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CECL: Where to start

08.30.16

By now you have heard that the Financial Accounting Standards Board’s (FASB) answer to the criticism the incurred-loss model for accounting for the allowance for loan and lease losses faced during the financial crisis has been released in its final form. The Current Expected Credit Loss model (CECL), which was developed through an arduous (and sometimes contentious) process following the crisis, will bring substantial changes to the way community banks account for expected losses in their loan portfolios. 

Working closely with community banks in the years building up to final issuance, we recognized an uncomfortable level of uncertainty created by the ever-changing proposals and lack of concrete examples. Now that the guidance is final, we feel a strong sense of responsibility to provide our interpretations, thoughts and insights where we can. As the FASB has shown recently with its new revenue pronouncement, there is a good chance that updates to the guidance will occur as we move closer to the implementation dates. The banking regulators who have thus far been mostly silent on the guidance will also have their interpretations.

We find that with substantial new guidance breaking it down into bite size pieces can be the best approach to understanding and implementation. With that said, this is the first of a number of planned articles from BerryDunn to do just that.

Building your team

One of the first things your institution should do is create an implementation team. Building it now with staff from diverse backgrounds and experience including finance, lending and collections will bring significant rewards in the long run. This is also a good time to consider opportunities to include your auditor in the process. Ultimately, you will need them to perform audit procedures on your CECL allowance as part of your financial statement audit. That also means your model and the resulting estimate must be auditable. Including auditors in the early stages should also help your team think about implications the audit requirements may have for expectations related to retaining documentation and supporting assumptions. In addition, your auditor may be able to share observations based on how other institutions are implementing CECL that may be helpful for your team.  Auditors can do all this while maintaining independence if their services are structured properly.

When your team is assembled and is up-to-speed on the basics of what CECL is and isn’t, defining the team’s goals and creating a roadmap to get there will be your keys to success. And asking the right questions while creating the roadmap is a great place to start. 

Questions to consider:


What available method (under CECL) is the best fit for the institution?
We expect that largely most community institutions will start with a top-down approach using an adaption from their current loss-rate approach to reflect the change from the old incurred loss method to the “life of the loan” current expected credit loss method. We believe the following step-by-step model will be one practical approach that should fit most community banks and credit unions:

  1. Determine which loans for specific reserves are appropriate, much in the same manner as you’re likely doing now. The notion of “impaired” loans goes away with CECL; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it’s been pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
  2. Secondly, for the rest of the portfolio:
    1. Group loans by common characteristics – same as you are likely doing now. These groups can match your portfolio or class groupings used now in financial reporting, but can also be broken down further.
    2. For each group, create subgroups for each origination year. One of the disclosure requirements in the guidance suggests the current year and previous four years are the critical ones to focus on; anything older than five years could be combined together.
    3. For each subgroup:
      1. Establish economic and other relevant conditions for the average remaining term of loans in the subgroup. This will be a combination of forecasted conditions for the near future, probably based on the Fed’s three-year forecast, and long-term historical conditions for the remaining average loan term.
      2. Select an historical loss period that best approximates the conditions established in 2c(i).
      3. Determine average remaining lifetime losses for the historical loss period established in 2c(ii) for that loan type.
      4. Adjust the average determined in 2c(iii) for any current or expected conditions that you believe are different from this historical data. The regulators have indicated their expectation that these will likely be the types of items for which qualitative factors have been developed under the incurred loss model, or a subset thereof.

These adjustments should themselves be based on historical data, or peer historical data if institution-specific data isn’t available (for example, a new loan product); for example, a 25 basis point upward adjustment for actual and expected declines in real estate values beyond the average in the historical period in 2c(ii) should be supported by data that shows a 25 basis point increase in losses for this type of loan in previous periods in which real estate values had shown a similar decline.

What data do we need to start collecting?
The clock has started! The CECL model requires analysis of loss rates and environmental factors. Detailed loss-rate calculations for as far back as you can get is your goal. The next step after collecting the historical data on your losses is to document other factors that were in play during each period. You will also need to consider the factors that affected charge-off rates for different periods. Changes in overall economic conditions, underwriting (both risk and quality), the legal environment and other factors need to be documented and correlated to trends in charge-offs. Remember one of the first steps in preparing a CECL model is to decide which time period of losses best matches the current environment. Without considering the full picture, including the external forces in play, it will be impossible to select an appropriate time period.

How do we retain and access that data?
Many core providers restrict access to older loan level data, and in some cases historical information is readily available only for very short time periods. Knowing the restrictions on your older data will be key in planning for CECL. The model suggests that a starting point for considering historical data needs is to consider what time periods matter. This may vary for different types of loans.

Some core providers have started reaching out to their institutions to discuss CECL and options for collection of data through webinars and one-on-one meetings. Consider reaching out directly to your provider to see what options in terms of data collection, retention and reporting will be available to your team.

