Current expected credit losses

What Is Current Expected Credit Losses?

Current expected credit losses (CECL) is an accounting standard that mandates the recognition of lifetime expected credit losses for a broad range of financial instruments. As a key component of accounting standards and financial reporting, CECL represents a significant shift from previous methodologies, requiring entities to estimate losses that are anticipated to occur over the remaining contractual life of an asset, even if no loss event has yet taken place. This forward-looking approach, part of the broader category of financial reporting and regulatory compliance, aims to provide more timely and insightful information about potential losses on assets like loans, trade receivables, and debt securities.

History and Origin

The framework for Current Expected Credit Losses (CECL) emerged as a response to criticisms of the "incurred loss" model, particularly in the aftermath of the 2008 global financial crisis. Under the old model, credit losses were only recognized when there was objective evidence that an impairment loss had been incurred, leading to delays in recognizing deterioration in asset quality and potentially exacerbating economic downturns. Policy makers determined that the increase in allowances for credit losses occurred too late in the business cycle under this methodology.¹¹

In response to calls for more forward-looking accounting for loan losses, the Financial Accounting Standards Board (FASB) in the United States issued Accounting Standards Update (ASU) 2016-13, "Financial Instruments—Credit Losses (Topic 326)," in June 2016. T¹⁰his update introduced the CECL methodology. Simultaneously, the International Accounting Standards Board (IASB) developed IFRS 9, Financial Instruments, which also introduced an "Expected Credit Loss" (ECL) framework. B⁹oth standards fundamentally shifted impairment recognition from a backward-looking approach to a forward-looking methodology, requiring entities to recognize expected credit losses at all times, taking into account past events, current conditions, and reasonable and supportable forecast information.

⁸## Key Takeaways

• Current Expected Credit Losses (CECL) is a U.S. Generally Accepted Accounting Principles (GAAP) standard that requires entities to forecast and record expected credit losses over the lifetime of a financial asset.
• It replaced the "incurred loss" model, which only recognized losses when a specific loss event had occurred.
• CECL considers historical data, current conditions, and reasonable and supportable forecasts of future economic scenarios.
• The standard aims to provide more timely and transparent information about potential credit losses, especially during economic downturns.
• It significantly impacts financial institutions, including banks and credit unions, as well as other entities with financial instruments such as trade receivables and contract assets.

Formula and Calculation

While Current Expected Credit Losses (CECL) does not prescribe a single formula, it requires an estimate of the expected credit losses over the contractual life of a financial instrument. This estimate is generally based on a combination of factors, often expressed conceptually as:

[
\text{ECL} = \text{PD} \times \text{LGD} \times \text{EAD}
]

Where:

• (\text{PD}) = Probability of Default – the likelihood that a borrower will fail to meet their contractual obligations.
• (\text{LGD}) = Loss Given Default – the estimated proportion of the exposure that will be lost if a default occurs, considering any recoveries.
• (\text{EAD}) = Exposure at Default – the total value of the exposure expected to be outstanding when a default occurs.

The calculation of Current Expected Credit Losses must incorporate forward-looking information, moving beyond just historical loss rates. Entities are required to use reasonable and supportable forecasts of future economic conditions to adjust their estimates. For instance, if an economic downturn is predicted, the probability of default for a loan portfolio might increase, leading to a higher estimated allowance for loan losses. The standard allows for various estimation methods, provided they meet the core principles, and the estimation process is complex, involving significant judgment and robust data.

Interpreting the Current Expected Credit Losses

Interpreting Current Expected Credit Losses involves understanding its implications for an entity's financial statements and its overall financial health. A higher CECL allowance on the balance sheet typically indicates that the entity anticipates greater future credit losses. This can reflect a deterioration in the credit quality of its loan portfolio, or a more pessimistic outlook on future economic conditions, or a combination of both.

The adoption of CECL means that provisions for credit losses are recognized earlier than under the previous incurred loss model. This can lead to more volatile earnings reported on the income statement, as changes in macroeconomic forecasts or shifts in credit quality can immediately impact the allowance. Financial analysts and investors closely scrutinize the CECL allowance to gauge management's view on credit risk and the potential impact on future profitability and capital. A transparent disclosure of the methodologies and assumptions used in the CECL calculation is crucial for meaningful interpretation.

Hypothetical Example

Consider "LendCo," a hypothetical bank that originates a $1,000,000 corporate loan with a five-year term at amortized cost. On the day the loan is originated, even before any payments are due, LendCo must estimate the Current Expected Credit Losses over the loan's entire five-year life.

1. Historical Data: LendCo reviews its historical experience with similar corporate loans, observing that 1% of such loans typically default over a five-year period. Of those that default, the bank typically recovers 60% of the outstanding balance.

2. Current Conditions: The current economic environment is stable, with low unemployment and steady GDP growth.

3. Forward-Looking Information: LendCo's economists forecast a moderate economic slowdown in the third year of the loan's term, which is expected to slightly increase corporate bankruptcies. Based on this forecast, LendCo adjusts its expected default rate for similar loans from 1% to 1.5% over the five years.

4. Calculation:

   • Expected Default Rate: 1.5%
   • Expected Loss Given Default (LGD): 100% - 60% recovery = 40%
   • Exposure at Default (EAD): $1,000,000 (assuming the full principal is outstanding at the time of potential default for simplicity).

