CECL requires loss estimates to include relevant information about past events, current condition and reasonable and supportable forecasts using both internal and external information, including a range of qualitative and quantitative factors. Estimates of expected credit losses must consider information related to the borrower’s creditworthiness, the issuer’s underwriting practices, and the current and forecasted direction of the economic environment. As per FASB:
“When developing an estimate of expected credit losses on financial asset(s), an entity shall consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts. An entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s). When financial assets are evaluated on a collective or individual basis, an entity is not required to search all possible information that is not reasonably available without undue cost and effort. Furthermore, an entity is not required to develop a hypothetical pool of financial assets. An entity may find that using its internal information is sufficient in determining collectability.”
Whereas historical loss information generally provides a basis for an entity’s assessment of expected credit losses, it may not fully reflect an entity’s expectations about the future. Management should adjust the actual historical loss experience, incorporating the current conditions and reasonable and supportable forecasts, while considering each asset’s relevant risk characteristics. For periods an entity is unable to make a reasonable and supportable forecast (e.g., due to a lengthy time horizon), entities would revert to the historical credit loss experience.
Entities can develop credit loss estimates on a pooled basis only if the assets share similar risk characteristics. If not, an individual evaluation is appropriate. In evaluating financial assets on a collective (pool) basis, an entity should aggregate financial assets on the basis of similar risk characteristics.
Since there is no single prescribed method of calculating credit loss under CECL, a variety of models have thus far emerged in the industry to address the requirement, each with its own advantages and downsides. It should be noted that a firm does not need to select one of the existing approaches, but is open to whatever solution best addresses their book of business, data availability, and accounting and systems capabilities, while remaining an effective, accurate, and compliant reporting tool. It should also be noted that the FASB states that “an entity is not required to search all possible information that is not reasonably available without undue cost and effort.”
Some of the models that have emerged include:
- Discounted cash flow analysis: In one of the most widely used models in current practice, the discounted cash flows are calculated using the present value of expected future cash flows discounted at the loan’s effective interest rate. This type of analysis is one of the currently prescribed methods for measuring impairment on an individual impaired loan.
- Average charge-off method: The most commonly used approach for evaluating impairment on pools of financial assets, this method is fairly straightforward relative to many other approaches. This method calculates an estimate of losses primarily based on past experience.
- Vintage analysis: In this method, impairment is based on the age of the accounts and the historical asset performance of assets with similar risk characteristics. Those who adopt this methodology typically have financial assets that follow patterns or loss curves comparable and predictive for subsequent generations of financial assets (indirect auto loans, for example).
- Static pool analysis: This method is typically confused with the vintage analysis. The main difference is that a vintage analysis is based on the year of origination and/or the age of the asset while static pool analysis is based on a type of shared pooling criterion and assets originated in a similar time period.
- Roll-rate method (migration analysis): Roll rates in this method are determined by predicting credit losses by segmentation (by delinquency or risk rating, for example) of a portfolio of financial assets.
- Probability-of-default method: This modelling method incorporates three components: probability of default, exposure at default, and loss given default. It is used by many risk management systems and within the Basel II and Basel III frameworks.
- Statistical analysis (Regression, Markov Chains, etc.): This is one of the more complex models. Essentially, an entity uses statistics to determine an estimate of credit losses (the dependent variable) based on one or multiple inputs (independent variables).
Whichever methodology is initially chosen and implemented, the credit losses predicted by the model will be audited against the actual losses over a given period to ensure accuracy. Entities are required to disclose a description of how expected loss estimates were developed and the accounting policies and methodology used to estimate the allowance for expected credit losses for each portfolio segment. The disclosure is to include a discussion of the factors that influenced management’s current estimate. Any policy or methodology changes from the prior period would be highlighted, as well as the justification for significant write-offs. The historical credit loss experience would also be disclosed for periods beyond which the entity is unable to make or obtain reasonable and supportable forecasts.
As part of the government’s implementation of the Dodd-Frank Act Stress Test (DFAST), the Federal Reserve Board periodically issues sets of macroeconomic variables for Base, as well as Adverse and Severe scenarios. Since these factors and scenarios have become industry standards, many entities will choose to adopt the DFAST Base scenario for their CECL loss reserve estimation.
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.