Understanding Current Expected Credit Losses (CECL)

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In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13 - Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments to address the recognition of credit losses in a more timely manner.  Prior to the issuance of ASU No. 2016-13, estimating the allowance for credit losses was based on performance in the years past.  This traditional model was determined to be untimely and ineffective after the financial crisis of 2007 - 2010. 

The methodology for measuring credit losses according to this newest standard is called Current Expected Credit Losses (CECL). The CECL approach is a proactive approach to calculating potential credit losses and the amount of impairment to record in the financial statements.  The basic requirements of CECL include using forward-looking data and not relying solely on prior losses and grouping assets by risk profiles not type (i.e. accounts receivable and loans receivable would not be automatically grouped together because they are receivable-type accounts).

While this update has the greatest effect on the financial services industry, non-banking companies have assets that are subject to CECL.  CECL applies to financial assets that are not recorded at fair value.  Some of these assets are trade receivables, contract assets, lease receivables, reinsurance recoverables, receivables related to repurchase agreements, receivables related to securities lending, certain financial guarantees and held-to-maturity securities.  Although available-for-sale (AFS) debt securities are measured at fair value, ASU 2016-13 does change the accounting for credit losses for these securities.

Organizations implementing ASU 2016-13 will need to analyze the expected impact of CECL including assessing their current processes and what changes will be needed.  After assessing the changes needed, developing an implementation plan will be crucial.

Recognition:

Prior to CECL credit losses were recognized when it was probable that a loss had been incurred.  CECL removes the probability threshold for determining the credit loss to record.  CECL requires the allowance for credit losses to represent a portion of the financial asset’s amortized cost basis that a company does not expect to recover, even if the likelihood of the loss is remote.  This new model could cause a company to recognize a loss that would have not been recognized previously or recognize a loss much earlier that expected.

 

Economic Conditions:

CECL requires the consideration of future economic conditions in addition to current economic conditions when determining the allowance for losses.  Prior to CECL only current economic conditions had to be considered when calculating the allowance.  Gauging future economic conditions will require developing a process for evaluating the available information and data internally and externally, as needed.  Additionally, the consideration of future economic conditions increases the risk of more volatile changes in the allowances.

Asset Pooling:

CECL requires assets with similar credit risk characteristics be pooled when determining the allowance for credit losses.  CECL also requires on-going re-evaluation of the asset pools.

ASU 2016-13 is in effect for SEC filers with fiscal years and interim periods beginning after December 15, 2019 and will be effective for all others in fiscal years beginning after December 15, 2022.