The current expected credit losses (CECL) impairment model applies to a broad scope of financial instruments, including financial assets measured at amortized cost. The new standard is intended to provide a more holistic review of the conditions (past, current and future) that have a potential impact on a company’s collection rate and what should be reserved for anticipated losses. Historical losses are the starting point for the CECL analysis and additional factors should be considered at transition to determine whether the historical loss rate is adequate, any increases or decreases based upon the company’s assessment of current conditions, and reasonable and supportable forecasts. There are many challenges that companies have encountered during the adoption of CECL which are discussed below.
Companies should currently be assessing the balance sheet to identify all instruments that are in scope and determining the updates that are needed to replace the legacy allowance for leases and loan losses (ALLL) methodology for all in scope assets. The historical loss model is updated by the CECL model, which should consider an assessment of both current conditions and reasonable and supportable forecasts. Companies will also need to review accounts receivable to determine if there are any risk characteristics and segmentation that would necessitate different loss rates.
Scoping
For private companies, the first step we recommend performing as part of the adoption of CECL is to identify all in scope financing receivables. The adoption of CECL will require a balance sheet scoping exercise to review and identify the below instruments which are in scope:
- Loans
- Trade Account Receivables
- Notes Receivables
- Credit Card Receivables
- Net Investments in Leases (Sales Type and Direct Financing Lessor Leases)
Off-balance sheet credit exposures not accounted for as insurance are also in scope (e.g., standby letters of credit and financial guarantees).
Risk Segmentation
CECL requires that risks that could be linked to different collection rates be addressed in separate risk pools. For example, accounts receivable for a customer located in a different geography than the U.S. or that have a higher credit risk profile may be considered separately from U.S.-based customers or customers that have higher credit ratings. CECL provides segmentation guidelines that can be used during the evaluation of the company’s risk segmentation, including:
- Internal or External (Third Party) Credit Score or Credit Ratings
- Risk Ratings or Classification
- Financial Asset Type
- Collateral Type
- Term
- Geographical Location
- Industry of the Borrower
Modeling
CECL does not prescribe a specific type of model to be used to calculate loss rates. Many examples are highlighted in the accounting standard, including cohort methods, traditional AR aging approaches, discounted cash flow and probability of default/loss given default (PD/LGD) models. Depending upon the assets in scope, the available data and internal capabilities, companies will need to determine which model best suits their needs.
Data
A widespread problem for companies has been the lack of historical data. Startups and companies that do not have any (or very limited) historical losses or limited information about their losses, frequently struggle to build an allowance that adequately considers historical information, current events, and reasonable and supportable forecasts. This is another reason why appropriate risk segmentation is a crucial activity to be performed during the implementation process to separate higher credit risk assets from any assets that have lower amounts of credit risk. In the absence of data, companies may also benchmark their loss rates with competitors in a similar industry or independently source data from publicly available information. In our experience, companies have also opted to purchase third-party data and CECL modeling tools and services to alleviate the burden and cost of performing the modeling in-house.
Operational Challenges
During the adoption of CECL, thought should also be given to the ongoing need to update CECL calculations, and approval of reasonable and supportable forecasts. New processes and activities will need to be considered as part of the overall control environment and should not be overlooked. For example, data validation, model validation, governance over the creation of loss estimate, approvals over updates to the forecast and the corresponding journal entries associated with the allowance, are all key operational and control considerations.
Summary
Adopting CECL was a monumental task, requiring consideration across a wide array of activities including scoping, data, risk segmentation, models, internal controls and news processes for banks. Even though companies do not have large loan portfolios like banks, auditors will expect, at a minimum, that companies have conducted a balance sheet scoping exercise, risk segmentation evaluation and a CECL impact assessment. We do not believe that companies can simply state that there is no impact without performing these baseline activities.
How Can We Help?
Cherry Bekaert’s CECL Technical Accounting professionals provide a full range of CECL accounting advisory consulting services, including a scoping and impact assessment memo that is auditor ready. Additionally, our CECL control validation program covers areas such as the evaluation of the CECL accounting standard and overall implementation process, assessment of key user control considerations identified related to SOC reports and management’s assessment of those controls, review of user access to CECL models and segregation of duties, and evaluation that proper management oversight and approval of the CECL estimates are operating and in place as designed.
Cherry Bekaert’s approach is to understand your business and your current allowance process, to facilitate an efficient transition to CECL and to provide practical solutions to optimize the CECL program, while demonstrating the overall conceptual soundness to management and regulators alike.
For more information on how we can help you implement CECL, reach out to your Cherry Bekaert advisor or our Accounting Advisory practice today.
