Here’s CECL: FASB Issues Final Standard for Credit Losses

June 16, 2016


On June 16, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.”

The final standard will significantly change estimates for credit losses related to financial assets measured at amortized cost and certain other contracts. For estimating credit losses, the FASB is replacing the incurred loss model with an expected loss model, which is referred to as the current expected credit loss (CECL) model. The largest impact will be on lenders and the allowance for loan and lease losses (ALLL). Financial reporting cannot prevent another financial crisis like the one that began in 2007, but the CECL model will require financial institutions to present expected losses in a timelier manner, which in turn will provide investors with information about expected losses.

The CECL Model

The CECL model is applicable to the measurement of credit losses on financial assets measured at amortized cost, including loan receivables, held-to-maturity (HTM) debt securities, and reinsurance receivables. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor. The scope excludes financial assets measured at fair value through net income, available-for-sale (AFS) debt securities, loans made to participants by defined contribution employee benefit plans, policy loan receivables of an insurance company, pledge receivables of a not-for-profit entity, and receivables between entities under common control.

An allowance for credit losses reflecting the current estimate of expected losses (or cash flows that an entity does not expect to collect) on financial assets held at the reporting date will be established on the balance sheet. The income statement will reflect the credit loss provision (or expense) necessary to adjust the allowance estimate since the previous reporting date.

The expected credit loss estimate should consider available information relevant to assessing the collectibility of contractual cash flows – including information about past events (for example, historical loss experience), current conditions, and reasonable and supportable forecasts. Adjustments to historical loss experience should be made to reflect differences in the historical risk characteristics of the current financial asset portfolio and the assets on which the historical experience is based or when management’s expectations of current conditions and reasonable and supportable forecasts differ from the conditions that existed when the historical loss information was evaluated. For periods beyond which the entity is able to make or obtain reasonable and supportable forecasts, entities may revert to unadjusted historical loss experience. When reversion is necessary, a straight-line reversion is one acceptable technique.

Credit losses on troubled debt restructurings, including concessions given to the borrower, will be measured using the CECL model instead of being limited to the measurement techniques required under existing generally accepted accounting principles for impaired loans (e.g., discounted cash flow technique).

Purchased Credit Impaired (PCI) Assets

The new standard also overhauls the purchased credit impaired (PCI) model in an effort to simplify recordkeeping. Those familiar with current accounting will appreciate the fact that, under the new guidance, an allowance and noncredit discount or premium will be established on day one. The noncredit discount or premium will be recognized as a yield adjustment over the life of the asset. A significant point is that no day one allowance is established through earnings – which differs for purchased assets that do not meet this scope. For purposes of scope, the bar is being lowered to “more-than-insignificant deterioration,” which means more assets will meet the definition to use this model – a welcome change. All of these changes essentially abolish the current PCI model and replace it with a new model and new moniker: “purchased financial assets with credit deterioration (PCD).”

With the revised PCD model, loss estimates will be more dynamic. Under today’s model, decreases in expected cash flows are recorded immediately as expense, and expected improvements are recognized prospectively. Under the revised PCD model, both positive and negative changes in expected cash flows will be recorded immediately – either through provision expense or through a negative provision in the case of improving credit loss estimates.

Available-for-Sale (AFS) Debt Securities

Outside the scope of the CECL model but included in the new standard are revisions to the credit loss model for AFS debt securities. The FASB is tweaking the other-than-temporary-impairment (OTTI) model by removing two factors: 1) the length of time that a security has been underwater and 2) whether recoveries or further declines in fair value exist after the balance sheet date. This likely will result in recognizing losses sooner than under today’s guidance. Another welcome change is that debt securities will use an allowance for credit losses instead of a direct write-down – which means losses may be reversed if conditions improve.

Because AFS debt securities are carried at fair value, the FASB limits the amount of credit losses to fair value. As such, a fair value floor has been incorporated into the credit loss model for AFS debt securities such that the credit losses on AFS debt securities are limited to the difference between the debt security’s amortized cost basis and its fair value.

Disclosures

One of the more significant disclosure requirements is the vintage disclosure introduced by the standard. Credit-quality indicators for all classes of financing receivables (excluding revolving lines of credit such as credit cards) disaggregated by year of origination (that is, vintage year) must be disclosed. Five annual reporting periods will be presented, with the balance for financing receivables originated before the fifth annual reporting period shown in aggregate.

One of the last decisions the board made was to provide relief for certain entities.

  • For public business entities (PBEs) that do not meet the definition of a Securities and Exchange Commission (SEC) filer, a practical expedient in transition is available that allows these entities to disclose only three years of the required vintage information in the year of adoption and four years in the year after adoption. In years thereafter, PBEs that are not SEC filers must comply with the full five-year disclosure requirement.
  • Non-PBEs (including private companies, employee benefit plans, and not-for-profit entities) may elect not to make the vintage disclosure.

Transition

For debt securities with OTTI, the guidance will be applied prospectively.

Existing PCI assets will be grandfathered and classified as PCD assets at the date of adoption. An entity may elect to maintain pools of loans accounted for under Accounting Standards Codification 310-30 at adoption. The asset will be grossed up for the allowance for expected credit losses for all PCD assets at the date of adoption and will continue to recognize the noncredit discount in interest income based on the yield of such assets as of the adoption date. Subsequent changes in expected credit losses will be recorded through the allowance.

For all other assets within the scope of CECL, a cumulative-effect adjustment will be recognized in retained earnings as of the beginning of the first reporting period in which the guidance is effective.

Effective Dates

Recognizing the definition of PBEs includes many financial services entities, the FASB split the definition to provide additional time for PBEs that are not SEC filers.

For PBEs that meet the definition of an SEC filer, the standard is effective in fiscal years beginning after Dec. 15, 2019, including interim periods within those fiscal years. For calendar year-ends, this first applies to March 31, 2020, interim financial statements.

For PBEs that do not meet the definition of an SEC filer, it is effective in fiscal years beginning after Dec. 15, 2020, and interim periods within those fiscal years. For calendar year-ends, this first applies to March 31, 2021, interim financial statements.

For all other entities, the standard is effective in fiscal years beginning after Dec. 15, 2020, and interim periods within the fiscal years beginning after Dec. 15, 2021, which first applies to Dec. 31, 2021, annual financial statements for calendar year-end non-PBEs.

Early adoption is permitted for all entities in fiscal years beginning after Dec. 15, 2018, including interim periods within those fiscal years. That means, any calendar year-end entity may adopt the standard as early as March 31, 2019, interim financial statements.

Next Steps

For most financial services entities, including banks, thrifts, credit unions, insurance entities, and specialty finance entities, the CECL model represents the most significant financial reporting change in decades. For many, implementation will require a meaningful effort. To be accommodating, the FASB is providing a healthy amount of implementation time, and the standard does not proscribe a particular approach for determining expected credit losses. As a result, we expect that a variety of approaches will be employed and practices will evolve as preparer, auditor, and regulator views coalesce.


Staci Shannon contributed to this article. 

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Sydney K. Garmong

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