In June 2016, the Financial Accounting Standards Board (FASB) issued the new accounting standard that changes generally accepted accounting principles (GAAP) for Credit Losses on Financial Instruments (Topic 326). Although ASU 2016-13, entitled “Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments” is applicable for all financial instruments, here we summarize new GAAP only for accounting for loan (or other receivable) losses.
The new standard introduces the current expected credit losses (CECL) methodology for estimating allowances for credit losses. The CECL methodology replaces the incurred loss/impairment methodology in current GAAP. Under current GAAP, recognizing credit losses is delayed until a probable loss has been incurred. Over the years, financial institutions and users of their financial statements have expressed concerns that current GAAP restricts the ability to record credit losses that are expected, but do not meet the ‘probable’ threshold. In issuing the new guidance, FASB has responded to those concerns aligning accounting standards with the economics of lending by requiring immediate recognition of credit losses expected in a loan portfolio.
Does CECL Apply to You?
CECL applies to all entities holding financial assets not accounted for at fair value through the income statement. Accordingly, it applies to all credit unions, banks, savings associations, and financial institution holding companies (financial institutions) of all sizes. However, CECL will affect financial institutions in varying degrees depending on the credit quality, the types of loans held, their duration (estimated average life of a portfolio segment), and how the financial institution applies current GAAP. Unfortunately, there is significant diversity in practice today in applying the incurred loss methodology. Therefore, before adopting CECL, some financial institutions may be more aligned under current GAAP, than other financial institutions, to the new methodology of measuring expected credit losses.
Measurement of Expected Credit Losses
Expected credit losses will be measured based on historical experience, current conditions, and reasonable and supportable forecasts. The use of forward-looking information is NEW in the CECL methodology. The theory is a financial institution should not rely solely on past events to estimate expected credit losses. The adjustments to historical information are subjective and generally qualitative in nature. They should reflect changes in relevant data such as changes in unemployment rates, property values, underwriting standards, delinquencies or collection policies, credit quality, and other relevant economic factors. However, a financial institution is not required to develop forecasts over the contractual term of a loan portfolio segment.
Many of the loan loss estimation techniques applied today will still be used and are permitted. If a financial institution has already segmented its portfolio by collateral type and further by credit risk; and has included current qualitative and economic factors in its allowance for loan loss calculation, it is ahead of the game. However, certain inputs into the calculation will need to change in order to achieve an estimate of lifetime losses.
Today, it is customary for financial institutions to use an average net charge-off ratio based on a number of recent historical years (generally two to five years) and apply that average ratio (a one-year average) to the applicable segment of its loan portfolio. Under CECL, the calculation must be adjusted to represent remaining lifetime losses (calculating the remaining life of the portfolio). To estimate lifetime losses, estimated prepayments must be considered. However, contractual lives of loans should not be extended for expected loan extensions, renewals, or modifications unless there is a reasonable expectation that a Troubled Debt Restructuring (TDR) will be executed. In addition, the historic loss experience must be adjusted for current conditions and supportable forecasts, as noted above.
CECL requires credit losses to be measured on a collective pool basis when similar risk characteristics exist. Accordingly, the financial institution should segment its loan portfolio by similar risk characteristics and capture historical payoff and charge-off data for each segment to properly estimate CECL.
If it is determined that a loan does not share characteristics with other loans, the unique loan should be individually evaluated for its expected credit loss. The loans evaluated on an individual basis should NOT be included in collective pool assessments. Today, individually evaluated loans are often referred to as classified loans and/or troubled debt restructurings.
The new CECL standard does not specify a single method for measuring expected credit losses. Rather financial institutions should use good judgement to develop a methodology that is suitable for the size and risk characteristics of each loan portfolio segment. The methodology should apply the principles of the new standard, be well documented, and applied consistently. Because a high degree of judgement is needed, a strong internal control process and written allowance for loan loss policy should be developed to implement the new CECL methodology.
Many of the credit quality note disclosures have been retained. But, they have been updated to reflect the change from an incurred loss methodology to the CECL methodology. A new disclosure requirement for public entities is a disaggregation of portfolio segments by year of origination (or vintage). This new disclosure is optional for nonpublic entities.
Effective Date and Transition
For all credit unions, savings banks/associations, and privately held banks or other financial institutions, the new accounting standard is effective for fiscal years beginning after December 15, 2020 (calendar 2021 and fiscal 2022 year ends).
For public company SEC filers, the effective date is for fiscal years beginning after December 15, 2019 (calendar 2020 and fiscal 2021 year ends), including interim periods within that period.
For all financial institutions, the new standard is permitted to be applied early for fiscal years beginning after December 15, 2018 (calendar 2019 and fiscal 2020 year ends).
The effects of CECL will be accounted for as a cumulative effect adjustment to retained earnings as of the beginning of the first reporting period that the standard is adopted. Accordingly, for nonpublic financial institutions on a calendar year, the cumulative effect will be as of January 1, 2021.
What To Do Now?
Although the effective date is years away, it is prudent to become familiar with the new standard and to determine the data that will be needed to make the required changes for CECL. It would also be a good idea to segregate your loan portfolio by risk characteristics to begin accumulating payoff and charge-off data, as well as average loan lives (taking into account prepayments) by each segment. Each year until the effective date, consider calculating the allowance for loan losses under current GAAP and under the new CECL methodology to determine the potential effect on the allowance for loan losses, the income statement, and the financial institution’s capital (and capital ratio).
The new accounting standard leaves much up to judgement and planning is crucial. Please contact us if we can be of further assistance in evaluating your financial institution’s loan portfolio in order to move to the future CECL methodology or to provide answers to specific questions that you might have.