CECL. It seems pretty top-of-mind these days, doesn't it? And that’s for good reason, given how private companies are now officially on the CECL model clock. But there's more to the new Current Expected Credit Loss (CECL) model than meets the eye. Or at least what many commercial businesses are accustomed to.

That's because the new and improved accounting for current expected credit losses – as outlined in ASC 326 – now requires reporting entities to estimate and provide for credit losses on their loans and other financial assets. And that’s a lot to take in.

But change isn't always bad, of course, including in the case of CECL. While the new requirements definitely ratchet things up for CFOs and their teams, they can also be a boon for forecasts, helping organizations foresee major losses before they become a stark reality.

So, on that note, let's take a closer look at the new CECL model and what private companies have waiting for them to help you get and stay compliant.

Understanding CECL for Private Companies

The CECL standard pushes companies to take a forward-looking approach to financial assets and estimated expected credit losses. As companies are discovering, CECL casts a wide net, encompassing a spectrum of financial assets not reported at fair value, including loans, held-to-maturity debt securities, trade receivables, off-balance-sheet credit exposures, reinsurance receivables, and net investment in leases.

Distilling the standard down to its basics, there are certain key principles in CECL that companies must adhere to:

• There is no recognition threshold for credit losses under CECL so companies must recognize even remote losses
• Losses must be estimated over the expected remaining contractual life of the asset, adjusted for any prepayments
• Companies need to consider available relevant information when estimating credit losses, including information on past events, current conditions, and reasonable and supportable forecasts.  

Also, under the CECL standard, companies must group or pool their in-scope financial assets based on similar risk characteristics. For example, assets can be pooled by: 

• Type of financial asset 
• The term of the asset 
• Risk rating 
• Credit scores 
• Borrower's industry 
• Borrower's geographical location

A company should measure a financial asset individually when it does not share similar risk characteristics with other financial assets. Further, a financial asset's contract term is crucial in determining the size of the expected loss since a longer contract term will generally result in a larger expected loss. Note, however, that additional complexities can arise with the contractual term when certain features are present such as options to extend the contractual term or call options.

To calculate the expected losses, start with historical losses and adjust based on specific risk characteristics and economic conditions, both current and forecasted. Also, since not all companies are created equally, the Financial Accounting Standards Board (FASB) allows you to choose how to estimate your expected credit losses. Some suggested and commonly used methods included in the standard are:

• Discounted cash flow 
• Loss rate 
• Roll rate
• Probability of default 
• Aging methods

Presentation and Disclosure

For financial assets measured at amortized cost under CECL, you present the allowance for credit losses separately as a reduction to the amortized cost basis.   

The standard also introduces a number of new disclosure requirements. These new requirements are intended to provide information that helps investors and other users of the financial statements understand a company's exposure to credit risk and how management estimates their allowance for credit losses.

CECL vs. the OG Incurred Loss Model

The new credit loss standard was introduced to replace the old-school incurred loss model. Under the old model, companies only recognized losses when they became probable of occurring, using past events and current conditions as their guide rails. This contrasts sharply with the CECL model, where financial institutions must estimate the expected credit losses on their loans and other financial assets, also providing for those losses when the loan or asset originated or was purchased.

The origin of the new CECL model goes back to the financial crisis of 2008. While those events were extreme, they also exposed the general – and often severe – limitations of the incurred loss model. Before CECL, even if companies could predict potential problems down the road, they couldn't act on them. So, as an alternative, a more forward-thinking model was born with the FASB establishing the final standard of CECL. And in doing so, it changed the way credit losses are considered for in-scope assets, including commercial companies.

Adoption and Transition Considerations for Private Companies

For SEC filers – excluding those falling under smaller reporting company eligibility – CECL's requirements took effect on January 1, 2020. For everyone else, the effective date was pushed to January 1, 2023. In other words, no matter what type of in-scope organization you have, CECL is on like Donkey Kong.

But that leads us to the million-dollar question – how can your company adopt the new guidance without a hitch? Well, the simplest way is through the modified retrospective approach. With this method, you’re using a cumulative effect adjustment to retained earnings as of the beginning of the first reporting period you adopt the standard. So, for companies adopting in 2023, they apply the cumulative effect adjustment to opening 2023 retained earnings.

Looking bigger picture for a moment, if there's anything we can learn from public companies that have already adopted this standard, it's that preparation is key. Therefore, for a smooth transition to an entirely new way of doing things, your company will need to take a fresh look at internal controls, data sources, and processes in general. And that takes time companies don’t really have at this point.

Benefits of CECL for Private Companies

As we said up top, CECL isn't all doom and gloom for companies, even as they’re staring a rather steep implementation in the face. In many ways, CECL can also be the foundation of a financial strategy that, when done right, can steel your company against unnecessary losses, amongst other significant benefits.

