Current Expected Credit Losses Methodology Explained
The Current Expected Credit Losses Methodology (CECL) for estimating allowances for credit losses, unlike poor Cecil the lion, lives. On June 16 after much contentious debate, the Financial Accounting Standards Board (FASB) issued ASU (No. 2016-13) Financial Instruments – Credit Losses (Topic 326): “Measure of Credit Losses and Financial Instruments implementing CECL.” On June 17, the prudential banking regulators issued a Joint Statement in respect of ASU No. 2016-13. Although not effective for entities that are SEC filers until fiscal years ending after December 15, 2019, and for non-SEC filers until fiscal years ending after December 15, 2020, extensive early planning will be required.
Under CECL, the allowance for credit losses is a valuation account that is “deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset.” In other words, expected lifetime credit losses are to be incorporated into the allowance for credit losses. The new accounting standard introduces a single measurement objective to be applied to all financial assets carried at amortized cost, including loans held for investment and held-to-maturity securities. Existing Generally Accepted Accounting Principles requirements encompass a number of impairment models for different types of financial assets.
Regulatory agencies expect the new accounting standard will be scalable to institutions of all sizes and specific estimation methods are not prescribed, similar to the current incurred loss methodology. Thus, different estimation methods may be applied to different groups of financial assets. Current standards that are retained include existing write-off principles and current non-accrual practices. The transition will require a cumulative effect adjustment to be recognized on the balance sheet as of the beginning of the first reporting period for financial assets carried at amortized cost such as loans held for investment and held-to-maturity debt securities, triggering a potential capital cost. However, debt securities on which other-than-temporary impairment has been recognized will transition to the new guidance on a prospective basis. The new standard records credit losses on available-for-sale debt securities through an allowance for credit losses rather than the current practice of write-downs of individual securities for other than temporary impairment.
The Joint Statement encourages institutions to start planning and preparing for the transition by becoming familiar with the new accounting standard with discussions among their boards, peers, auditors, and supervisory agencies as to how best to implement the new account standard in a manner appropriate to an institution’s size and the nature, scope, and risk of its portfolios. This will include reviewing existing allowance and credit risk management practices to identify those processes that can be leveraged when applying the new accounting standard and, most importantly, identifying data needs and necessary system changes to implement the new accounting standard requirement to assess the remaining estimate of lifetime losses as opposed to historic annual loss rates. Most importantly, assessment of the impact of such adjustments on capital will be required early in the process.