In late 2019, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2019-10, which delayed the effective date for standard ASC 326 – Current Expected Credit Losses (CECL). The FASB pushed back the effective date of CECL from January 2021 to January 2023 for smaller SEC reporting companies, and from January 2022 to January 2023 for nonpublic companies. The SEC defines a small reporting company as one with public float of less than $250 million or annual revenue of less than $100 million, and either no public float or a public float of less than $700 million.
COVID-19 has also impacted ASC 326 adoption plans. The CARES Act was signed into law in March 2020 in response to the COVID-19 pandemic and includes specific guidance that financial institutions are not required to comply with CECL until the end of the COVID-19 national emergency or December 31, 2020—whichever is earlier. (For more info, visit our CARES Act FAQs.) Large accelerated filers will have to weigh their options on whether they delay CECL for the short term under the CARES Act or continue with their plans to report and disclose under the CECL model effective as of January 1, 2020. If a decision to delay adoption of CECL is made, the financial institution would still be required to disclose the potential impact of CECL in their footnotes.
Are you ASC 326 CECL Ready?
When it comes time to prepare for ASC 326 CECL adoption, there are three major areas to consider when deciding if your institution is ready to move forward:
1. Annual Loss Experience Is Out! Lifetime Loss Approach Is In!
Some smaller financial institutions historically used annual loss experiences to calculate the historical loss rate, but under ASC 326 CECL, the annual loss rate can no longer be used for calculating historical loss experience. The new standard requires the loss rate to be based on some form of lifetime loss approach, and the method for calculating the lifetime loss rate is fairly open.
To be CECL ready, your financial institution must update their current method of loan loss calculation to the lifetime loss approach, with one caveat — the Weighted Average Remaining Maturity (WARM) method. Under the WARM method, an annual loss rate is applied to the projected paydown of existing loans. This method is expected to be popular with small financial institutions. In any case, it’s important to nail down the approach to your loss calculations under ASC 326 to ensure you are prepared for CECL adoption.
2. The Three Elements to CECL
The allowance calculation under CECL is derived from these three elements:
- Historical Loss rate (as discussed above)
- +/- Current Economic Conditions/Qualitative Factors
- +/- Reasonable Forecasted Economic Conditions.
While updating the approach to the Historical Loss Rate is important for CECL readiness, care must be taken not to overlook the current economic/qualitative factors and the forecasted economic elements of the CECL calculation. As part of the preparation process, you should look for information that covers all aspects of the CECL calculation process.
3. Historical Data
Obtaining historical loan data may be difficult, or it may be limited. However, much of the needed data may be stored with your institution’s third-party servicers. Also consider using previous monthly board reports that show loan information related to that month. From the data gathered, your team will be able to calculate the historical loss rate.
Consider Early Adoption
Due to COVID-19’s impacts on financial institutions, some banks are expecting to adopt CECL as early as January 1, 2021. The theory is, most of the damage to loan portfolios caused by the COVID-19 disruption will ripple through in the next 12–18 months. By adopting CECL early, when the true impact of the expected COVID-19 recession hits, financial institutions will have an opportunity to run the COVID-19 impact directly to retained earnings. This will create earnings tailwinds after the early adoption adjustment.
By starting early in the adoption phase, financial institutions will be better prepared for implementing CECL. Here are five important steps your financial institution can take as you work through CECL adoption:
1. Build an adoption team.
This is the group that will guide your bank through the process. They will need to get familiar with ASC 326 CECL requirements, review the available options, pick an approach that meets the bank’s needs, gather information for the adoption, set timelines for completion of each phase, perform dry runs of the selected method and guide final adoption. There’s a lot to be done across multiple functional areas, but many of these people already work together on Asset/Liability Management Committees, like senior credit officers and the chief financial officer. However also consider personnel who work in IT and Operations, who will be helpful as you automate certain aspects of ASC 326 CECL.
2. Review CECL options.
The standard doesn’t prescribe a particular model or method that must be used. Instead, it provides basic guidelines along with some examples, but otherwise offers flexibility. Some of the common approaches being discussed include migration analysis, discounted cash flow, WARM method, probability of default/loss given default (PD/LGD) and vintage analysis. Institutions can use one or more methods, but smaller institutions may prefer only one method.
3. Select a method.
This step can be challenging as there are several methods and versions of the same method that could be used. Selecting the one that fits your institution can take some time. The method that is selected may be driven by available data, ease of use, cost, time commitment, relevancy, availability of support and your institution’s complexity. Leveraging advice from consultants or your auditors may be key to making final decisions. For smaller institutions, the WARM method may be more practical because the information needed is more readily available and the method is simpler to use.
4. Data collection.
Adopting ASC 326 CECL will require in some cases significant access to historical data. Institutions want to make sure needed historical data isn’t being purged, overwritten or replaced. However, collecting data without selecting the CECL approach first may be a waste of time since some of the data collected may not be needed or correct. Basic data that should be considered for early gathering includes:
- Origination date and amount
- Prepayment dates and amounts
- Maturity date
- Date and amount of write-offs
- Dates and amounts of recoveries
- Date restructured as a TDR
- Payment dates and amounts
5. Conduct trial runs.
Once a method has been chosen and the data gathered, the institution should begin trial runs. This will help identify weaknesses in the calculation process and data collection. The approach may need to be refined based on the initial calculations and as experience is gained.
Automated Tools & Additional Support
When it comes time to select automated tools to support your CECL adoption, you want a solution that fits your institution’s unique needs. A customizable, easy to use CECL solution with built in features, such as customizable security, tools for analyzing economic trends, and robust reporting capabilities can help your financial institution succeed.
By following the tips and steps above, you can have a successful CECL adoption. But as always, if you need support, the team at 8020 Consulting can help. Learn more about our financial reporting and accounting expertise by clicking below:
About the Author
Mark has more than 20 years of diverse financial and operational leadership experience, including positions as CFO and Corporate Controller of several mid-market firms in the Fin-Tech, Brokerage and Investment Management industries. Mark was the CFO of Rustic Canyon Partners, where he developed a budgeting process, implemented controls, policies and procedures, and was instrumental in the implementation of several cloud-based infrastructure initiatives. Mark began his career in public accounting at Ernst & Young and KPMG, where he focused on Investment Services and Insurance clients. Mark holds bachelor’s degrees in both Accounting and Finance from Loyola Marymount University.