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CECL and the art of divination

October 11, 2016

By: James A. Swanson


In June, the Financial Accounting Standards Board (FASB) issued its long-awaited—some might say dreaded—accounting standard, which introduces the current expected credit losses methodology (CECL) for estimating allowances for credit losses.  CECL will replace the existing incurred loss methodology that most of us know as FAS 5 and FAS 114 (also ASC 450 and 310). 

Before looking at the new standard, let’s take a quick look back at the methodology being mothballed. Though leery of what the new standard will bring, we suspect a number of bankers won’t be sad to see the current approach go. While it brings a level of familiarity and comfort that comes from its being around for a generation, it’s also caused frustration and head scratching among bankers trying to get their arms around the concepts in the methodology.

Structuring ALLL methodologies to meet regulatory expectations has been a frequent source of vexation as well. Some of these challenges included clearly understanding what an “impaired” loan is; understanding and properly using the different methods for quantifying impairment; defining and quantifying meaningful environmental considerations under FAS 5 that aren’t just “plug” figures; and determining an appropriate time horizon for historical loss analysis. Further, the recession highlighted flaws in the methodology’s framework that left some institutions significantly under  reserved given the risk in their loan portfolios.  

Under CECL, the allowance for credit losses is a valuation account, measured as the difference  between the financial assets’ amortized cost basis and the net amount expected to be collected on the financial assets (specifically, lifetime credit losses).
The first part of this equation is straightforward,  of course. The second part is where the questions  regarding CECL start to swirl.  

According to the brief interagency regulatory guidance issued to date, to estimate expected credit losses under CECL, “institutions will use a broader range of data than under existing U.S. generally accepted accounting principles (GAAP). These data include information about past events, current  conditions, and reasonable and supportable forecasts relevant to assessing the collectability of the cash flows of financial assets.” 

The elephant in the room seems to be what is “reasonable” and “supportable.” The limited interagency guidance also states that the standard will be “scalable to institutions of all sizes” and that  it “allows institutions to apply judgment in developing estimation methods that are appropriate  and practical for their circumstances.” 

While subsequent interagency guidance to provide further clarification seems inevitable, we expect a prolonged, bumpy transition similar to that experienced during the implementation of the incurred loss methodology in the 1990s, as bankers and  regulatory agencies work to interpret, comply with, and enforce the new standard.   

The effective date for CECL is either 2020 or 2021 depending on SEC filing status, with optional  compliance as early as year-end 2018. For bankers who can’t play the “I’ll-be-retired-by-then” card, the existing interagency guidance provides recommendations to help institutions prepare for the transition. One idea not included in the guidance that you might consider is to find yourself a good old crystal ball.

About Bank Strategies LLC 

Bank Strategies, LLC is a Denver, Colorado based consulting firm founded in 1982 that provides a wide array of enterprise-wide risk management solutions which assist executive management teams and Boards of Directors of mid- and lower-tier size financial institutions in improving overall performance and profitability, assessing and controlling risk profile, and strengthening shareholder value.   Bank Strategies LLC and its team of professionals are well known and respected in the community banking sphere of banking institutions, attorneys, CPAs, trade association executives, and the press due to their quality of service, expertise and knowledge. More information is available at www.bankstrategiesllc.com.

To learn how the Bank Strategies LLC team can put more than 100 years of collective industry experience to work in helping your institution reach its potential as a high performing bank, call 303-903-9369. Or email Jim Swanson at jim@bankstrategiesllc.com.

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