Decoding CECL: Here Are Key Concepts You Need to Know
This article represents the first installment in a series examining the intricacies of the Current Expected Credit Loss (CECL) standard.
CECL At a Glance
The Current Expected Credit Loss (CECL) model marks the largest transformation in bank accounting to date, born out of the need to rectify the deficiencies in financial reporting that were exposed during the Great Recession. This new model compels entities to adopt a more forward-looking approach in recognizing potential credit losses, aiming to enhance financial stability and transparency.
Background
ASC 326-20, Financial Instruments – Credit Losses, was issued in June 2016 and is effective for private companies for fiscal years beginning after Dec. 15, 2022 (or 2023 for calendar year entities). The standard represents a new impairment model for financial assets carried at amortized cost. The new principles-based model moves away from an incurred loss model to a forward-looking credit loss model, with the objective of presenting the entity’s estimate of the net amount expected to be collected on financial assets.
The development of the CECL standard was a response to the 2008 mortgage crisis when U.S. accounting rules were criticized for requiring delayed recognition of losses associated with financial assets such as loans and other financial instruments. CECL addresses how to account for credit impairment of most financial assets carried at amortized cost.
It should be noted that the CECL model is not just a bank or other financial institution standard. All entities most likely have financial instruments on their balance sheets that fall within the scope of CECL. Financial institutions may have the greatest direct impact from the standard, but non-banks will feel the impact to some extent as well.
What CECL Covers
For entities other than traditional financial institutions, typical financial assets held by these non-banks that may fall within the scope of the CECL standard include (but are not limited to) trade receivables, contract assets, financing receivables (including loan and note receivables to officers), held-to-maturity debt securities and net investments in leases. It’s important to note the definition of a financial asset broadly includes any contract that conveys to one entity a right to (a) receive cash or another financial instrument from a second entity or (b) exchange other financial instruments on potentially favorable terms with the second entity.
The standard specifically excludes financial assets carried at fair value with changes in fair value reported in net income, available-for-sale debt securities, loans made to participants by defined contribution employee benefit plans, insurance policy loan receivables, not-for-profit pledge receivables, receivables between entities under common control, and operating lease receivables under ASC 842.
Highlight of the Major Changes
Recognition Threshold: Because CECL replaces the legacy incurred loss model with an expected credit loss model, entities no longer wait for the loss to be incurred or be probable of incurring (i.e., a triggering event) before recognizing an allowance for credit losses. Instead, entities will recognize an allowance for expected lifetime credit losses upon initial recognition of the asset, which results in earlier recognition of credit losses. This is what is commonly referred to as the CECL “Day 1 loss. Entities will estimate the expected credit losses even when that risk is deemed remote. The standard acknowledges that there may be instances when the potential for default is expected to be remote, resulting in an expected loss of zero. Holding U.S. treasuries is an example. However, zero expected loss for other instruments (non-U.S. treasuries) is expected to be uncommon and must be robustly supported.
Unit of Measurement: Under the legacy accounting model, pooling of financial assets was permitted but not required, while under the CECL model, entities are required to measure expected credit losses collectively or on a pooled basis when the financial assets share similar risk characteristics such as risk rating, effective interest rate, type of receivable, size, term, geographic locations, vintage and industry sector. Entities are required to reconsider whether financial assets within a pool continue to share similar risk characteristics at each reporting period. If a financial asset is no longer similar to an existing pool, the estimate of credit loss should be measured at the individual financial asset.
Consideration of Economic Conditions: In contrast to the legacy incurred loss model, which considers only current economic conditions, the CECL model requires that an entity’s estimate of expected credit losses reflect all reasonably available information relevant to assessing the collectability of cash flows. This includes historical loss information adjusted for current conditions and forecasts about future economic conditions that are reasonable and supportable. Selecting the most appropriate historical loss information and determining the needed adjustments to the extent that the current conditions and forecasts differ from the conditions that existed during the selected historical period evaluated may involve significant judgment. Historical loss information need not be sequential or from the most recent periods as long as it best represents the specific risk characteristics of the entity’s current financial asset portfolios. Adjustments to the historical information, if needed, may be qualitative or quantitative and based on internal or external data. Entities revert to historical loss information when developing a forecast is no longer reasonable and supportable.
Consideration of Contractual Term: The contractual life of a financial asset represents the time span over which the entity is exposed to credit risk. Shorter-term financial assets frequently do not have explicit contractual terms. For these assets, entities should utilize the payment terms while considering the counterparty’s historical repayment behavior. For example, a pool of customers may typically prepay to take advantage of early payment discounts, while another pool of customers may routinely remit payment 30 days beyond the payment terms. Financial assets with longer expected lives naturally involve greater uncertainty when forecasting expected cash flows and the timing of credit losses, which ultimately impacts the credit loss estimate. Entities should consider whether the historical loss information used covers a sufficient time period that reflects the contractual term of the financial assets. Understandably, the timing of credit loss on shorter-term receivables, such as trade accounts receivable and contract assets, may not significantly impact the credit loss estimate.
The next article in our series will provide a detailed roadmap for estimating expected credit losses, offering a step-by-step guide within the CECL framework.
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Published on November 08, 2023