With the deferred effective date (for financial institutions with a Dec. 31 fiscal year end) coming right around the corner, it is more important than ever to ensure that your organization has achieved current expected credit loss (CECL) compliance. Adoption requirements are mandated for Jan. 1, 2023. Make sure your organization is prepared with model implementation, parallel runs and validations.
During the 2008 financial crisis, substantial losses suffered by both financial and nonfinancial entities forced critical consideration of methods by which entities account for credit losses. Regulators and other market participants perceived that loan loss reserves recognized under then current U.S. generally accepted accounting principles (GAAP) were “too little, too late.” In response, the Financial Accounting Standards Board (FASB) introduced the current expected credit loss (CECL) model. The CECL method incorporates forward-looking information about expected credit losses, effectively accelerating the recognition of impairment losses.
Considered one of the most significant accounting changes in decades, the new CECL standard affects the way companies evaluate impairment of financial assets such as loans, receivables, and investments in debt securities. While banks and other financial services institutions will be most impacted by the FASB’s new credit impairment model, all entities with balances due or that have an off-balance-sheet credit exposure will feel the effects as well. These companies include those in the consumer and retail, manufacturing, and other nonfinancial industries.
Financial and nonfinancial institutions can expect major changes through both the changes in loss reserve methodology itself, as well as the associated technological, operational, and reporting advances required for proper implementation.
In June 2016, the FASB issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses (ASC Topic 326). The ASU requires entities to measure credit losses on most financial assets carried at amortized costs and certain other instruments using an expected credit loss model (aka the CECL model). Per this model, companies will estimate credit losses over the entire “contractual term” of the instrument from the date of initial recognition of that instrument (i.e., origination or purchase).
Entities will record the initial measurement of expected credit losses, as well as any subsequent change in the estimate, as a credit loss expense (or reversal) in the current period of the income statement. Ultimately, the primary objective of the CECL model is to provide financial statement users with an estimate of the net amount the entity expects to collect on those assets.
CECL covers a broad range of financial instruments including financial instruments carried at amortized costs (such as loans held for investments, held to maturity debt securities, trade receivables, receivables that relate to repurchased agreements and securities lending agreements, and reinsurance receivables), finance leases and off balance sheet credit exposures that are not accounted for as insurance contracts or derivatives (such as loan commitments, standby letters of credit and financial guarantees).
Current US GAAP requires the use of an incurred loss model that delays recognition of credit losses until it is probable the loss has been incurred. This methodology does not require (or allow) the incorporation of forward-looking economic forecasts, consideration of industry cycles or the impact and potential adjustments related to the creditworthiness of borrowers. As such, the incurred loss approach can result in reserves that do not reflect expected future developments.
ASU 2016-13 replaces the incurred loss model with the CECL model, which requires entities to estimate and immediately recognizes credit losses expected to occur over the contractual life of the financial asset.
Under the new methodology, entities must base their measurements on current market conditions, reasonable and supportable forecasts over the lifetime of the financial institutions, availability and quality of data, and segmentation and granularity of financial instruments that share similar risk characteristics.
Examples of shared risk characteristics include payment status, internal or external credit score, risk rating or classification, financial asset type, collateral type, size, effective interest rate, term, geographic location, industry of borrower, and vintage, among others. The ASU provides an indicative list of risk characteristics, which includes both credit and noncredit related characteristics.
If an asset’s risk characteristics change such that it no longer shares similar risk characteristics with other assets in the existing pool, you should evaluate that asset individually. For instance, if a customer files for bankruptcy, that asset is unlikely to share similar risk characteristics, as collection would now be based on that customer’s facts and circumstances.
The new guidance significantly changes the accounting for credit losses. Although it has a greater impact on banking institutions, all entities with in-scope financial assets are subject to the requirements in the new standard.
Many companies will find that they are subject to the new CECL requirements because the standard applies to a number of commonly held assets:
The CECL model does not apply to available-for-sale debt securities.
Unlike the incurred loss models in legacy US GAAP, the CECL model does not specify a threshold for the recognition of an allowance. An entity will instead recognize its estimate of expected credit losses for financial assets as of the end of the reporting period. Entities will recognize credit losses as an allowance, which is a contra asset, rather than as a direct write-down of a financial asset’s amortized cost basis.
Because the CECL model does not have a minimum threshold for recognition of credit losses, entities will need to measure expected credit losses on in-scope assets even if there is a low risk of loss (investment-grade, held-to-maturity debt securities, for example). In some limited instances, recognizing zero credit losses may be appropriate.
The ASU does not indicate a specific methodology for measuring the allowance for expected credit losses. Entities using discounted cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilize an aging schedule may continue to be appropriate under the CECL standard.
Regardless of the measurement method, the estimate of expected credit losses should reflect the losses that occur over the contractual life of the financial asset. While the entity should consider estimated prepayments, it generally should not consider expected extensions, renewals, and modifications.
An entity should consider all available relevant information, including details about past events, current conditions, and reasonable and supportable forecasts, when estimating credit losses.
Unit of account
As noted above, when measuring credit losses under CECL, entities should evaluate financial assets that share similar risk characteristics on a collective (pool) basis. The new standard provides examples of these characteristics, including geography, credit ratings, financial asset type, size, and term. Based on the ASU, an entity can aggregate financial assets based on any one or combination of risk characteristics. If an asset’s risk characteristics are not similar to those of others, it requires individual evaluation.
The write-off guidance in the new standard is similar to legacy US GAAP. An entity must write off a financial asset when it is “deemed uncollectible.”
Available-for-sale debt securities
The CECL model does not apply to available-for-sale debt securities. However, the FASB made several targeted changes to the credit loss model for available-for-sale debt securities:
CECL expands the disclosure requirements related to credit losses. Many of the disclosures required by ASU 2016-13 carry forward from existing requirements. However, CECL made certain amendments to the scope and content of the existing disclosures, and introduced new ones as well.
The CECL standard includes specific guidance to assist entities with developing an estimate of expected credit losses for the following:
To adhere to the financial reporting requirements of CECL, your CECL solution must address and document the following:
Other aspects to consider prior to making your CECL election include:
(Assuming calendar year end reporting)
Large SEC Registrants: January 2020 (excluding smaller reporting companies)
All others: January 2023 (All Other Public Business Entities (PBEs), smaller reporting companies (SRCs), private companies, nonprofits)
COVID-19 Update: The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed in March 2020, provides an option to delay the implementation of CECL for banking institutions until December 31, 2020, or the end of the coronavirus emergency, whichever comes earlier. In addition, a joint statement by regulators including the Treasury, FRB, FDIC and OCC was made in the adoption of a CECL Interim Final Rule (IFR) which states that banks which were required to adopt CECL as of January 1, 2020 now have an optional extension to delay CECL’s impact on regulatory capital by two years (until 2022). This election can still be made for regulatory reporting even if the banking organization chooses to apply CECL pursuant to GAAP in 2020.
CECL is one of the most significant accounting changes to confront institutions, particularly financial services organizations, in decades. Not only does it present new accounting challenges, but it also generates important new compliance obstacles. This is where we come in.
Baker Tilly has a robust audit and assurance service department prepared to help your organization navigate these new challenges. Even with a delay in effective dates, now is the time to prepare for implementing your new CECL accounting methods.