On July 17th, 2019, the Financial Accounting Standards Board (FASB) agreed to formally propose extending the effective date of the Current Expected Credit Loss (CECL) standard to January 2023, for all but the larger SEC filers. This highly anticipated announcement of additional relief for most understandably overshadowed another document the FASB also issued that same day – a second FASB Staff Q&A aimed to address more than a dozen frequently asked questions related to ASU 2016-13, to help organizations better estimate expected credit losses on financial assets. Further explained in the Q&A: “As part of the Board’s continuing commitment to educate stakeholders, the staff has developed this question and answer (Q&A) document to respond to some frequently asked questions about using historical loss information, developing reasonable and supportable forecasts, and requirements regarding applying the reversion to historical loss information.”
These FAQ’s and the FASB’s formal response to each, address components of the allowance estimate newly introduced by the CECL standard and are the areas that are causing angst throughout the industry as institutions attempt to appropriately incorporate these new components into their respective methodologies. Considering this, it seems prudent to dedicate the time to examine each of these questions/responses as we collectively aim towards promoting a smooth, well-thought-out and supportable transition to CECL compliance. The Q&A document includes information taken directly from ASU 2016-13, including certain paragraphs in the basis for conclusions. Unless otherwise indicated, italicized wording herein represents that language excerpted directly from the standard.
Per the Q&A document, “Topic 326 requires the entity to consider available and relevant information, including historical experience, current conditions, and reasonable and supportable forecasts, with the objective of presenting the entity’s estimate of the net amount expected to be collected on the financial assets.”
There are a variety of approaches to developing the estimate of credit losses, with FASB restating that there are a number of credit loss estimation methods available to an entity (i.e.; no singular “right answer”), and that an entity must use judgment in selecting both their methodology, as well as underlying assumptions within their model(s). One of the key assumptions that will need to be documented and defended is the estimates surrounding reasonable and supportable forecast period (R&S period). This key concept led to several questions posed to the FASB staff, and the subsequent creation of the Q&A document.
Concerning documentation, Abrigo encourages clients to always point to the standard, then utilize a “therefore what?” approach. FASB utilizes a similar approach, highlighting Paragraph 326-20-30-7 of Topic 326, with key topics such as:
- …an entity shall consider available information relevant to assessing the collectability of cash flows.
- This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts.
- An entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s)
- …an entity is not required to search all possible information that is not reasonably available without undue cost and effort.
- An entity may find that using its internal information is sufficient in determining collectability. [Emphasis added.]
The above statements, pulled directly from the standard, are non-prescriptive in nature and will require management to maintain a full understanding of their model and provide proper documentation to substantiate the inputs and assumptions concerning the collectability of cash flows, the data utilized, and assumptions surround the R&S period.
Noting the non-prescriptive nature of the CECL standard, the FASB states that …any approach to estimating the collectability of financial assets is subjective. The FASB continues to highlight that not every institution will utilize the same approach, the same model, or the same adjustments in their model. The FASB recognizes that different outcomes for expected credit losses due to these and other factors are acceptable under the amendments in this Update.
Over the course of the next three weeks, in a three-part series, we’ll further explore each of the sixteen FAQ’s presented in this FASB Staff Q&A. Each of the questions will be presented individually, supported by FASB’s documented responses, and then further supplemented by the author’s additional thoughts.
Question #1 – “Does the application of the word forecast in paragraph 326-20-30-7 infer computer-based modeling analysis is required?”
“No, developing forecasts does not require an entity to perform computer-based modeling. Topic 326 allows a quantitative or a qualitative adjustment to be made when assessing current conditions and reasonable and supportable forecasts. One way to apply a forecast on a qualitative basis is by using qualitative factors (Q-factors). Similar to how many entities consider Q-factors under existing practice in determining the allowance for credit losses, another approach can be used for forecasting.”
Computer-based modeling certainly offers its own advantages to those looking to perform and leverage such analysis. However, for many community financial institutions, using such modeling in their forecasts would represent a significant shift from current practice; therefore, the FASB has highlighted the fact that, for those institutions, the determination and application of qualitative factors (Q-factors), similar to today’s practice, may be a reasonable and acceptable alternative. Concerning Q-factors, in its April 29th, 2019 Meeting Takeaways, the AICPA CECL Task Force Auditing Subgroup advised that when applying Q-factors to a model, they must be “adequately documented, applied consistently over time, supportable and quantifiable, and designed to compensate for limitations of the model.” Accordingly, if Q-factors are the preferred route, particular attention must be given to ensuring a framework is established that considers and addresses each of these mandates.
Question #2 – “If an entity’s actual credit losses differ from its estimate of expected credit losses, is it required to modify its forecasting methodology?”
