The 2008 financial crisis left its mark on the financial world, spurring a more cautious approach to lending as a whole. The previous Allowance for Loan and Lease Losses (ALLL) accounting standard proved itself to be insufficient and allowed untenable loans to build up without the funds to secure it.
ALLL focused on accounting for losses that were incurred but not yet realized, meaning that interruptions in cash flow collections were not accounted for and the economy’s overall negative sentiment wasn’t taken into consideration. This meant that realistic future losses failed to be expected and reserves were not adjusted.
Lessons learned from the crisis spurred change with a focus on ensuring such as situation could never arise again. One of these changes, introduced in 2016 and adopted in 2020 is the CECL (Current Expected Credit Losses) accounting standard.
What is CECL?
CECL stands for Current Expected Credit Losses. It is an accounting standard that focuses on a forward-looking predictive model that calculates bad debt or estimated credit loss. CECL is a replacement for the defunct ALLL model and current incurred loss (ICL) method, which focuses on incurred debt not expected loss.
The current CECL methodology was published by the FASB (Financial Accounting Standards Board) in 2016 in its Accounting Standards Update (No. 2016-13). It aims to replace previous standards used for accounting for estimated credit loss. These new standards aim to:
- Increase the simplicity of calculating debt by reducing the number of models used to calculate debt.
- Avoid dictating a specific method for estimating credit loss
- Make the lifetime expected credit losses a requirement for financial providers
- Reduces the time needed to recognize credit loss. This is done by focusing on expected rather than incurred losses.
- Helps provider deeper analysis into credit risks
- Acts as a stress test for a company’s accounting system, ensuring it is fit for its purpose.
- Constantly audits financial accounts for losses.
- Takes a forward-thinking approach to credit and borrowing.
CECL Implementation Date for Banks and Financial Providers
Although the CECL, current expected credit losses model, was introduced in 2016, entities were not required to implement it immediately. In November 2019, the FASB again updated the Accounting Standard Update (ASU), extending the effective date for all businesses. Now the CECL implementation date stands at:
- January 2023 for smaller reporting companies (previously January 2021)
- January 2023 for non-public companies (previously January 2022)
Small reporting company, according to SEC (Securities and Exchange Commission) is one with less than $250 million float or an annual revenue of less than $100 million.
For financial institutions, CECL compliance has been delayed until the end of the COVID-19 national emergency or the end of December 2020, whichever is earlier. At this stage, the financial organization will have to either decide to delay CECL implementation short-term or report under the new CECL model.
What Methods are Available to Calculate under the CECL Methodology?
KYC and AML Processes or How Automation Improves Compliance in Lending CECL implementation doesn’t demand a business use a specific model to estimate current expected credit losses. Instead, it acts as guidance for companies to ensure they are more effectively able to do so. For example, some of the methods used can include (but are not limited to):
- Probability of Default: Using loan default timeline, probability of default, and loss-given, companies can calculate the expected credit loss by multiplying these values to calculate the amount.
- Loss Rate: By assigning risk profiles and segmentation the borrowers, each segment’s risk rate can be calculated based on historical data. Adjusting these losses according to loss rate and asset cost gives the true overall amount of expected loss.
- Roll Rate: By taking the loss-rate number and then calculating the percentage of account balances that move to the delinquency stage, your company can get an expected loss amount.
- Discounted Cash Flow: This is calculated by estimating the current value and discounting the loan’s interest rate. By subtracting these you will arrive at credit losses.
- Aging Schedule: Predicts the allowance for delinquent debt by calculating historical loss rates and amount receivable (aka by age).
How to Prepare your Financial Company for CECL Implementation?
When preparing for CECL implementation, it’s important to get your organization, its process, and its tech in place even before the changes are due to take place. Here are some of the steps you can take to start off on the right foot:
Select a CECL accounting methodology
Decide which CECL accounting methodology you want to use. Explore how it fits within your overall business strategy, your business needs and whether it meets the CECL expectations.
Prepare your data
Organizations tend to collect tons of data, but utilizing that data is another matter. To highlight this, one study showed that over 42% of organizations did not have sufficient data for CECL. Often it will need to be prepared (cleaned and stored) correctly.
Find a tech solution
Now that your data is in order. It’s time to onboard a tech solution to do the necessary calculations for CECL. Take the lead from early adapters who are quick to find the latest tech solutions. For example, GiniMachine utilizes smart AI technology and models to work with historical data collection and model validation to act as CECL software and take care of all the calculations for your business giving you clear, visual results.
Develop your internal processes
CECL isn’t just about accounting, it’s likely to affect other areas of your business as well. Find out what these are and create a strategy so that CECL implementation can happen seamlessly.
Get your team onboard
Like all changes to an organization, CECL will first and foremost impact the work of your team. Ensure they remain informed and trained on any changes and considered onboarding new staff to help with CECL if you don’t have enough internal resources.
Create governance for your CECL
Can you effectively govern your CECL processes within your organization? If not, you may consider looking for audit and risk team members who can take control of the government to ensure CECL compliance.
CECL Next Steps
The CECL implementation deadline is not too far away. As your organization prepares what one of the biggest changes in credit loss prediction, it’s important to take the right steps early. Using this guide, you can see the basics of where your organization should move to get ready. But for deeper insights, don’t be afraid to reach out to the team who will talk you through the process of developing online lending software with the functionality to get the compliance you need.