Navigating the Challenges of CECL Implementation
The deadline for implementing the Financial Accounting Standards Board’s (FASB) current expected credit loss (CECL) model established in Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments was recently delayed for nonpublic financial institutions and smaller reporting entities. For most credit unions and community banks with a calendar year end, this means the standard will be effective beginning Jan. 1, 2023. While it may seem far away, financial institutions should avoid delaying their implementation plans and closely monitor the methodologies employed by public lending institutions and early adopters of the standard.
The core principle of CECL is the requirement to estimate expected credit losses over the lifetime of a financial asset, considering available information relevant to assessing the collectability of cash flows. Under current U.S. Generally Accepted Accounting Principles (GAAP), allowances for loan losses are established using an incurred loss model, whereby loss contingencies are estimated relying principally on historical information and other current qualitative factors. CECL expands upon this method by requiring companies to consider available information that will support forecasts of future conditions, in addition to historical loss information, to estimate lifetime credit losses, even if the risk of loss is remote. A key change for most lending institutions resulting from the application of the new standard is that credit losses may be recognized earlier. For instance, under the incurred loss model, reserves for loan losses would not be established for an individual or pool of homogenous loans at the date of origination because financial institutions are not able to meet the criteria for accruing a loss contingency in accordance with FASB ASC 450-20-25-2. Under the new standard, companies must estimate future losses that may occur over the contractual term of the loan and, therefore, must establish this estimate at loan inception.
One of the most challenging areas of applying the new standard will be forecasting future conditions and being able to support assumptions used in calculating an estimate of future losses. Institutions will need to justify to their auditors and regulators that the inputs and the forecast period they have used in their modeling are reasonable. As such, the reasonable and supportable language included in Topic 326 will mean that entities must apply a consistent process and ensure that it is well documented with clear explanations of the rationale used in developing estimates. Credit unions and other financial institutions should begin implementation preparations as soon as possible in order to determine what data is needed and what process will be used to accomplish the objective of the standard.
ASC 326-20 does not provide prescriptive guidance to estimate losses. Common methods currently employed in loss estimation include discounted cash flow analysis, regression or a probability of default model. Choosing a model often comes down to the complexity of the entity and the information it plans to capture. Companies should begin their analysis with the existing historical information they already use to establish loan loss reserves, such as charge-off frequency for a group of financial assets with similar risk characteristics, changes in underwriting standards or the portfolio mix. Adjustments to historical information should consider available economic information relevant to the environment in which the lender operates as well as other factors specific to borrowers. These may include, but are not limited to, monetary policy, GDP growth, unemployment rates, trends in credit scores and industry trends. Forecasted data from government agencies and other reputable sources may be used in a company’s own CECL methodology.
Those involved with CECL implementation efforts should review FASB Staff Q&A — Topic 326, No. 2: Developing an Estimate of Expected Credit Losses on Financial Assets, as this publication addresses common questions regarding the use of historical loss information, developing reasonable and supportable forecasts, and requirements regarding applying the reversion to historical loss information. The AICPA Financial Reporting Center Working Draft: Allowance for Credit Losses Implementation Issue #6 also considers many factors in developing the reasonable and supportable forecast period as well as how an entity would determine the historical loss information it will revert to once it is beyond a period in which it can make or obtain such forecasts.
Vincent Cigna, CPA, is a semi-senior at MSPC Certified Public Accountants and Advisors, P.C.
This article appeared in the March/April 2020 issue of New Jersey CPA magazine. Read the full issue.