Implementing CECL: A Practical Perspective on Documentation Requirements

Angelo Spaneas, Audit Senior Manager
June 2018

As your institution moves closer to implementation of the Current Expected Credit Losses (CECL) model of the allowance for loan losses, one of the key elements that management should be thinking about in addition to the technical aspects like actually building the model, is the practical question: What kind of documentation will be required to support the assumptions and variables that go into the estimate of expected credit losses, and in larger institutions, also substantiate the effectiveness of internal control over the data used in the model? Therefore, appropriate consideration and forethought should be given to what changes may be necessary in the level and nature of documentation surrounding the development and implementation of your institution’s expected credit loss estimation model – and the best time to do that is now. Underneath all the industry hype and hoards of technical information out there about CECL, the practical or unglamorous side – documentation - can oftentimes be overlooked. This article will discuss some of the key points to consider as you go through the implementation process to ensure you end up with adequate documentation which supports all elements of management’s estimate of expected credit losses under CECL, and which can be maintained going forward.

Reading the guidance, it’s hard not to notice how often you see the term “reasonable and supportable;” this should be the dead giveaway as to how important having good documentation will be. In addition to regulators, two other important groups/constituents will have their own expectations of, and different needs for, this documentation: external auditors and those charged with oversight (i.e. Board of Directors, Credit Committee).

First let’s talk about External Auditors who, among other things, will need to:

  • Obtain an understanding of the policies, processes, and controls over how management developed the estimate;
  • Assess the appropriateness and significance of assumptions and variables used, based on how complex, subjective, and reliable they are;
  • Evaluate the design, and in some cases the effectiveness, of internal controls over the development of the estimate and ongoing monitoring of the model;
  • Perform testing of key assumptions within the model such as assessing the attributes used by management to segment the portfolio into similar risk pools, the basis for selecting the lookback period, as well as other assumptions and forecasts used;
  • Evaluate the adequacy of financial statement disclosure.

Therefore, documentation and information auditors will likely be looking for will relate to these five points and will include management’s description of the process used to develop the estimate, who was involved, what data was used and how it was tested, and how one method was selected over others out of a range of alternatives, and why. For example: what attributes were used in determining whether similar risks exist among a group of loans? Or, why are discounted cash flows used vs. probability of default? A detailed memo or narrative describing each of the relevant factors, identifying key assumptions and variables and measuring the relative impact of each, as well as the basis for forecasts must be supported with verifiable data and should demonstrate that all possible outcomes were considered. For example, to support estimates of prepayment speeds, documentation should include what assumptions were used in getting to the estimate, as well as how these assumptions correlate or don’t correlate to the estimated prepayment speeds for similar loans used in the valuation of mortgage servicing rights. Additionally, for institutions subject to an audit of internal control over financial reporting (ICFR), documentation should not only identify the controls management has deemed relevant and key to the development of the credit loss estimate, but also demonstrate that there are controls in place over the data used and the basis for ensuring they are operating effectively. For any variable or key assumption that significantly impacts the results, management should have strong and defensible support. The more complex, subjective, or uncertain the factor is, the more detailed the documentation should be. For example, the development of the historical loss rate has two components: (1) actual losses and (2) the lookback period.  Because it is highly subjective by nature and vulnerable to management bias, auditors will expect to see a more robust discussion of how the lookback period was determined than how the historical loss rate is calculated. Remember, in some cases, discussion of why you didn’t select one alternative is stronger than the argument for why you chose another.

One final note relating to management’s overall level of documentation: many institutions may be considering outsourcing to a third party vendor. If your institution is considering this, remember that outsourcing does not alleviate, or transfer responsibility away from, management. Furthermore, in such cases, management will also be required to have clear documentation of the due diligence process that was followed in the determination of an appropriate third party.

Now, Those Charged With Oversight:

In most cases, oversight responsibility over management’s estimate of expected credit losses falls to the Board of Directors or one of its committees such as the credit, audit, or loan committees, or a combination thereof. In order to properly and effectively oversee this, those charged with oversight perform a high-level review of the allowance calculation and the development of the factors that affect it. Going forward under CECL, this means that oversight members must have a working knowledge of the new standard and therefore should be part of the implementation process.

A large piece of this responsibility will rely on the accuracy, relevance, and adequacy of reporting by management to the board. Most likely this reporting will reflect substantial changes from the current board package they may be accustomed to seeing. Now is a good time for management and the board to start from scratch in determining what information is relevant and necessary and how frequently they expect it. Too much information could overwhelm and dilute the effectiveness of their oversight; not enough data puts them at risk of not having an appropriate level of knowledge to discharge their responsibilities. Furthermore, for institutions subject to an ICFR audit, management review controls, such as review of the allowance by the credit committee, are almost always a key entity level control identified by management, and therefore inadequate reporting can limit the precision of their review to the point where it is not considered effective.

A good starting point for this would be the documentation provided to external auditors. Like the auditors, the board needs to understand the process and methodology used in the final development of the expected credit loss estimate. At a minimum, for each element of the estimate where a choice of alternatives exists, a documented discussion of each and a “buy in” of the selected method should be included. They should be provided documentation that highlights the most important assumptions and variables in the calculation, and the relative level of estimation uncertainty or subjectivity. Overall, the board should have access to all of the information furnished to the external auditors, as well as any additional or pared down reports they may request. Remember, regulators examine and evaluate the adequacy of board oversight, and this will certainly be an area of focus and a big part of their assessment of your institution’s governance.  The ultimate quantity and technical level of documentation required and requested by the board will evolve over time; however what has been discussed in this article thus far is a good starting point.

A general observation is that management should be mindful of the evidence and documentation that will be required to support the information and assumptions used, the variables considered, and the judgments made throughout this entire process to ensure that the final result is, as they say, “reasonable and supportable.”

If you have any questions on CECL documentation or any other aspect of CECL, please reach out to Angelo Spaneas or your BNN advisor.

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.