What Is Current Expected Credit Loss (CECL)?
Current Expected Credit Loss (CECL) is an accounting standard that dictates how financial institutions and other organizations must account for credit losses on their financial assets. It falls under the umbrella of Accounting Standards. Under CECL, entities are required to estimate and record an allowance for credit losses for the full lifetime of a financial asset from the moment it is originated or acquired, rather than waiting for a loss to be probable or incurred. This forward-looking approach aims to provide a more timely reflection of potential losses on the balance sheet and income statement. The standard applies to a broad range of financial assets measured at amortized cost, including loans, trade receivables, and held-to-maturity debt securities.22, 23
History and Origin
The genesis of the Current Expected Credit Loss (CECL) standard is deeply rooted in the 2008 financial crisis. Before CECL, U.S. Generally Accepted Accounting Principles (GAAP) required entities to use an "incurred loss" model for recognizing credit losses. Under this model, a credit loss could only be recognized when it was probable that an asset was impaired and the amount of loss could be reasonably estimated. This meant that banks often could not record losses until they had already been incurred, leading to delays in recognizing potential financial distress.21
Critics argued that this backward-looking approach contributed to the severity of the financial crisis by allowing credit losses to build up unrecognized on banks' books. The Financial Accounting Standards Board (FASB) responded to these concerns by initiating a project to develop a more proactive and forward-looking impairment model. After years of deliberation and feedback, FASB issued Accounting Standards Update (ASU) No. 2016-13, Topic 326, "Financial Instruments—Credit Losses," on June 16, 2016, which introduced the CECL methodology. T20his new standard became effective for most public business entities (SEC filers) for fiscal years beginning after December 15, 2019, with a later effective date for other entities. T19he Federal Reserve Bank of San Francisco published an explanation of how CECL aims to address the limitations of the prior incurred loss model by requiring consideration of current conditions and reasonable and supportable forecasts. [FRBSF CECL explanation]
Key Takeaways
- CECL mandates a forward-looking approach to estimating expected loss over the entire contractual life of financial assets.
*17, 18 It requires entities to consider not only historical data but also current conditions and reasonable and supportable forecasts when determining the allowance for credit losses.
*15, 16 The standard aims for earlier recognition of credit losses, intending to provide a more accurate and timely picture of a financial institution's health.
*14 CECL replaced the previous incurred loss model, which only recognized losses when they were probable and incurred.
*13 Implementation of CECL can significantly impact financial institutions, potentially increasing their allowance for credit losses and affecting net income and regulatory capital.
12## Interpreting the Current Expected Credit Loss
Interpreting the Current Expected Credit Loss (CECL) involves understanding its impact on a company's financial reporting. The CECL allowance represents management's estimate of the credit losses expected to occur over the remaining contractual life of a loan portfolio or other financial assets. A higher CECL allowance typically indicates a greater anticipated level of future credit defaults or deterioration in the overall credit risk of the assets.
For investors and analysts, the CECL allowance provides a more forward-looking view into a company's credit quality compared to the prior incurred loss model. Changes in the allowance from period to period reflect shifts in expectations about future economic conditions and their potential impact on asset collectability. A significant increase in the CECL allowance might signal management's concern about an impending economic downturn or specific stresses within their loan portfolios. Conversely, a decrease could suggest an improved economic outlook or better credit performance. It's crucial to examine the methodology and assumptions a company uses to estimate its CECL, as the standard allows for flexibility in approach.
11## Hypothetical Example
Imagine "Diversified Bank," which issues a $100,000, 5-year personal loan with a 5% interest rate. Under CECL, at the time of origination, Diversified Bank cannot wait for the borrower to miss payments before setting aside funds for potential losses.
Instead, the bank would:
- Analyze historical data: Look at its past experience with similar loans, considering factors like borrower credit scores, loan type, and economic conditions during previous periods.
- Assess current conditions: Evaluate the current economic environment, including unemployment rates, interest rates, and industry-specific trends.
- Incorporate reasonable and supportable forecasts: Project how these conditions might evolve over the next five years. For instance, if forecasts suggest a slight economic slowdown, the bank might adjust its expected loss upward.
Let's say Diversified Bank determines that, based on all these factors, there's an expected loss of 1.5% over the loan's lifetime. Therefore, the bank would immediately establish an allowance for credit losses of $1,500 for this specific loan. This $1,500 would be recognized as a credit loss expense on the bank's income statement at origination, reducing its profitability, even before any actual defaults occur. As economic conditions or forecasts change over the five years, the bank would adjust this allowance, increasing it if prospects worsen (e.g., higher unemployment) or decreasing it if they improve. This continuous reassessment is a core aspect of CECL, ensuring the impairment allowance reflects the current best estimate of lifetime expected losses.
Practical Applications
The Current Expected Credit Loss (CECL) standard has profound practical applications, primarily impacting financial institutions such as banks, credit unions, and other lenders, as well as any entity holding financial assets measured at amortized cost.
- Loan Origination and Pricing: Banks now incorporate lifetime expected losses into their pricing models from the outset of a loan. This can influence interest rates, loan terms, and ultimately, the availability of credit, particularly for borrowers perceived as having higher credit risk.
