The Current Expected Loss Model, or CECL, has caused quite a stir in the Banking community as it is likely the most significant overhaul of financial reporting requirements in some time. But what exactly was the purpose of this new implementation and how will it be any different from the current incurred loss model?
The Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2016-13 during June 2016. The update will create a new section in the FASB’s Account Standards Codification (ASC) referenced as ASC Topic 326, “Financial Instruments – Credit Losses.” The statement from the formal update release during June 2016 cited the main objective of the update was to provide financial statement users with more decision useful information about expected credit losses. In order to achieve this objective, FASB has amended current accounting standards to replace the current incurred loss model with a methodology that is designed to be forward looking with consideration of a broader range of reasonable and supportable information to develop credit loss estimates. However, it is also important to note that not only are loans held by financial institutions subject to the new guidance, but certain investments held could also be impacted. At TJS Deemer Dana LLP, we have read through the entirety of the issued update and have compiled the following information we hope will answer many of your questions around the new standards.
Is there a specific example calculation that financial institutions should use to calculate its allowance under CECL?
This is a good news/bad news situation. The bad news is that there is no set example that has been established as the “golden calculation” at this time. The good news is that there is no standard requirement to how the calculation has to be performed and the updated standard is written to not force a specific methodology but to give guidance on what is to be considered and allow the freedom to implement a calculation methodology that management feels fits a specific segment of the loan portfolio. Various statements from regulatory agencies since the issuance of the update, as well as from the FASB at the time of issuance, have stated that entities can leverage current models in place as an acceptable starting point with revisions to inputs used in the calculation to meet the requirements of the new standards. The standard was designed to be scalable to the complexity and sophistication of each reporting entity. This expectation supports that entities will be able to leverage existing systems to a degree to conform with the new standards. As a result there will be various methods employed between different organizations, and even within an organization as different methods may best estimate expected losses for different loan segments identified.
While there are no standard methods required, it is worth noting that the following methods are specifically named within the updated standard in ASC 326-20 as potential methods to be used:
- Discounted cash flow (DCF),
- Loss rate,
- Roll rate,
- Probability of default, and
- Aging schedule.
Are historical loss rates still utilized under CECL?
Yes, in estimating future losses historical performance remains as a solid factor in establishing loss rates. As the updated standard reads, “Historical credit loss experience of financial assets with similar risk characteristics generally provides a basis for an entity’s assessment of expected credit losses” (ASC-326-20-30-8). However, unlike the current methodology where only losses from your establish look back period are considered (12, 24, 36 months) loss rates used in the various models under CECL should be established based on all available data. However, historical rates alone are not sufficient under the standard as they will need to be adjusted for current conditions and other reasonable, and supportable future forecasts.
Are qualitative or environmental factors still utilized under CECL?
Again, yes. The standard states that, “An entity shall not rely solely on past events to estimate expected credit losses” (ASC 326-20-30-9). As referenced in both the initial measurement documentation and the implementation guidance within the new standard, historical rates should be adjusted for current conditions as well as reasonable and supportable future forecasts that are relevant to the evaluated financial assets. When an entity uses historical information, adjustments are expected to reconcile historical events to the current environment and over the reasonable foreseeable future events over the contractual term of the assets being evaluated. However, it should be noted that for long lived financial assets, the standard is not intended to require management to develop internal evaluations or assumptions of future conditions. In these cases the standard allows the entity to revert to historical loss information that is reflective of the contractual term of the financial asset or group of assets. In these scenarios, in which reasonable and supportable conditions are available, no adjustments to the historical losses should be reflected.
