CECL Practical Transition Guide
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Introduction
The FASB’s Accounting Standards Update, Topic 326 (CECL) released in June 2016 presents institutions with new guidance for measurement of an Allowance for Credit Losses (ACL, or commonly, ALLL). Regardless of an institution’s required or targeted adoption timeline, and regardless of an institution’s complexity, both supervisory and accounting entitites have made clear that financial assets within the scope of ASU 2016-13 will need to be measured for lifetime credit loss expectations, incorporating reasonable and supportable forecasts.
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Guidance Summary
This chapter introduces the FASB’s Accounting Standards Update 2016-13, Topic 326 (CECL) standard and offers annotation to the guidance. We will be referring back to the guidance often over the course of this guide, and it is important for practitioners to have an understanding of the main provisions introduced by the standard.
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Discounted Cash Flow
Discounted Cash Flow (DCF) models, while not widely adopted under ASC 450-20 (current GAAP), have been accepted as best practice for adherence to other analogous accounting standard objectives. For example, fair value measurement (ASC 820) and purchased credit impaired (ASC 310-30) both inherently require an estimate of lifetime credit loss. Forward-focused cash flow models are commonly deployed to accommodate both fair value and purchased credit impaired requirements resulting in an approach that has a precedent of successful audits and examinations.
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Loss Driver Analysis
The standard’s requirement to apply forward-looking projections in Allowance modeling is one of the main provisions of the ASU and a key difference from the ASC 450-20 (FAS 5) standard – hereafter, the “Incurred Loss Model” (ILM) – and its supervisory interpretation. There is not a single, prescribed way to fulfill this requirement, and institutions of different sizes, natures, and complexities may take very different approaches. Of these possible approaches, our experience guiding institutions through this transition effort indicates that that use of multiple linear regression techniques is the most broadly appropriate and conceptually satisfying exercise.
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Selected Benchmark Credit Loss Reserves
The CECL standard includes specific guidance for the application of the Net Present Value of Discounted Cash Flows (DCF) in estimating lifetime credit loss expectations. This approach is well-understood and is symmetrical to commonly accepted—and in some cases, required—methods for producing journal entries and financial statement disclosures under currently implemented accounting standards such as ASC 310-20 and ASC 310-30. This whitepaper examines specific benchmark results for a variety of inputs when this methodology is applied.
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Expedients Versus Cash Flows
Given the fundamental exercise under the standard is the estimation of collectability of future cash flows given periodic, time-specific assumptions such as those for reasonable and supportable forecasts and reversion periods, we consider the use of DCF techniques to be the most conceptually sound and defensible approach for the challenge at hand; moreover, the DCF approach is broadly applicable to a wide variety of financial assets. We consider the other measurement approaches commonly evaluated to be expedients to the cashflow method of estimation, each with unique conceptual challenges.
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Peer & Industry Data
Use of external information, while allowed under the standard and in many cases required for practical purposes, presents unique considerations for defensibility. Institutions should privilege their own, internal measurements and strongly defend use of such data. That said, it is our experience that the use of such information is a near-requirement for smaller, conservative institutions when the measured loss experience is zero, and in certain other applications.
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Qualitative Policy
institutions should use qualitative adjustment for its original intent – a less formal framework to adjust, in a consistent and directionally sensible manner, allocation based on the defensible application of
management’s judgment. We recommend a qualitative policy result in adjustments that are Minor, Independent, Disclosable, Auditable, and Specific – MIDAS. The MIDAS framework for qualitative allocation, combined with the more rigorous consideration of available internal and external information in the Loss Driver Analysis exercise, should result in a justified allowance reserve in a manner optimized for the broadest interpretation of “users of financial statements”.
Data Field Guide
The field guide to CECL data examines the data elements that would commonly drive measurement under a variety of methodologies. The purpose of this field guide is to provide the detailed functional nuance of each requested field, both for ongoing and historical collection.
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