CECL for nonbank entities: New models for estimating credit losses

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By: Brett D. Schwantes, Director, Wipfli LLP

The Accounting Standards Board has added a new topic to Accounting Standards Codification (ASC) 326 that has important ramifications for businesses when measuring credit losses for most financial assets.

One of these impairment models in ASU 2016-13, Financial Instruments-Credit Losses, called the current expected credit loss model (CECL), applies to most financial instruments measured at amortized cost.

What is CECL?

Existing accounting principles require entities to recognize credit losses on financial instruments (generally through an allowance) when it is probable a loss has been incurred.

Under CECL, entities will recognize an allowance for credit losses that have probably been incurred and losses that are expected to be incurred in the future. This will require entities to use historical loss experience as a base adjusted for current conditions and future expectations.

Here is a guide to what is — and isn’t — in scope for CECL:

Financial instruments in the scope of CECLFinancial instruments NOT in the scope of CECL
Financing receivables (loans, notes receivable)Receivables between entities under common control
Trade receivablesEquity securities
Contract assets (under ASC 606)Other financial assets measured at fair value through net income (e.g., derivatives)
Securities held to maturitySecurities available for sale
Lessor sales-type and direct financing lease receivablesLessor receivables arising from operating leases
Receivables related to repurchase and securities lending agreementsLoans made to participants by defined contribution employee benefit plans
Reinsurance recoverablesPolicy loan receivables of an insurance entity
Off-balance sheet credit exposure not accounted for as insurancePromises to give (pledges receivable) of a not-for-profit entity

Although ASU 2016-13 will likely have the biggest effect on financial institutions and insurance companies, all entities will be required to adopt CECL and may, therefore, be impacted by this new standard.

Measuring a CECL allowance

Several different methodologies may be used to estimate a CECL allowance. The methodology can vary between entities and between types or classes of financial instruments held by the same entity. Some basic principles apply to all methodologies.

An entity must evaluate financial instruments in pools based on similar risk characteristics, such as credit quality, geography, and customer type. How many pools an entity uses is a matter of judgment. If an instrument does not share risk characteristics with other instruments—for instance, because the credit quality of the customer is different from other customers — it then should be evaluated individually. Whether evaluated in a pool or individually, an entity must always consider the risk of credit loss, even if the risk is deemed to be remote.

A CECL accounting methodology must consider expected credit losses for a reasonable and supportable forecast period, which is generally thought to be between 1 and 3 years but may be different in certain circumstances. During this forecast period, the entity should consider how expected events may alter historical experience. For example, if the entity believes the economy is entering a recession that will cause higher credit losses, base historical loss rates should be adjusted upward.

The methodology must estimate future expected losses during the remaining term of the financial instruments. If the remaining contract term of the asset or pool is longer than the forecast period discussed above, the entity will revert to historical loss experience for periods after the forecast period.

Some of the more common CECL methodologies include:

  • Snapshot (loss rate)
  • Remaining life
  • Vintage
  • Migration (roll rate)
  • Probability of default
  • Discounted cash flow

A practical example

The following is one example of how an entity may estimate an allowance for trade receivables under CECL. (This is not the only way a CECL allowance could be estimated.)

An entity sells products to customers on account. Terms of the sale require customers to remit payment to the entity within 30 days of the sale. To currently estimate an allowance for doubtful accounts, the entity has calculated the following average historical loss rates:

Past due statusLoss rate
1-30 days8%
31-60 days26%
61-90 days58%
More than 90 days82%

The entity believes this information is a reasonable base to estimate a CECL allowance since the composition of the trade receivables at the reporting date is consistent with those used when developing the historical loss rates. The entity also notes the unemployment rate has decreased as of the reporting date and is expected to continue to decrease over the next year. Based on knowledge of how similar decreases in the unemployment rate impacted credit losses in prior periods, the entity expects credit losses will be 10 percent lower than historical loss rates in each of the aging buckets.

The entity calculates an estimated allowance for credit losses under CECL as follows:

Past due statusAmortized Cost BasisLoss rateExpected Credit Loss
1-30 days8,2727.20%596
31-60 days2,88223.40%674
61-90 days84252.20%440
More than 90 days1,10073.80%812
Total CECL allowance 18,681

Securities available for sale

The second impairment model in ASU 2016-13 specifically addresses securities available for sale. Currently, securities available for sale are evaluated for other-than-temporary impairment at each reporting period. If an entity determines a security is other-than-temporarily impaired, the entity then determines how much of the impairment is related to credit loss and how much is related to other factors (e.g., changes in interest rates, market liquidity, etc.). The estimated credit loss is recognized as a reduction of the security’s carrying basis and as a loss in net income.

The impairment methodology for securities available for sale under ASU 2016-13 is similar to the existing other-than-temporary impairment methodology with some key differences:

  • The impairment evaluation no longer considers the length of time fair value has been less than amortized cost.
  • Entities should not consider changes in fair value after the reporting date.
  • Any credit impairment is recognized as a valuation allowance (rather than a direct write off to the carrying basis).
  • Any allowance for credit losses is limited to the difference between fair value and amortized cost.

Getting ready for CECL

ASU 2016-13 is effective as follows:

Entity TypeEffective for Periods Beginning After…
SEC filers, excluding those that are eligible to be a “Smaller Reporting Company”December 15, 2019
All other entitiesDecember 15, 2022

In addition to the change in the methodology used to estimate credit losses described above, ASU 2016-13 will also require changes to financial statement presentation and disclosures and changes to the accounting for financial assets acquired with more than insignificant deterioration in credit quality since origination (formerly known as purchased credit impaired assets).

How Wipfli can help

Wipfli’s CECL readiness snapshot can help you evaluate where you stand today and give direction on your next steps. Contact us today to get your snapshot or learn more on our CECL services web page.

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