Written By: Will Neeriemer
For financial services companies, June 2016 was a major milestone with the FASB’s issuance of the new accounting standard for loan losses and held-to-maturity debt securities. Designated the current expected credit loss model (CECL), the standard requires entities to record credit losses at origination based on a life of loan loss concept. This is an extensive, impactful change in accounting guidance, which brings significant questions regarding interpretations, implementation and challenges financial services professionals and others are facing.
Will the acceptable estimation methods vary by size of the entity?
Yes, each entity manages credit risk differently. Based upon the varying degrees of portfolio complexity and the entity’s sophistication, various methods will be used. As stated in ASC 326, Financial Instruments – Credit Losses, section 20-30-3, clarifies that “An entity may use discounted cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilize an aging schedule. An entity is not required to utilize a discounted cash flow method to estimate expected credit losses. Similarly, an entity is not required to reconcile the estimation technique it uses with a discounted cash flow method.”
How does the concept of “expected” vary from the current concept of “probable,” especially when there is an extensive loss history over a variety of conditions?
The fundamental transition from the current concept of “probable” to an “expected” loss recognition notion is arguably one of the most substantial changes resulting from CECL. Intended to align the accounting requirements with the forward-looking information utilized by financial statement users, this concept has generated substantial questions as it relates to implementation, particularly for institutions that have extensive historical loss information that may span over multiple business cycles. As noted in ASC 326-20-30-10, “An entity’s estimate of expected credit losses shall include a measure of the expected risk of credit loss even if that risk is remote.”
This change in the new guidance affirmatively lowers the recognition threshold from probable to effectively capture all expected losses. Additionally, the accounting guidance restricts an entity from relying solely on past events to estimate expected credit losses, and at a minimum, requires that an entity considers the need to adjust historical loss information.
How will CECL impact the use of qualitative factors?
Depending on the type of model and assumptions utilized by the entity, there may be instances where qualitative adjustments are necessary to accurately estimate expected credit losses. For instance, under the new standard, ASC 326-20-30-8 states, “An entity shall consider adjustments to historical loss information for differences in current asset specific risk characteristics, such as differences in underwriting standards, portfolio mix, or asset term within a pool at the reporting date or when an entity’s historical loss information is not reflective of the contractual term of the financial asset or group of financial assets.” In addition, ASC 326-20-30-9, further states, “When an entity uses historical loss information, it shall consider the need to adjust historical information to reflect the extent to which management expects current conditions and reasonable and supportable forecasts to differ from the conditions that existed for the period over which historical information was evaluated. The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors that are associated with credit losses on the financial asset or in the group of financial assets).” Qualitative adjustments will need to be assessed by each entity based upon their individual facts and circumstances, to the extent necessary, to support the expected loss calculation.
What makes a forecast “reasonable” and “supportable?”
The CECL accounting guidance states that entities shall develop reasonable and supportable forecasts to be used in conjunction with historical loss information. Apart from clarifying that forecasts are not required for either the full contractual term of the asset or beyond what is reasonably estimated, the guidance is unclear with regards to the requirements of a reasonable and supportable forecast. However, these concepts of reasonable and supportable are not drastically different from the current accounting standards and requirements outlined in the 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses as it relates to determining qualitative and economic factors. Entities should consider the following three factors among others when determining whether a forecast is reasonable and supportable. First, is the forecast relevant to the entity’s unique credit risk? For example, for a community bank operating in one state, using a forecast of state unemployment may be more relevant than national unemployment. Second, is the forecast from a reliable source? An entity should determine that the information they are using is from a trusted source that uses acceptable methods to generate the forecast. Finally, is the forecast current? An entity should consider whether or not the source data used in the forecast has considered the most current developments as of the balance sheet date.
When determining your future losses, should an entity discount back to present value or reserve the full future losses undiscounted?
The total amount of future expected losses shall be reserved, and a discount to present value of this amount will not be necessary. If an entity chooses to estimate expected credit losses under a discounted cash flow method, the allowance for credit losses shall reflect the difference between the amortized cost basis and the present value of the expected cash flows.
When developing the allowance, how should an entity consider the fact that prepayments result in lost interest as compared to what was expected? In other words, is interest not received a credit loss if prepayment is allowed?
