What is the discounted cash flow (DCF) methodology?
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.
CECL – Data and Methodology
The Financial Accounting Standards Board's (FASB) Accounting Standards Update (ASU) 326 provides the guidance for estimating allowances for credit losses, as the current expected credit losses methodology (CECL) will be applied. The allowance will be reported as a valuation account, or the difference between the financial assets’ amortized cost basis and the net amount expected to be collected. Two common questions that bankers ask about FASB's CECL model are: 1) What methodologies make the most sense for CECL? 2) What are the data requirements for my institution?
Measures of Loss
When calculating the FAS 5 portion of the ALLL, various methodologies can be used. These consist of peer analysis (for financial institutions that may still be in de novo status), historical loss, migration analysis and PD/LGD.
ASC 450-20 (FAS 5)
ASC 450-20 (FAS 5) loans are deemed as “performing” loans, and are pooled as opposed to being examined individually. Various measures of loss can be used to determine the expected loss from ASC 450-20 (FAS 5) pools. Institutions who are diligent about segmenting these pools can gather insight into the performance of each pool.