CECL: All Loans Are Born in Sin

Under CECL, “all loans are born in sin,” remarked Dorsey Baskin at the MST 2017 National ALLL Conference. Baskin, recently retired from Grant Thornton as a National Professional Standards Group Partner, is a leading expert on allowance accounting and consultant to MST Advisory Services clients on their CECL preparations. “Comparatively, today’s loans ‘fall from grace,’” he noted, as they decline through various risk ratings to impaired status. 

Indeed, the biblical metaphor paints a clear picture of the essential difference between today’s incurred loss model and estimating the allowance under the impending CECL accounting standard. 

The conceptual shift changes how loans will be broken down for allowance estimations. Under the incurred loss model, loans are separated into three buckets: identified as impaired, general allowance, and allowance for purchased deteriorated loans. Under CECL, expected credit losses for financial assets are estimated on a pooled basis when similar risk characteristics exist, or on an individual basis when the individual asset does not share risk characteristics with a pool. All loans and debt securities not marked-to-market fall into one of the two categories. 

“The concept of impaired loans will no longer exist in GAAP under CECL,” Baskin told conference attendees. Instead each loan from inception will have a loss expectation associated with it, an expected loss based not only on the institution’s history with similar loans, but in light of projected changes in future economic and loan servicing conditions over the life of the loan. 

The elimination of the concept of loan impairment has resulted in substantial changes to the disclosures required with a CECL-based estimate. 

“As impaired loans will no longer exist in GAAP, all related disclosures will be removed from GAAP,” Baskin offered. 

The disclosures that have been eliminated by CECL are “those related to how impairment is identified and measured,” Baskin said. “They are replaced by disclosures on how expected losses are measured – and that leads to additional disclosures about forecasts, how reasonable and supportable forecasts are created.” 

He noted that impairment as a concept still applies to asset-for-sale (AFS) debt securities, which are carried at fair value. Essentially, if the market or fair value falls below the amortized cost basis and it is due to credit loss, or to the extent it is due to credit loss, then it is considered “impaired” and will require an allowance. 

“The analogy might make it easier to understand that fundamental shift in GAAP,” Baskin explained. “We no longer assume loans are good until they become impaired, that a lender expects to collect all the cash flows at the time a loan is made until something happens to impair it. That notion underlying GAAP for decades is going away, and it can be hard to get your head around that when implementing CECL.”

Wonder what disclosures will look like under CECL? Check out this whitepaper entitled CECL Modifications of Typical ALLL Disclosures by Dorsey Baskin and contributor Rahul Gupta, Partner, Grant Thornton.

Learn more about Dorsey Baskin and MST Advisory Services.