A new accounting standard, which uses an “expected loss” measurement for the recognition of credit losses, goes into effect for all financial institutions by January 2023, but is already changing how financial institutions plan — and in some cases — set up its forthcoming bookkeeping procedures.

The Financial Accounting Standards Board (FASB) announced in 2016 a new accounting standard introducing the current expected losses, or CECL, methodology for estimating allowances for credit losses. The CECL methodology will apply to all banks, credit unions, saving associations, and financial institution holding companies, regardless of the size of the financial institution.

In general, the updated standard requires entities to recognize losses on bad loans earlier than under current generally accepted accounting principles (GAAP).

Originally, the FASB set CECL to take effect for most public companies in 2020. However, in October 2019, the FASB extended the deadlines for smaller reporting companies (SRCs) from 2021 to 2023, and for private entities and nonprofits from 2022 to 2023. In March 2020, the CARES Act gave large banks the option to delay CECL reporting by a year. Most community banks (with assets under $1 billion) and credit unions will implement CECL in 2023. Financial institutions may adopt the CECL standard sooner than the deadline.

What is the New CECL Accounting Framework?

Allowance for credit losses is a financial institution’s estimate of its unrecoverable financial assets. CECL replaces the incurred loss methodology (ILM) because increases in allowances occurred too late in the business cycle under ILM. CECL also effects the timing and level of capital, which could impact lending. According to MarketScreener, in comparison to ILM, CECL requires financial institutions to forecast expected losses over the entire life of the loan when originating the loan. CECL does not change the total amount of credit losses ultimately recorded, but does impacts how early the financial institutions provisions for credit losses.

CECL will cover:

  • All financial instruments carried at amortized cost, including loans held for investment, net investment in leases, held-to-maturity (HTM) debt securities, trade and reinsurance receivables, receivables that relate to repurchase agreements and securities lending agreements.
  • Off-balance-sheet credit exposures not accounted for as insurance, including loan commitments, standby letters of credit and financial guarantees.
  • The accounting for credit losses on available-for-sale debt securities, including lending arrangements that meet the definition of debt securities under GAAP.

CECL will not cover trading assets, loans held for sale, financial assets that selected the fair value option, and loans and receivables between entities under common control.

Getting Ready for CECL

Fortune magazine calls the CECL rule “a game changer.” Under the old rule based on the accrual model, provisions tended to build gradually. CECL changed that methodology, by compelling financial institutions to forecast potential losses for the entire life of the loan at the outset.

As a result, most financial institutions must switch from its current allowance for loan and lease losses (ALLL) method and start reserving for loan losses based on CECL calculations.

Some elements of calculating expected losses will remain the same: management’s responsibility to choose the most appropriate estimation method for the bank or credit union for evaluating credit risk; scalability to a financial institution’s asset size and complexity of its assets; requirement to recognize credit losses’ inclusion of historical loss averages; incorporation of qualitative factors; and determination of policies for nonaccrual of interest and charge-offs.

Financial institutions should select its modeling methodology/vendor in the near future so that the CECL calculations run in parallel with their current allowance for loan ALLL calculations. By doing so, banks and credit unions can predict the changes to their loan loss reserves required by January 1, 2023.

Preparing for CECL with Help

OmniLytics, a division of NXTsoft (formerly known as FIMAC Solutions until purchased by NXTsoft in 2018) offers a solution, CECL Services, a standalone product that clients can purchase, that helps financial institutions prepare for CECL.

CECL Services provides a reserve for loan losses calculation that follows the overall premise of CECL: it calculates the financial institution’s historic life of loan loss rates for each loan type, and then to adjust from that point by looking 12-24 months into the future.

One of the major changes involved in switching to the CECL methodology is to look at loss rates on a “life of loan” basis, instead of the previously acceptable annualized method. NXTsoft’s CECL Services model utilizes a life of loan figure for each different type of loan in the portfolio. NXTsoft has calculated the life of loan for numerous institutions in its 30 years of asset liability management (ALM) modeling and consulting, and uses these lifetimes as the initial settings in the CECL Services model.

CECL Services pulls the loan balances and loss history data for every financial institution. NXTsoft then works with the client in an online meeting to determine the settings in the CECL Services model to use (i.e., to use the all periods or the most recent loss rate as the starting point, or how much to skew toward the peer group’s loss rates or alternative loss timeframe). These settings, according to NXTsoft, generally stay fairly constant from quarter to quarter.

NXTsoft encourages adjustments to fine tune the model, such as changing the timeframe of the utilized data and/or capping the asset size of the peer group data. The default setting for the data timeframe is to start with March 2007 call report data. The timeframe although chosen purposely, as it includes the downturn from the Great Recession years of 2008-2009, is customizable.

Once the client settles on the initial settings, the NXTsoft staff prepares and delivers a formal quarterly 12-14-page report designed for sharing with regulators, auditors and boards of directors. Included in the report is a synopsis of calculations related to each loan type, known as the Impact Report. In addition, each quarter NXTsoft requests clients respond to a list of 10 questions, known as the “Q Factors” or “Qualitative Factors.”

NXTsoft provides pre-purchase estimates of CECL reserve with a free CECL report. OmniLytics’ ALM, Fixed Income Accounting, Credit Stress Analytics and CECL Services products are available as separate products or bundled.