CECL standard expected to make a major impact
Substantial losses suffered by both financial and nonfinancial entities during the financial crisis prompted the Financial Accounting Standards Board to consider changes to its guidance on accounting for credit losses. Regulators and other market participants perceived that loan loss reserves recognized under then current GAAP were “too little, too late.”
In response, in June 2016 the FASB issued Accounting Standard Update (ASU) 2016-13, Measurement of Credit Losses on Financial Instruments (Topic 326), which requires a new method for recognizing credit losses that is referred to as the current expected credit loss (CECL) method. CECL represents a significant change from prior GAAP, which is still used by most entities. Under prior GAAP, loss reserves are recognized when it is probable a loss has already been incurred. The CECL method requires the recognition of all losses expected over the life of a financial instrument upon origination or purchase of the instrument, unless the company elects to recognize such instruments at fair value with changes in profit and loss (the fair value option).
Given the nature and characteristics of the financial instruments involved within this ASU, the accounting impact is estimated to affect more than 5,000 commercial banks and other financial entities that provide credit in the U.S., as well as non-financial institutions. According to current public disclosures made by various institutions, the estimated increases to allowance of loan and lease loss reserves could range from $50 billion to $100 billion (30 to 50 percent) for about $10 trillion of applicable loans, for the financial services industry alone. Certain implementation questions are still being addressed and further guidance will continue to be provided in the future.
The updated guidance is anticipated to significantly impact institutions, both financial institutions, as well as non-financial institutions, through both the changes in loss reserve methodology itself as well as the associated technological, operational and reporting advances that will be needed for proper implementation.
The broad range of financial instruments covered by CECL include financial instruments carried at amortized cost (such as loans held for investments, held to maturity debt securities, trade receivables, receivables that relate to repurchase 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.)
Given the recent changes, CECL will be required to be implemented by public companies that are not included as smaller reporting companies in fiscal years beginning after Dec. 15, 2019, including interim periods within those fiscal years. Other entities are permitted to wait until their first fiscal year beginning after Dec. 15, 2022.
The accounting methodology prior to the adoption of CECL requires the use of an incurred loss model, which recognizes reserves only for losses that are probable of having already been incurred. This methodology does not require (or permit) 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.
Under ASU 2016-13, the incurred loss model is replaced with the CECL model, which requires entities to estimate and immediately recognize credit losses expected to occur over the contractual life of the financial asset. Measurement under the new methodology is based on, but not limited to, current market conditions, reasonable supportable forecasts over the lifetime of the financial instruments, 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.
There is no one method or model that is prescribed by the FASB within the ASU; however there are various models and methodologies that should be contemplated depending on the availability and quality of data and the segmentation of the financial instruments. For example, these models and methodologies would include loss rate, discounted cash flows, vintage analyses, probability of defaults/loss given defaults, provision matrices and regression analyses.
To adhere to the financial reporting requirements of CECL, an institution’s CECL solution must address and document the following: (i) the historic information gathered and analysis performed on such data, as well as considering the impact of the current environment and prospective economic forecasts over the horizon period, (ii) the rationale for the appropriate segmentation or pooling of financial instruments by category, (iii) the selection of the appropriate models and methodologies, (iv) the identification and assessment of any potential qualitative factors, (v) how the institution interprets and understands the results and impacts from the models and methodologies applied for the CECL reserves, and (vi) the calculation of management’s current estimation of lifetime losses, as well as back testing for reasonability of results through normal and stressed economic environments.
Other aspects that an institution must consider prior to making their CECL election include (i) the implementation and process requirements, or alternatively through the fair value option election, (ii) the necessary documentation and governance requirements across audit, risk and compliance, and (iii) the impact of the decision and assessment on its total allowance for credit losses when an institution acquires another company.
Companies, auditors and regulators are expected to observe CECL’s impacts and disclosures during the 2020 financial reporting year. To ensure CECL is meaningful to all preparers, auditors, investors, analysts and other users and reviewers of financial statements, during this time, refinements will be made by each institution, with potential recommendations and guidance to follow.
Jonathan Jacobs is the global financial services industry leader at Duff & Phelps, with more than 30 years of experience in financial consulting. Jennifer Press is a managing director in the Alternative Asset Advisory practice at Duff & Phelps and is responsible for service capabilities in structured credit and whole loans, bringing over 17 years of fixed-income and capital markets experience. John Schrader is a managing director in the Alternative Asset Advisory practice at Duff & Phelps, with over 20 years of fixed-income, capital markets and investment banking experience.