Current Expected Credit Losses

On June 16, the Financial Accounting Standards Board (FASB) issued its final standard on credit losses; the Current Expected Credit Losses (CECL) model.  The standard follows a Life of Loan Concept that allows financial institutions to leverage its current internal credit risk systems as a framework for estimating expected credit losses.  The standard requires organizations to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The standard will replace current Generally Accepted Accounting Principles (GAAP) which require an “incurred loss” methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred.

At the same time, the Banking Brotherhood (Federal Reserve, FDIC, NCUA, and OCC) released a Joint Statement on the new accounting standard.

Effective Date:  The standard will be effective for credit unions (and other private companies) for annual periods beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021.

Implementation of the new standard will result in increases in the allowance for loan and lease losses, and will require significant changes to operations, since it will require analysis of data supporting the modeling of loss expectations, and forecasting losses into the future.

From the Joint Statement:

The agencies expect the new accounting standard will be scalable to institutions of all sizes.  Similar to today’s incurred loss methodology, the new accounting standard does not prescribe the use of specific estimation methods. Rather, allowances for credit losses may be determined using various methods. Additionally, institutions may apply different estimation methods to different groups of financial assets. Thus, the new standard allows institutions to apply judgment in developing estimation methods that are appropriate and practical for their circumstances. The agencies do not expect smaller and less complex institutions will need to implement complex modeling techniques.

Credit unions will recognize a cumulative-effect adjustment on the balance sheet as of the beginning of the first reporting period in which the new standard is effective for loans held for investment and held-to-maturity debt securities.

The new accounting standard allows expected credit loss estimation approaches that build on existing credit risk management systems and processes, as well as existing methods for estimating credit losses (e.g., historical loss rate, roll-rate, discounted cash flow, and probability of default/loss given default methods).  However, certain inputs into these methods will need to change to achieve an estimate of lifetime credit losses. For example, the input to a loss rate method would need to represent remaining lifetime losses, rather than the annual loss rates commonly used under today’s incurred loss methodology. In addition, institutions would need to consider how to adjust historical loss experience not only for current conditions as is required under the existing incurred loss methodology, but also for reasonable and supportable forecasts that affect the expected collectability of financial assets.

The new accounting standard requires institutions to measure expected credit losses on a collective or pool basis when similar risk characteristics exist.  Although the new accounting standard provides examples of such characteristics, smaller and less complex institutions may continue to follow the practices they have used for appropriately segmenting the portfolio under an incurred loss methodology or they may refine those practices.

Further, if a financial asset does not share risk characteristics with other financial assets, the new accounting standard requires expected credit losses to be measured on an individual asset basis. As with practices applied under the incurred loss methodology, financial assets on which expected credit losses are measured on an individual basis should not also be included in a collective assessment of expected credit losses.

To implement the new accounting standard, institutions should collect data to support estimates of expected credit losses in a way that aligns with the method or methods that will be used to estimate their allowances for credit losses. Depending on the method selected, institutions may need to capture additional data. Institutions also may need to retain data longer than they have in the past on loans that have been paid off or charged off.

The new accounting standard does not change the existing write-off principle in U.S. GAAP or current nonaccrual practices, nor does it change the current accounting requirements for loans held for sale, which are measured at the lower of amortized cost or fair value.

Credit unions will need to begin to analyze the new standard and determine what data it will use to establish its expected credit losses for each risk characteristic pool.  Credit unions should also determine the extent of the cumulative-effect adjustment on its balance sheets.

FASB News Release on Accounting for Credit Losses

FASB Understanding Costs and Benefits for Credit Losses

FASB In Focus Credit Losses Accounting Standards Update