What is the next step?
Build a simple model so that your team can better grasp and discuss the fundamentals of CECL. This can serve to solidify the concept of “life of loan losses” vs. the incurred loss method, as well as get your task force focused on what is important in collecting data.

Now that you’ve got your team assembled and have begun to tackle these questions, it’s time to look at other factors to consider. In our next installment, we’ll take you through how to implement CECL for loans obtained in a merger or acquisition. In the meantime, please call us if you have any questions.

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Read this if you are a CFO or controller.

The Governmental Accounting Standards Board (GASB) recently provided much needed guidance for governmental organizations struggling to account for relief provided in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). In their Technical Bulletin No. 2020-1, Accounting and Financial Reporting Issues Related to the CARES Act and Coronavirus Diseases, GASB addressed a number of pressing recognition and presentation questions that you should be aware of when preparing financial statements. The following is a summary of the guidance:

  • Resources received under the Coronavirus Relief Fund (CRF) subject to restrictions should be recognized as voluntary nonexchange transactions, subject to eligibility rather than purpose restrictions. As such, the entity should recognize resources received from the CRF as liabilities until the applicable eligibility requirements are met, including the incurrence of eligible expenditures. When the eligibility requirements have been met, revenue should be recognized for CRF resources received.
  • Provisions of the CARES Act that address the entity’s loss of revenue should be considered an eligibility requirement for purposes of revenue recognition. 
  • Any possible amendments to the CARES Act issued subsequent to the statement of net position date but before the issuance of financial statements, even when enacted with retroactive provisions, do not represent conditions that existed as of the period-end being reported and should only be reported as a nonrecognized subsequent event.
  • With the exception of CARES Act funds provided through the Provider Relief Fund's Uninsured Program (operating revenues), funds received under the CARES Act are subsidies and should be reported as nonoperating revenues and presented as noncapital finance activities in the statement of cash flows.
  • Outflows of resources incurred in response to the coronavirus disease due to actions taken to slow the spread of the virus or the implementation of "stay-at-home" orders should not be reported as extraordinary items or special items.
  • In addition to the guidance provided with the Technical Bulletin, the GASB also provides a number of additional stakeholder resources that may be useful during this period on its website, including an Emergency Toolbox that provides guidance on donated assets, management’s discussion and analysis (MD&A), asset impairment, and many more. 

Please contact Robert Smalley if you have questions on the latest GASB updates.
 

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GASB releases guidance for organizations receiving relief from the CARES Act

Recently the Governmental Accounting Standards Board (GASB) finished its Governmental Accounting Research System (GARS), a full codification of governmental accounting standards. The completion of the project allows preparers easy access to accounting guidance from GASB. The overall project, starting from the codification of older pre-1989 Financial Accounting Standards Board (FASB) pronouncements in 2010, was focused on pulling together all authoritative guidance, similar to what FASB had done in 2009.

Here’s what we found interesting.

Poking around the GARS (Basic View is free) I was struck by a paragraph surrounded by a thick-lined box that read “The provisions of this Codification need not be applied to immaterial items.” If you have ever read a GASB or FASB pronouncement, you have seen a similar box. But probably, like me, you didn’t fully consider its potential benefits. Understanding this, GASB published an article on its website aimed at (in my opinion) prompting financial statement preparers to consider reducing disclosure for the many clearly insignificant items often included within governmental financial statements.

After issuing more than 80 pronouncements since its inception in 1984, including 19 in the last five years, GASB accounting requirements continue to grow. Many expect the pace to continue, with issues like leases accounting, potential revision of the financial reporting model, and comprehensive review of revenue and expense recognition accounting currently in process. With these additional accounting standards come more disclosure requirements.

With many still reeling from implementation of the disclosure heavy pension guidance, GASB is already under pressure from stakeholders with respect to information overload. Users of financial statements can be easily overwhelmed by the amount of detailed disclosure, often finding it difficult to identify and focus on the most significant issues for the entity. Balancing the perceived need to meet disclosure requirements with the need to highlight significant information can be a difficult task for preparers. Often preparers lean towards providing too much information in an effort to “make sure everything is in there that should be”. So, what can you do to ease the pain?

While the concept of materiality is not addressed specifically in the GASB standards, by working with your auditors there are a number of ways to reduce the overall length and complexity of the statements. We recommend reviewing your financial statements periodically with your auditor, focusing on the following types of questions:

  • On the face of the financial statements, are we breaking out items that are clearly inconsequential in nature and the amount?
  • Are there opportunities to combine items where appropriate?
  • In the notes to the financial statements are we providing excessive details about insignificant items?
  • Do we have an excess amount of historical disclosure from years past?
  • In the management’s discussion & analysis, is the analysis completed to an appropriate level? Is there discussion on items that are insignificant?

