Community Banking Advisor: Accounting for Credit Losses – Get Ready for CECL

In a dramatic change to bank accounting guidelines, the Financial Accounting Standards Board (FASB) recently finalized its long-awaited Current Expected Credit Loss (CECL) model for estimating credit losses. The new standard — Accounting Standards Update (ASU) No. 2016-13 — applies to all organizations. But financial institutions will be affected the most.

Although CECL’s impact will depend on a particular institution’s facts and circumstances, it will cause many banks to increase their allowances for loan and lease losses (ALLL), affecting both earnings and capital.

Forward-Looking Approach

Currently, banks measure credit impairment based on incurred losses. Under CECL, they’ll adopt a forward-looking approach, recognizing an immediate allowance for all expected credit losses over the asset’s life.

The FASB believes that the incurred-loss model, which delays recognition of credit losses until they become probable, provides information that’s “too little, too late.” CECL addresses this problem by requiring organizations to record credit losses that are expected, but don’t yet meet the “probable” threshold. It also sets a single impairment model for all financial assets carried at amortized cost, in contrast to the multiple models used today.

Here are some highlights of the new standard, which doesn’t take effect for several years (see “When must you adopt CECL?”):

Covered assets. CECL will apply to 1) financial assets measured at amortized cost, including loans, held-to-maturity debt securities, trade and reinsurance receivables and net investments in leases, and 2) certain off-balance-sheet credit exposures, such as loan commitments and financial guarantees.

Estimating losses. The allowance for credit losses will be the difference between financial assets’ amortized cost basis and the net amount expected to be collected. To estimate expected losses, banks will consider a broader range of data than they do under current standards, including not only historical and current information, but also “reasonable and supportable forecasts that affect the collectability of the reported amount.”

Potential impact. Some experts, including the Comptroller of the Currency, predict that CECL will increase banks’ loan loss reserves by 30% to 50%. Other estimates are lower, but ultimately the impact on a particular institution will depend on a variety of factors, including historical experience, current conditions and market forecasts.

Accounting for AFS securities. The new standard will change the way credit losses are measured for available-for-sale (AFS) debt securities, requiring banks to use an allowance for credit losses. Unlike the current practice of writing down individual securities for other-than-temporary impairment, the new approach will allow banks to recognize subsequent reversals in credit loss estimates in current income. In addition, the credit losses on AFS debt securities will be limited to the amount by which fair value falls short of amortized cost.

Treatment of PCD assets. To simplify the accounting for purchased credit-deteriorated (PCD) assets, the ASU requires institutions to recognize an initial allowance for credit losses. Thereafter, such assets will be treated similarly to other financial assets measured at amortized cost.

Impact on Community Banks

In the years after CECL was first proposed, many community banks expressed concern about its potential complexity and the need to implement sophisticated modeling techniques. A recent joint statement by federal banking agencies should help ease these concerns. According to the statement, CECL will be scalable to institutions of all sizes. And it doesn’t prescribe specific estimation methods — rather, institutions should apply judgment in developing methods that are appropriate and practical.

The agencies “do not expect smaller and less complex institutions will need to implement complex modeling techniques.” Rather, they expect that these institutions will be able to meet CECL’s requirements by building on existing systems and methods for estimating credit losses. For example, a bank that uses historical loss rate methods would need to adjust its inputs to estimate remaining lifetime credit losses.

The statement also points out that CECL contemplates pooling assets with similar risk characteristics when estimating expected credit losses. In most cases, smaller banks will be able to continue using established practices for segmenting their portfolios.

Be Prepared

CECL’s effective date is several years away. Nevertheless, banks should begin preparing soon to develop institution-appropriate credit loss models, evaluate the potential impact on capital, and identify any necessary system changes or additional data collection requirements.

Sidebar: When Must You Adopt CECL?

Here’s a summary of the new standard’s effective dates:

Organization type Takes effect for: Interim periods affected
SEC filers Fiscal years beginning after 12/15/19 In 2020
Other PBEs* (non-SEC filers) Fiscal years beginning after 12/15/20 In 2021
Private companies Fiscal years beginning after 12/15/20 Beginning after 12/15/21

*Public business entities

Early application is permitted by all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For loans and other financial assets carried at amortized cost, banks will recognize a cumulative-effect adjustment on their balance sheets as of the beginning of the first reporting period in which CECL is effective.