Summary of the Current Expected Credit Loss (CECL) Standard

On June 16, 2016, the Financial Accounting Standards Board issued Accounting Standards Update 2016-13, Financial Instruments – Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments.  This has been codified in the Accounting Standards Codification as ASC 326-20.

This new standard replaces the incurred loss model of recognizing loss on loan portfolios.  The incurred loss model requires that it is probable that a loss has been incurred at the balance sheet date and that it can be estimated.  Instead, the expected loss model requires an estimate of the lifetime expected credit loss.  This lifetime expected credit loss is recorded as an allowance.

Major components of ASC 326-20 include:

• Scope
  • Financing receivables
  • Lease receivables
  • Trade Receivables
  • Held-to maturity debt securities, loan commitments, financial guarantees, standby letters of credit, reinsurance receivables
• Expected lifetime losses recognized upon recognition of the loan
• Loss estimation considerations
  • Historical information
  • Current information
  • Supportable forecasts
• Expected credit losses will be reported in current income through the Allowance for Loan and Lease Losses
  • Purchased financial assets with credit deterioration would be booked at face value with a noncredit discount (if applicable) and an allowance for credit losses.
• Implementation:
  • Public Business Entity that is an SEC filer – 2020
  • Public Business Entity – 2021
  • Not a Public Business Entity (Private Companies) – 2021

How CECL Differs from FAS 5

FAS 5 has two components for loss recognition; (1) It is probable that an asset has been impaired and (2) The amount of the loss can be reasonably estimated.  This meant that to accrue a loss, something must have happened at or before the date of the financial statements that caused the loss to occur.  Expected future losses beyond those for which something already happened to cause the loss would not be recognized.  This loss estimation is known as an incurred loss model.

Under the incurred loss model, any estimate of loss relates only to those loans that have been impaired as of the balance sheet date.  So, it is an estimate of who has lost their job, who has large medical bills, or who has divorced that makes it probable that the customer is unable or unwilling to pay as of the balance sheet date.  It does not include an estimate of loss for those customers for whom nothing has yet happened to incur a loss.  The other component of the incurred loss model is that the amount of the loss may be reasonably estimated.

Under the CECL model, all expected losses over the life of the loan must be estimated and recognized when booking the loan.  Past events, current conditions and reasonable and supportable expectations about the future must be utilized to quantify the expected credit losses.  The loan assets on the balance sheet will be reduced by the lifetime estimate of losses.  This reduction will be accomplished through current earnings using the allowance for loan and lease losses.

Assume a pool of five year loans with the following incurred loss characteristics:

Year	1	2	3	4	5	Total
Incurred Loss	2%	5%	5%	2%	1%	15%

 

Using the incurred loss model, each year would have a valuation allowance entry that impacted the income statement through provision for loan losses.  The lifetime losses are spread out over a five year period in this example.

Using the CECL model, the total expected credit loss on the portfolio of 15% would be recognized when the loans are booked.  This results in a much greater impact to current income in many cases than the incurred loss model.

Both the incurred loss model and CECL require the use of historical information to support the loss estimate.  However, the incurred loss model has a much smaller “window” of loss to consider.  Accordingly, only loss data related to the period of time when the loss is incurred needs to be considered.  As a practical matter, most companies use 12 months of actual loss data as a starting point, then adjust this amount for any changes in company or overall economic conditions at the balance sheet date.

The CECL model will require that lifetime historical losses be maintained and used as the starting point for loss estimates.  If the company does not maintain lifetime loss information, this is a good place to start the CECL implementation process.

CECL also requires a forecast of future economic conditions and a methodology to use these forecasted conditions as an adjustment to expected lifetime losses.  Most published literature uses expected unemployment rate as an economic indicator to use as an adjustment factor.  Part of the CECL evaluation process will be to determine if there are any economic indicators that have a specific correlation to the loans being evaluated.

Another component of CECL not used in the incurred loss model is the necessity of determining the life of the loan(s).  Since CECL requires an estimate of lifetime losses, the actual lifetime of the loan(s) must be quantified.  CECL requires that prepayments be considered in the estimated lifetime of the loan, but extensions, renewals and modifications should not be considered.

The key differences between CECL and FAS 5 for loan portfolios are:

	Incurred Loss Model	Expected Credit Loss Model
Loss Recognition	It is probable that a loss has been incurred and can be estimated	All expected losses over the lifetime of the loan portfolio
Adjustments to historical loss	Only adjust for conditions as of the balance sheet date	Adjust for forecasted conditions over the life of the loan portfolio
Life of loan portfolio	Not considered	Must be quantified to estimate expected losses over the life of the portfolio
Content of allowance	Incurred losses not yet charged off	All expected losses over the lifetime of the loan portfolio that have not yet charged off