- Financial Reporting and Disclosure: CECL necessitates significant enhancements to financial reporting and disclosure. Companies must provide detailed information about their credit loss methodologies, assumptions, and the drivers of changes in their allowance for credit losses to ensure transparency for investors.
310. Risk Management and Capital Planning: The forward-looking nature of CECL integrates more closely with risk management practices. Banks must develop robust models and processes to forecast economic conditions and their impact on future credit losses, which, in turn, influences their capital adequacy and strategic planning. The U.S. Department of the Treasury recognized the seriousness of CECL's impact on financial institutions and their regulatory capital.
49. Mergers and Acquisitions: When evaluating potential acquisitions, companies must now conduct thorough CECL assessments of the target's financial asset portfolios to understand the potential impact on financial metrics and the overall deal. T8his involves assessing the target's existing allowance process, data availability, and the specific instruments subject to CECL.
Limitations and Criticisms
Despite its aims, the Current Expected Credit Loss (CECL) standard has faced several limitations and criticisms, particularly concerning its practical implementation and potential economic impacts.
One primary criticism centers on the inherent subjectivity and complexity of forecasting. CECL requires entities to predict future economic conditions over the entire life of a loan, which can span many years. As forecasting is inherently challenging, especially for long-term horizons, the resulting expected loss estimates can be highly subjective and prone to significant volatility. This subjectivity can lead to less comparability across institutions and introduce potential for earnings management.
Another significant concern is the potential for procyclicality, meaning that CECL could amplify economic cycles. During an economic downturn, pessimistic forecasts would lead to immediate and substantial increases in the allowance for credit losses, reducing bank profitability and potentially constraining lending precisely when the economy needs credit the most. Conversely, during boom times, low expected losses could lead to reduced allowances, potentially encouraging excessive lending. While regulators provided some transitional relief, the interaction of CECL with economic shocks, such as the COVID-19 pandemic, demonstrated how rapidly allowances could increase, potentially straining capital. [Reuters article on CECL impact] Some critics argue that CECL forces banks to recognize future losses immediately without allowing for the immediate recognition of higher future interest earnings that compensate for risk, which could reduce lending to non-prime borrowers and hinder economic recovery. The U.S. Treasury, FASB, and SEC continue to monitor CECL's effects on regulatory capital and lending practices.
7Furthermore, the implementation of CECL has imposed substantial operational burdens on financial institutions, requiring significant investment in new data, systems, and modeling capabilities, especially for smaller entities with less sophisticated risk management infrastructure.
6## Current Expected Credit Loss (CECL) vs. Incurred Loss Model
The fundamental difference between Current Expected Credit Loss (CECL) and the incurred loss model lies in the timing of credit loss recognition.
| Feature | Current Expected Credit Loss (CECL) | Incurred Loss Model |
|---|---|---|
| Loss Recognition | Losses are recognized over the entire expected life of a financial asset at its origination or acquisition. | Losses are recognized only when they are probable and incurred (i.e., when an event has already occurred). |
| Timing | Forward-looking and anticipatory. | Backward-looking and reactive. |
| Information Used | Historical data, current conditions, and reasonable and supportable forecasts. | Primarily historical experience and current, observable impairment events. |
| Aim | Provide timelier recognition of potential credit losses and improve financial reporting transparency. | Reflect losses only after objective evidence of impairment exists. |
| Impact on Reserves | Generally leads to higher and more volatile allowance for credit losses. | Tendency for allowances to be established later in the credit cycle. |
The incurred loss model was criticized for its "too little, too late" approach, as it delayed the recognition of losses until after a triggering event had occurred, such as a missed payment or a significant credit rating downgrade. This meant that the balance sheet might not fully reflect the true credit quality of assets during periods of deteriorating economic conditions. CECL was introduced to address this by moving to an "expected loss" approach, requiring institutions to record an estimate of lifetime losses upfront, based on all available information, including future expectations. This shift aims to make financial statements more reflective of current and anticipated credit risk.
FAQs
What types of financial instruments are subject to CECL?
CECL primarily applies to financial instruments measured at amortized cost, including loans held for investment, trade receivables, net investments in leases, and held-to-maturity (HTM) debt securities. It also applies to certain off-balance-sheet credit exposures.
4, 5### How does CECL impact the income statement?
Under CECL, an estimate of lifetime expected loss is recognized as a credit loss expense on the income statement upon the initial recognition of a financial asset. Subsequent adjustments to this estimate, due to changes in expectations or actual credit performance, also flow through the income statement, impacting net income.
Is there a specific method required to calculate CECL?
No, the CECL standard does not prescribe a single method for estimating expected credit losses. Entities have flexibility to use various approaches, as long as the chosen method incorporates historical data, current conditions, and reasonable and supportable forecasts over the contractual life of the financial asset. Common methodologies include discounted cash flow models, loss rate models, and vintage analysis.
3### What are the main challenges in implementing CECL?
Key challenges include the need for extensive and granular data, the development and validation of complex forecasting models, the subjective nature of future economic assumptions, and the potential for increased volatility in the allowance for credit losses and reported earnings. These factors necessitate significant investment in systems and expertise.
2### Does CECL apply to all companies?
CECL applies to all entities that issue financial statements in accordance with U.S. GAAP and hold financial assets within its scope. While its most significant impact is on financial institutions like banks, non-financial companies with significant trade receivables or other relevant financial assets also fall under the standard's requirements.1