Understanding Current Expected Credit Losses (CECL)
After the 2008 financial crisis, the Financial Stability Board determined that the banking industry’s failure to recognize future credit loss was compounding the disaster. It recommended that the Financial Accounting Standards Board (FASB) come up with a better way to account for losses in the financial system.
The model in place at that time, called the incurred loss model, calculated a bad debt reserve based on previous years. By this standard, if a company had written off $400,000 worth of bad debt from their accounts in the past, the board would designate roughly the same amount for their future credit impairment.
This model was deemed to be too subjective and failed to recognize true credit loss early enough. The finance industry realized it was no longer sufficient to use prior losses as the standard for consideration. Thus, the forward-looking CECL methodology was developed to account for more precise future credit losses, and it then is replacing the incurred loss model.
What Is the CECL Methodology?
The current expected credit loss (CECL) accounting standard is the improved way that financial institutions are shifting to in order to accurately estimate allowances for credit loss. The CECL model utilizes predictive analytics to calculate bad debts, encouraging banks and credit unions to be more proactive about potential future credit losses and to record deductions in their revenue.
Institutions now estimate their credit losses by considering past experiences, current circumstances, and evidence-based forecasts. Companies must report losses consistently so that auditors can test to see how these losses would impact the institution’s health.
CECL Implementation Timeline for Small and Private Institutions
The new CECL accounting standard was announced in June 2016. Implementation timelines were introduced simultaneously and differed based on the institution type. All public institutions are required to start using the CECL method by January 2022, while small and private institutions (private companies, nonprofit organizations, small public companies) will have until January 2023, to prepare their implementation.
The delay for small institutions is intended to help them avoid making any possible missteps made by larger banks, who are set to adopt the new accounting standard first.
How to Prepare to Implement CECL at Your Institution
Step 1: Understand the new standard and what it requires.
One of the first things to do to prepare is to research the CECL standard. You can find it outlined on the FASB website here under topic 326. It may not be immediately clear how the standard applies to your institution and what specifically you’ll need to change, but this is where you can seek the expertise of the banking community through webinars, conferences, third-party experts, trade group leaders, and more. Keep close tabs on the FASB to see if they issue any new updates or clarifications about the transition.
Step 2: Set up a CECL task force.
When you implement CECL, it will touch every team within your institution. As such, you should involve key players from every department of your organization — from loan review to IT — in a discussion about what changes need to be made across the company to accommodate this standard.
Step 3: Discuss the gaps in your current processes.
The FASB hasn’t laid out black-and-white steps for calculating expected credit losses. But once you understand the CECL standard and have a general idea of your plan to implement it, you’re better prepared to hone in on a plan that addresses gaps in your calculation abilities.
Meet with your teams to discuss factors such as these and find out if you’re equipped for a smooth transition:
- What weaknesses exist within your infrastructure?
- Do you have sufficient data to produce accurate credit risk projections?
- Will you need additional resources or tools to make your processes more consistent and efficient?
Step 4: Create a plan to fill the gaps in your processes.
Having an understanding of what your institution lacks in terms of resources and capabilities will guide the efforts in your plan to fill these needs. Consider addressing each pain point one by one. You can consult institutions similar to your own to see how they’re addressing the same pain points, seeking public resources, or using third-party methods and tools.
Before implementing your plan, test your newly-developed processes and procedures alongside existing ones to make sure they’re actually helping you meet the new accounting standard.
Use BMA for Your Credit Storage and Impairment Calculations
All financial institutions switching to the CECL method need sophisticated systems to help them calculate expected credit losses, aggregate data, report risks, and accommodate changing processes. BMA’s innovative software suite can assist with the specific information storage and the impairment estimation process needed to conduct precise calculations.
BMA’s open architecture platform can be customized to your institution’s needs and is able to provide the information required to support your reporting requirements.
Contact us today for a free demonstration and to find out how we can help you now and in the future.