The spirit behind the box is that GASB was specifically thinking about material amounts and disclosures. It was not their intention to clutter the financials with what their article referred to as “nickel and dime” items. With more disclosure requirements on the way, now might be the time to think INSIDE the box.  

For more guidance on this and other GASB information, please contact Rob Smalley.

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Extra information for GASB organizations: How to lessen information overload

Recently, federal banking regulators released an interagency financial institution letter on CECL, in the form of a Q&A. Read it here. While there weren’t a lot of new insights into expectations examiners may have upon adoption, here is what we gleaned, and what you need to know, from the letter.

ALLL Documentation: More is better

Your management will be required to develop reasonable and supportable forecasts to determine an appropriate estimate for their allowance for loan and lease losses (ALLL). Institutions have always worked under the rule that accounting estimates need to be supported by evidence. Everyone knows both examiners and auditors LOVE documentation, but how much is necessary to prove whether the new CECL estimate is reasonable and supportable? The best answer I can give you is “more”.

And regardless of the exact model institutions develop, there will be significantly more decision points required with CECL than with the incurred loss model. At each point, both your management and your auditors will need to ask, “Why this path vs. another?” Defining those decision points and developing a process for documenting the path taken while also exploring alternatives is essential to build a model that estimates losses under both the letter and the spirit of the new rules. This is especially true when developing forecasts. We know you are not fortune tellers. Neither are we.

The challenge will be to document the sources used for forecasts, making the connections between that information and its effect on your loss data as clear as possible, so the model bases the loss estimate on your institution’s historical experience under conditions similar to those you’re forecasting, to the extent possible.

Software may make this easier… or harder.               

The leading allowance software applications allow for virtually instantaneous switching between different models, permitting users to test various assumptions in a painless environment. These applications feature collection points that enable users to document the basis for their decisions that become part of the final ALLL package. Take care to try and ensure that the support collected matches the decisions made and assumptions used.

Whether you use software or not there is a common set of essential controls to help ensure your ALLL calculation is supported. They are:

  • Documented review and recalculation of the ALLL estimate by a qualified individual(s) independent of the preparation of the calculation
  • Control over reports and spreadsheets that include data that feed into the overall calculation
  • Documentation supporting qualitative factors, including reasonableness of the resulting reserve amounts
  • Controls over loan ratings if they are a factor in your model
  • Controls over the timeliness of charge-offs

In the process of implementing the new CECL guidance it can be easy to focus all of your effort on the details of creating models, collecting data and getting to a reasonable number. Based on the regulators’ new Q&A document, you’ll also want to spend some time making sure the ALLL number is supportable.  

Next time, we’ll look at a lesser known section of the CECL guidance that could have a significantly negative impact on the size of the ALLL and capital as a result: off-balance-sheet credit exposures.

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CECL: Reasonable and supportable? Be ready to be ALLL in

Read this if you are at a financial institution. For more CECL information, tune in to the latest episode of BerryDunn’s CECL Radio podcast. It features Susan Weber and David Stone discussing how to handle unfunded commitments and debt securities during CECL preparation.

I love a big surprise! Of course, I mean the fun, uplifting kind—like birthday parties, a best friend’s unexpected visit, or that special anniversary gift. Not that other kind of surprise that’s more like biting into an apple only to find half a worm. Calculating a loss reserve for unfunded commitments is not a new concept, but the reach and significance of it may end up surprising institutions. How much? A review of 2020 public filings and disclosures shows that some adopters saw unfunded commitment reserves increase millions of dollars, from one percent of total reserves pre-adoption to six percent or more post-adoption. In this article, we take a close look at unfunded commitments under CECL, in an effort to help you avoid that “other kind” of surprise.  

Within the CECL standard (Accounting Standards Codification (ASC) 326 – Financial Instruments-Credit Losses), key considerations for estimating reserves tied to unfunded commitments are covered in section 326-20-30-11. The section lays out three key fundamentals: it applies to credit commitments that are not unconditionally cancellable, and that institutions should consider how likely the commitment is to be funded, and its expected life. 

First, let’s look at unconditionally cancellable—this essentially means that unless an institution can, at any time and for any reason, cancel its commitment to lend, then the commitment has to be included in this part of the estimate. Institutions may be surprised to discover that a portion of its commercial sales pipeline should now be included in unfunded commitment balances. Why? Because commitment letters issued to business loan applicants are often considered legally binding and they typically do not contain language that would make them unconditionally cancellable by the institution. This makes sense when you realize the primary goal of the commitment letter is to assure the applicant that the bank is committed to making the loan. This discovery, in turn, has led those involved in CECL implementation to develop (1) processes to ensure commercial loan pipelines are sufficiently detailed enough to know what, when, and how these commitments should be included in the calculation, and (2) internal controls that assure the accuracy, completeness, and timeliness of the information. 