This is an area that the implementation guidance section of the new standard provides specific examples of what may be considered, but again is not intended to be required or an exhaustive list of factors for adjusting historical loss rates as taken directly from ASC 326-20-55-4:
- The borrower’s financial condition, credit rating, credit score, asset quality, or business prospects
- The borrower’s ability to make scheduled interest or principal payments
- The remaining payment terms of the financial asset(s)
- The remaining time to maturity and the timing and extent of prepayments on the financial asset(s)
- The nature and volume of the entity’s financial asset(s)
- The volume and severity of past due financial asset(s) and the volume and severity of adversely classified or rated financial asset(s)
- The value of underlying collateral on financial assets in which the collateral-dependent practical expedient has not been utilized
- The entity’s lending policies and procedures, including changes in lending strategies, underwriting standards, collection, write off, and recovery practices, as well as knowledge of the borrower’s operations or the borrower’s standing in the community
- The quality of the entity’s credit review system
- The experience, ability, and depth of the entity’s management, lending staff, and other relevant staff
- The environmental factors of a borrower and the areas in which the entity’s credit is concentrated, such as:
- Regulatory, legal, or technological environment to which the entity has exposure
- Changes and expected changes in the general market condition of either the geographical area or the industry to which the entity has exposure
- Changes and expected changes in international, national, regional, and local economic and business conditions and developments in which the entity operates, including the condition and expected condition of various market segments.
Many of these recommended adjustment areas are likely already in place in current models being used by financial institutions.
Determination of financial assets with similar risk characteristics.
The new standard requires that entities measure expected credit losses of financial assets on a collective basis (i.e. pools) when similar risk characteristics exist. While the establishment of those pools will differ between entities this is another area where factors to consider are specifically identified within the new accounting standard. As outlined directly from ASC 326-20-55-5 the factors for grouping financial assets may include any one or a combination of the following:
- Internal or external (third-party) credit score or credit ratings
- Risk ratings or classification
- Financial asset type
- Collateral type
- Effective interest rate
- Geographical location
- Industry of the borrower
- Historical or expected credit loss patterns
- Reasonable and supportable forecast periods.
While these specific factors for consideration are identified directly in the accounting standard the use of all or any of them are not required, and the above listing of factors is not meant to be all inclusive.
How are impaired loans and TDR’s treated under the new standard?
When the new standards become effective, the current accounting standards addressing the treatment of impaired loans will no longer be in effect. This means that the concept of a defined “impaired” loan that requires a specific impairment calculation is no longer in place.
For TDRs the identification and reporting of TDRs remains unchanged under the new standards, however as there is no longer the specific identification of impaired loans, the reporting of all TDRs required to be reported as impaired loans with specific impairments will no longer be in effect.
Under the new guidance financial assets should be grouped and evaluated on a collective basis when similar risk characteristics are in place. However, for any financial assets that cannot be reasonably included into a pool of other assets, those individual items will be measured for a specific impairment in a manner that is similar to the current treatment for impaired loans. Similar to current guidance on impaired loans is also the statement in the new standard that if the financial asset is evaluated individually, it should not also be evaluated collectively.
Updates to collateral dependent financial assets.
The new standard will also include a change in the measurement of collateral dependent financial assets. Under the new standards, an entity shall measure expected credit losses based on the fair value of collateral when it is determined that foreclosure is probable. The use of “probable” in the standard is the help with the forward looking aspect of the model so that the reporting of any potential credit loss is not delayed until the actual date of foreclosure.
However, the standard also includes a practical expedient for measuring those assets as collateral dependent. Under this expedient, the fair value of collateral for a financial asset in which repayment is expected to be provided from the operation or sale of collateral when the borrower is experiencing financial difficulty as of the reporting date. When using this expedient, if it is expected that the sale of the asset will be the ultimate satisfaction of debt, then collateral valuations should also be adjusted for expected selling costs. However, if it is determined that the asset will satisfy debt through its operation, then no such adjustment for selling costs are required.
It should be noted in a FAQ issued by the joint agencies, regulators will expect financial institutions to continue to measure loans as collateral dependent under the practical expedient discussed above when a loan held meets the requirements of collateral dependent under the new standards. However, regulatory agencies do not intend for this to be expanded to other financial assets (such as held to maturity debt securities).
What about investment securities reported on the balance sheet?
The new standards also make changes to reporting related to investment’s held by an entity, but the required treatment will depend on if the investment is classified as held to maturity or available for sale.
Held to maturity investments
For investments reported as held to maturity (HTM), meaning they are reported on the balance sheet at amortized cost an evaluation of potential losses should be applied similar to that for loans reported by the entity. Since the standard is related to financial assets, and not specific to loans, HTM securities should include a consideration of potential future losses under the same considerations as mentioned previously that would be needed for loans. The related calculation and reporting would need to be included on the balance sheet along with the investment securities, meaning there will be no single line on the balance sheet for all allowance balances to be aggregated.
