The Financial Accounting Standards Board’s (FASB) latest Accounting Standards Update, ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326), sets out the final impairment credit accounting standard with detailed guidance on the new loss reserve model, Current Expected Credit Loss (CECL). FASB claims the new standard will improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations.
“The new standard addresses concerns from a wide range of our stakeholders – including financial statement preparers and users – that the existing incurred loss approach provides insufficient information about an organization’s expected credit losses,” said FASB Chair Russell G. Golden. “The new guidance aligns the accounting with the economics of lending by requiring banks and other lending institutions to immediately record the full amount of credit losses that are expected in their loan portfolios, providing investors with better information about those losses on a more timely basis.”
The new ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates.
Many of the loss estimation techniques applied today will still be permitted under the new ASU, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances.
The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.
Additionally, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.
In summary, the new guidance:
- Eliminates the probable initial recognition threshold in current GAAP and, instead, reflects an organization’s current estimate of all expected credit losses over the contractual term of its financial assets;
- Broadens the information an entity can consider when measuring credit losses to include forward-looking information;
- Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses;
- Increases comparability of purchased financial assets with credit deterioration (purchased credit-impaired [PCI] assets) with other purchased assets that do not have credit deterioration, as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses (ACL) for all assets;
- Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage); and
- For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write-down.
The Regulatory Response
The Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) also issued a joint statement on the new rules, providing initial supervisory views regarding the implementation of the new accounting standard.
“The move to an expected credit loss methodology represents a change to current allowance practices for the agencies and institutions. The agencies support an implementation of the FASB’s new accounting standard that is both reasonable and practical, taking into consideration the size, complexity, and risk profile of each institution.”
The agencies provide their view on measurement methods, use of vendors, portfolio segmentation and data, as well as qualitative adjustments and systematic allowance processes. They also urge firms to start planning for their transition to the new standard by first becoming familiar with the new accounting standard before initiating discussion with the board of directors, industry peers, external auditors and supervisory agencies on how best to implement the new rules “in a manner appropriate to the institutions’ size and the nature, scope, and the risk of their lending and debt securities investment activities."
Firms are further advised to review their existing allowance and credit risk management practices to identify processes that can be leveraged when applying the new accounting standard. Organizations also need to identify their data needs, which may require them to collect additional data, and any necessary system changes to implement the new accounting standard, the allowance estimation method or methods to be used, and supervisory expectations. All firms are further advised to begin to plan for any potential impact of the new accounting standard on capital.
The ASU on credit losses will take effect for U.S. Securities and Exchange Commission (SEC) filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. For public companies that are not SEC filers, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. For all other organizations, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021.
Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.
The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income. It affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial assets not excluded from the scope that have the contractual right to receive cash.
The ASU will impact the entire financial services industry, from global banks to community banks, credit unions and non-core financial services organizations with financing arms, such as car companies offering financing in-house. Organizations in many other industries will be affected as well, including all those that hold large leasing portfolios will be most impacted by the new rules, especially as they will also have to comply with the FASB’s new leasing standard that forces lessees to put proceeds from operating leases on their balance sheets.
Compliance Action Plan
The regulators urge all firms to put in place an action plan for compliance with the new standard. In fact, the joint agency statement advises all departments to work together closely.
“Senior management, under the oversight of the board of directors, should work closely with staff in their accounting, lending, credit risk management, internal audit, and information technology functions during the transition period leading up to the effective date of the new accounting standard as well as after its adoption."
Firms need to first recognize that the transition to CECL is a significant undertaking and should be planned and managed accordingly. They should begin now to organize a program management office (PMO) and to obtain appropriate sponsorship support at the outset.
Subsequent steps should include performing a gap assessment, setting out implementation plans and prioritizing tasks, and identifying required resources.
Affected organizations face several compliance challenges but the main areas of impact are modeling, data and IT systems, business processes, accounting, disclosures and reporting, as well as internal audit and controls. These areas are examined more closely in the following sections.
The new guidance has identified several potential methodologies:
Estimating expected credit losses using a loss-rate approach
An institution can apply its segment-level historical loss rate for similar financial assets to estimate the credit losses. The segmentation can be defined by key risk characteristics. For commercial loans, the key risk characteristics can include internal credit rating, industry type and collateral type. For retail loans, such as mortgages, the key risk characteristics can include credit risk scores and a loan-to-value (LTV) ratio.
Estimating expected credit losses using a vintage-year basis
Similar to the loss-rate approach, this approach also relies on the historical loss rate but adds one more dimension, vintage year, to segment the portfolio. Additionally, when performing the analysis, the institution should include the vintage year to generate the historical loss rate curves since the origination of the loans. Then, on the reporting date, the historical loss curve can be applied to the current portfolio to generate the expected credit losses based on the vintage year and other risk characteristics of the assets.
