Skip to main content
← Back to E Definitions

Expected credit loss cecl

What Is Expected Credit Loss CECL?

Current Expected Credit Loss (CECL) is an accounting standards methodology that mandates financial institutions and other entities to forecast and immediately recognize expected credit losses over the lifetime of their financial instruments54. This proactive approach to credit loss recognition falls under the broader category of accounting and financial reporting. Unlike previous methods, CECL requires an entity to estimate anticipated losses from the moment a financial asset is originated or acquired, reflecting a more forward-looking assessment of credit risk53. The standard applies to a wide array of financial assets measured at amortized cost, including loans, trade receivables, and held-to-maturity debt securities52.

History and Origin

The Financial Accounting Standards Board (FASB) introduced the Current Expected Credit Loss (CECL) methodology on June 16, 2016, through Accounting Standards Update (ASU) 2016-13, codified as FASB ASC Topic 32651. This significant change was a direct response to criticisms that the previous "incurred loss" model delayed the recognition of credit losses, particularly evident during the 2008 financial crisis50. Under the incurred loss model, losses were only recognized when they were "probable" and could be reasonably estimated, often leading to inadequate and untimely provisions for potential losses48, 49. The FASB aimed to improve financial reporting by requiring a timelier recording of credit losses, enhancing transparency and providing a more realistic reflection of a company's financial health47. Public business entities that are Securities and Exchange Commission (SEC) filers were generally required to adopt CECL for fiscal years beginning after December 15, 2019, while other entities, including private companies, adopted it for fiscal years beginning after December 15, 202244, 45, 46. The SEC statements on CECL adoption highlighted its significant impact, particularly for banks and finance companies, due to increased reserve requirements43.

Key Takeaways

  • CECL requires entities to recognize an allowance for credit losses over the entire contractual life of financial assets at amortized cost, moving away from the "incurred loss" model41, 42.
  • The estimation of expected credit losses must consider historical loss experience, current conditions, and reasonable and supportable future forecasting39, 40.
  • CECL applies broadly to financial assets beyond just loans in the banking sector, affecting any business holding trade receivables or other financial instruments37, 38.
  • The standard aims to provide more timely and accurate recognition of credit losses, enhancing the transparency of a company's financial health35, 36.
  • While increasing initial allowances and potentially introducing volatility to financial statements, CECL promotes a more proactive approach to managing credit risk34.

Formula and Calculation

While CECL does not prescribe a single formula, it requires an estimate of expected credit losses over the contractual term of a financial asset. The core concept involves considering a range of factors:

ECL=t=1N(PDt×LGDt×EADt)ECL = \sum_{t=1}^{N} (PD_t \times LGD_t \times EAD_t)

Where:

  • (ECL) = Expected Credit Loss
  • (PD_t) = Probability of Default at time (t)
  • (LGD_t) = Loss Given Default at time (t) (the proportion of the exposure lost if a default occurs)
  • (EAD_t) = Exposure at Default at time (t) (the total value a lender is exposed to when a default occurs)
  • (N) = Contractual life of the financial asset

This formula represents a common conceptual framework, but entities may use various methodologies, including discounted cash flow, loss rate, roll-rate, or vintage analysis, adjusted for historical data, current conditions, and future forecasts33.

Interpreting the Expected Credit Loss CECL

Interpreting the Expected Credit Loss (CECL) amount involves understanding that it represents management's best estimate of losses on financial assets over their entire projected lives, not just losses that have already occurred or are probable32. A higher CECL allowance on the balance sheet generally indicates a more conservative outlook on asset collectibility or a higher perceived credit risk within the portfolio31.

For instance, an increase in a company's CECL allowance might signal deteriorating economic conditions or a change in the credit quality of its customers30. Conversely, a decrease could reflect an improving economic outlook or stronger asset quality. Financial statement users, including investors and analysts, look at the CECL allowance to gauge a company's vulnerability to credit losses and its overall financial resilience. The CECL model also influences the income statement by leading to higher initial credit loss provisions, which can affect net income and introduce volatility due to periodic updates based on economic forecasts29.

Hypothetical Example

Consider "Alpha Lending Co.," a hypothetical financial institution, with a portfolio of new loans totaling $10 million, all with a 5-year contractual life.

Under the traditional "incurred loss" model, Alpha Lending Co. would only set aside reserves for loans where a default event was probable or had already occurred. For newly originated loans with no immediate signs of distress, the initial reserve might be negligible.

Under CECL, Alpha Lending Co. must estimate the expected credit losses for the entire $10 million portfolio over its 5-year life from day one.

  1. Gathering Data: Alpha Lending Co. reviews its historical data on similar loan portfolios. It finds that historically, 2% of such loans default over their lifetime, with an average loss of 50% of the outstanding balance upon default.
  2. Current Conditions: The current unemployment rate is stable, and the regional economy is growing moderately.
  3. Future Forecasts: Alpha Lending Co.'s economists predict a slight economic slowdown in years 3 and 4, which could increase defaults by an additional 0.5% for loans outstanding during that period.
  4. Calculation:
    • Historical expected loss: $10,000,000 \times 2% \times 50% = $100,000
    • Adjustment for forecasted slowdown: $10,000,000 \times 0.5% \times 50% = $25,000
    • Total Expected Credit Loss (CECL) allowance: $100,000 + $25,000 = $125,000

On day one, Alpha Lending Co. would record an allowance for credit losses of $125,000 on its balance sheet. This amount would be adjusted in subsequent periods based on updated economic forecasts and actual credit performance.