   Estimated CECL = $1,000,000 (EAD) * 1.5% (PD) * 40% (LGD) = $6,000

On its balance sheet, LendCo would record a $6,000 provision for credit losses as part of its allowance for credit losses from the inception of the loan. This allowance would be updated in subsequent reporting periods to reflect changes in economic forecasts, loan performance, or other relevant factors.

Practical Applications

Current Expected Credit Losses (CECL) has broad practical applications across various sectors of the financial industry. Its primary impact is on financial institutions, including banks, credit unions, and other lenders, as it fundamentally changes how they account for credit risk. For these entities, CECL affects the level of their allowance for loan losses and, consequently, their reported earnings and regulatory capital. Banks m⁷ust invest in robust data analytics and forecasting capabilities to comply with the standard. The Federal Reserve, for instance, has even developed tools like the Scaled CECL Allowance for Losses Estimator (SCALE) to assist smaller community banks in their implementation efforts.

Beyond⁶ traditional lenders, CECL also applies to any entity that holds financial assets measured at amortized cost, such as trade accounts receivable, contract assets, and held-to-maturity debt securities. This means non-financial companies must also assess and provision for expected losses on their receivables. The standard impacts internal processes for credit risk management, financial planning, and regulatory compliance. It also influences how financial assets are priced and how lending decisions are made, potentially leading to more prudent lending strategies. The Bas⁵el Committee on Banking Supervision, an international body, has also been actively involved in strengthening credit risk management principles globally, complementing the objectives of CECL and IFRS 9.

Lim⁴itations and Criticisms

Despite its aim to improve financial reporting, Current Expected Credit Losses (CECL) has faced several limitations and criticisms. A primary concern revolves around its potential for procyclicality, meaning it could amplify economic cycles. In an economic downturn, forward-looking models might predict higher future losses, leading to larger provisions. This, in turn, can reduce a bank's reported capital and profitability, potentially tightening credit supply precisely when it is most needed.

Anothe³r major criticism centers on the complexity and subjectivity inherent in forecasting future economic conditions. Estimating expected credit losses over the lifetime of an asset requires significant judgment and sophisticated models, making the process challenging and potentially inconsistent across different institutions. The rel²iance on "reasonable and supportable forecasts" can lead to variability in allowances, making it difficult for investors to compare financial institutions. The cost of implementation, particularly for smaller financial entities, has also been a significant point of contention due to the extensive data requirements and modeling capabilities needed. Further¹more, some argue that while the standard addresses the "too little, too late" problem of the incurred loss model, it introduces new challenges related to earnings volatility and capital management.

Current Expected Credit Losses vs. Incurred Loss Model

Current Expected Credit Losses (CECL) represents a fundamental paradigm shift from the prior Incurred Loss Model, particularly in U.S. GAAP. The core difference lies in the timing and triggers for recognizing potential losses on financial assets.

Under the Incurred Loss Model, a bank would only set aside reserves for a loan once there was objective evidence of impairment, such as a missed payment or a downgrade in the borrower's credit rating. This "wait-and-see" approach was criticized for delaying the recognition of true credit risk. CECL, in contrast, requires an entity to estimate expected credit losses over the entire lifetime of a loan at the time of origination, and to continuously update that estimate based on evolving economic conditions and forecasts. This means that even a performing loan with no current signs of distress may have an allowance for credit losses against it under CECL, a stark departure from its predecessor.

FAQs

What types of financial instruments are subject to CECL?

CECL applies to a wide range of financial instruments measured at amortized cost, including loans, loan commitments, trade accounts receivable, notes receivable, lease receivables, and held-to-maturity debt securities. It generally does not apply to assets measured at fair value through profit or loss.

How does CECL impact banks specifically?

For banks, CECL significantly changes how they provision for loan losses. It generally leads to higher and more volatile allowances for credit losses on their balance sheets compared to the previous incurred loss model. This impacts their reported earnings, net income, and regulatory capital ratios, requiring more sophisticated credit risk modeling and data management.

Is CECL the same as IFRS 9's Expected Credit Loss (ECL) model?

While both CECL and IFRS 9's ECL models are forward-looking and aim for earlier recognition of credit losses, they are not identical. Key differences exist in their scope, measurement methodologies (e.g., the "three-stage" approach in IFRS 9 vs. the single "lifetime expected loss" for most assets under CECL), and transition provisions. Both standards, however, represent a global move towards more predictive credit loss accounting.

How do macroeconomic factors influence CECL calculations?

Macroeconomic factors such as unemployment rates, GDP growth, interest rates, and commodity prices play a crucial role in CECL calculations. Entities must incorporate reasonable and supportable forecasts of these factors into their models to estimate future probabilities of default and loss given default. For example, a projected increase in unemployment might lead to a higher expected default rate across a consumer loan portfolio.

Does CECL apply to all companies, or just financial institutions?

CECL applies to all entities whose financial statements conform to U.S. Generally Accepted Accounting Principles (GAAP) that hold financial assets measured at amortized cost. While it has a particularly significant impact on banks and other financial institutions due to the nature and volume of their lending activities, it also affects non-financial companies that have assets like trade receivables or contract assets on their balance sheets.