CECL, or current expected credit loss, is a new accounting standard that will change how financial institutions account for expected credit losses. Complying with the new CECL standard will have a major impact on an institutions’ operations, accounting/finance, IT, credit, and risk processes and systems.
Under current US GAAP (generally accepted accounting principles), an “incurred loss” method of recognizing credit losses must be followed. This approach restricts the accounting of those credit losses that are expected but have not yet met the threshold of an incurred “probable” loss In the period leading up to the financial crisis of 2007-2008, this sub-optimal scenario was exacerbated. As financial institutions could not recognize these expected credit losses in their financial statements, investors and analysts had to estimate the potential impact on valuations.
With the CECL approach, the Financial Accounting Standards Board (FASB) replaced the incurred loss impairment methodology with a forward-looking methodology that reflects expected credit losses over the life of loans and other in-scope financial instruments. In order to develop the expected credit loss estimates, an entity will need to consider a broad range of reasonable and supportable information including, but not limited to, historical data, current conditions, and reasonable forecasts of projected market and economic conditions that may affect the collectability of the scheduled cash flows. An entity must use judgment in determining the relevant risk factors, macroeconomic variables and estimation methods that are appropriate in its circumstances, given their specific product portfolios, markets, underwriting policies, customer segments, etc.
It’s important to note that the FASB does not specify a method for measuring expected credit losses and allows an entity to apply methods that reasonably reflect its expectations of the credit loss estimate. As such, there is no one right way to implement CECL, but rather a range of potential solutions.
Regardless of the approach taken, an entity will require certain baseline data attributes for the financial instruments within scope (inclusive of other financial assets that have the contractual right to receive cash). For example, for loans, baseline attributes would include:
- Basic loan data
- Loan number
- Origination date
- Initial/remaining term
- Balances
- Unamortized premiums/discounts
- Accrued interest
- Net deferred fees
- Guaranteed balances
- Borrower information
- Transaction-level data
- Charge-offs (a charge-off is the declaration by a creditor that an amount of debt is unlikely to be collected)
- Recoveries (a recovery is debt from a loan, credit line or accounts receivable that is recovered either in whole or in part after it has been written off or classified as a bad debt)
- Prepayments
- Status changes (e.g., non-accrual basis: A nonaccrual loan is a nonperforming loan that is not generating its stated interest rate because of nonpayment from the borrower)
- Delinquency thresholds
- Dates
- Segmentation data
- Loan pools [risk, type of loan, call codes – as per FFIEC Call Report (e.g., construction 1-4 family homeowners, loans to depository institutions and acceptances of other banks)]
- C&I (commercial and industrial) loans by industry code
- Commercial loans by collateral type or loan size
- Residential loans by geographical locations
- Key characteristic(s) of risk
- Loan pools [risk, type of loan, call codes – as per FFIEC Call Report (e.g., construction 1-4 family homeowners, loans to depository institutions and acceptances of other banks)]
- Risk data (governed by loan pools)
- Days delinquent
- Risk ratings (commercial)
- FICO scores (consumer)
For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, the new credit loss reporting requirements will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For all other public business entities, the amendments are effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.
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If you are interested in learning more about the rationale and timing for the accounting change, as well as the financial process and system changes required to comply, please download our new guide: Building a Current Expected Credit Loss (CECL) Response Program.
