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The Curtain is Closing: “Current Expected Credit Losses”

Article
An important change in methodology for loans will have considerable impacts on the reserves of banking clients.
12 minute read
March 28, 2023

What Is CECL vs. ACL?

For those that have not implemented the Current Expected Credit Loss (CECL) standard, the time is here. For financial institutions, an Allowance for Credit Loss (ACL) using the CECL methodology for loans replaces the former Allowance for Loan and Lease Losses (ALLL). The ALLL, originally referred to as the “reserve for bad debts,” was a valuation allowance each entity established and maintained with credits or debits against operating income – referred to as the provision for loan and lease losses.

The objective of a valuation allowance is to estimate uncollectible balances used to reduce the book value of loans and leases to amounts expected to be collected. An ACL similarly represents an estimate of uncollectible balances maintained through charges to a valuation allowance trued-up to an estimate through operating income – now referred to as expense for credit loss.

Under the CECL framework, ACLs are estimates of expected credit losses on financial assets measured at amortized cost. The measurement framework and conceptual basis supporting an ACL differs from that of the ALLL. As such, implementing CECL may have considerable impact on how the loan valuation allowance is computed. The methodology also applies to other financial assets such as receivables, held-to-maturity securities and net investments in leases for non-financial institutions.

Decoding CECL Implementation

Recently, the Financial Accounting Standards Board (FASB) issued a Practice Aid that lays out a simple five-step process to implement and adopt the requirements of FASB Accounting Standard Codification (ASC) Topic 326, Financial Instruments – Credit Losses

The following is a summary of the Practice Aid from FASB:

Measurement of Credit Losses on (ASC 326-20-15-2):

The CECL Model does not apply to available-for-sale debt securities.

Step 1: Identify and gather contracts for all financial assets that are owned by the entity.

Step 2: Apply the following guidance for first-time adoption of CECL: (ASC 326-10-65)

Step 3: Develop an Estimate of Credit Losses. (ASC 326-20-30)

Step 4: Review implementation guidance and illustrations as needed.

Step 5: Identify and prepare required presentation and disclosures.

What Are the Risks and How Can You Mitigate Them?

As financial institutions and other entities implement CECL, it’s important to consider potential risks and internal controls that can mitigate those risks. Examples or risks and controls include:

Risks Example Controls
Inaccurate economic variable assumptions obtained from external source are used in calculations Prepare and periodically update an ACL memo based on economic forecasts and outlooks that is presented to an Asset Review Committee. The Committee meets at least quarterly to review economic forecasts, outlooks, changes from prior periods, and potential adjustments to the ACL calculation or model, minutes of the meetings are maintained.
Loan setup at inception is inaccurate Independently review system inputs of new loans against supporting documentation such as the note, loan approval memo, loan setup sheet or checklist to ensure new, renewed loans are on-boarded properly.
Inaccurate calculations within the ACL model or workbook Perform periodic reconciliations to compare balances used in ACL calculations to the core system and/or Call Report.
Inaccurate calculations within the ACL model or workbook Perform periodic reconciliations to compare unfunded commitments in ACL calculations to the core system.
Inaccurate calculations within the ACL model or workbook; qualitative adjustments are inconsistent with changes in loan portfolio or economic conditions Independently review ACL calculations in the model by comparison to supporting documentation as well as approved Q-factors at periodic intervals.
Loan segmentation or other conditions required by the new CECL standard are not appropriately considered In the ACL memo presented to the Asset Review Committee, document methodology, assumptions used (including management estimates).
Third party systems are inaccurate If using a third-party model, obtain and review third-party SOC Type 1 and 2 reports at least annually. Verify validation controls were documented and tested and determine whether there are established complementary end user controls.
Data inputs or calculations in internally developed ACL model are inaccurate Establish data quality validations at multiple points through the entire data pipeline from system of origin to data preparation. On a periodic basis, have the ACL model independently reviewed for accuracy of calculations, completeness and accuracy of data inputs, and accurate inputs and usage of assumptions.

How Can Weaver Help?

Weaver’s Risk Advisory Services group has a dedicated team with the knowledge to walk you through the new CECL standard. We have consulted with several organizations to help strengthen their internal control environment and help mitigate related risks.

Please contact us for more information; we would enjoy helping you. You can also learn more about our service offerings or subscribe to our newsletter here.

Authored by Priyanka (Pree) Wakharkar, CPA, CA.

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