“The Board notes that estimates of expected credit losses often will not predict with precision actual future events. The objective of the amendments in the Update is for entities to present their best estimate of the net amount expected to be collected on financial assets. The amendments do not require a specific loss method; rather, an entity is required to use judgment in determining the relevant information and estimation methods that are appropriate in its circumstances. The Board understands that there generally is a range of reasonable outcomes and, therefore, expects there to be differences between estimates of expected credit losses and actual credit losses. Ultimately, estimates of future losses and actual losses should converge to the same amount. An entity should continue to refine future estimates of expected credit losses based on actual experience. For example, if actual results indicate that macroeconomic conditions are having a greater or lesser effect than originally projected, an entity may need to adjust future loss projections to reflect this change.”
The development of a CECL methodology is not a one-time exercise that is completed, put into production and then left unadjusted. Rather, CECL compliance will necessitate continued consideration of, and possibly necessary calibrations to model assumptions/inputs. These refinements may be driven by, but not limited to, additional data gathered and/or observed, including additional insight into the loss drivers within a portfolio, as well as fluctuations in economic activity and reconciliation of how actual experience differed from prior forecasts.
Question #3 – “Can an entity’s process for determining expected credit losses consider only historical information?”
“No. The guidance states that an entity should not rely solely on past events to estimate expected credit losses. When an entity uses historical loss information to forecast expected credit losses, it should consider the need to adjust historical loss 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 loss information was evaluated. The adjustments, if needed, to historical loss information may be qualitative or quantitative in nature and should reflect changes related to relevant data.
In addition, an entity should consider adjustments to historical loss information for differences in current asset-specific risk characteristics, such as underwriting standards, portfolio mix, or asset term within a pool at the reporting date. An entity also should consider whether historical loss information used covers a sufficient time period such that it reflects the term of the financial asset or group of financial assets.”
It is important that management maintain the ability to adjust the allowance for current conditions and R&S forecast, should they be different from the historically evaluated period. Similar to the above statements over Q-factors, any adjustments will need to be properly quantifiable and documented.
Additionally, institutions may consider adjustments for historical loss information that does not cover a complete economic cycle (National Bureau of Economic Research states the current economic cycle began in Q4 of 2007).
Question #4 – “How should an entity determine which historical loss information to use when estimating expected credit losses?”
“In determining what historical loss period information best represents the financial assets, an entity may use historical loss information that is nonsequential (such as historical loss percentages based for each year since origination as opposed to an average 5-year historical loss percentage). The appropriate historical loss period can vary between loan portfolios, products, pools, and inputs. An entity should consider both the appropriate historical period and the appropriate length of the period when developing those estimates.
An entity should use judgment in determining which period or periods to consider when determining which historical loss information is most appropriate for estimating expected credit losses. An entity does not have to use historical losses from the most recent periods. For example, an entity may determine that the historical loss information that best represents the specific risk characteristics of the entity’s current portfolio relates to periods from 20X2–20X5. Using the historical loss information from 20X2–20X5 as an input to the measurement of expected credit losses, an entity would then consider how current conditions and reasonable and supportable forecasts affect the estimate of expected credit losses. Once the historical period has been chosen, an entity should consider adjustments to historical loss information for differences in current asset-specific risk characteristics, such as underwriting standards, portfolio mix, or asset term within a pool at the reporting date or when an entity’s historical loss information does not reflect the contractual term of the financial asset or group of financial assets. For periods beyond the reasonable and supportable forecast period, an entity should revert to historical loss information that may not be from the same period used to estimate its reasonable and supportable forecast and should reflect the contractual term of the financial asset or group of financial assets. In other words, an entity should use historical loss information that is more reflective of the remaining contractual term of the financial assets for periods beyond the reasonable and supportable forecast period.”
The piece to note is: “The appropriate historical loss period can vary between loan portfolios, products, pools, and inputs. An entity should consider both the appropriate historical period and the appropriate length of the period when developing those estimates”
Is the life of loan concept captured in our historical information? Do we have enough loss data to inform our model? Do we need to evaluate peer information? Decisions here will need to be adequately documented and explained, it is important that “an entity should use historical loss information that is more reflective of the remaining contractual term of the financial assets for periods beyond the reasonable and supportable forecast period.”
Once that period has been selected, it is important for an institution to “consider adjustments to the historical period for differences in current asset-specific risk characteristics, such as underwriting standards, portfolio mix, or asset term within a pool at the reporting date or when an entity’s historical loss information does not reflect the contractual term of the financial asset or group of financial assets.”
Documentation surrounding potential adjustments, as well as the basis for the historical period evaluated, will be a key part of the support for each decision.
Zach Englert is a member of Abrigo’s Advisory Services team, where he assists with data analytics, CECL model creation, and the portfolio segmentation of a variety of financial institutions utilizing industry data and the ASU 2016-13. As a Senior Analyst, Zach aids customers in the implementation of CECL and regularly presents at CECL workshops and conferences. Zach earned his bachelor’s degree in accounting and finance and an MBA from Piedmont College.