CECL: A Novel Idea
The core methodology of CECL is not unlike that of Dickens’ A Christmas Carol, requiring a look at the Ghost of Christmas Past (historical data), the Ghost of Christmas Present (current data) and the Ghost of Christmas Yet To Come (forecasts).
As I read through CECL, I couldn’t help but think that the FASB must be fans of the great literary classic “A Christmas Carol” by Charles Dickens. The core methodology for CECL is not unlike the core premise of that beloved Christmas story. CECL methodology requires historical data (Ghost of Christmas Past), current data (Ghost of Christmas Present) and forecasts (Ghost of Christmas Yet to Come) to measure expected credit losses. Also due to uncertainty, some bankers are still skittish about CECL and see it as an unneeded and complicated change. To them, FASB represents the greedy and selfish Ebenezer Scrooge. But hopefully, with time, education and practice, bankers will find CECL to be a good change that improves financial reporting with no undue financial burden to the institution. Once implemented we can only hope that all goes well and FASB can become a kind and generous Scrooge in the eyes of the bankers.
On June 16, 2016, The Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) that improves financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations. This new accounting standard (ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments) introduces the current expected credit losses methodology (CECL) for estimating allowances for credit losses.
The new accounting standard allows a financial institution to leverage its current internal credit risk systems as a framework for estimating expected credit losses.
According to FASB, the new standard addresses concerns from a wide range of stakeholders - including financial statement preparers and users - that the existing incurred loss approach provides insufficient information about an organization’s expected credit losses.
FASB noted the new guidance aligns the accounting with the economics of lending by requiring banks and other lending institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, providing investors with better information about those losses on a timelier basis.
The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.
The ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on:
- historical experience,
- current conditions, and
- reasonable and supportable forecasts.
Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates.
Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances.
The FRB, FDIC, NCUA and OCC recently issued a joint statement that provided initial information on this new accounting standard and emphasized the importance of this accounting change and the requirement of the attention of each financial institution’s board of directors and senior management.
The new accounting standard applies to all banks, savings associations, credit unions, and financial institution holding companies, regardless of asset size.
The Joint Statement identified several key elements of the new accounting standard including:
Under CECL, the allowance for credit losses is a valuation account, measured as the difference between the financial assets’ amortized cost basis and the net amount expected to be collected on the financial assets (i.e., lifetime credit losses).
To estimate expected credit losses under CECL, institutions will use a broader range of data than under existing U.S. generally accepted accounting principles (GAAP). These data include information about past events, current conditions, and reasonable and supportable forecasts relevant to assessing the collectability of the cash flows of financial assets.
Single measurement approach: Impairment measurement under existing U.S. GAAP is often considered complex because it encompasses a number of impairment models for different financial assets. In contrast, the new accounting standard introduces a single measurement objective to be applied to all financial assets carried at amortized cost, including loans held for investment and held-to-maturity securities.
Scalability: While there are differences between today’s incurred loss methodology and CECL, the agencies expect the new accounting standard will be scalable to institutions of all sizes. Similar to today’s incurred loss methodology, the new accounting standard does not prescribe the use of specific estimation methods. Rather, allowances for credit losses may be determined using various methods. Additionally, institutions may apply different estimation methods to different groups of financial assets. Thus, the new standard allows institutions to apply judgment in developing estimation methods that are appropriate and practical for their circumstances. The agencies do not expect smaller and less complex institutions will need to implement complex modeling techniques.
Purchased credit-deteriorated assets: Another change from existing U.S. GAAP involves the treatment of purchased credit-deteriorated assets. For such assets, the new accounting standard requires institutions to estimate and record an allowance for credit losses at the time of purchase, which is then added to the purchase price rather than being reported as a credit loss expense. In addition, the definition of purchased credit-deteriorated assets is broader than the definition of purchased credit-impaired assets in current accounting standards.
Accounting for available-for-sale debt securities: The new accounting standard also updates the measurement of credit losses on available-for-sale debt securities. Under this standard, institutions will record credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of write-downs of individual securities for other- than-temporary impairment.
Retained accounting concepts: The new accounting standard does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change the current accounting requirements for loans held for sale, which are measured at the lower of amortized cost or fair value.
Effective dates: The FASB has set the following effective dates for the new standard, which depend on an institution’s characteristics:
Public business entities (PBE) that are U.S. Securities and Exchange Commission (SEC) filers (SEC filers): Fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
Other PBEs (non-SEC filers): Fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.
Non-PBEs (private companies): Fiscal years beginning after December 15, 2020, including interim periods beginning after December 15, 2021.
For all institutions, early application of the new standard is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
Currently, the regulatory agencies appear to be in agreement that the new accounting standard does not specify a single method for measuring expected credit losses; rather, institutions should use judgment to develop estimation methods that are well documented, applied consistently over time, and faithfully estimate the collectability of financial assets by applying the principles in the new accounting standard.