Next up—how likely is it that the commitment will be funded? For unused portions of existing loans and lines, this may mean taking a look at average utilization rates. For in-scope pipeline commitments, institutions may find that they need to dig through information that is not commonly held in a central system to come up with a success or close rate. The likelihood of funding may vary widely between products or segments, and over its expected life. For example, the expected funding of a residential or commercial real estate construction line may approach 100%, whereas only 40% or less of a revolving line may ever be used. These funding rates become the basis for “discounting” the unfunded balances subject to reserve estimation and should be re-evaluated on some periodic basis, which can be detailed in the institution’s CECL model documentation related to governance and monitoring.

Finally, let’s look at the expected life of the loan component. This language and expectation are consistent with on-balance sheet credit, leading institutions to (1) make sure they are able to segment their off-balance sheet commitments in the same pools used for boarded loans, and (2) apply the appropriate pool reserve factor to unfunded commitments over the expected life of that type of loan. One-way institutions may accomplish this is by making sure that they are using the same fully adjusted reserve factor and expected life assumptions for unfunded pools as they do for their funded pool counterparts. 

You may discover that your CECL model or software vendor does not provide for unfunded commitment calculations, or only provides support for the available credit portion of loan facilities boarded to your core loan system. In either case, this means institutions must consider, support, and complete calculations outside of the model. Writing clear step-by-step instructions and ensuring a robust independent review/approval process will help off-set risks posed by such manual calculations.

Could you use an experienced resource to help you document or validate your CECL model?  

No matter what stage of CECL readiness you are in, we can help you navigate the requirements as efficiently and effectively as possible. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

For more tips on documenting your CECL adoption, stay tuned for our next article in the series. You can also follow Susan Weber on LinkedIn.

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Unfunded commitments and CECL: You may be in for a big surprise

Read this if you are a financial institution.

One of the new components to CECL is the consideration of how future economic conditions may impact your estimate of expected losses. What forecasts do you need, how to find and evaluate forecasts, and what are the things you need to think about regarding the forecast choices you make are all excellent questions. Below are 10 things that may help you make, evaluate, and support your “reasonable and supportable” forecast decision:   

  1. Source(s): Even though many understand that economic forecasts, like their weather counterparts, are often wrong, reputation and experience of the forecaster(s) matter. Beyond name recognition, learning more about the people and process of how the forecast is derived will go a long way to helping you defend the source you’ve chosen.  
  2. Types: Forecasts may be produced by an individual, model(s), or group. You may have heard the term “consensus” to describe a forecast—literally, a forecast that results from the majority or average opinion of a group of contributors. An awareness of the type of forecast will help you identify the unique risks of each.    
  3. Assumptions: With any forecast, it is important to understand the specific assumptions on which the forecast is based. “This forecast assumes…,” or “The accuracy of this forecast is contingent upon….,” or “In developing this forecast we relied on….” are just a few examples of what to look for when reviewing introductions, footnotes, or disclaimers to the forecast(s).  
  4. Cost: Fee-based economic forecasts are not inherently more “reasonable and supportable” than free ones; remember, no forecast is perfect. Some fee-based providers may offer a version of their forecast for free. In these cases, having a clear understanding of what’s included in each version may be a deciding factor.
  5. Completeness: The more economic forecasts you read, the more you realize that what they are actually forecasting varies. Evaluating whether or not a forecast is complete is really about discovering if it forecasts all the economic conditions—or economic factors1—that you want to use in your model. For example, you may have mathematically shown that a local or regional unemployment rate is more informative about loss risk in your portfolio, but is there a forecast source for that local or regional rate?
  6. Frequency: Knowing how often a forecast is updated, and when it will be made available is crucial to the timing of your CECL reserve calculation, and the answers may affect more than just your decision of which forecast to use (see “Trade-offs”). For now, consider how reliably and consistently the forecast is available, and if you can count on it with enough time each quarter-end to use it in your reserve calculation.
  7. Future: With all the uncertainty of the past couple of years, it may seem optimistic to think about sources providing more than a one-year forecast. Yet, for some, this may be an important option. For this reason, finding out if a source does, can, or charges extra for providing one-, two-, and three-year (or longer) forecasts may be necessary.  
  8. Bias: It is important to be aware that forecasts can be biased, meaning that they always tend to be more or less enthusiastic about the future. Bias is not the same thing as providing alternative outlooks or scenarios—such as best case/worst case, or neutral/severe, which are more about the assumptions being made. Bias is often detected when over a period of time you compare sources against each other and discover that one source tends to forecast consistently higher or lower than others. This may be especially important when you consider how a forecast does or does not align with the views of the institution’s management.  
  9. Accuracy: Again, since all forecasts will be wrong to some degree, let’s set a new standard for thinking about accuracy. Perhaps the goal here is to find the less-wrong forecast. One way you might want to do this is to locate (or ask for) previous forecasts over different periods of time and compare them to what actually happened. This one is tricky because of assumptions and bias, but if you’ve narrowed it down to a few choices, you may find this kind of exercise helps you decide.
  10. Trade-offs: Given all the forecasting options and considerations, it may be re-assuring to hear that there is no one right answer. But in order to properly support your choices, it is important to think through and document what trade-offs have been made along the way, how they may affect your reserve calculation, and whether or not you feel it should be addressed elsewhere in your methodology.