Available for sale investments
For investments reported as available for sale (AFS), no significant changes in the regular reporting of these securities will be required, as they are already presented on the balance sheet and reported at fair value as of the reporting date. However, the new treatment related to AFS debt securities is considered to be an improvement over the current methods as it primarily changes the accounting for other than temporary impairments of AFS debt securities. Note that there will be no changes in the treatment of securities AFS in which no permanent impairment is identified, and the unrealized gains and/or losses will be adjusted through the asset, deferred tax accounts, and equity as needed. However, when an impairment of an AFS is identified as other than temporary and the security is written down to a new cost basis, under current accounting standards, that loss is recognized in current period income and the new cost basis of the security is established until disposals. Under the updates that will be implemented through ASC 326, when an other than temporary impairment is identified, while the initial measurement is still recognized through the income statement, an allowance for loss is established on the balance sheet as opposed to a permanent write down of the carrying basis of the security. As a result if during subsequent periods, conditions either improve or continue to deteriorate, subsequent adjustments through the allowance for credit losses on AFS securities with a corresponding adjustment recorded in the credit loss expense on AFS securities. However, the entity shall not reverse a previously recorded allowance to an amount below zero.
So when do the new standards take effect?
The implementation of ASU 2016-13 will come in phases, as do most updates, depending on the structure of your organization. The following are the implementation dates:
- For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, the update is effective for fiscal years that begin after December 15, 2019, including interim periods within those fiscal years. This means that the first annual reports that must include the updated standards and disclosures (assuming December 31st year end) will be December 31, 2020; and the first quarterly filings (call reports and Form 10 Q reports) that must include the updated standards will be March 31, 2020.
- For other public business entities (PBE), the update is effective for fiscal years that begin after December 15, 2020, including interim periods within those fiscal years. This means that the first annual reports that must include the updated standards and disclosures (assuming December 31st year end) will be December 31, 2021; and the first quarterly filings (call reports) that must include the updated standards will be March 31, 2021. There was some debate in the past over whether or not financial institutions would qualify as a public business entity due to filing certain regulatory required reports (such as call reports), however if your institution is below $500 million in total assets you are likely exempt from PBE status. If your institution is above $500 million in total assets then there are multiple factors that play in to PBE status is required. If you have any questions or concerns over the classification of your institution as a PBE please to do not hesitate to reach out to our office and we will be glad to help answer any of your questions or concerns.
- For all other entities, the update is effective for fiscal years that begin after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. This means that the first reports that must include the updated standards and disclosures (assuming December 31st year end) will be annual financial statements as of December 31, 2021; and the first quarterly filings (call reports) that must include the updated standards would also be the December 31, 2021 filing.
- As the final option, all entities may elect early adoption in which case the implementation date for the update is effective for fiscal years that begin after December 15, 2018, including interim period within those fiscal years. This means that the first annual reports that must include the updated standards and disclosures (assuming December 31st year end) will be December 31, 2019; and the first quarterly filings (call reports and Form 10 Q reports) that must include the updated standards will be March 31, 2019.
My institution is a non-public entity and also does not qualify as a PBE, how will I file my 2021 Call Reports?
If your financial institution falls into the “all other entities” category above for implementation, the filing of your 2021 call reports will be unique in that only the reporting as of December 31, 2021 will be reflective of the institutions estimated allowance and related provision under the CECL model. Reports filed as of March 31, 2021, June 30, 2021, and September 30, 2021 will be filed using the current allowance standards (incurred loss model), and would also not include any adjustments to retained earnings required upon implementation of the standard. To make sure adequate measurement of the estimate under the new standard and proper reporting for call reporting purposes the institution may need to run the two calculations concurrently during 2021 through September 30, 2021.
We hope that this information will help to answer some of your questions about what is to come with the new standard and accounting requirements for credit losses. However, know that at TJS Deemer Dana LLP we are here to help. Please reach out to us with any questions or concerns you may have regarding the implementation and application of these new standards.