A discounted cash flow methodology in the context of ASU 2016-13 (Topic 326/CECL) is one way to estimate credit losses. Discounted cash flow (DCF) methodologies utilize a bottom-up approach—meaning they model expected cash flows on a loan-level basis and aggregates results at the pool-level.
As financial institutions develop and execute plans for implementing CECL, a critical component of the decision-making process will be selecting the appropriate methodology for calculating life-of-loan loss experience and estimating future losses. Institutions are discovering DCF modeling to be an effective method of measurement for a variety of reasons, namely when historical loan data is insufficient and/or application toward longer-term assets.
Proper expected cash flow models will calculate and apply a statistical tendency to default some portion a loan balance over time. Loan losses as they pertain to DCF should not be thought of as a binary event resulting in total loss—they are incremental, compounding and based on historical loss tendencies. The calculation can, therefore, take into account the seasoning and blend of loan maturities, their structures, any adjustments for current/future conditions and any expected prepayments.
Many institutions have historically used discounted contractual cash flows for analysis of impaired assets or Troubled Debt Restructurings (TDR) under ASC 310-10-35, and that model is different from the expected cash flows used in a DCF model. A few material differences between the two calculations are modeling factors such as prepayment, default estimates, loss estimates and recovery activities that otherwise would not be used in a contractual cash flow calculation.
For more information watch the on-demand webinar: CECL Methodologies