Current expected credit loss

What Is Current Expected Credit Loss?

Current Expected Credit Loss (CECL) is an accounting standard that dictates how financial institutions and other entities should account for credit losses on various financial instruments. It is a key component of financial reporting and falls under the broader category of accounting standards. Unlike previous methodologies, CECL requires entities to estimate and recognize expected credit losses over the entire lifetime of a financial instrument at the time of its initial recognition, or at each reporting period thereafter. This forward-looking approach aims to provide a more timely and accurate representation of potential losses on a company's Balance Sheet and Income Statement. The standard applies to a wide range of Financial Instruments measured at amortized cost, including loans, trade receivables, and held-to-maturity debt securities.

History and Origin

The Current Expected Credit Loss (CECL) standard, officially known as Accounting Standards Update (ASU) 2016-13, Financial Instruments—Credit Losses (Topic 326), was issued by the Financial Accounting Standards Board (FASB) in June 2016. Its development was largely a response to concerns that existing accounting practices delayed the recognition of credit losses, particularly highlighted during the 2007-2009 global financial crisis., ¹⁶B¹⁵efore CECL, the "incurred loss" model required losses to be recognized only when they were deemed probable and estimable. This often meant that significant losses were recognized "too little, too late."

¹⁴The U.S. Securities and Exchange Commission (SEC) supported the shift to a more forward-looking approach, noting that the new standard would replace the existing incurred loss model for determining the Allowance for Loan Losses with an expected credit loss model. T¹³he FASB intended CECL to provide users of financial statements with more insightful information about expected credit losses by requiring a broader range of reasonable and supportable information, including future economic conditions., ¹²F¹¹or many public companies, CECL became effective for fiscal years beginning after December 15, 2019, while private companies and smaller reporting companies had later effective dates.,
¹⁰
⁹## Key Takeaways

CECL mandates the recognition of expected credit losses over the entire contractual life of a financial asset at the time of its initial recognition or at each reporting period.
It replaced the "incurred loss" model, which only recognized losses when they were probable.
The standard requires entities to consider historical data, current conditions, and reasonable and supportable Forward-Looking Information.
CECL aims to provide a more timely and comprehensive measure of potential credit losses on a company's financial statements.
Its implementation has necessitated significant changes in data collection, modeling, and Auditing processes for affected entities.

Formula and Calculation

While CECL does not prescribe a single calculation method, it requires entities to estimate the expected credit losses. The core idea is to project the present value of the cash flows that are not expected to be collected over the life of the financial asset.

A simplified conceptual representation of the CECL calculation could be:

\text{Expected Credit Loss} = \sum_{t=1}^{n} (\text{Exposure at Default}_t \times \text{Probability of Default}_t \times \text{Loss Given Default}_t \times (1 + \text{Discount Rate})^{-t})

Where:

(\text{Exposure at Default}_t) (EAD): The outstanding balance or exposure of the financial asset at the time of a potential default at time (t).
(\text{Probability of Default}_t) (PD): The likelihood that a borrower will default on their obligations at time (t).
(\text{Loss Given Default}_t) (LGD): The proportion of the exposure that an entity expects to lose if a default occurs at time (t), after considering any collateral or recoveries.
(\text{Discount Rate}): The rate used to bring future expected losses back to a Net Present Value.

Entities leverage various methodologies, including discounted cash flow models, loss rate methods, and roll-rate methods, using historical loss experience as a base, adjusted for current conditions and reasonable and supportable future forecasts., ⁸T⁷he resulting estimated amount is recorded as a Provision for Credit Losses.

Interpreting the Current Expected Credit Loss

Interpreting the Current Expected Credit Loss (CECL) involves understanding its implications for a company's Financial Performance and overall Asset Quality. A higher CECL allowance generally indicates that management anticipates greater potential future credit losses on its financial assets. This could stem from deteriorating economic conditions, changes in a specific industry, or a shift in the company's lending portfolio.

Conversely, a lower CECL allowance suggests a more optimistic outlook regarding future collectability. Investors and analysts use CECL disclosures to gauge the health of a financial institution's loan portfolio and its exposure to credit risk. It offers a forward-looking perspective, rather than simply reflecting losses that have already occurred, enabling a more proactive assessment of potential financial vulnerabilities. The standard’s emphasis on "reasonable and supportable forecasts" means the allowance reflects management's best estimate of lifetime losses, informed by both quantitative data and qualitative factors.

Hypothetical Example

Consider "LendCo," a hypothetical financial institution, that originates a new portfolio of consumer loans totaling $10 million. Under CECL, LendCo must immediately estimate the expected credit losses over the entire contractual life of these loans.

