The economic crisis of 2007-2008 was caused by negligence in financial institutions. In response to the crisis, the federal government with boards of professional accountants created standards for reporting financial activities. One of the widely used standards was the US Generally Accepted Accounting Principles (GAAP). However, the GAAP had shortcomings that the Current Expected Credit Losses (CECL) model is designed to make up for.
The CECL model of reporting financial information encourages entities to recognize as allowance estimates of expected credit losses over the lifetime of each credit/loan. This is different from the GAAP and other previous models in the sense that they allow entities to recognize only incurred losses as allowance, therefore, poorly positioning them for future preventable downturns.
When will the CECL model take effect?
Issued in 2016 by the Financial Accounting Standards Board (FASB), the CECL model is proposed to be a widely accepted model of reporting credit losses allowance.
After the legislation was signed, it was expected to take effect from December 15, 2019 starting with listed (publicly traded) companies filing reports with the SEC. Other public listed companies not filing with the SEC were expected to be CECL-compliant after December 15, 2020 while non-listed (private) companies are supposed to be compliant one year after.
However, only publicly listed SEC-filing companies are currently required to implement CECL models. Due to the COVID-19 outbreak in 2020, the implementation of the CECL model for non-SEC-filing companies was held off.
The pandemic created a difficult-to-predict credit market, putting financial institutions at risks of high credit losses.
In December 2019, the Consolidated Appropriations Act (CAA) was signed to help revitalize the COVID-struck economy. The economic relief measures included in the CAA allowed the financial industry to hold off mandatory implementation of the CECL until 2023 for good reasons.
Nevertheless, encouraged to implement these new standards early and with seriousness, many financial institutions have invested heavily in technologies to help them stay CECL compliant. Therefore, these businesses are ready to adopt the change in credit allowance reporting despite the delay.
What’s the relevance of the CECL allowance?
A few other standards were available before the CECL although the FASB designed this new model to be all-encompassing. The Current Expected Credit Losses allowance law is relevant in the following ways.
- It reduces the complexity of financial reporting by decreasing the number of credit loss models imposed by the US GAAP and, thereby, creating a uniform model of evaluation across board.
- Unlike the GAAP which focuses only on finance-related activities, the CECL cuts across all activities of financial institutions including leadership and governance, credit analysis, financial reporting, and information technology.
The implications of CECL adoption
Since the CECL requires businesses to estimate lifetime credit losses, better investment in tech and data science will be essential for collecting and processing the data needed to compute near accurate estimations. Big financial institutions have reportedly poured money into acquiring these technologies before the CAA delayed implementations.
Also, the scope of the CECL expands beyond what was covered by previous credit loss allowance laws. With the CECL, not only banks and credit unions are required to be compliant. All firms with loans and debt instruments (like bonds), trade receivables, and off-the-book credit exposures must be CECL compliant by January 2023.
How to prepare for CECL
As this swift fundamental change sweeps the financial industry, finance executives need to be well prepared to adopt new models for expecting credit losses as well as maintaining compliance with the new legislation. Here are some steps to keep in mind as you put your house in order.
- Assemble the right team
As organizations pursue CECL compliance, senior management must take center stage. Other key members of the organization can be included in the team based on their relevance. Board members could offer valuable insights in the process. Also, finance and treasury, credit, risk, and IT teams should make the team.
- Identify data and tech gaps
With the right team, organizations can identify the data and tools needed to estimate future credit losses. Also, they should be aware of the data and tools currently available. Then, the gap between these data and tools can be made up for through investment in IT.
Financial institutions find this step very challenging. Many expressed that identifying the data necessary for developing a good CECL model was a major challenge.
- Collect data
“Data is the new oil” and must be collected and refined appropriately. After identifying the data needed to better estimate future credit losses, your IT team should set out to collecting and processing these necessary data.
- Develop a loss estimation model
Having the data is not enough. Unfortunately, the FASB does not prescribe a specific loss estimation model for businesses. Therefore, you have to develop a methodology that fits your business, judging by the data collected. However, a good model is pretty flexible.
Because expected credit loss estimation is a new concept, some institutions may lack the expertise required for developing models. You can hire the service of a CPA or an auditing firm to champion the model development process.
- Plan for capital increases
To be CECL compliant, financial institutions must reserve enough capital to cover for current (as well as expected) credit losses. Organizations may have capital reserve enough to cover historical and current losses as prescribed by the GAAP. By adopting the CECL allowance law, they need to reserve more capital for the possible losses in the future. As a result, the team needs to plan for adjustments in reserve capital.
Once bitten twice shy, the federal government with the help of professional accounting bodies are putting measures to prevent future economic crises. With the FASB’s CECL allowance legislation, banks and other financial institutions can be better prepared for all credit losses including those possible in the foreseeable future.
Other than being compliant, businesses have several reasons to adopt a CECL methodology including better investors relations and sound auditing processes.
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