Transitioning into Current Expected Credit Loss (CECL)
By Michelle Alger, Senior, Assurance Services
As companies wrap up financial reporting for fiscal year 2020, the most unpredictable and unprecedented times we have and will ever see during our lifetimes, hindsight truly is “2020.” Previously banks and financial institutions were able to use the benefit of hindsight to predict their allowances for loan losses by applying historical credit performance to estimate current and future losses. Under the new Current Expected Credit Loss (CECL) standard (ASU 2016-13), banks and financial institutions will have to predict their losses in the most unpredictable environment to date.
ASU 2016-13 was originally issued in June 2016 following the 2008 financial crisis. The new guidance was aimed at enhancing standards around the loan loss provision to include a more forward-thinking approach to anticipated losses. Fast-forwarding to 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act granted temporary relief by delaying mandatory CECL implementation for public accelerated filers until the end of the pandemic. Private and smaller public filers will implement CECL beginning in January 2023. This delay creates an opportunity for private and smaller public filers to leverage data, information and resources from their public counterparts to make a seamless transition into the CECL standard and gather foresight for 2023.
After the 2008 financial crisis, it was clear to regulators and financial statement users that estimating uncollectable amounts based on historical loss rates is “too little, too late.” CECL incorporates the net amount expected to be collected with supportable forecasts. Inherently, these forecasts are limited. Under the new CECL model, banks should consider a longer lookback period in the data collection and analysis process, in order to incorporate varying economic conditions, given that 10-12 years passed between the two most recent recessions.
CECL does not specify a valuation method but suggests various methods that reasonably estimate the expected collectability and are consistently applied. These include the discounted cash flow rate, roll-rate, probability of default, and vintage rate. The most crucial component in determining what valuation method to employ is documenting and supporting the considerations and assumptions used throughout the process. While these methods may sound similar to current methodologies, the underlying shift is in the inputs from “incurred” to “expected” in creating supportable forecasts of expected losses.
Perhaps the largest undertaking in the process of implementation is obtaining and producing meaningful data. Input data may include: origination and maturity dates, origination paramount, initial and subsequent charge-off amounts and dates, and recovery amounts and dates by loan; and cumulative loss amounts for loans with similar risk characteristics. Additionally, qualitative factors will still play a vital role in calculating expecting credit losses. The updated standard does not address when an asset should be placed on nonaccrual status nor does it change existing write-off guidance, which requires institutions to write off an asset in the period in which it was deemed uncollectable.
While smaller public and private banks have been given an extension from the initial required adoption date of CECL, no further deferrals are currently in process. As such, banks and financial institutions should prepare for implementation in 2023. Upon adoption, any changes to the allowance under CECL will be reflected in retained earnings as the adoption of a new accounting pronouncement.
In most cases, banks that adopted CECL during 2020 noted an increase in their allowances by shifting to a life-of-loan reserving model. This is a reflection of both adopting CECL and the unpredictable economic environment due to the COVID-19 pandemic. Additionally, large public filers with a considerable portion of their loan portfolios consisting of consumer credit cards saw an increase due to the lifetime loss coverage under the CECL methodology.
So what can private or small public banks and financial institutions do now to take advantage of the delay? Continue to gather and organize data related to the loan portfolio; review and leverage other companies’ disclosures to determine what your entity will need to disclose in 2023; analyze the effects of different methodologies on your allowance, capital and financial statements overall; and, most importantly, document each and every step of the process.