In closing, two words of caution. First, while having a good single source for a forecast may sound like a great idea, have a back-up plan. Some forecast sources did not produce an update in March-April 2020, the time when first-wave adopters were trying to produce their first quarter CECL estimates, sending some folks scrambling. With this in mind, making use of several forecasts may help you mitigate single-source risk in the long-run. Second, having a process in place to ensure the same economic outlook is being used in all major functions is important. For example, relying on a “severe” future outlook to build loss reserves while at the same time using a “neutral” economic outlook for budgeting and ALM purposes could call into question the reasonableness of your CECL estimate. 

No matter what stage of CECL readiness you are in, we can help you navigate the requirements as efficiently and effectively as possible. For more information, visit the CECL consulting page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

For more tips on managing your CECL adoption, stay tuned for our next article in the series. You can also follow Susan Weber on LinkedIn.

1In this context, economic factors” are measured conditions – such as unemployment, gross national product, consumer price index, etc. 

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Reasonable and supportable forecasts, oh my! 

Read this if you are a financial institution.

Have you ever noticed how a countdown seems to want to pick up speed the closer you get to the finish? 10, 9, 8… The chanting gets louder, and excitement builds with each passing number: 7, 6, 5… For me, the adrenaline really kicks in below 5: at 4, 3, 2.

Whether it’s excitement or anxiousness you’re feeling as CECL adoption approaches, staying focused on the remaining decisions is vital to your success. One of those decisions—and a frequently asked question in recent discussions with 2023 adopters—is about implementing Q factors (qualitative adjustments). So let’s take a look at some key considerations for Q factors.

10, 9, 8…

The role and nature of Q factors are to adjust for certain things you know or think will be different about losses in the future than they were in the past. They are also intended to be transitory. Like a scientific hypothesis, each Q factor adjustment exists until it bears out and is picked up in your primary model output, or it doesn’t. Either way, the need for that particular adjustment would presumably end. The one adjustment that most often comes to mind is economic forecasts, a new component of CECL. Let’s assume you have a qualitative adjustment for an expected upcoming recession—depending on your chosen method, for instance, the difference in reserve calculated when using a more severe economic scenario, or using historical losses only from a time period that was recessionary. Regardless, one would not expect this to be a permanently held adjustment—at some point, the recession happens, or it does not, and the adjustment may no longer be warranted. Categories of Q factors give us a place to start thinking through what specifically is different or what is changing, whether it is something broad, like economic forecasts, or something specific like new products or geographies in which you lend money. The key here is that it is something not accounted for already in the design, structure, inputs, or output of your core model.1  

7, 6, 5…

Effectively implementing Q factors requires you understand how your segmentation (pools for collective analysis) and method selection affect your opportunity to make and support adjustments. What does this mean? 

Segmentation under CECL requires grouping loans based on similar risk characteristics. This is inherently about behavior that has to do with risk and loss. Grouping all first lien residential mortgage loans together is a common one. If you have a big enough portfolio with enough historical loss history to support it, you may be able to further sub-segment that pool by geography (region, state, county), or by nature of use (primary residence, vacation home, or investment property), or by collateral lien position (first lien, junior lien). You’d want to do this if the inherent risk of loss you face is different. This loss risk difference could be a matter of customer behavior, or a difference in market conditions.

But what if, through the model development stage, you realize (or are told) that you don’t have enough data or big enough pools to model effectively at your preferred level of segmentation? Or, what if the method you chose comes with a level of segmentation already built-in?

4, 3, 2…

Let’s stick with residential mortgages. If you’ve accepted a higher level of segmentation, for example at the product level (residential mortgages) or even higher at the call report code level (1c), you may be thinking you have lots of leeway to make qualitative adjustments for all the nuances underneath. Not so fast. Are there any other modelling choices you’ve made that may prevent you from doing that? What about the use external loan data?

A common modeling technique is to use peer data to help establish the mathematical relationship between historical losses and changes in the economy. Most peer data is only available at the call report code level, which means that all those nuances in your “1c segment” that you want to further adjust may already be embedded in your methodology because of the connection to peer data. This may be even further complicated by situations in which you have no say in more proprietary loan data sets model developers may be using to support their model design, assumptions, and formulas. External loan pool data is just one of many things to consider when evaluating when, and if there are opportunities to support a Q factor adjustment.

So what’s a responsible CECL adopter to do when considering how best to make qualitative adjustments? 

