Tips for a smooth CECL Implementation

By Maria L. Murphy, CPA

June 10, 2019

Although FASB’s current expected credit loss (CECL) standard will be a significant game-changer for the financial services industry, it is critical that companies that hold financial instruments understand how it will apply to them, said Barry M. Pelagatti, CPA, partner in the Audit Services Group and leader of the Financial Services Industry Group at RKL LLP.

All industries should have an appreciation for CECL because, if they have any instrument that potentially has loss associated with it, they should be considering some sort of model, Pelagatti, who presented a session on CECL implementation on Monday at AICPA ENGAGE 2019 in Las Vegas, said during a preconference telephone interview.

What is CECL? Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, introduces a new model to estimate expected credit losses and record an allowance using forward-looking information for the estimated contractual cash flows not expected to be collected. It applies to financial assets at amortized cost, including loans, reinsurance and trade receivables, held-to-maturity (HTM) debt securities, impairment model for available-for-sale debt securities, net investment in leases, and certain off-balance-sheet credit exposures, such as loan commitments.

The measurement is based on reasonable and supportable forecasts that are created using information about past events, including historical payment and loss experience, along with current market and economic conditions. Judgment must be applied to determine the relevant information and appropriate estimation methods.

“Whatever position a company takes, they must find objectively verifiable data that supports it through multiple economic cycles,” Pelagatti said.

This is a major change from current GAAP, which requires an incurred loss method, where recognition of credit losses is delayed until it is probable that a loss has been incurred. CECL is an expected loss model, so it can significantly change the amount and timing of recognized losses.

“The loss horizon has changed from one reporting or audit cycle of 12–15 months to the remaining [contractual] life of the instruments,” Pelagatti said. “For many organizations that have these financial instruments, this is a true game-changer because it goes beyond booking a reserve. For many companies, it will impact their capital levels, future product offerings, and product pricing.”

ASU 2016-13 is effective:

  • For public business entities that are SEC filers for fiscal years beginning after Dec. 15, 2019, including interim periods within.
  • For all other public business entities for fiscal years beginning after Dec. 15, 2020, including interim periods within.
  • For all other entities for fiscal years beginning after Dec. 15, 2020, and interim periods within fiscal years beginning after Dec. 15, 2021.

Early adoption is permitted for all entities for fiscal years beginning after Dec. 15, 2018, including interim periods within.

“For those organizations that realize that this standard will impact them in some way, the biggest challenge, which is very different from many other standards, is that they face a real struggle with how to support their decisions, appropriately validate them, and explain them to regulators and auditors,” Pelagatti said. “It will be a challenge to be proven to be right or wrong by anyone without the benefit of hindsight.”

Because expected losses must now be estimated and recorded upfront and then remeasured at each reporting date, companies must have the right relevant data, relevant factors, and reasonable and supportable forecasts. The ASU permits the use of a number of models and methodologies to estimate losses, so this is an area of significant judgment.

“The parameters and models used can result in remarkably different risk-of-loss assumptions,” Pelagatti said. He anticipates that this will create a lot of discussion and concern as companies begin to implement CECL from 2020 to 2022.

Data must be relevant and reliable, so they must also be available and objectively verifiable. “I think there’s been as much time spent trying to understand, ‘Am I doing enough for the people who need to approve this?,’ as has been spent trying to get everyone’s hands around this,” he said.

CECL implementation is a multiphase process. Step one is the realization that this is not going away, so it must be planned for. Step two includes walking through all systems, choosing a CECL model, developing reporting, assessing internal controls, and getting auditor and regulatory feedback as early as possible.

“It takes a village,” Pelagatti said. He recommends having a cross-functional team and an organized process, including the accounting team, IT, finance, lending groups, the audit committee, and the board of directors. “To go down the right track, communicate, document, stay involved, don’t just look at it once a quarter but have daily conversations,” he said.

CECL will have to be considered before every capital raise and acquisition discussion going forward.

As with any accounting change, the impact on the internal control environment must be evaluated and documented. All companies adopting CECL, regardless of their size, must have a process to build their models, support the validity of their data, and have in-house checks and balances over this process.

“They can’t rely on audit adjustments to get it right,” Pelagatti warned.

For public companies, lack of controls over accuracy and completeness of data and management review can result in deficiencies or material weakness findings.

CECL implementation requires a multiphase process that includes assessment of the assets impacted, obtaining and evaluating data, assessing needed management review and governance controls, implementing the transition on day one, and then accounting and reporting going forward.

“All the ICFR steps must be performed and documented, but these are all more of a challenge under CECL,” Pelagatti said.

There will potentially be changes to key metrics, regulatory requirements, and disclosures. There may be a need to use third-party data and models. “And this will be with us forever because, as soon as you record a reserve, you must start thinking about the reserve for the next quarter and the next,” he said.

From the perspective of investors and analysts, Pelagatti predicts the response to the new model could

either be to look past the reserve and normalize CECL impacts, or to have management and finance provide forward-looking projections so they can predict or model what future earnings impacts might be.

Once the large public companies begin to implement CECL, this may become clearer. “We will have to wait and see,” Pelagatti said.