CECL explained: current expected credit losses

What does CECL require?

An allowance for credit losses that reflects all the losses expected over the contractual life of financial assets measured at amortized cost, adjusted for expected prepayments. The allowance is deducted from the amortized cost basis, so the balance sheet shows the net amount expected to be collected. Changes in the allowance are recognized in earnings as credit loss expense.

How is the CECL estimate built?

• Pooling: assets with similar risk characteristics are evaluated together; assets that do not share characteristics are evaluated individually.
• Historical loss information is the starting point, adjusted for differences in current asset characteristics and conditions.
• Reasonable and supportable forecasts of future economic conditions adjust the estimate for the period over which the company can forecast.
• Reversion: beyond that period, the estimate reverts to historical loss information, immediately or on a straight-line or other systematic basis.

No single method is required; see CECL methods.

Why did the FASB replace the incurred loss model?

Under the old model, losses were recognized only when they were probable and had been incurred, which the financial crisis showed was "too little, too late": allowances built up only after borrowers were already in trouble. CECL brings forward recognition to when assets are originated or bought, using forecasts as well as history.

What did CECL change for companies that are not banks?

Trade receivables, contract assets and lessors' net investments in leases now carry an allowance for expected losses even when every customer is paying on time. For most commercial companies with short-term receivables, the change in the allowance was modest, but the process and documentation needed to support it became more formal.

What about purchased assets with credit deterioration?

Financial assets bought with more than insignificant credit deterioration since origination are recorded with an allowance at purchase that is added to the purchase price, rather than charged to earnings, so no day one loss arises. Later changes in the allowance go through earnings.

Which assets does CECL cover?

A simple example

A lender originates a five-year loan portfolio of $10 million. Its historical lifetime loss rate for similar loans is 2.0%, and its economic forecast for the next two years is somewhat worse than the historical average, adding 0.3 points. On day one it records an allowance of $230,000: Dr Credit loss expense, Cr Allowance for credit losses. Under IFRS 9, the same portfolio in stage 1 would carry only 12 months of expected losses.

Can the expected loss be zero?

Yes, where historical experience and current conditions support it, such as US Treasury securities or assets fully secured by cash collateral. A company still has to assess and document why no allowance is needed.

How is the allowance presented?

As a deduction from the amortized cost of the related assets, so receivables and loans are shown at the net amount expected to be collected. The allowance for off-balance-sheet exposures, such as loan commitments, is a separate liability.

When did CECL take effect?

For SEC filers other than smaller reporting companies, fiscal years beginning after December 15, 2019. For all other entities, including private companies, fiscal years beginning after December 15, 2022. CECL was introduced by ASU 2016-13. For receivables, see CECL for trade receivables, and for IFRS, IFRS 9 vs CECL.

This guide is general information. It is not tax or legal advice for your situation.