First, understand that the intention is to account for changes and differences, which inevitably is a moving target. Adjustments and their related reserve dollars are not fixed, which is why they should be subject to re-assessment each time you update your CECL calculation. Second, if you’re using a vendor’s model, it is imperative that you know how, when, and to what extent loan data other than yours is or has been used, both in developing the model and in its on-going operation. Third, you need to understand, document, and think through the interplay between the segmentation you have and model design or other assumptions made along the way. Finally, if in the normal course of operation, you change any of those assumptions or inputs, it should trigger a re-evaluation of your Q factors to ensure they remain relevant. 

Want help with your Q Factor approach? Are you struggling with CECL documentation or other elements of CECL? 

No matter what stage of CECL readiness you are in, we can help you navigate the requirements as efficiently and effectively as possible. For more information, visit the CECL consulting page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

For more tips on documenting your CECL adoption, stay tuned for our next article in the series. You can also follow Susan Weber on LinkedIn.

1If you haven’t already, I highly recommend that you read these sections of the accounting standards codification (ASC) 326, commonly referred to as the CECL standard: 326-20-55-4, 326-20-30-7, 326-20-30-8, and 326-20-30-9.

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Implementing Q factors under CECL: Why your segmentation and other modeling choices matter

What the C-Suite should know about CECL and change management

Read this if you are at a financial institution. 

Some institutions are managing CECL implementation as a significant enterprise project, while others have assigned it to just one or two people. While these approaches may yield technical compliance, leadership may find they fail to realize any strategic benefits. In this article, Dan Vogt, Principal in BerryDunn’s Management and IT Consulting Practice, and Susan Weber, Senior Manager and CECL expert in BerryDunn’s Financial Services Practice, outline key actions leaders can take now to ensure CECL adoption success.  

Call it empathy, or just the need to take a break from the tactical and check in on the human experience, but on a recent call, I paused the typical readiness questions to ask, “How’s the mood around CECL adoption – what’s it been like getting others in the organization involved?” The three-word reply was simple, but powerful: “Kicking and screaming.”  

Earlier this year, by a vote of 5-2, the FASB (Financial Accounting Standards Board) closed the door to any further delays to CECL adoption, citing an overarching need to unify the industry under one standard. FASB’s decision also mercifully ended the on-again off-again cycle that has characterized CECL preparation efforts since early 2020. One might think the decision would have resulted in relief. But with so much change in the world over the past few years, is it any wonder institutions are instead feeling change-saturated?  

Organizational change

CECL has been heralded as the most significant change to bank accounting ever, replacing 40+ years of accounting and regulatory oversight practices. But the new standard does much more than that. Implementing CECL has an effect on everything from executive and board strategic discussions to interdepartmental workflows, systems, and controls. The introduction of new methods, data elements, and financial assets has helped usher in new software, processes, and responsibilities that directly affect the work of many people in the organization. CECL isn’t just accounting—it’s organizational change. 

Change management

Change management best practices often focus on leading from optimism—typically leadership and an executive sponsor talk about opportunities and the business reasons for change. Some examples of what this might sound like as it relates to CECL might include, by converting to lifetime loss expectations, the institution will be better prepared to weather economic downturns; or, by evolving data and modeling precision, an institution’s understanding and measure of credit risk is enhanced, resulting in more strategic growth, pricing, and risk management. 

But leading from optimism is sometimes hard to do because it isn’t always motivating—especially when the change is mandated rather than chosen.  

Perhaps a more judiciously used tactic is to focus on the risk, or potential penalty, of not changing. In the case of CECL, examples might include, your external auditor not being able to sign-off on your financials (or significant delays in doing so), regulatory criticism, inefficient/ineffective processes, control issues, tired and frustrated staff. These examples expose the institution to all kinds of key risks: compliance, operational, strategic, and reputational, among them.

CECL success and change management

With so much riding on CECL implementation and adoption going well, some organizations may be at heightened risk simply because the effort is being compartmentalized—isolated within a department, or assigned to only one or two people. How effectively leadership connects CECL implementation with tenets of change management, how quickly they understand, then together embrace, promote, and facilitate the related changes affecting people and their work, may prove to be the key factor in achieving success beyond compliance.  

One important step leaders can take is to perform an impact assessment to understand who in the organization is being affected by the transition to CECL, and how. An example of this is below. Identifying the departments and functions that will need to be changed or updated with CECL adoption might expose critical overlaps and reveal important new or enhanced collaborations. Adding in the number of people represented by each group gives leaders insight into the extent of the impact across the institution. By better understanding how these different groups are affected, leaders can work together to more effectively prioritize, identify and remove roadblocks, and support peoples’ efforts longer term.           

 
No matter where your institution is currently in its CECL implementation journey, it is not too late to course-correct. Leadership—unified in priority, message, and understanding—can achieve the type of success that produces efficient sustainable practices, and increases employee resilience and engagement.