Approaches based on PD and LGD parameters
Besides applying the historical loss rate for estimating the expected losses, an institution can also estimate the expected loss through risk parameters, probability of default (PD), loss given default (LGD) and exposure at default (EAD). The industry has developed multiple methodologies to estimate PD and LGD. Many of these methods are statistical-based. For PD estimation, the most common methodologies include logistic regression, transition matrix, linear regression and fractional regression. Furthermore, LGD can be estimated based on linear and fractional regressions or segmentation approaches.
Institutions have the flexibility to use any of the above approaches to estimate their credit. Each approach, which could be suitable for different types of organizations, has its advantages and disadvantages, as detailed in the following table.
Expected Loss Rate
- Easy to implement and comprehend.
- Consistent with existing ALLL approaches that many financial institutions are using.
- Allows management adjustment based on current conditions and supportable projection.
- Lack of integration with other risk and macroeconomic factors into the expected loss rate factor.
- Low levels of transparency for the loss rate decision process.
- Easy to comprehend.
- Able to generate quarterly/monthly and cumulative loss estimations.
- Provides flexibility for management to leverage more recent portfolio performance information to guide loss estimation.
- Does not integrate other risk and macroeconomic factors into the expected loss rate factor.
- Requires long-term historical data to generate the vintage loss curve.
PD and LGD Modeling Approach
- Flexible and able to take into account more information for the credit loss estimation.
- Involves multiple statistical methodologies to estimate the losses.
- Requires significant historical data.
- Due to the complexities involved, this may be a less transparent approach.
- The calculations may require significant controls to verify the accuracy of the outputs.
Discounted Cash Flow Approach
- Takes into account the economic value of cash inflow.
- Requires significant computational power for long-term cash flow projection of a large number of instruments in the banking book.
Data and Information Technology Systems
To support the new accounting standards, organizations need to collect data with granular information for longer periods of time. Firms need to assess their existing data and IT systems and take steps to enhance their data warehouses and IT systems accordingly.
For example, to form lifetime loss forecasts using vintage analysis, an organization will need long-term loan-level data to construct the vintage curves. The following table offers samples of loan-level variables that may be needed for vintage analysis. Depending on the types of products and the model framework, more data should be collected in the historical database to support CECL calculations.
Processes, Systems and Internal Controls
Organizations will need to modify or redesign their loss reserve processes and systems based on the new accounting standard to reflect changes in methodologies and asset classification. As CECL requires a forecast of life of loan losses at the time of origination and an ongoing reevaluation of remaining expected life of loan losses, as mentioned previously, institutions will need to incorporate extended periods of history at a more granular level than many track today, as well as implement enhanced data capture and analysis into their processes. Additionally, certain existing processes will need to be revisited and enhanced.
For example, the input to a loss rate method would need to represent remaining lifetime losses, rather than the annual loss rates commonly used today. In addition, institutions would need to consider how to adjust historical loss experience not only for current conditions as required under the existing incurred loss methodology, but also for reasonable and supportable forecasts that affect the expected collectability of financial assets.
Further, the existing accounting standard separates impaired and non-impaired assets and requires different measurements for these two groups. However, the new accounting standard requires that the same measurement be applied to all assets, regardless of whether the asset is impaired or not. Thus, organizations will need to make process updates to remove analysis based on the prior impairment classifications.
Additionally, the different assets under the new accounting rule, such as troubled debt restructurings (TDR), PCI financial assets and held-to-maturity assets, will need to be reclassified under the new estimation methodology.
CECL will also result in the need for new metrics to be created, as the recorded allowance at inception will reflect expected life of loan losses, which is not typically the measuring point for most organizations’ ongoing reporting. In order to effectively implement the required process and systems changes, communication with the board, management, investors and regulators will be critical.
The new standard will change the scope of internal controls and internal audit requirements surrounding the ACL because the methodology will change. New sources of data will be employed and new modeling tools will be implemented. Internal audit departments should start planning now to ensure that adequate resources will be available prior to and after the transition. Among the steps internal audit should take include the following:
- Actively participate in the planning, scoping and execution processes that will be taking place as part of CECL implementation.
- Partner with operating groups in the design of required new internal controls to ensure that the controls integrate into the existing Sarbanes-Oxley (SOX) control framework.
- Assess additional internal audit skills that may be needed in designing audit programs and executing internal audits. Recent guidance from the Public Company Accounting Oversight Board (PCAOB) on auditing estimates and fair value measurements specifically addresses the use of specialists during an audit. CECL may expand the scope of activities subject to PCAOB oversight, including loan origination processes, data systems, and asset/liability management (ALM) models.
Accounting, Disclosures and Reporting
Affected organizations will face new accounting and reporting requirements that will impact income and capital, as well as new disclosure requirements that will require additional detail compared to the existing requirements.
