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commercial banking

Preparing for the Current Expected Credit Loss (CECL) Model

Accountants can’t afford to let their collective guard down these days. They need to have eagle eyes and a swiveling neck to navigate the steady stream of changes rolling down Mt. Guidance. And as if other new accounting standards like revenue recognition and lease accounting weren’t enough, Embark has another significant curveball to lob your way – the new expected credit losses standard from the Financial Accounting Standards Board (FASB).

To take a slightly Dickensian bent to it, the changes coming across the Current Expected Credit Loss (CECL) turnpike are a dramatic shift from the days of yore. Moreover, given the prominent position that borrowing and lending entities occupy in the overall economy – not to mention rapidly approaching adoption guidelines – understanding how to prepare for the new credit loss model is far more a requirement than option for most enterprises.

Thankfully, you know us well enough by now to understand Embark just can’t let you, our financial friends, head off into the CECL woods alone without a trusty guide in hand. Therefore, Embark has put together a few critical insights to help prepare you for CECL. Think of it as a heads-up of sorts to prevent you from being blindsided by significant changes that you can’t afford to fumble.


Far-Reaching Standards

For entities that borrow and lend money, the CECL standard – as spelled out in ASU 2016-13 – is one of the most significant accounting changes to come along in decades. Sure, banks and credit unions are the most overtly impacted organizations, but companies from a wide variety of industries will also feel the effect of this landmark accounting standards update.

In fact, the new credit loss standard impacts any enterprise that accounts for investments and receivables or is susceptible to credit risk through commitments, guarantees, and other financial instruments. Naturally, that includes everything from small businesses to global conglomerates, with plenty in between.

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So what does this mean in plain English? The CECL model impacts the following items for an enterprise that falls under its wide-reaching spell:

  • Trade receivables resulting from revenue transactions
  • Particular lease receivables recognized by lessor
  • Financial guarantee contracts
  • Loan commitments
  • Reinsurance receivables resulting from insurance transactions
  • Held-to-maturity debt securities


Legacy GAAP vs CECL

Think of the new credit loss accounting standard as an elimination of the incurred loss model you're probably well acquainted with, replacing it with an expected loss approach built to have an eye focused on the road ahead. To put a finer point on it, let's look at the key differences between the legacy guidance and the new current expected credit loss model.


Loss Horizon

Current US GAAP standards produce an estimate of incurred losses in the portfolio as of the date of the balance sheet. By contrast, the CECL model requires companies to estimate the lifetime losses of an asset, beginning at the purchase of the asset or origination of the contract and extending through its entirety, making it more forward-looking in nature.


Loss Recognition

Under existing GAAP, a company delays recognition until it is probable that the loss has been incurred. The CECL model takes a significantly different approach, providing an allowance for losses expected over the contractual life of the asset – even if the probability of loss is remote – which the enterprise recognizes immediately upon origination or acquisition.


Basis for Credit Loss Estimates

Under the existing incurred loss model, management is only allowed to consider historical information when estimating losses on financial assets. Under the CECL model, companies should continue to include historical loss information in their estimate, but they should also consider current conditions and reasonable, supportable forecasts in determining estimated losses on similar financial assets.

While this departure from legacy GAAP and vintage analysis makes loss estimation more decision-useful and forward-looking, you’ll want to adequately document these considerations to make sure stakeholders and auditors alike are satisfied.


Effective Dates

Of course, understanding what you're up against is only half the battle. Even the most thorough knowledge does you no good if you don't adopt the new standards within the proper time frame. With respect to CECL, the FASB permitted early adoption for all entities for annual periods beginning after December 15, 2018, and interim periods therein. For enterprises that did not elect early adoption, the CECL day one implementation timelines are as follows:

  • Public business entities (SEC filers) – Fiscal years beginning after December 15, 2019, including interim periods
    • Due to the economic conditions and financial crisis stemming from the COVID-19 pandemic, the CARES Act delays required implementation of the CECL model and related disclosures for insured banks and financial institutions until the earlier of:
      • December 31, 2020, or
      • A presidential declaration that the national crisis has ended
  • Nonpublic entities – Fiscal years beginning after December 15, 2022, including interim periods. Please note the FASB has deferred this effective date for nonpublic entities from its original FY 2021 mandate.


Other Considerations

We understand that change isn't necessarily fun but, as the saying goes, it's inevitable. So aside from the details and deadlines we've provided above, we also wanted to point a few other considerations out. Think of these as items to keep in the back of your mind as you prepare for the CECL model.

  • The new standard will impact a bank's annual stress test protocol since the scenarios used under CECL differ from the stress testing used by the Federal Reserve.
  • The CECL standard may very well affect your internal controls and, in turn, the data used for your financial reporting.
  • Unlike updates to most other accounting principles, CECL isn't relegated to your accounting and finance functions. Therefore, since it impacts your overall risk management procedures, everyone from IT and FP&A to your Board of Directors should be involved.
  • Given the relative complexity of the CECL model, your financial statement preparers must develop disclosures that are transparent enough for a user to understand, but not so much that they become overwhelming.


Final Thoughts

Obviously, companies within the financial services industry – from community banks to massive Wall Street firms – are first to come to mind when reviewing this new standard. However, as previously mentioned, the CECL standard’s potential impact is in no way relegated to that lone industry, and has everyone from the SEC and Federal Reserve to the OCC (Office of the Comptroller of the Currency) and FDIC closely watching. In fact, the OCC, Federal Reserve, and FDIC even issued a joint statement on the matter, discussing regulatory capital requirements around the CECL standard and how it interacts with the CARES Act.

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For all of you non-banks that might be reading this, though, please take solace in the fact that the new guidance is flexible, giving you leeway to chart your own CECL implementation course as long as your procedures are accurate and practical relative to the facts and circumstances. Likewise, you must always comply with the guiding principles of the rules for the measurement of expected credit losses, particularly when it comes to using reasonable and supportable forecasts.

Remember, the underlying motive driving these new standards is to provide stakeholders with more reliable, insightful, and timely information on expected credit losses, not to throw another arbitrary hurdle into your accounting procedures. So keep your chin up, the deadlines clearly marked on your calendar, and get to work, knowing that Embark is here to support you every step of the way.