Practical Applications

CECL has widespread practical applications across various sectors, significantly impacting how companies manage and report credit risk. While initially seen as primarily affecting banks, its scope extends to virtually any entity that holds financial assets at amortized cost28.

  • Banking and Financial Services: This is where CECL has its most pronounced impact. Banks must estimate lifetime expected losses on their loan portfolios, affecting their capital ratios and lending capacity. The new standard requires more sophisticated forecasting models and robust data analytics capabilities27. Regulatory bodies, including the Federal Reserve, FDIC, and OCC, have issued an Interagency Policy Statement on Allowances for Credit Losses to provide guidance on implementation26.
  • Non-Financial Corporations: Businesses with substantial trade receivables, such as manufacturers, retailers, and service providers, are also subject to CECL. They now need to estimate expected losses on these receivables over their full contractual term, considering future economic conditions25. This can lead to earlier recognition of bad debt expenses.
  • Investment Management: Entities holding held-to-maturity debt securities must apply CECL to these investments, assessing their expected losses. This impacts how investment portfolios are valued and how potential impairments are reported in financial reporting.
  • Leasing Companies: Lessors with net investments in leases are also under the purview of CECL, requiring them to estimate expected losses on lease receivables24.

Overall, CECL prompts companies to integrate credit risk assessment more deeply into their operational and financial planning, leading to potentially higher initial loss provisions but offering greater transparency into future risks23.

Limitations and Criticisms

While designed to improve financial reporting by promoting timelier recognition of losses, CECL has faced several criticisms and presents certain limitations. One major concern is its potential for "procyclicality," meaning it might exacerbate economic downturns22. Critics argue that requiring banks to recognize expected future losses immediately, particularly during a recession, could lead to higher loan loss provisions, which in turn reduces regulatory capital and discourages new lending21. This could potentially slow economic recovery. A Federal Reserve Bank of Atlanta Economic Letter elaborates on these procyclicality concerns20.

Another limitation stems from the requirement for entities to incorporate "reasonable and supportable forecasts" of future economic conditions19. Forecasting is inherently challenging, even for experts, and introducing forward-looking elements into loss estimations can introduce significant subjectivity and volatility into financial statements. This reliance on future projections, rather than just historical data and current conditions, can make the allowance for credit losses more susceptible to changes in economic outlooks, potentially leading to more frequent and larger adjustments18.

Furthermore, for some non-financial entities, particularly private companies with shorter-term trade receivables, the effort and complexity involved in developing robust CECL models and gathering the necessary macroeconomic data can be substantial, with potentially little material impact on their overall allowance for credit losses16, 17. This has led the FASB and the Private Company Council (PCC) to consider simplified approaches for these specific cases14, 15.

Expected Credit Loss CECL vs. Incurred Loss Model

The fundamental distinction between Current Expected Credit Loss (CECL) and the incurred loss model lies in the timing and triggers for recognizing credit losses.

FeatureIncurred Loss ModelCurrent Expected Credit Loss (CECL)
Loss RecognitionLosses recognized when "probable" and "incurred."Lifetime expected losses recognized immediately upon asset origination/acquisition.
Timing of ProvisionDelayed; based on past events and current evidence of loss.Proactive; based on past events, current conditions, and future forecasts.
TriggersRequires a "trigger event" (e.g., missed payment, default).No specific trigger event required; continuous estimation.
ScopeNarrower focus, often on specific loans or events.Broader; applies to most financial assets measured at amortized cost.
Data ReliancePrimarily historical data and current observable facts.Historical data, current conditions, and reasonable and supportable future forecasts.
Allowance ImpactGenerally lower reserves, potentially "too little, too late" during downturns.Generally higher initial reserves, aiming for timelier recognition of potential losses.

Under the incurred loss model, a company would only establish an allowance for credit losses when there was objective evidence that a loss had already been incurred, or was probable13. This meant that if a portfolio of loans was performing well with no signs of distress, no significant allowance would be recorded, even if a future downturn was anticipated. This delayed recognition was a key criticism during the 2008 financial crisis, where reserves were insufficient to absorb unexpected losses.

CECL, on the other hand, removes this "probable" and "incurred" threshold12. It mandates that an entity estimate the full amount of credit losses expected to occur over the entire contractual life of the financial asset from its initial recognition11. This necessitates incorporating forward-looking information, such as economic forecasting, which was largely absent from the incurred loss model. The shift aims to provide a more comprehensive and timelier view of credit risk exposure on the balance sheet under Generally Accepted Accounting Principles (GAAP)10.

FAQs

1. What types of financial instruments are subject to CECL?

CECL primarily applies to financial assets measured at amortized cost. This includes loans held for investment, held-to-maturity debt securities, trade receivables, net investments in leases, and certain off-balance sheet credit exposures like loan commitments and financial guarantees8, 9.

2. How does CECL impact a company's financial statements?

CECL can lead to higher initial allowance for credit losses on the balance sheet and an increase in credit loss expense on the income statement, potentially reducing net income7. The allowance is a contra-asset account, meaning it reduces the net carrying value of the asset. The adjustments to the allowance are recorded as credit loss expense or a reversal of expense through net income6.

3. Does CECL apply only to banks?

No, while CECL has a significant impact on the banking industry due to their extensive loan portfolios, it applies to any entity that holds financial assets at amortized cost5. This includes non-financial companies with trade receivables, manufacturing companies, and other businesses with outstanding payment rights3, 4.

4. What factors are considered when estimating expected credit losses under CECL?

Entities must consider all available information that is relevant to assessing the collectibility of cash flows. This includes historical data on past credit losses for similar financial assets, current economic conditions, and reasonable and supportable forecasting about future economic trends that could affect collectibility1, 2.