For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions. For more tips on documenting your CECL adoption, stay tuned for our next article in the series, revisit past articles, or tune in to our CECL Radio podcast. You can also follow Susan Weber on LinkedIn.

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Implementing CECL: Kicking and screaming

Read this if you are a financial institution.

Choosing a method for estimating lifetime expected losses is a commitment. A commitment that signals, in spite of any other option, you’re certain this method is the right one for you—your segment, portfolio, and institution. While you might be able to support a change in method later, it is much more likely you’ll be living with this decision a good long while. So, how exactly does one know which method is the right one? Let’s take a few minutes to answer some frequently asked questions about selecting methods for CECL.

How many CECL methods are there?

This depends on who you ask. Section 326-20-30-3 of the standard names five (5) categories: discounted cash flow, loss-rate, roll-rate, probability of default, and aging schedule. Some categories, like loss-rate, have several methods. Additionally, some methods seem to be referred to by different names, giving people the impression that there are exponentially more options out there than there really are. With this in mind, I tend to think of two (2) broad categories, and seven (7) unique methods:  

  • Loss-rate methods
    • Snapshot (open pool, static pool, cumulative loss rate)
    • Remaining Life and Weighted Average Remaining Maturity (WARM)
    • Vintage
       
  • Other methods
    • Scaled CECL Allowance for Losses Estimator (SCALE) (option for banks with assets <$1 billion)
    • Discounted Cash Flow (DCF)
    • Probability of default 
    • Migration (roll rate, aging schedule)  

What’s the difference?

The loss-rate methods use actual historical net charge-off information in different ways to derive a loss rate that can then be used to calculate expected losses over the remaining life of a pool. In general, they do this by holding the mix of a group of loans constant (e.g., by year of origination) and then tracking net losses tied to that grouping over time. The “other” methods employ a variety of mathematical techniques and/or credit quality information to estimate expected lifetime losses. For a quick overview of each method and corresponding resources, access our CECL methodologies guide here.

How do I know which to use?

This is the CECL equivalent of the proverbial million-dollar question. Technically, any institution could use any one, or all of these methods. But there are considerations that make some of them a more or less likely fit. For example, if your institution has >$1 billion in assets, SCALE is not even an option for you, and you can cross it off the list. If you are not in a position to afford software, or lack the internal expertise to build a similar model internally, then discounted cash flow and probability of default methods would likely be extremely burdensome in the normal course of business. For that reason, you may need to cross those off your list. If you lack large pools with consistently diverse performance over time, then migration methods will be difficult to support. If you have a relatively stable loan mix, consistent credit culture, and a lot of reliable historical loss data—especially through multiple economic cycles—the loss-rate methods may be a good fit, with or without software. If your portfolio has undergone a lot of changes—products, underwriting standards, merger and acquisition activity—and/or there are significant gaps in key data that cannot be restored, then you might want to re-consider software and one of the “other” methods. 

What are the pros and cons of the various methods?

One pro of the loss-rate and SCALE methods is they have been shown to be manageable without software. Examples of all of these methods have been illustrated using Excel spreadsheets. The use of Excel is also potentially a con, given that more spreadsheets and, maybe more people, are likely going to be involved in computing the Allowance for Credit Losses (ACL). As a result, version control as well as validation of spreadsheet macros, inputs, formulas, math, and risk of accidentally overwriting or deleting values should be addressed. One pro of the discounted cash flow method is that it is a bottom-up approach, meaning each loan’s discounted cash flow (DCF) is computed and then rolled up to the segment level. Because of this, DCF can more easily handle mixed pools, e.g., loans of all vintages, sizes, terms, payment and amortization schedules, etc. A potential con of DCF is that it really requires software, staff trained to use the software appropriately, and an understanding of the vast array of choices, levers, and decisions that come with it.     

Does my choice of method affect my qualitative adjustment options?

How’s this for commitment: maybe. In general, I think it’s safe to say that CECL requires additional thought be given to the nature and degree of adjustments. This is especially true when you look at the combination of potential segmentation changes, new elements of the calculation, and the variety of methods now available. Consider the example of a bank using a loss-rate method and facing a potential economic downturn. If that bank has sufficient history and a relatively stable portfolio mix, credit culture, and geography, then it might elect to use a different time period—say, historical loss-rates observed from the last recession—rather than those more recently computed. In this case, the loss-rate method would already be using a recessionary experience. 

How then, would the bank approach additional qualitative adjustments for changing economic outlooks to ensure it is not layering (or double counting) reserve? Going back to the original “maybe” response, perhaps the answer is less about inherent conflicts between methods and qualitative adjustments. Rather, it’s about understanding that given your chosen method, you may be faced with even more decisions about if, where, and how much adjusting you are doing.

CECL adoption is required. Struggling to adopt isn’t. We can help.

No matter what stage of CECL readiness you are in, we can help you navigate the requirements as efficiently and effectively as possible. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

For more tips on documenting your CECL adoption, stay tuned for our next article in the series. You can also follow Susan Weber on LinkedIn.

