On June 16, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13 and added to US generally accepted accounting principles (GAAP) ASC Topic 326, Financial Instruments–Credit Losses.

The main objective of this new standard is to provide financial statement users with more decision-useful information about the expected credit losses on financial assets and other commitments to extend credit held by a reporting entity at each reporting date. Effective dates vary according to business entity type, and early adoption is permitted for all entities. Find details of these dates below.

Changes

The aftermath of the global economic crisis and the delayed recognition of credit losses associated with loans (and other financial instruments) was identified as a weakness in the application of existing accounting standards. Specifically, because the existing “incurred” loss model delays recognition until it’s probable a credit loss was incurred, the FASB explored alternatives that would use more forward-looking information.

Under the FASB’s new standard, the concepts used by entities to account for credit losses on financial instruments will fundamentally change. This will have a particularly significant impact on how financial institutions, insurance companies, and other financial service companies account for estimated credit losses on their loans and debt securities.

Here’s what’s changed:

• The existing “probable” and “incurred” loss recognition threshold is removed.
• Loss estimates are based upon lifetime “expected” credit losses.
• The use of past and current events must now be supplemented with “reasonable and supportable” expectations about the future to determine the amount of credit loss.

The collective changes to the recognition and measurement accounting standards for financial instruments and their anticipated impact on the allowance for credit losses modeling have been universally referred to as the CECL (current expected credit loss) model. 

What's Affected

The new standard applies to financial assets measured at amortized cost basis, including:

• Financing receivables (loans, for example)
• Held-to-maturity debt securities
• Receivables that result from revenue transactions
• Reinsurance receivables
• Receivables that relate to repurchase agreements
• Lease receivables recognized by a lessor
• Loan commitments
• Financial guarantees that aren’t accounted for at fair value through net income and are exposed to potential credit risk

Available-for-sale debt securities guidance has been separately amended, and there’s no change to the accounting for trading debt securities.

Excluded from the scope of the new standard:

• Financial assets measured at fair value through net income
• Defined contribution employee benefit plan loans
• Policy loan receivables of an insurance entity
• Promises to give (pledges) of not-for-profit entities
• Loans and receivables between entities under common control

Key Provisions

Following are several of the key areas to be aware of when considering the impact of CECL and the related amendments:

• The amortized cost basis of a financial instrument (as defined)—net of the CECL allowance—is representative of the amount expected to be collected for that financial instrument over its contractual life. Changes to the CECL estimate would be recognized in the income statement.
• CECL is measured over the contractual term with consideration given for prepayments but not for expected extensions or renewals—unless a troubled-debt restructuring is likely.
• Pooling of instruments is encouraged in applying the model if they share similar risk characteristics.
• There isn’t a prescribed method for determining your CECL allowance. Discounted cash flows, historical loss rates, probability of default-loss given default, provision matrices, vintage analysis, and regression modeling are widely expected to be utilized.
• Methodologies and models can vary by financial instrument pool.
• All available information relevant to collectability shall be considered, including historical credit loss information and qualitative factors specific to the borrower and the entity’s operating environment.
• Future forecasts of estimated losses shall consider all relevant internal and external information. This includes using “reasonable and supportable” forward-looking information to inform credit loss estimates.
• For future periods where forecasts can’t be adequately supported, an entity will revert to its historical credit loss information—adjusted for borrower-specific considerations. For example, if an entity can reasonably support a forecast for only the next two years and the contractual life of the financial instrument is five years, the last three years should be based on this reversion methodology.  
• CECL will also impact off-balance sheet credit exposure, considering both the likelihood of funding and amount expected to be funded over the estimated life of the commitment.
• Held to maturity, securities will require an allowance for credit losses with some limited exceptions when the expected nonpayment risk is zero (US Treasury securities, for example).
• Purchase credit “deteriorated” (PCD) assets (formerly known as purchase credit “impaired”) will follow a “gross-up” approach and establish an allowance upon acquisition but won’t have an immediate impact to the income statement.
• The scope of PCD assets is being changed to “more-than-insignificant deterioration,” which will likely broaden the scope of PCD assets relative to current guidance.
• Troubled debt restructurings will follow CECL to measure credit losses.
• Differing degrees of model sophistication are expected for entities of different sizes and capabilities. Smaller and less complex entities are expected to be able to adjust existing allowance methodologies without the use of complex and costly models.
• Enhanced qualitative and quantitative disclosures, including further disaggregation of credit quality indicators by year of origination is required for public business entities. Certain new disclosure requirements don’t apply to short-term trade receivables.  
• Allowance rollforward and past-due aging analysis now is also required for debt securities.
• Available-for-sale securities will bifurcate their fair value mark and establish an allowance for credit losses through the income statement for the credit portion of the mark (subject to a fair value floor). Subsequent changes in the credit loss estimate will flow through the income statement as well. The interest rate portion of the fair value mark will continue to be recognized through accumulated other comprehensive income or loss.

Effective Dates and Transition 

For public business entities that meet the definition of a Securities and Exchange Commission (SEC) filer, the effective date of the ASU is for fiscal years beginning after December 15, 2019 (and interim periods within those fiscal years). For other public business entities, the ASU is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.

For all other entities, including not-for-profit organizations and employee benefit plans, the ASU is effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021.

Early adoption is permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

Specific transition guidance exists for PCD assets, other-than-temporary impairment, and certain new disclosures. The change in allowance recognized as a result of adoption will be done through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective.

Next Steps

Focus on data—internal and external—particularly for entities with loans. Here are some practical steps: 

• Preserve what you have (stop the data purges) 
• Develop a formal data and document management process
• Determine what data you can recover quickly without significant cost 
• Determine what data you’re missing that you need (and the cost to acquire)
• Understand your data better when it comes to collateral values and credit scores as well as your ability to update them in your system
• Improve quality of guarantor data
• Accumulate historical and forecasted national economic data (unemployment rate, GDP growth, Treasury rates, prime rate, consumer price index, Dow Jones index, commercial real estate price index, etc.) to correlate to historical losses for forecasting purposes
• Understand what your data does and doesn’t interface with

Segmentation (or pooling or grouping) of the portfolio—by interest rate tiers, fixed versus variable, maturity, and origination—will be critical to the estimation process. Current and historical loan-to-values for commercial real estate are likely to be of great value in the process as well. Once the data is available, establish preliminary groups and begin testing pool segments by correlating losses to economic data before forecasting and running CECL estimates.

Open the dialogue entity-wide to improve the understanding of the impact of credit risk at origination or purchase. Profit will be detrimentally impacted when originating or purchasing a high-risk loan with larger expected credit losses relative to a lower risk loan with fewer expected credit losses.

We encourage entities to move quickly regarding their data. But understand what you have before signing on for a software solution that may be heavily reliant on data you don’t have or don’t anticipate having. Spend a few months educating yourself and other stakeholders about the new standard and establish a plan as to how your entity will implement the requirements.

As your implementation plans solidify, consider the interpretive guidance from regulators, audit firms, the American Institute of Certified Public Accountants, the FASB’s Technical Resource Group, the Center for Audit Quality, and the SEC, along with input from your external auditor and other stakeholders.

We're Here to Help

We’ll continue to follow this topic and provide more in-depth guidance that dissects the new rules and explains how we anticipate they’ll be implemented. We expect to publish an in-depth guide on CECL by the end of August 2016. For any questions or to better understand how this new standard may affect your business, contact your Moss Adams professional.