Improved Financial Reporting and Transparency

CECL shines the spotlight on your potential credit risk. This forward-thinking approach to estimating credit loss with more nuanced and timely inputs can provide a clearer picture of your financial position, improve transparency, and boost credibility with investors and other stakeholders.

Better Preparation for Future Economic Downturns

The validation process in the CECL framework meets regulatory expectations. What's more, it offers a deeper understanding of how certain economic conditions can affect your credit risk profile. That understanding is incredibly handy in the face of hard financial times, including economic recession, an unsavory interest rate environment, and countless others.

Likewise, examining specific assumptions relevant to your company provides a more accurate and comprehensive assessment – endlessly preferable to a reliance on the same generic assumptions every other kid on the playground is using. 

Enhanced Risk Management and Business Planning

Private companies can also think of CECL as a risk management and business planning tool. When you understand the potential impact of credit losses on your financial position, you can take proactive steps to avoid going off the rails. The CECL model also helps companies identify trends and potential problem areas, allowing you to adjust your business strategies as needed.

Challenges of CECL for Private Companies

Like most new things in life – and accounting – the new credit impairment guidance can be difficult to implement for first-time adopters, especially given the scope of CECL. And that’s not even taking into account everything else going on. To that point, just as CFOs and their teams started catching their collective breath after the lease adoption and transition last year, CECL is forcing them to put their sprinting shoes back on. And that’s no fun.

But simply catching their breath isn’t the only hurdle accounting teams face, of course. In fact, CECL presents several potential challenges for organizations.

Increased Complexity and Costs of Implementation

The transition to CECL can be daunting for private companies. The model for calculating expected credit losses under CECL can be more complex than the incurred loss model, which could result in higher CECL implementation costs.

Limited Historical Data for Modeling Credit Losses

One of the main challenges for private companies in implementing CECL is the need for historical data and other relevant information to estimate expected losses for each pool of financial assets. Unfortunately, some private companies may not have access to or track the data at the level necessary to make accurate and reliable estimates.

In other words, they will have to scrub historical information and data to align with the requirements of CECL. Namely, this will involve finding historical data for each pool of financial asset they determined as part of grouping their in-scope assets.

Lack of Clarity on Regulatory and Reporting Requirements

Another challenge for private companies is simply getting clarity on the finer points of CECL. With so many new concepts and processes to understand, it can be difficult to know exactly what is expected of you to comply with the new standards.

Best Practices for Implementing CECL for Private Companies

Moving from the incurred loss model to CECL is a multiphase process with many moving parts and steps, including:

• Determining which financial assets, net investment in leases, or other exposures are impacted 
• Obtaining and evaluating data
• Assessing your credit loss estimation model 
• Assembling your team of accounting superheroes (move over, Avengers) 

Thankfully, we've compiled some best practices to help you implement this new little corner of US GAAP smoothly.  

Gather the Right Team

A cross-functional team with varying skill sets and perspectives will serve you best when implementing CECL. To ensure a well-rounded approach to the process, consider involving folks from: 

• Accounting & finance
• Risk management & legal
• IT
• Internal audit 

Our advice is to start by defining the end goal, working backward from there to create a realistic timeline. Note our use of the word realistic. 

Also, don’t forget how nuanced the CECL standard is. To that point, establishing a framework to document the assessment will make it easier to keep track of your decisions and also provide robust documentation for examiners and auditors.

Start From the Beginning with Data

Data is absolutely, positively, undeniably paramount in CECL. So, yes, data is important. Because your model can only operate within the framework your data creates. Sure, historical loss data can be a good starting point, and if you don't have sufficient internal historical loss data, you can also use external or peer data. However, use this as an opportunity to identify and address pain points across your data environment while also evaluating external data sources for quality.

Monitor and Continuously Improve the CECL Model

Implementing CECL isn’t a set-it-and-forget-it deal. You have to continually monitor your credit loss models and make changes as needed. That means accounting for new data, changing economic conditions and forecasts, and adjusting other assumptions like your financial asset pools to maintain accurate and up-to-date financial reports.

CECL for Private Companies: Final Thoughts

To end on a high note, we recommend starting the CECL implementation process by asking a few questions:

• Has your financial portfolio experienced credit losses in the past, or do you expect any in the future?
• Are your borrowers' or customers' credit ratings or risks likely to change?
• Do your borrowers or customers operate in an industry that's sensitive to economic changes?
• Is your company at risk of not collecting on outstanding payments due to interest rate exposure?
• Have your borrowers or customers asked for changes in terms in the past, or are they likely to in the future?

Answering these questions will give you a sense of direction as you begin what could very well be – real talk – an arduous and frustrating process without a well-defined gameplan. However, if you need guidance at any point along the way, our experts here at Embark have your back. So let’s get to work.