The new Current Expected Credit Loss accounting standard will require an extensive implementation effort for financial service institutions and other companies that have significant financial assets recorded at amortized cost or portfolios of debt securities classified as available for sale. The new standard is effective starting in 2020 for public business entities that are SEC filers and 2022 for nonpublic entities.
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Current Expected Credit Losses (CECL)
In June 2016, the FASB issued a new accounting standard ASC 326 Measurement of Credit Losses on Financial Instruments, that significantly changes the accounting for credit losses of financial assets recorded at amortized cost, such as loans, capital lease receivables, unfunded commitments, investment securities classified as held-to-maturity, and trade receivables from revenue transactions.
ASC 326 is effective in the first quarter (January 1st) of 2020 for public companies with calendar fiscal years. For non-public entities with calendar fiscal years, ASC 326 is effective at the beginning of 2022, giving such entities an additional two years to implement the Standard. Early application is permitted starting in 2019.
The current method of estimating the allowance for credit losses (ACL) is being replaced. This method is based on “probable” incurred losses, which limits the ACL to losses (resulting from a past event) deemed “probable” of being realized in the foreseeable future (e.g., 12 months). Instead, the new approach requires the ACL to capture current expected credit losses (CECL) over the entire contractual term of the asset without regard to a recognition threshold. The FASB made the change in response to limitations in recognizing an adequate allowance for expected credit losses experienced during the mortgage crisis in 2008 and 2009.
Under the CECL approach, a company is required to adjust historical loss data with reasonable and supportable forecasts of future economic conditions to estimate credit losses that are expected to be realized over the contractual term of the financial asset. In other words, it extends the credit loss measurement period to the entire contractual term and requires the use of reasonable and supportable forecasts of relevant future economic conditions (e.g., unemployment rates, housing prices, GDP) to estimate that credit loss. By eliminating the recognition threshold, even credit losses with a remote chance of occurring must be considered.
The reasonable and supportable forecast period applied is a matter of judgment and the length of that period is not specified in the guidance, including no minimum or maximum period required. When a company no longer can use a reasonable and supportable forecast to estimate future expected credit losses, it must revert to a long-term historical loss rate for the remaining contractual term to complete the estimate. A company must consider expected prepayments in measuring the ACL, but cannot forecast expected term extensions or renewals.
CECL requires financial assets to be pooled by similar credit risk characteristics, unless a financial asset has unique characteristics, in which case it can be evaluated individually. The pools must be reviewed each period to ensure that all assets within the pool continue to share the same risk characteristics.
There is no prescribed method required to measure expected credit losses, which can be done based on either discounted or non-discounted cash flows. Some possible methods that could be used are adjusted historical loss rates, adjusted roll rates, probability of and loss given default rates, discounted cash flows, and vintage analysis.
The accounting for purchased loans with credit deterioration since origination under ASC 310-30 (formerly SOP 03-3) is being eliminated. Instead, ASC 326 expands the definition of purchased financial assets that are deemed “purchased with credit deterioration” (PCD) and provides a new accounting approach that incorporates CECL for recognizing credit losses. Significantly more disclosures will be required in the notes to the financial statements.
ASC 326 also requires credit losses expected to be realized from investment securities classified as available-for-sale to be recorded in an allowance for credit losses (rather than as a direct writedown), although the determination of those credit losses remains essentially the same as before.
What’s the Impact?
Generally, the application of CECL is expected to increase the overall ACL due to the extended measurement period and the elimination of the “probable” recognition threshold. However, for certain pools of loans, the ACL may be lower due to the prohibition against projecting term extensions or renewals.
Banks and other financial institutions will be affected significantly due to their portfolios of loans and other financial assets recorded at amortized cost, although companies in other industries are likely to have financial assets such as trade or lease receivables that fall within the scope of the new guidance.
New and, most likely, complex models will need to be developed that incorporate reasonable and supportable forecasts, extend the measurement period, and exclude the “probable” threshold. Relevant economic factors and other assumptions will need to be identified and their use in those models will need to be developed. Because ASC 326 does not provide specific measurement guidance, significant forethought and planning will be required to develop these models.
New procedures and related internal controls and policies will need to be designed, documented, and implemented for the new measurement process.
