Current Expected Credit Losses (CECL)
In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016 – 13, Financial Instruments – Credit Losses (ASC Topic 326). The update requires entities holding financial assets measured at amortized cost to measure credit losses using the new Current Expected Credit Loss model (CECL). Companies will be required to estimate credit losses over the entire contractual term from the date of initial recognition. They will record the initial measurement of expected credit losses as credit loss expense as well as any change after initial recognition.
With the CECL methodology, companies will evaluate financial assets on a collective or pooled basis that share similar risk characteristics. These include:
- Credit score
- Financial asset type
- Collateral type
- Size
- Effective interest rate
- Location
- Industry
- Historical patterns
A financial asset should be evaluated individually if it doesn’t share the same risk characteristics. Note: it cannot be included in both.
While this ASU will have a significant effect on the banking industry, it will also impact companies holding common assets measured at amortized cost, such as:
- Trade receivables
- Financing receivables
- Held-to-maturity debt securities
- Net investments in leases recognized by lessor
- Off-balance-sheet credit exposures
- Reinsurance recoverables
Significant shifts
The CECL model creates three significant shifts from the current incurred loss model:
- First, the forward-looking analysis requires the utilization of future information/forecasts to estimate the allowance for loan losses
- Second, this new standard removes the probability threshold and requires you to evaluate the possibility that a loss exists or it does not
- Lastly, this changes the loss horizon from 12-18 months to view the life of the asset
This model will be applied at the origination of the financial asset and in subsequent reporting periods. It will also require a frequent re-evaluation of historical loan performance, current conditions, and expectations about future conditions.
While evaluating the adoption of this standard, we recommend management identify the items on their balance sheet that are in scope and determine the materiality of that impact. Additionally, have documentation around the assessment and a process to monitor it should it be concluded to be immaterial on a go-forward basis.
Disclosure
Additional disclosures will focus on accounting policy, description of estimates and quantitative models. The FASB added this disclosure requirement so the financial statement user can understand how management arrived at the allowance.
Adoption
This standard became effective for public business entities that meet the definition of an SEC Filer, excluding small reporting companies (SRCs) as defined by the SEC, for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. SRCs and all other non-public entities must adopt for fiscal years beginning after December 15, 2022.
Contact us for assistance with CECL implementation or other SEC requirements.
Article written by:
Ed Bannen, CPA
Senior Manager, Assurance & Business Advisory Services