The classification of financial assets does not change substantially from existing U.S. GAAP rules. CECL only affects financial assets not measured at fair value through the income statement. For most entities, this corresponds to held-for-investment (HFI) or held-to-maturity (HTM) instruments (classified at amortized cost) and available-for-sale (AFS) instruments classified at fair value with qualifying changes recognized through other comprehensive income. (Trading and held-for-sale, or HFS, instruments continue to be classified at fair value, with changes recognized through income and are not in scope.) Asset classification does not change; only the reserve model changes under the new rules. But classification will now include a second level: the critical parameters used by the entity to assess credit risk. While most financial institutions and other organizations utilize risk classifications, many do not use vintage for all their financial instruments.
As discussed, CECL provides for a single ACL. Thus, for financing receivables, the separate evaluations required for the general reserve and for specific reserves for receivables that are evaluated individually for impairment are replaced with a single evaluation of all receivables (individually or as pools of receivables with similar credit risk characteristics).
Accounting for PCI instruments changes substantially under CECL. PCI instruments are to be recorded at par value at acquisition; the difference between the par value and the purchase price is to be recorded as an ACL. Expected credit losses are reevaluated each quarter based on the remaining par value of the receivable, with an adjustment to the allowance to reflect increases or decreases in the expected credit loss. Such adjustments would be classified as “Provision for Credit Loss” through the income statement. Interest income recognition will be based on the amortized cost (equal to the sum of the purchase price and the allowance for credit loss).
AFS and HTM financial instruments, other than financing receivables, will transition from an “Other Than Temporary Impairment” (OTTI) model – in which it must not be probable that a credit loss is temporary – to a concept of establishing an allowance for credit loss soon after the acquisition date. This change will have the greatest impact on financial institutions – such as life insurance companies – that hold debt instruments to maturity and have historically recognized impairment only when it met the probability standard.
As no unallocated reserves will be permitted under CECL, any “on top” adjustments to reserves will require allocation to specific instruments. As a practical expedient, current groupings of small-value, homogeneous instruments continue to be permitted under proposed CECL methodologies. However, the definition of “homogeneous” may change.
Documentation, such as whitepapers and/or technical memos that support model choices, data analysis and other similar assertions, will be necessary to support the elections made. These documents are typically maintained by the accounting organization and are subject to review by external auditors and regulators.
Credit risk disclosures will change under CECL, particularly the level of detail about the factors that drive the ACL estimates. While disclosure about the class of asset has always been required (trading, HFS, AFS, HTM, HFI), additional disclosures stratified by risk characteristic, including vintage, will now be required.
An entity should provide a period-to-period roll-forward of its allowance for expected credit losses, both for financial assets measured at amortized cost and fair value through other comprehensive income.
The proposed guidance requires that an entity disaggregate the credit quality indicators, for all classes of financing receivables (excluding revolving lines of credit such as credit cards) that are disclosed under current GAAP, by year of the asset’s origination (that is, vintage year). The disaggregation by vintage year would be limited to no more than five annual reporting periods, with the balance for financing receivables originated before the fifth annual reporting period shown in aggregate. For an interim reporting period, the year-to-date (YTD) originations of the current annual reporting period would be considered to be current-period originations. Vintage year would be based on current guidance for determining whether a loan refinancing or restructuring is a new loan.
An entity should disclose in the notes to the financial statements the method applied to revert to historical credit loss experience for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts.
The disclosure requirements that apply to loan commitments would also apply to financial guarantees not accounted for as insurance or at fair value through net income.
All disclosure requirements related to credit risk and the recognition of credit losses, except for the requirement to disaggregate the credit quality indicators of those receivables by vintage, would apply to reinsurance receivables.
Once the transition to CECL is complete, applying CECL to all financial assets should simplify accounting by eliminating the numerous approaches to credit loss estimation and income recognition – for financing receivables, purchased credit-impaired loans, troubled debt restructurings, debt securities, etc. – that have existed in the past.
Companies should start now to draft the disclosures to provide adequate time to ensure that all reported values have a verified source subject to appropriate Sarbanes-Oxley controls.
They also should document the methodology and the deliberations that went into choosing alternative approaches. Other recommended actions include the following:
- Evaluate and diagnose accounting and reporting changes that will be required. A gap analysis between current practice and practice required under CECL highlights the potential changes to people, processes and technology. Additional skills may be required (for example, mathematical modeling), accounting entries may be generated by different parts of the organization and new data systems may be utilized.
- Prepare the necessary documentation of methodology and accounting white papers necessary to support the accounting decisions made.
The final CECL accounting standard will have ramifications across many industries. Numerous functions and departments within financial services institutions and other organizations will be impacted. Even though the new standard does not come into effect for a number of years, the overall effort, including data capture and process changes, will demand careful thought and planning in the near future.