CFOs’ Checklist for Current Expected Credit Loss Standard (“CECL”) Implementation

February 22, 2023

By Angela Veal

The current expected credit loss (“CECL”) standard is next on CFOs’ radars following a rather intensive exercise of implementing the new lease standard (“ASC 842"). So, what is CECL? The Financial Accounting Standards Board (“FASB”) issued a new Accounting Standards Update (“ASU”) No. 2016-13, Topic 326, Financial Instruments – Credit Losses (“ASC 326”). This introduces the current expected credit loss methodology for estimating allowances for credit losses. Public business entities have already adopted CECL. Calendar year-end private companies are required to adopt CECL on January 1, 2023. Based on lessons learned from the new lease standard, companies have realized that implementations can be extremely time-consuming. As a result, many CFOs are eager to get started with their CECL implementation. The following is a checklist they are urged to follow.

Checklist Step 1: Do you understand what the key changes are?

While banks and other financial institutions are expected to be impacted by CECL, you may also be subject to CECL if your company holds any financial assets that are carried at amortized cost (e.g., loans held-for-investments [“HFI loans”] and held-to-maturity [“HTM”] debt securities). This article will focus only on financial assets carried at amortized cost, primarily HFI loans and HTM debt securities, or collectively the “loan portfolio.” Key changes from CECL include the following, which are not meant to be exhaustive:

  • Typically affects companies with financial assets carried at amortized cost (e.g., HFI loans), however, may also impact HTM debt securities (excluding those measured at fair value through net income), trade receivables and contract assets recognized under ASC 606, lease receivables from sales-type or directing-financing leases, reinsurance receivables from insurance transactions, financial guarantee contracts and loan commitments.
  • Earlier recognition of credit losses due to the removal of "probable" and “incurred loss" concepts. CECL will reflect the net amount expected to be collected, which is equal to the amortized cost of financial assets less allowance for lifetime credit losses.
  • Recognition of credit impairment as an allowance (contra-asset), rather than as a direct write-down of the amortized cost basis of financial assets.
  • Introduction of forward-looking information to be used in the credit loss estimation. This information must be reasonable and supportable.
  • No prescription of specific credit impairment models under CECL as compared to legacy U.S. Generally Accepted Accounting Principles (“GAAP”), as long as the credit loss estimation method is reasonable and meets the objective of the new standard.
  • CECL does not apply to available-for-sale (“AFS”) debt securities.

Checklist Step 2: Does your loan portfolio need to be segmented?

CECL requires companies to measure expected credit losses on financial assets carried at amortized cost on a collective basis when similar risk characteristics exist. Therefore, CFOs should first analyze their loan portfolio and evaluate whether the loan portfolio needs to be or can be segmented based on certain risk characteristics. These characteristics may include internal or external credit score or credit ratings, risk ratings or classification, financial asset type, collateral type, size, effective interest rate, term, geographical location, borrower’s industry, historical or expected credit loss patterns, vintage, etc. From what we have seen so far, companies that are less complex may be able to conclude that their loan portfolio’s existing segmentation categories (with a bit of refinement) are also appropriate under the CECL. It is recommended to CFOs that their process and segmentation basis be adequately documented.

Checklist Step 3: Have you determined the appropriate credit loss estimation method to apply to each segment of the loan portfolio?

CECL does not prescribe the use of specific estimation methods. Rather, allowances for credit losses may be determined using various methods if (a) these methods reasonably estimate the expected collectability of financial assets with the use of current conditions, historical data and reasonable and supportable forecasts; and (b) these methods are applied consistently to each of the loan portfolio segment(s) over time. The common modeling approaches include loss rate, roll rate, vintage-year, discounted cash flows and probability of default/loss given default (“PD/LGD”). There are pros and cons for each approach.

As an example, the vintage‐year approach groups risks based on the year of origination and therefore can establish a strong historical basis for expectation of lifetime losses. However, this approach is not suitable for revolving loans. Another example is the PD/LGD approach, which would be useful in situations where there is limited historical or peer data (e.g., for a financial institution who lends to companies within the cannabis industry). However, this is a relatively straightforward approach for less complex companies. We recommend that CFOs’ estimation process, inputs and assumptions used in the selected approach be adequately substantiated and documented.

Checklist Step 4: Now that you have determined the modeling approach, what data do you need to collect?

It is highly recommended that you have a good understanding of your loan portfolio segment(s) and the modeling approach(es) that will be used to estimate the credit losses before deep diving into collecting all the data needed. From what we have seen, data typically collected includes the origination, prepayment and maturity dates, origination par amounts, charge-off information and recovery information, as well as any cumulative loss amounts. The data should be summarized for each respective loan portfolio segment.

Checklist Step 5: What is the accounting on adoption date?

On the adoption date (“Day 1”) (January 1, 2023 for calendar year-end private companies):

  • Create an allowance for credit losses account.
  • Calculate the allowance for credit losses based on the difference between the financial assets' amortized cost basis and the amount expected to be collected (this must be the lifetime credit losses).
  • Recognize a cumulative-effect adjustment for the allowance for credit losses in beginning retained earnings (January 1, 2023) on the balance sheet. If there was an allowance account set up for credit losses prior to the adoption date, then the cumulative-effect adjustment on Day 1 would be the difference between the newly calculated allowance under CECL and the legacy allowance balance already recorded as of December 31, 2022. There may be tax effects that need to be considered which are not covered on this article.
  • Note that the allowance amount will need to be re-measured every reporting period-end, as applicable.

The checklist above is for general consideration only, and we encourage companies to consult with their accounting and tax advisors based on their specific facts and circumstances.

Our Current Issue: Q1 2023

About Angela Veal

Angela Veal is a Managing Director in EisnerAmper. She has over 20 years of experience in both public and private accounting, with focus on financial services, SPACs, IPOs as well as mergers & acquisitions.