Current Expected Credit Losses (CECL) and what institutions need to know

One of the most critical concepts that institutions need to understand regarding accounting and finance is current expected credit losses, or CECL. This new model was introduced by the Financial Accounting Standards Board (FASB) to help institutions better predict future credit losses. CECL is used to help institutions evaluate current and expected credit losses and gives institutions the ability to plan for potential loss scenarios.

 What is CECL?

In 2016, the FASB issued the Accounting Standards Update (ASU) No. 2016-3, Financial Instruments - Credit Losses (ASC Topic 326). Under this requirement, institutions must adopt the current expected credit losses (CECL) model. The CECL model is a forward-looking approach that estimates lifetime expected credit losses over the entire contractual term of the instrument, starting from the origination date.

Institutions are expected to record initial measurements of expected credit losses and any subsequent estimated changes as a credit loss expense in the current period of the income statement. The main objective of the CECL is to create an estimate of the net amount the institutions expect to collect on those assets that financial statement users can use.

 CECL covers the following:

•  financial instruments carried at amortized costs
• finance leases
• off-balance-sheet credit exposures not accounted for by insurance contracts

 What makes CECL different from older accounting methods?

 CECL is a significant change from the current incurred loss model, which only looks at past events to estimate credit losses. The CECL model requires institutions to incorporate current information and expectations about the future when estimating credit losses which means that CECL will need institutions to base their estimates on the following:

•  current market conditions
• reasonable forecasts during the lifetime of the institution
• quality of data
• segmentation of financial institutions that share similar risk characteristics

 CECL Key Takeaways

The CECL has significantly changed the way institutions account for credit losses. Institutions need to identify if they are subject to CECL requirements. Institutions may find they are subject to CECL requirements if they offer some commonly held assets including:

•  debt instruments held until maturity
• trade receivables and contract assets
• lease receivables from resulting sales or direct financing leases
• reinsurance receivables from insurance transactions
• financial guarantee contracts
• loan commitments

 Allowance Recognition

 The CECL model doesn't specify a threshold for recognizing an allowance. Institutions must recognize estimates of expected credit losses for financial assets as of the reporting period's end. In-scope assets, even those with a low risk of loss, will need to be measured for expected credit losses.

 Measurement Expectations

The CECL model doesn't include specifics for measuring allowing expected credit losses meaning institutions may need to continue using one of the following methods:

•  discounted cash flow
• loss-rate
• roll-rate
• probability of default
• methods that use an aging schedule

 Regardless of the method used, the estimate of expected credit losses must reflect current information and expectations about the future.

 Account Units Used

As mentioned above, institutions should evaluate assets of similar risk characteristics on an aggregate basis such as:

• geography
• credit ratings
• asset type
• size
• term

 Institutions can pool financial assets based on risk characteristics, but if an asset's risk profile is not similar to others, it requires singular evaluation. One way to do this is by understanding all of the factors that go into current expected credit losses.

 Write-offs

 Like US GAAP, institutions must write off financial assets when considered "uncollectible".

Disclosures

 The CECL included many of the disclosures required by ASU 2016-13 but made amendments to the scope and content of existing disclosures and added new ones.

 Estimate of Expected Credit Losses Guidance

 CECL standards include guidance to assist institutions in developing their estimates of expected credit losses for the following: 

• purchased credit-deteriorated assets
• particular benefit interests within the scope of ASC 325-40
• collateral-backed financial assets

 How do institutions comply with CECL requirements?

 Adherence to the requirements of CECL requires institutions to address and document the following: 

• gather and analyze historical data and consider the impact of the current environment and economic forecasts
• segmentation strategy for aggregate financial instruments
• selecting proper methods and models
• qualitative factor identification and assessment
• institutional strategy for interpreting results from methods and models used
• calculation of a current estimate of lifetime losses and testing of reasonability of results through normal and stressed economic conditions

 By understanding all of these factors, institutions can start to build a CECL model that works for their business.

 Conclusion

By taking the time to understand all of the factors that go into CECL, institutions can make sure that they are prepared for the future.

If an institution is interested in learning more about current expected credit losses or if it needs help implementing this new model, contact RADD LLC.  Our experienced professionals can help institutions quickly implement CECL requirements.

For more information, updates, best practices, or assistance with meeting regulatory requirements, schedule a consultation with me:

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