Historical Data: LendCo reviews its Historical Data for similar loan portfolios. Past experience shows an average lifetime loss rate of 1.5%. This would suggest a base expected loss of $150,000 ($10,000,000 * 0.015).
Current Conditions: LendCo assesses current economic indicators. Unemployment rates are slightly rising, and consumer debt levels are increasing. These current conditions suggest a higher risk than historical averages.
Forward-Looking Information: LendCo's economists forecast a mild recession in the next 12-18 months. This Forward-Looking Information further suggests that future defaults might exceed historical averages.
Adjustment: Based on current conditions and future forecasts, LendCo's Risk Management team adjusts the historical loss rate upward to 2.0%.
Calculation: The new expected credit loss is $200,000 ($10,000,000 * 0.020).
Accounting Entry: LendCo records a $200,000 Provision for Credit Losses on its income statement and establishes an Allowance for Loan Losses of $200,000 on its balance sheet for this new loan portfolio. This reflects the expected lifetime losses from day one.

As the loans mature and economic conditions evolve, LendCo will periodically review and adjust this CECL allowance.

Practical Applications

Current Expected Credit Loss (CECL) has broad practical applications across various sectors, particularly within the financial industry. Banks, credit unions, and other lending institutions use CECL to calculate their Allowance for Loan Losses, which directly impacts their reported earnings and capital levels. This impacts how they assess new loans and manage existing portfolios. For⁶ example, financial institutions raising their loan loss provisions in anticipation of an economic slowdown demonstrate CECL in action. Thi⁵s proactive approach means that potential losses are accounted for earlier, providing a more transparent view of an entity's financial health.

Beyond traditional lenders, CECL also affects non-financial companies with significant trade receivables, lease receivables, or other [Financial Instruments] (https://diversification.com/term/financial-instruments) that carry credit risk. These companies must also implement robust processes for estimating and reporting expected credit losses. The standard's emphasis on Forward-Looking Information encourages more sophisticated Risk Management practices, incorporating macroeconomic forecasts into credit risk assessments. Furthermore, CECL has implications for debt investors and financial analysts, who rely on these provisions to understand the underlying credit quality of a company's assets and make more informed investment decisions.

Limitations and Criticisms

Despite its aim to provide more timely and transparent information, Current Expected Credit Loss (CECL) has faced several limitations and criticisms. One significant concern is the potential for procyclicality, meaning that CECL might amplify economic cycles. During economic downturns, forecasts for future losses would naturally increase, leading to larger Provision for Credit Losses and a reduction in reported earnings and potentially in lending. Con⁴versely, during boom periods, the allowance might decrease, potentially encouraging more lending. This dynamic could exacerbate recessions and fuel speculative bubbles. Res³earchers at the Federal Reserve Bank of San Francisco have explored this, suggesting that CECL could slightly dampen fluctuations in bank lending over the economic cycle, but the concern persists.

An²other common critique revolves around the inherent subjectivity and complexity of requiring Forward-Looking Information and management judgment. Estimating future economic conditions, especially over the lifetime of a loan, involves considerable uncertainty. This can lead to variability in CECL allowances across different entities, even those with similar portfolios, potentially reducing comparability. The¹ reliance on complex models and the need for extensive Historical Data and macroeconomic forecasts can also be burdensome, particularly for smaller entities with fewer resources. Some also argue that the standard might not fully capture the dynamic nature of [Cash Flow] (https://diversification.com/term/cash-flow) and credit risk over long periods.

Current Expected Credit Loss vs. Incurred Loss

The primary distinction between Current Expected Credit Loss (CECL) and the Incurred Loss model lies in the timing of loss recognition. Under the incurred loss model, entities only recognized credit losses when they were "probable" and "estimable." This meant that a loss event, such as a missed payment or a significant decline in a borrower's creditworthiness, generally had to occur before a loss could be recognized. This backward-looking approach often resulted in delayed recognition of credit losses, particularly during periods of economic stress.

In contrast, CECL requires a forward-looking approach, necessitating the recognition of expected credit losses over the entire contractual life of a financial instrument from its initial recognition. This means entities must forecast potential losses based on Historical Data, current conditions, and reasonable and supportable Forward-Looking Information, even if no loss event has yet occurred. The shift aims to provide more timely and proactive financial reporting of potential credit deterioration, offering a clearer picture of future financial vulnerabilities.

FAQs

What types of financial instruments does CECL apply to?

CECL applies to a broad range of Financial Instruments measured at amortized cost, including loans, trade receivables, net investments in leases, and held-to-maturity debt securities. It also covers certain off-balance-sheet credit exposures.

How does CECL impact a company's financial statements?

CECL primarily affects a company's [Balance Sheet] (https://diversification.com/term/balance-sheet) and [Income Statement]. On the income statement, it requires a Provision for Credit Losses to be recorded upfront for expected lifetime losses. On the balance sheet, this provision creates an Allowance for Loan Losses, which reduces the net carrying value of the assets to their estimated collectible amount.

Is CECL applicable to all businesses?

CECL applies to all entities that issue financial statements under U.S. Generally Accepted Accounting Principles (GAAP) and hold financial assets susceptible to credit losses. While it has a significant impact on financial institutions, it also affects non-financial businesses with substantial trade receivables or other eligible financial instruments.

What information is used to estimate CECL?

Estimating CECL requires considering three main types of information: [Historical Data] (https://diversification.com/term/historical-data) on past credit losses, current economic conditions and asset-specific factors, and reasonable and supportable [Forward-Looking Information] (https://diversification.com/term/forward-looking-information), such as macroeconomic forecasts.