In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-13, Measurement of Credit Losses on Financial Instruments. This standard replaces existing financial asset impairment models with two new models—one for financial assets measured at amortized cost, such as loans held for investment and debt securities held to maturity (the CECL model), and one for debt securities classified as available for sale. It is effective for different entities as follows:
- Public business entities that are U.S. Securities and Exchange Commission (SEC) filers—Fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.
- All other public business entities—Fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.
- All other entities—Fiscal years beginning after December 15, 2020, and interim periods within subsequent fiscal years.
The CECL Model
The CECL model will require institutions to estimate expected credit losses over the contractual life of each asset. Institutions will have to consider relevant available quantitative and qualitative information about past events, current conditions, and reasonable and supportable forecasts. Loans that share similar risk characteristics will be evaluated on a collective (pool) basis. Loans that do not share risk characteristics with other loans will be evaluated individually.
Institutions may use different methodologies to estimate expected credit losses for different loans or loan pools as long as the methodology is appropriate for the loan or loan pool and for the size and complexity of the institution. Methodologies that might be used include, but are not limited to:
- Loss-rate methodologies (including vintage analysis and migration analysis).
- Discounted cash flow methodologies.
- Probability-of-default methodologies.
For collateral-dependent loans, institutions may continue to use the fair value of underlying collateral (less selling costs) as a practical expedient to estimate expected credit losses. (In all likelihood, regulatory agencies will expect institutions to use the underlying collateral for impaired collateral-dependent loans.) Management teams should begin thinking about appropriate methodologies for different loans as well as significant judgments that will be required when developing reasonable and supportable forecasts of expected credit losses, such as:
- The process for determining appropriate loan pools.
- The method of measuring the historical loss amount for loss-rate statistics.
- The method of adjusting historical information to reflect current conditions and forecasts.
- The method of adjusting loss statistics for recoveries.
- The effect of prepayments.
A separate impairment model for debt securities available for sale will allow institutions to recognize credit loss recoveries if the credit quality of applicable securities subsequently improves. The standard also simplifies accounting for loans acquired with credit deterioration (currently known as purchased credit impaired, or PCI, loans) by allowing the purchasing institution to separately recognize an allowance for the credit discount related to these loans.
In addition to substantial changes in the measurement and recognition of impairment, the standard will make changes to required loan (and security) footnote disclosures, including, but not limited to, the following:
- Accounting policies, methodologies, and factors affecting the institution’s reasonable and supportable forecasts.
- (Public business entities only) – Amortized cost basis of loans within each credit quality indicator by year of origination (vintage).
- For impaired collateral-dependent loans, information about the underlying collateral by loan class.
Institutions can begin planning for the adoption of CECL by taking the following steps:
- Study the CECL model and any additional guidance provided by the FASB or regulators.
- Communicate and discuss key challenges and opportunities with leaders from different areas within the institution, including the CEO/President, accounting, loan origination, credit analysis, loan processing, and even Board members.
- Talk to the core processing system provider about how current data can be archived in data formats that can be easily read and manipulated and what changes may need to be made going forward.
- Begin collecting data – Institutions should probably begin archiving loan-specific information regarding loan origination dates and amounts as well as loan-specific charge-off and recovery dates and amounts. Institutions may also want to begin archiving information about risk ratings, credit scores, or other factors management believes may be important.
- Investigate different CECL model options available to the institution, both internally and through third parties.
- Create an action plan the institution can use to measure progress toward a successful CECL implementation.
CECL will be one of the most significant changes in financial institution accounting ever, and many are anxious about this change, particularly because not all questions about CECL have answers yet. We have some time to figure this out before CECL is effective, but careful planning now will be the key to making the transition to CECL as smooth as possible. Stay tuned to future Wipfli articles and webinar invitations as we continue to share thoughts and information to help financial institutions as they implement CECL. If you have questions today, please contact your Wipfli relationship executive or email us at firstname.lastname@example.org