The Financial Accounting Standards Board recently issued a proposed Accounting Standards Update (ASU), Financial Instruments – Credit Losses (Subtopic 825-15), which introduces the concept of the Current Expected Credit Loss (CECL) model.
The proposed model applies to all financial assets not reported at fair value – including loans, debt instruments and leases. It replaces the incurred loss model currently used by removing the probable threshold and permitting the recording of credit losses on day one. Wilary Winn believes the CECL model will primarily affect:
- Calculating the allowance for loan and lease losses
- Accounting for loans and investments with deteriorated credit quality (ASC 310-30 or SOP 03-3)
- Accounting for other than temporary impairment (“OTTI”)
The CECL model requires management to estimate credit losses based on information about past events, current conditions, and reasonable and supportable forecasts about the future. It requires that credit losses be estimated over the entire life of the financial asset. The model also incorporates the time value of money concept by requiring the future expected cash flows to be discounted at the asset’s effective interest rate.
Wilary Winn believes implementation of the CECL will require many of our clients to significantly increase their allowance for loan and lease losses. Interestingly, we believe the new model will have less of an effect on our clients that have recently experienced substantial losses as the incurred credit loss model does not always accurately reflect rapid and substantial changes in credit conditions – improvements in this case.
According to the proposal, accounting for Purchased Credit Impaired (ASC 310-30) assets will follow the same approach to estimating expected credit losses as originated assets. Under the current ASC 310-30 guidance, a decrease in future expected cash flows is recognized immediately as an addition to the allowance, while improvements in future expected cash flows are reflected over through an increase in the accretion rate. This asymmetry in earnings is eliminated under the CECL model as any changes in future expected cash flows will be recognized through the provision immediately.
With regards to debt securities, the proposal eliminates the current “other than temporary impairment” (OTTI) model. Instead, the CECL model requires an allowance to be recorded instead of a direct write-off if future expected cash flows decrease. The proposal also allows for a reversal of the allowance if the future expected cash flows increase at a later period. As in the case of ASC 310-30, institutions will be able to immediately recognize improvements in cash flow instead of recognizing the benefit over time through a higher rate of accretion.
For loans that qualify as Troubled Debt Restructurings (TDRs), the CECL model requires that the effective rate of the TDR asset equals the original effective interest rate. Therefore, a basis adjustment will be calculated as the amortized cost of the asset before modification less the present value of the future expected cash flows (discounted at the original effective interest rate). Essentially the standard requires a direct write-down of the loan versus the establishment of a reserve.
The proposal does not specify an effective date for the new guidance. Once an effective date is determined, the proposal will be effective for periods beginning on or after the effective date.
We believe the proposal presents pluses and minuses for our clients. Our ASC 310-30 accounting and OTTI clients will benefit by being able to immediately recognize improvements in cash flow. On the other hand, many of our clients will have to record additional loan loss provision expense under the new standard. Wilary Winn believes financial institutions will be challenged by the complexity of the calculations required. We note that our discounted cash flow models explicitly incorporate the expected repayment rate (CRR), the expected constant default rate (CDR), the estimated loss severity percentage, and the time value of money. Many of our clients have noted that our existing models should enable us to provide assistance with the implementation of the new standard.