Additional Considerations by Non-Financial Institutions
CECL generally applies to almost any financial instrument asset that is recorded at amortized cost. However, operating lease receivables are excluded from the scope. For companies that are not financial institutions, common examples of such financial instruments include (but are not limited to):
- Trade and accounts receivables resulting from revenue transactions
- Financing receivables
- Net investments in leases recognized by a lessor in a capital lease
Currently, past loss experience often is used to estimate the reserve for bad debts. Under CECL, companies will be required to also apply reason able and supportable forecasts to estimate the total credit losses that are expected to be realized. That means adjusting historical loss experience for forecasted future economic conditions, provided those forecasts are reason able and supportable. After that period, companies must revert (either immediately or gradually) to their long-term average loss experience.
However, if the collection period is short, any adjustments for forecasted future economic conditions likely would be small.
Non-financial institutions should conduct a thorough search for all assets that qualify as financial instrument assets recorded at amortized cost and assess the impact of applying CECL in measuring the related allowance for bad debts.
Suggested Actions and Considerations
As the implementation of CECL will require considerable forethought and planning as well as the development of new measurement models, forecasts, policies, procedures, and internal controls; all companies, but particularly banks and other financial institutions, should begin immediately to assess the impact and resource needs (e.g., adequacy of skills and staff availability) and develop a robust implementation plan.
A key element to a successful CECL implementation will require adequate and reliable historical credit loss data for each designated pool of financial assets. New data elements (e.g., timing of prepayments and partial charge-offs) may need to be tracked. To the extent that a company’s historical data is insufficient, it will need to consider supplementing it with industry data obtained from external sources. An important first step in the implementation process will be to assess the completeness, reliability, and adequacy of the data needed to estimate lifetime expected credit losses for each designated pool of financial assets.
Audit Commit tees, auditors, and regulators will be focused on how well the implementation effort is planned, managed, and executed as well as how the reasonableness of the resulting CECL estimate was ensured. To that end, a well-developed project plan and the application of formal project management and governance will go a long way in giving them comfort about the implementation process.
Also, well documented policies, procedures, and internal controls will further support the notion that a rigorous implementation process was applied.
As the CECL guidance does not provide a lot of specific guidance, significant judgment and interpretation must be applied. For that reason, auditors and regulators are not expected to provide detailed implementation guidance prior to the effective date for public companies.
Companies should run their new models in parallel for at least two quarters (and preferably four quarters) to identify and resolve any issues prior to formal adoption.
Auditors will likely seek comprehensive sup porting documentation regarding decisions and assumptions made during the implementation process (e.g., pooling of similar assets and selection and use of forecasted economic factors). Although many vendors offer assistance in developing mathematical models and providing supplemental industry historical loss data to help measure CECL, they may be ill-equipped to prepare accounting related supporting documentation such as accounting policies, implementation memos, and interpretations of ASC 326 made by the company or designing the post-implementation operational process to update the ACL each reporting period.
The shift to expected forecast credit losses from “probable” incurred credit losses will require new ways of analyzing the allowance for credit losses.
New credit related performance metrics will need to be developed for investors.
Because no specific measurement method was prescribed under CECL, there likely will be a wide range and lack of comparability of results among peer companies at least initially.
Due to the larger allowance for credit losses and higher provision for credit losses, regulated banks will need to assess the potential impact on meeting regulatory minimum capital levels. Companies will need to figure out how to best present and explain the higher allowance level and subsequent changes in the allowance to stock analysts and investors.
How We Can Help
As the implementation of CECL is likely to require additional ac counting resources, here are some of the ways we can help:
- Developing a project plan
- Providing supporting documentation for significant processes that require judgment
- Drafting accounting memos to support interpretations of ASC 326 that are applied
- Drafting a comprehensive implementation memo that describes how the model and assumptions were developed and the transition adjustment was measured
- Draft new accounting policies
- Design and document internal controls over the CECL process
- Designing the on-going process after adoption of CECL
- Project management
Who We Are
CNM LLP is a technical advisory firm that provides high value, specialized accounting advisory services to a broad client base ranging from startups and mid-market companies to multi-national Fortune 500 companies. As an organization of professionals, our mission is to understand the business of our clients, to help our clients identify their business and financial needs, and to provide the services that will help them achieve their business goals. We are committed to providing the most effective services possible, efficiently and expeditiously, while always maintaining our ultimate focus on our clients’ needs and objectives.