The guidance issued in the ASU is clear that an entity shall consider prepayment either as a model input if using a discounted cash flow (DCF) method or embedded in credit loss information if using a loss-rate method. When utilizing a DCF method, the cash flows are discounted using the effective interest rate, which is the contractual interest rate adjusted for any net deferred fees or costs, premiums or discounts. Therefore, the only impact on the allowance, as a result of uncollected interest as a result of prepayment, would be the result of differences in the effective interest rate as compared to contractual. However, changes in the timing of payments or losses from what was modeled initially may result in changes in the calculated reserve necessary when using a discounted cash flow method. The new standard allows the entity to recognize these timing related changes in either the provision for loan losses expense or in interest income (ASC 326-20-45-3).
How will an entity account for loans with terms of one year or less?
An entity should account for loans with different durations using the same estimation methodology adjusted for the different term of the loan. Expected credit losses shall be measured on a collective (pool) basis if assets have similar risk characteristics. Shorter duration loans with similar risk profiles should be pooled together in order to assess expected credit losses. An entity shall not extend the contractual term for expected extensions, renewals and modifications unless it has a reasonable expectation that it will execute a troubled debt restructuring.
Is there still an impaired loan concept under CECL?
As stated in ASC 326-20-30-2, “If an entity determines that a financial asset does not share risk characteristics with its other financial assets, the entity shall evaluate the financial asset for expected credit losses on an individual basis.” When a financial asset meets this criteria, it will be assessed in a similar manner as an impaired loan under the old standards, but will not be considered “impaired” as the ASU eliminated that concept. The new standard does not provide the prescriptive guidance that was previously available to define impaired loans; therefore an entity will need to develop and consistently follow a reasonable policy for determining when it is appropriate to separately evaluate a loan.
Most of the discussion surrounding changes in accounting for acquired loans has related purchased credit deteriorated loans, but what about purchased performing loans?
There will be differences in accounting for purchased performing loans. According to the ASU, purchased loans that do not have more-than-insignificant credit deterioration since origination are to be treated in a manner similar to originated loans. Given that the allowance for loan loss can be determined using several methods (e.g., discounted cash flow or historical loss rate), the treatment can vary based on methodology and will differ significantly from the legacy ASC 310-20 guidance as institutions will no longer compare a calculated allowance to the purchase discount when evaluating whether a reserve is necessary. In both methods, any discount or premium on the acquired loans will be considered within the amortized cost basis used in the calculations. The guidance also directly states that any discount that an entity expects to be accreted into interest income should not be used to offset the entity’s expectation of credit losses (ASC 326-20-30-5).
What happens to the unaccreted discount on purchased credit impaired loans at the date of adoption?
Upon the adoption of Topic 326 (CECL), entities will gross up the carrying value of purchased credit deteriorated loans by the amount of the expected credit losses estimated using a CECL compliant methodology. The non-credit discount will then be the difference between the contractual amount due and the carrying value of the loan (as adjusted for the gross up), and should be accreted into income using an effective yield method similar to other discounts. In the basis for conclusions, the Financial Accounting Standards Board acknowledged that this method of transition was preferable rather than requiring entities to adjust the carrying value of assets to reflect a retrospective adoption of the new standard.
There is no doubt that the changes made to credit loss accounting as a result of the new accounting standard update will have a significant impact on most financial institutions who will have to deal with potential increases in reserve amounts, while simultaneously navigating the increased cost and complexity of calculating the reserve. As evidenced above, there are substantial questions all entities must work through as part of the implementation process, and getting an early start by creating an implementation team, assessing personnel resources and involving outside professionals where necessary, is key to planning for the change required by the new standard.
About the Authors
Neeriemer is a partner in the DHG Financial Services practice. Will has more than 15 years of experience in providing attest and advisory services to financial institutions. He has extensive experience with the accounting and auditing issues related to mergers and acquisitions, mortgage banking and complex valuations. Will currently serves as the professional practice partner for the financial services group, where he is a resource on complex accounting and auditing matters for all the financial services engagement teams.
McGregor Holmes is a manager in the DHG Financial Services practice. McGregor’s primary experience includes audit, advisory and compliance assistance for clients ranging from small local companies to super-regional public companies.
Che Carrasquillo is a manager in the DHG Financial Services practice where he serves on external audit engagements for both public and private entities. In addition to his external audit responsibilities, Che manages the delivery of internal audit, ACH compliance audit, Sarbanes-Oxley and FDICIA services to community and regional financial institutions.