CPAs & ADVISORS
experience clarity //
CURRENT EXPECTED CREDIT LOSS (CECL) MODEL
Debbie Scanlon, Partner
FINANCIAL INSTRUMENTS PROJECT – CREDIT IMPAIRMENT MODEL
WHERE WE HAVE BEEN…
Financial Crisis Advisory Group (FCAG)
• Formed in 2008 by FASB & IASB
Recommendation
• Explore alternative to ‘incurred loss model’
• Reduce complexity by having a single model
• Utilize more forward-looking information
Response
• Proposals that result in more timely recognition of credit losses
• FASB model—recognize all (lifetime) expected credit losses
• IASB model—recognize some (12 months) expected credit losses until
significant deterioration threshold is met, then recognize lifetime expected
credit losses
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WHERE WE HAVE BEEN…
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WHERE WE HAVE BEEN…
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WHERE WE ARE TODAY…
Probable incurred loss model
2 primary components
• General reserve
• Specific reserve
General / Specific
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WHERE WE ARE TODAY…
General reserve
• ASC 450-10 (FAS No. 5)
• Starting point
Historical losses over some period
• Qualitative factors
Adjust historical losses to reflect the current portfolio
Internal factors, i.e., changes in underwriting
External factors, i.e., changes in economy
Check for directional consistency
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WHERE WE ARE TODAY…
Specific reserve
• ASC 310-10 (FAS No. 114)
• Identify impaired loans
• Specifically evaluate impaired loans for reserves
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WHERE WE ARE GOING…
History
 IASB’s 2009 ED
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Expected (life of loan) cash flow model
Recognize impairment over time (as interest income is recognized)
Conceptual appeal (to some) of reflecting the economics of lending
Major concerns with operational issues
• FASB’s 2010 ED
 Expected (life of loan) cash flow model
 Assume existing conditions remain the same
 Interest income recognized by multiplying effective rate times net carrying amount
of asset
• Boards redeliberate together
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WHERE WE ARE GOING…
History (continued)
• Jan 2011 “joint supplemental document (SD)”
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Removes the concept of “probable”
Introduces good book/bad book concepts
Boards continue to redeliberate based on comments about SD
Both boards develop 3 bucket approach
FASB conducts outreach on model being developed
July 2012 FASB tells IASB it has significant concerns about operability of 3 bucket
model based on significant feedback from US constituents (preparers, auditors &
users)
 Constituents question understandability, operability, auditability & workability
 FASB develops Current Expected Credit Loss (CECL) model
 IASB continues to develop 3 bucket model
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WHERE WE ARE GOING…
Similarities in the models
• Expected credit loss models, reflecting more forward-looking information
• No initial recognition threshold
• Assets that have deteriorated significantly since initial recognition, i.e.,
performing & underperforming assets, recognize lifetime expected credit losses
• Measurement of expected credit losses (ECL)
Reflects management’s expectation based on past events, current conditions, &
reasonable & supportable forecasts
Reflect the risk of loss, i.e., the possibility that a loss will occur, as opposed to
reflecting the most likely outcome (statistical mode)
Reflect the time value of money
Entities can revert to long term mean average as part of the estimate for periods
beyond the foreseeable future
• Provide enhanced disclosures compared to current GAAP/IFRS
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WHERE WE ARE GOING…
Differences in the Models
• Measurement approach—single vs. dual
• Initial recognition—lifetime vs. 12 month
• Interest recognition for non-performing assets—nonaccrual vs. applying
effective rate on balance net of allowance
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WHERE WE ARE GOING…
Feedback on the models
• Strong support for IASB model from IASB constituents
• Although user feedback is subject to debate
• Strong (3-1 margin) user support for FASB proposal
• Preparers generally do not support recognition of full life time losses on day 1
• Concern with projecting losses beyond a reasonably foreseeable time period
• Concern that CECL does not reflect economics of lending
• Strong support for PCI model
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CURRENT PROPOSAL
DECEMBER 2012
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OPERATION OF CURRENT PROPOSAL
At each reporting date, recognize an allowance for expected credit losses
on financial assets (i.e. loans, securities, derivatives, etc.)