The new accounting standard allows expected credit loss estimation approaches that build on existing credit risk management systems and processes, as well as existing methods for estimating credit losses (e.g., historical loss rate, roll-rate, discounted cash flow, and probability of default/loss given default methods). However, certain inputs into these methods will need to change to achieve an estimate of lifetime credit losses. For example, the input to a loss rate method would need to represent remaining lifetime losses, rather than the annual loss rates commonly used under today’s incurred loss methodology. In addition, institutions would need to consider how to adjust historical loss experience not only for current conditions as is required under the existing incurred loss methodology, but also for reasonable and supportable forecasts that affect the expected collectability of financial assets.
However, taking these factors into account, the agencies were clear in their joint statement on initial information about the new accounting standard, that smaller and less complex institutions will be able to adjust their existing allowance methods to meet the requirements of the new accounting standard without using costly and complex models.
The new accounting standard requires institutions to measure expected credit losses on a collective or pool basis when similar risk characteristics exist. Although the new accounting standard provides examples of such characteristics, according to the joint statement, smaller and less complex institutions may continue to follow the practices they have used for appropriately segmenting the portfolio under an incurred loss methodology.
To implement the new accounting standard, institutions should collect data to support estimates of expected credit losses in a way that aligns with the method or methods that will be used to estimate their allowances for credit losses. Depending on the method selected, institutions may need to capture additional data. Institutions also may need to retain data longer than they have in the past on loans that have been paid off or charged off.
FASB and the regulators concur, that until institutions implement the new accounting standard, they must continue to calculate their allowances for loan and lease losses using the existing incurred loss methodology. Institutions should not begin increasing allowance levels beyond those appropriate under existing U.S. GAAP before the new standard’s effective date. However, regulators are encouraging institutions to take steps to assess the potential impact on capital.
Although the agencies recognize the impact of CECL will vary from institution to institution, the agencies encourage institutions to start planning and preparing for their transition to the new accounting standard by:
Becoming familiar with the new accounting standard.
Discussing with the board of directors, industry peers, external auditors, and supervisory agencies how best to implement the new accounting standard in a manner appropriate to the institutions’ size and the nature, scope, and risk of their lending and debt securities investment activities.
Reviewing existing allowance and credit risk management practices to identify processes that can be leveraged when applying the new accounting standard.
Identifying data needs and necessary system changes to implement the new accounting standard consistent with its requirements, the allowance estimation method or methods to be used, and supervisory expectations.
Determining how and when to begin collecting the additional data that may be needed for implementation.
Planning for the potential impact of the new accounting standard on capital.
The Agencies encourage senior management and the board of directors to work closely with staff in their accounting, lending, credit risk management, internal audit, and information technology functions during the transition period leading up to the effective date of the new accounting standard as well as after its adoption.
The Joint Statement notes that the move to an expected credit loss methodology represents a change to current allowance practices for the agencies and institutions.
While 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, many financial institutions across the U.S. are unprepared for the myriad changes that will be required as they implement the CECL standard. In fact, some may succumb to “paralysis by analysis” and fail to move forward or take appropriate action.
To help you prevent “paralysis by analysis” we offer a few pointers to help you get started or keep you moving along. Below are several key decisions you should be prepared to answer early in the CECL process.
Bank executives should make several key decisions upfront, including:
Deciding whether to tackle CECL manually or to use a system to do it.
Deciding whether you should build a system in-house or use a third-party vendor.
Determining what’s it going to take if you did it yourself.
Determining what’s it going to take if you worked with a vendor or outsourced it? And what does that mean for the implementation and the quality of work?
Key CECL decisions about data:
Do you have a sufficient amount of data to work with and does that data reflect what you know about your portfolio?
Do you need to acquire additional data?
Do you consider the use of peer data?
Part of this consideration should include the availability of data that is relevant to the institution’s unique portfolio.
An institution should analyze its data and see if the amount is statistically significant for the use of a certain methodology.
Key CECL decisions about Cross-functional collaboration:
Establish seamless collaboration and determine which functional departments will be involved in the implementation process.
Determine who in the organization needs to be involved, what their role is and what their tasks are as they prepare for implementation.
How much feedback do you get from auditors and regulators (auditors and regulators are still working through processes themselves)?
How much feedback do you get from your own management and board? (Again this is new to everyone).
Why are we concerned about the FASB Accounting Standards Update known as CECL anyway? Because in addition to the enhancements of the update itself, the FASB is the independent, private-sector, not-for-profit organization that establishes financial accounting and reporting standards for public and private companies and not-for-profit organizations that follow Generally Accepted Accounting Principles (GAAP). The FASB is recognized by the Securities and Exchange Commission as the designated accounting standard setter for public companies. FASB standards are recognized as authoritative by many other organizations, including state Boards of Accountancy and the American Institute of CPAs (AICPA). The FASB develops and issues financial accounting standards through a transparent and inclusive process intended to promote financial reporting that provides useful information to investors and others who use financial reports.
The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio.
Until CECL gets implemented, remember we’re all in this together, so in closing, I leave you with the immortal words of Tiny Tim “God Bless Us, Every One.”