past due, the amount of its consumer loans at the balance sheet date that were originated in each of the previous five annual periods. The standard provides an exemption from the requirement to present the amortized cost basis within each credit quality by year of origination for any entity that is not considered to be a public business entity. This provision eliminates some of the disclosure complexities for many community banks.
The professionals in the Baker Newman Noyes (BNN) banking and financial services practice are dedicated to remain current on the regulatory and accounting trends impacting our clients, and to keep our clients informed of those trends and how they might impact our client’s business. Should you have questions about CECL, the implementation of systems and procedures in preparation for CECL, or any other areas in which we can be of assistance, please contact Denise Taaffe, lead of the banking and financial services practice, or a member of your BNN service team at 800.244.7444.
The FASB has also assembled a Transition Resource Group to assist organizations with the implementation of this new standard and provided additional guidance that may be needed as organizations plan for and eventually implement changes required by CECL. When addressing more complex or unusual technical issues, BNN utilizes the Transition Resource Group, as well as contacts we have within regulatory bodies at the state and federal level.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.