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Questions to ask when deciding your CECL Method

Read this if you are a financial institution.

As you know by now, ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326), better known as the CECL standard, has already been implemented for some and will soon be implemented for all others (fiscal years beginning after December 15, 2022 to be exact). During your implementation process, the focus has likely been on your loan portfolio, and rightfully so, as CECL overhauls 40+ years of loan loss reserve practices. But, recall that the CECL standard applies to all financial instruments carried at amortized cost. So, it therefore includes held-to-maturity (HTM) debt securities. And, although not carried at amortized cost, the CECL standard also makes targeted enhancements to available-for-sale (AFS) debt securities. As if re-hauling your entire allowance methodology wasn’t enough! Before tearing out your hair because of another CECL-related change, let’s quickly review what is currently required for securities, and then focus on how this will change when you implement CECL.

Current US GAAP

Under current US generally accepted accounting principles (GAAP), direct write-downs on HTM and AFS debt securities are recorded when (1) a security’s fair value has declined below its amortized cost basis and (2) the impairment is deemed other-than-temporary. This assessment must be completed on an individual debt security basis. Providing a general allowance for unidentified impairment in a portfolio of securities is not appropriate. The previous amortized cost basis less the other-than-temporary impairment (OTTI) recognized in earnings becomes the new amortized cost basis and subsequent recoveries of OTTI may not be directly reversed into interest income. Rather, subsequent recoveries of credit losses must be accreted into interest income.

CECL: Held-to-maturity securities

Then comes along CECL  and changes everything. Once the CECL standard is implemented, expected losses on HTM debt securities will be recorded immediately through an allowance for credit loss (ACL) account, rather than as a direct write-down of the security’s cost basis. These securities should be evaluated for risk of loss over the life of the securities. Another key difference from current GAAP is that securities with similar risk characteristics will need to be assessed for credit losses collectively, or on a pool basis, not on an individual basis as currently prescribed. Also, contrary to current GAAP, since expected losses will be recorded through an ACL account, subsequent improvements in cash flow expectations will be immediately recognized through earnings via a reduction in the ACL account. CECL effectively eliminates the direct write-down method, with write-offs only occurring when the security, or a portion thereof, is deemed to be uncollectible. 

In practice, there may be some types of HTM debt securities that your institution believes have no risk of nonpayment and thus risk of loss is zero. An example may be a US Treasury debt security or possibly a debt security guaranteed by a government-sponsored enterprise, such as Ginnie Mae or Freddie Mac. In these instances, it is acceptable to conclude that no allowance on such securities is necessary. However, such determination should be documented and changes to the credit situation of these securities should be closely monitored.

Financial institutions that have already implemented CECL have appreciated its flexibility; however, just like anything else, there are challenges. One of the biggest questions that has risen is related to complexity, specifically from financial statement users in regards to the macroeconomic assumptions used in models. Another common challenge is comparability to competitors’ models and estimates. Each financial institution will likely have a different methodology when recording expected losses on HTM debt securities due to the judgment involved. These concerns are not unique to the ACL on HTM debt securities but are nonetheless concerns that will need to be addressed. A description of the methodology used to estimate the ACL, as well as a discussion of the factors that influenced management’s current estimate of expected losses must be disclosed in the financial statements. Therefore, management should ensure adequate information is provided to address financial statement users’ concerns.  

CECL: Available-for-sale securities

Upon CECL adoption, you are also expected to implement enhancements to existing practices related to AFS debt securities. Recall that AFS debt securities are recorded at fair value through accumulated other comprehensive income (AOCI). This will not change after adoption of the CECL standard. However, the concept of OTTI will no longer exist. Rather, if an AFS debt security’s fair value is lower than its amortized cost basis, any credit related loss will be recorded through an ACL account, rather than as a direct write-down to the security. This ACL account will be limited to the amount by which fair value is below the amortized cost basis of the security. Credit losses will be determined by comparing the present value of cash flows expected to be collected from the security with its amortized cost basis. Non-credit related changes in fair value will continue to be recorded through an investment contra account and other comprehensive income. So, on the balance sheet, AFS debt securities could have an ACL account and an unrealized gain/loss contra account. The financial institution will be responsible for determining if the decline in the value below amortized cost is the result of credit factors or other macroeconomic factors. In practice, the following flowchart may be helpful:

Although changes to debt securities may not be top of mind when working through CECL implementation, ensuring you reserve time to understand and assess the impact of these changes is important. Depending on the significance and composition of your institution’s debt security portfolio, these changes may have a significant impact on your financial institution’s financial statements from CECL adoption forward. For more information, visit the CECL page on our website. If you would like specific answers to questions about your CECL implementation, please visit our Ask the Advisor page to submit your questions.

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Don't forget about me! Changes in debt security accounting resulting from CECL