7 Models to Consider When Implementing the FASB’s New Credit Losses Standard
The Financial Accounting Standards Board has finalized its credit loss standard, Accounting Standards Update 2016-13—Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The new standard marks the end of accounting for credit losses using the Incurred Credit Loss model and replaces it with the Current Expected Credit Loss (CECL) model. The standard will have a significant impact on financial institutions. Additionally, it will apply to most debt instruments, trade receivables, lease receivables, reinsurance receivables, financial guarantee contracts and loan commitments.
Since the FASB did not restrict the type of methodologies institutions can use when implementing the new standard, I recommend that CPAs working at financial institutions, along with CPAs with financial institution clients, begin reviewing the different models now. You will want to consider the specific portfolio makeup of your or your clients’ institutions when deciding which method will work best. Here are some of the more common models currently in use by financial institutions that can be modified and used under the new standard:
- Discounted cash flow analysis. In one of the most widely used models in current practice, the discounted cash flows are calculated using the present value of expected future cash flows discounted at the loan’s effective interest rate. This type of analysis is one of the currently prescribed methods for measuring impairment on an individual impaired loan.
- Average charge-off method. The most commonly used approach for evaluating impairment on pools of financial assets, this method is fairly straightforward relative to many other approaches. This method calculates an estimate of losses primarily based on past experience.
- Vintage analysis. In this method, impairment is based on the age of the accounts and the historical asset performance of assets with similar risk characteristics. Those who adopt this methodology typically have financial assets that follow patterns or loss curves comparable and predictive for subsequent generations of financial assets (indirect auto loans, for example).
- Static pool analysis. This method is typically confused with the vintage analysis. The main difference is that a vintage analysis is based on the year of origination and/or the age of the asset while static pool analysis is based on a type of shared pooling criterion and assets originated in a similar time period.
- Roll-rate method (migration analysis). Roll rates in this method are determined by predicting credit losses by segmentation (by delinquency or risk rating, for example) of a portfolio of financial assets.
- Probability-of-default method. This modelling method incorporates three components: probability of default, exposure at default, and loss given default. It is used by many risk management systems and within the Basel II and Basel III frameworks.
- Regression analysis. This is one of the more complex models. Essentially, an institution uses statistics to determine an estimate of credit losses (the dependent variable) based on one or multiple inputs (independent variables).
Whichever model the institution decides to use will depend on the specific portfolio makeup of that institution. Hopefully most institutions have already devoted some time and resources toward researching how to implement the standard. If not, the time is now. The standard is effective for business entities that meet the definition of an SEC filer, for fiscal years (and interim periods within those fiscal years) beginning after December 15, 2019. For other public business entities, the standard will be effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For all other entities, including not-for-profit organizations and employee benefit plans, the standard will be effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. Early adoption will be permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those
The AICPA is here to help. The AICPA’s Financial Instruments webpage contains up-to-date information on the new standard. Additionally, the AICPA is hosting a webcast providing an overview of credit losses on financial instruments on July 28 at 2 p.m. ET. Several sessions at the National Conference for Banks & Savings Institutions on September 21-23 in Washington, DC as well as the Conference on Credit Unions on October 24-26 in Orlando, FL will be devoted to discussing Current Expected Credit Loss (CECL) implementation. In addition to attending the sessions, conferences are a great way to network with other practitioners and professionals working at financial institutions and learn what models they are considering.
Salome Tinker, Senior Technical Manager- Accounting Standards, American Institute of CPAs.
Financial instruments image courtesy of Shutterstock