Written By: Matthew Schell
Since the financial crisis, the Financial Accounting Standards Board (FASB) has been debating wholesale changes to the U.S. generally accepted accounting principles (GAAP) credit impairment model. The FASB completed the majority of its deliberations in April and expects to issue a final standard in the fourth quarter of 2015. This standard, which uses the current expected credit loss (CECL) model, fundamentally will change the way the allowance for credit losses is calculated. The standard will have a pervasive impact on all financial institutions, and questions are circulating about what changes are in store.
What Instruments Are Subject to CECL?
The FASB decided to apply the CECL model to financial assets measured at amortized cost. For financial institutions, CECL generally will apply not only to loans but also to held-to-maturity debt securities and loan commitments that are not classified at fair value through net income (FV/NI).
How Is the Allowance Measured Under CECL?
A current estimate of all contractual cash flows not expected to be collected should be recorded as an allowance. Providing flexibility, the FASB concluded that there will not be restrictions on the types of methodologies used to develop an estimate of expected credit losses. Specifically, the FASB said some of the models that could be used to develop estimates include discounted cash flow, loss rate, probability-of-default, or provision matrix models. Many models currently used by financial institutions would fit into one of these categories and could assist in developing an expected credit loss estimate.
One significant change will be the requirement to pool assets that share similar risk characteristics, which FASB has yet to define. If an institution does not have multiple assets with similar risk characteristics, it would evaluate those financial assets on an individual basis. When developing an estimate of expected credit losses on an individual asset, an evaluation of individual financial assets “should consider relevant internal information and should not ignore relevant external information” (for example, credit ratings and credit loss information for financial assets of similar credit quality).
What Are Some of the Inputs to the CECL Model?
Depending on the type of methodology applied to develop the allowance, the necessary inputs could vary greatly. Some items will be new to the analysis and will create needs for new data. As an example, the CECL model effectively is a lifetime estimate, which means financial institutions might need to estimate the life of the various assets. The FASB has indicated that estimating the life of an asset should consider the contractual term adjusted for expected prepayments but not consider expected extensions, renewals, or modifications unless the entity expects to execute a troubled debt restructuring (TDR). This new focus on payment speeds outside of an ALM calculation might be a challenge for some financial institutions in terms of both data availability and capability.
The FASB is attempting to make the CECL model as flexible as possible and is retaining some familiar terminology used today. For example, the allowance calculation still includes “relevant quantitative and qualitative factors” based largely on the business environment and similar factors that relate to an institution’s borrowers (such as underwriting standards). However, when developing this estimate, institutions also need to consider reasonable and supportable forecasts of the cash flows for the financial asset’s life, an exercise that typically was not done in the current incurred loss model unless the loan specifically was impaired and a discounted cash flow analysis was completed.
What Are Some Other Changes?
- Purchased credit-impaired (PCI) assets. The FASB is simplifying the model. Instead of using contractually required payments receivable, nonaccretable discount, and accretable yield, entities will record these assets using par amount and noncredit discount or premium (which is amortized or accreted into income) and allowance. Because this aligns to current accounting for assets with premiums and discounts, existing core loan systems should be able to accommodate the revised model. In addition, the FASB is modifying the definition of PCI and requiring immediate recognition for both increases and decreases in expected cash flows.
- TDRs. The FASB is retaining the TDR model, which will be subject to the CECL model, with a few tweaks. The adjustment at modification will include a basis adjustment rather than just an allowance entry. The basis adjustment may be upward or downward.
- Disclosures. The FASB is retaining the current disclosures with a few additions. In a welcome change from the proposal, the FASB decided not to require amortized cost roll-forwards. Instead, the FASB tentatively decided to require credit quality disaggregated by asset class and year of origination (in other words, vintage), subject to staff outreach.
What About Transition?
Upon adoption, there will be a cumulative-effect adjustment to the balance sheet (credit allowance, debit retained earnings). For debt securities with recognized impairment, previous write-downs are not reversed. For PCI assets, an allowance is established with an offset to cost basis.
What Is Next?
At the March 11, 2015, meeting, FASB staff received permission to begin drafting the standard. The FASB is putting in place a transition resource group to identify issues and will discuss at a future meeting any remaining issues identified during the drafting process, cost-benefit considerations, and effective date.
What Does My Financial Institution Need to Do Now?
Top on the list for any financial institution is to begin to think about what data would be necessary to develop better forward-looking estimates of expected cash flows and whether that data currently is being retained. More information about the various models that might be used to comply can be found in “FASB’s CECL Model: Navigating the Changes.”
Originally published by Pennsylvania Association of Community Bankers, Transactions, July 2015.