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Expected credit losses are a current estimate of all contractual cash flows not expected to
be collected
Practical expedient – meet both of the following, may elect not to
recognize expected credit losses for financial assets measured at fair value
with changes through OCI:
• Fair value is greater than amortized cost (unrealized gain)
• Expected credit losses are insignificant
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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL
Time Value of Money
• Explicit or implicit
• Discounted cash flow is an example of explicit – forecasts future cash flows (or
cash shortfalls) and discounts those amounts back to present value using the
effective interest rate
• Developing loss statistics on the basis of the ratio of amortized cost written off
due to credit loss to total amortized cost basis of the asset is an example of
implicit – computed loss statistic would then be applied to amortized cost
balance as of the reporting date
• As a practical expedient for collateral-dependent financial assets, may use
method that compares amortized cost with fair value of collateral
 Must continue to estimate costs to sell
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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL
Multiple Possible Outcomes
• Requires estimate of expected credit losses reflect both
 Possibility credit loss results
 Possibility no credit loss results
• In making these estimates, a variety of credit loss scenarios are not required to
be probability weighted when a range of at least two outcomes is implicit in the
method. Example methods where this requirement is implicit:
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Loss-rate method
Roll-rate method
Probability-of-default method
Provision matrix method using loss factors
ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL
Loan Commitments
• Required to recognize all expected credit losses for only those commitments
not measured at fair value with changes through net income
• Estimate credit losses over full contractual period which the entity is exposed
via legal obligation to extend credit, unless unconditionally cancellable by the
issuer
• For the period of exposure, must consider:
 Likelihood funding will occur
 Estimate of expected losses on commitment expected to be funded
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EXAMPLES
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EXAMPLE 1 – LOSS-RATE APPROACH
Entity A is a national bank that provides 5-year amortizing commercial
mortgage loans
The entity estimates expected credit losses for pools of similar asset types
by:
• Segregating into credit risk ratings
• Applying a current estimated loss-rate specific to each credit risk rating to the
amortized cost basis of the assets in that rating category
Entity A develops historical loss rates on the basis of its historical loss data
for 5-year commercial mortgage loans
• Form static pools by grouping borrowers by risk rating at beginning of year
• Follow each pool from that point forward through the life of the assets within
the pool
• For each pool, a historical loss rate applicable to the risk rating is determined….
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EXAMPLE 1 – LOSS-RATE APPROACH (CONTINUED)
To develop its current expected loss rate, Entity A updates the historical
data (computed on the previous slide) to reflect:
• Changes in current conditions
• Reasonable and supportable forecasts that differ from historical experience
Entity A has now developed the current expected loss rates by risk rating,
based on its historical loss rates, adjusted for current conditions and
reasonable and supportable forecasts about the future
For this example, let’s assume they have computed the following:
• 0.5% for loans with a “Pass Category 2” risk rating
• 3.0% for loans with a “Pass Category 4” risk rating
• 8.0% for loans with a “Special Mention” risk rating
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ENTITY A – EXPECTED CREDIT LOSS ESTIMATE
December 31, 20X1
($ in 000s)
Risk Rating Category
Pass Category 2 Pass Category 4 Special Mention
Expected loss rates
Ending balance
$
Expected credit loss estimate $
0.50%
27,500 $
138 $
3.00%
10,000 $
300 $
8.00%
2,500
200 $
1.59% *
40,000
638
* The 1.59% weighted-average loss rate is calculated as the total expected credit loss estimate
divided by the ending balance.
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DAY 2 ACCOUNTING – LOSS-RATE METHOD
Assume the following quarter Entity A expects the loss rates used on the
previous slide will be the same for this quarter end, because conditions
remain consistent with the economic conditions expected at March 31,
20X2.
Also, assume various activity has occurred such as some credits have
deteriorated, some have paid down, etc.
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ENTITY A - DAY 2 – EXPECTED CREDIT LOSS CALCULATION
March 31, 20X2
($ in 000s)
Risk Rating Category
Pass Category 2 Pass Category 4 Special Mention
Expected loss rates
Beginning balance
$
New originations
Paydowns on O/S loans
Loans charged off
Credit migration
Ending balance
$
Expected credit loss estimate $
0.50%
27,500 $
2,300
(1,510)
(320)
27,970 $
140 $
3.00%
10,000 $
(560)
115
9,555 $
287 $
8.00%
2,500 $
(130)
(9)
205
2,566 $
205
1.58% *
40,000
2,300
(2,200)
(9)
40,091
632
* The 1.58% weighted-average loss rate is calculated as the total expected credit loss estimate
divided by the ending balance.
