Current Expected Credit Loss

Anticipation is building as the final version of Financial Accounting Standards Board’s guidance on the Current Expected Credit Loss model is expected to be issued in the next few months. As we wait, most credit unions are wondering how they are going to take on the daunting task of implementing this new model. Here’s what you need to know about CECL and how you can start preparing for it now.

What is CECL?

Following the global economic crisis, the Financial Accounting Standards Board and Internal Accounting Standards Board were tasked with identifying weakness to the current incurred loss model. The group observed three main weaknesses to be addressed:

1. delayed recognition of credit losses due to probable and incurred levels;
2. inability to consider forward-looking information; and
3. the use of numerous and disparate credit impairment models– evidence of weakness in current accounting standards.

With a desire to support use of a more forward-looking model, the advisory group set out to provide an alternative for measuring incurred losses, which resulted in the new CECL method. To provide guidance on how an entity should recognize and measure expected credit losses on financial assets, based on an entity’s current expectations about collecting contractual cash flows, FASB released a proposed Accounting Standard Update in late 2012.

Aimed at providing financial statement users with more decision-useful information, the new model would also:

• remove probable and incurred levels for recognition of credit losses;
• extend the time horizon over which expectations are to be formed (life of loan);
• be more forward-looking by incorporating a reasonable and supportable forecast of the future; and
• reduce complexity by replacing numerous models with a consistent approach.

CECL—The Process

If the proposed amendments get the green light, credit unions would be required to impair existing financial assets based on the current estimate of contractual cash flows not expected to be collected on financial assets held at the reporting date. This impairment would be reflected as an allowance for expected credit losses, according to Financial Accounting Series, Exposure Draft, Proposed Accounting Standards Update, Issued: December 20, 2012. Financial Instruments – Credit Losses (Subtopic 825-15).

Initially, FASB expects many entities will base estimates on historical loss data for reasonably segmented types of assets. (Defining “reasonably segmented” could be the topic of another article, however, segmenting by such items as type, risk rating, and other concentration considerations should be considered.) Later these institutions are expected to update the historical data to reflect current conditions founded on supportable estimates of the future events that would modify the collectability of remaining cash flows.

In the long term, at each reporting period, the expected losses would be calculated, and any changes would flow through earnings. Losses would be based on current risk ratings, historical loss rates for similar pools of assets, and adjusted for any changes in current conditions and supportable expectations about the future. The resulting allowance does not relate to any specific asset, but rather relates to pools of assets with similar characteristics (e.g. types, credit risk ratings, remaining lives…).

How to Prepare

Preparing for this new standard will require credit unions to develop systems with the ability to handle additional key inputs required by CECL. Loan-level and risk-rating assessment capabilities, appropriate environmental and industry factors, and robust historical data are all important inputs that will need to be taken into consideration. With the changes right around the corner, your credit union should start preparing now to allow for a smooth transition from the current standards.

The Right Method for You
The proposed standard requires credit unions to use methods that estimate and reflect past events, current conditions, and reasonable and supportable forecasts about the future. Your credit union can choose from a variety of methods, including the loss-rate, roll-rate and probability-of-default models. When determining which method is the right fit for you, some key considerations include:

• balancing the results needed with the time and effort required to gather the applicable data;
• ability to apply the method consistently over time;
• support for any forward-looking views and subjectivity;
• governance and controls; and
• model risk.

Wondering what the models look like for your institution? Some examples are shared below.

• Loss-rate methods
  • Examples include average charge-off, vintage, and static pool models. These generally can be summarized into the following equation: Loss Rate = (Charge-offs – Recoveries) / Average Loan Balance X Remaining Average Life of Each Similar Asset Pool.
• Roll-rate methods
  • Often referred to as loss migration analysis, the portfolio is segmented into similar asset pools (type, credit risk, delinquency status). The purpose is to evaluate the probability of an asset migrating from one risk rating to another over a chosen timeframe (e.g. from “A – Current” to B – 30 days Delinquent,” etc.)
• Probability-of-default methods
  • Expected loss estimation is based on three risk components: probability of default (PD), exposure at default (EAD), and loss given default (LGD). The resulting formula can be expressed as: Credit Loss = PD x EAD x LGD.

Method Inputs
Based on the method your credit union chooses, your infrastructure database and gathering sources should, at a minimum, begin to be populated with such key attributes as the below:

Don’t Wait

The move to CECL will be a significant change for credit unions from an operational standpoint—not to mention increase allowance balances due to the “life of loan” characteristic. You can start preparing now by implementing a data gathering process, assessing model method need and documenting decisions in written procedures. Start now so you won’t find yourself scrambling to meet the implementation deadline.

David Ritter, CVA, MBA, is a shareholder with Doeren Mayhew, Troy, Mich.