By James Dowling, CPA, MBA, Manager, Assurance Services
As the community banking industry continues down the road towards implementation of the Current Expected Credit Loss Model (“CECL”), institutions are inundated with information, sound bites, webinars and conferences on the best approach to the new accounting pronouncement. Following is a synopsis of the most important aspects of CECL, what institutions should be focusing on now, and what challenges the industry will face from a financial reporting perspective.
The accounting guidance issued by the Financial Accounting Standards Board (“FASB”) for CECL totals 291 pages and includes various updates, changes and amendments to the previous guidance on the Allowance for Loan and lease Losses (“ALLL”). The following are what Marcum deems the five most important aspects of the CECL pronouncement:
- The Life of Loan Concept.
- Vintage Analysis.
- Data Collection.
- Lack of Current Guidance.
- Evolving Audit Process.
Let’s begin with the life of loan concept that comes into play with the implementation of CECL. This concept dictates that credit losses management estimates and expects over the entire life of a loan are recorded upon origination. Logic would dictate that no lender would close a loan when they are expecting a loss, but financial reporting is not always logical. The life of loan concept is the main driver of the new CECL calculation and impacts all other aspects of the new ALLL. As an example, current ALLL calculations use loss data over specific periods of time, while the new concept will require loss rates over the life of the loans within the institution’s portfolio.
Vintage analysis is the one concept that has been uniformly discussed as a means of calculating the ALLL under CECL. Simplistically, vintage analysis requires the institution to subdivide its loan portfolio by type into groups separated by origination date. Furthermore, there is the belief that vintage analysis may become the minimum requirement for the ALLL calculation under CECL, and many publically traded institutions already perform such an analysis. A vintage analysis will not only require more granular loan level data, but will also require more of management’s time, as well as forecasts of future loss levels by vintage. In the end, this could result in expanded calculations (i.e., a loan portfolio with an estimated life of 10 years would necessitate 10 different ALLL estimates).
Data collection is key now and in the future to ensure proper implementation of the CECL accounting guidance. This is and has been a topic of discussion at every conference, training seminar, audit committee meeting, and management meeting we have had attended over the past two years. What data do we collect? How long do we collect it? Where do we store it? The answer is simple: collect as much detailed, loan-level data as you can starting now. Since the guidance does not dictate a methodology to use, an institution really doesn’t know the exact data it requires until that methodology decision is made. Hopefully, your institution has formed a CECL Implementation Committee to champion the transition. For now, save all the data you can to avoid being caught short-handed when it is time to implement the new ALLL calculation.
We wouldn’t say there is a lack of accounting guidance (as mentioned above, the FASB pronouncement is 291 pages), but there is a lack of specific guidance as to how the calculation should be performed. Options are plentiful within the pronouncement, but what do the regulators want to see? What about the auditors (both internal and external)? As with any new accounting pronouncement it will take time to iron out the varying viewpoints on the calculation (and a cycle or two of exams/audits), but we know that the internal controls over loan originations are likely to change, the use of historical data will be altered, asset and liability models may be impacted by the new calculation, and credit quality disclosures will be expanding. Management needs time to set a calculation methodology, implement it through a dry run prior to its effective date, make changes to fine tune and then formulate the changes to other aspects of the institution (i.e., ALM) and financial reporting (i.e., expanded disclosures). This may seem heavy-handed coming from an auditor, but planning is paramount to success when it comes to CECL.
Furthermore, the audit process will continue to evolve under CECL and its implementation, as this is not only new for the institution, management, and the board, but also for the examiners and auditors of the institution. Ten sets of eyes typically result in 10 different interpretations, so be prepared to be pulled in many different directions. From an external audit perspective, the added future forecasts within the calculation adds subjectivity to the estimate, and subjectivity is always difficult to audit. The more support an institution has for the qualitative and future forecasts, the smoother the audit process will go. If those factors and forecasts are reasonable and supportable, they can become easy to audit. The audit process will continue to evolve each year, as the first year of implementation creates its own challenges, and the “go-forward” accounting creates a second set of challenges. In the end, preparation and documentation are the keys to success.
At this point, each institution should: 1) Form a CECL implementation committee on the Board; 2) Save as much loan-level detail as possible; 3) Continue to research, attend conferences and seminars and stay abreast of current information regarding the pronouncement and its implementation; 4) Correspond with its auditors and regulators; and 5) Be prepared!
Finally, outside of the changes to the calculation itself, there are other changes when it comes to financial reporting. As mentioned above, the credit quality disclosures within each institution’s financial statements will increase significantly under CECL. If vintage analysis is used or becomes a minimum required measurement, this could result in disclosures of credit quality by vintage, instead of the current only-by-loan–type standard. SEC-registered institutions would also need to disclose concerns about credit metrics and how they impact the ALLL and loss provision levels under CECL. Furthermore, it will most likely take institutions more time to accurate file their quarterly reports due to the Day 1 impact of CECL on an institution’s loan portfolio, and this may also become a larger focus within the audit process.
In the end, CECL is not going anywhere and needs to be implemented (except for the lucky ones who have a retirement date prior to the effective date). Stay informed, keep your ear to the ground, continue to research and plan, plan, and plan some more. Stay tuned for more on CECL coming from Marcum in the future.