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ENTITY A – ADJUSTMENT TO ALLOWANCE FOR MARCH 31, 20X2
Before the adjustment, Entity A would have an allowance for expected
credit losses balance of $629,000 (that is, $638,000 allowance as of
December 31, 20X1, minus the $9,000 of charge offs during the quarter)
As a result, the entity would record an additional provision of $3,000 for
the quarter ended March 31, 20X2, increasing the ALLL to $632,000
Although Entity A’s estimate of expected credit losses has increased from
the previous quarter, the estimate is largely consistent with the previous
quarter
• Extent of credit-quality deterioration experienced during the quarter consistent
with entity’s expectations
• Decrease in credit risk in the portfolio resulting from paydowns offset by
increases in credit risk on new loans
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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD
Another acceptable method of estimating the loss rates – the product of
POD statistic and loss-given default statistic
Under this method
• The POD statistic would reflect the likelihood of default occurring over the
remaining life of the asset, which gives rise to a shortfall in collection of
contractual cash flows
The POD statistic might be derived from:
• Entity’s own historical loss experience
• Externally available data such as a rating agency transition matrix, which uses
the data over the full contractual term of financial assets to capture cumulative
default experience
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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD
The POD statistic would then be updated to reflect current conditions and
reasonable and supportable forecasts about the future
Next, the loss-given default statistic would reflect the severity of the credit
loss if the borrower defaults
The loss-given default statistic could be based on studies performed on
historical loss experience or based on externally available data
WHAT?
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EXAMPLE 3 – BASE COMPONENT & CREDIT RISK ADJUSTMENT
The base statistical estimate of credit loss may reflect historical average of
credit losses that would be expected for financial assets with similar risk
characteristics
The base statistical estimate alone will not be adequate because it does not
consider current and forecasted conditions
Thus, the credit risk adjustment is necessary to adjust the base statistical
estimate so the current expected credit loss estimate reflects current
conditions and forecasts
The credit risk adjustment would be estimated using macro-level factors
such as
• Management’s evaluation of current point in the economic cycle
• Evaluation of borrower behavior and collateral values
• Recent trends in economic conditions
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MANY OTHER ACCEPTABLE METHODS IN THE PROPOSAL
By-vintage basis
Collective estimation method and an individual asset estimation method
Provision matrix
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PURCHASED CREDIT IMPAIRED
FINANCIAL ASSETS
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PURCHASED CREDIT IMPAIRED FINANCIAL ASSETS
Discount embedded in the purchase price that is attributable to expected
credit losses should not be recognized as interest income
Allowance for expected credit losses shall be recognized at acquisition date
as an estimate of all contractual cash flows not expected to be collected
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OPERATIONAL CONSIDERATIONS
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WHAT WILL YOU HAVE TO CONSIDER UPON IMPLEMENTATION?
Calculations of historical losses must still be tracked and measured – must
decide how far back is appropriate for purposes of forecasting
Current requirements for documentation of qualitative factors must stay in
place (and likely expanded)
Once an approach is selected, must determine what “systems” will or can
be used
Forecasts will require detailed documentation and computational support
which can be updated regularly
Monitoring processes over loans will need to be revised to allow that
process to gather more data to assist in forecasting
Education of Board, senior management and various other lending
personnel
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WHAT DOES ALL THIS MEAN?
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WHERE WE ARE GOING…
Operational concerns with FASB’s model
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Lack of historical information about “life of loan” losses
Cannot forecast beyond foreseeable future
Few securities will be eligible for practical expedient for FV-OCI
Why continue with TDR guidance under a life of loan model?
WHERE WE ARE GOING…
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UPDATE ON FASB PROGRESS
Currently in process of redeliberating significant issues raised through
feedback received on the December 2012 proposal
Tentative decisions reached at February 2014 meeting:
• Board will continue to refine the CECL model
• Proposed update will be clarified for the following:
 Reversion to historical average loss experience for future periods beyond reasonable
and supportable forecasts
 Consider all contractual cash flows over life of assets
 Consider expected prepayments but not extensions/renewals
 Estimate of expected credit loss should always reflect risk of loss, even when that
risk is remote
 In addition to using a discounted cash flow model, an entity would be allowed to use
loss-rate, probability-of-default or provision matrices using loss factors methods
 Implementation guidance for adjustments to historical loss experience
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UPDATE ON FASB PROGRESS (CONTINUED)
Tentative decisions reached at February 2014
meeting (cont’d):
• For purchased credit impaired loans, would be
required to allocate to each individual asset the
non-credit-related discount or premium resulting
from acquiring a pool of assets
• Clarification of cost basis adjustment for TDRs to
require an increase in cost basis of the restructured
asset through a corresponding increase in the
allowance for expected credit losses in certain TDRs
• No guidance at this time will be provided on when
an entity ceases to accrue interest income
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FASB NEXT STEPS
Continued redeliberations
Looks like IASB may be going their own way for now
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THANK YOU
FOR MORE INFORMATION // For a complete list of our offices
& subsidiaries, visit bkd.com or contact:
Debbie Scanlon, CPA // Partner
dscanlon@bkd.com // 713.499.4610
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