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  • 7 Min Read
  • May 16, 2019

CECL, the New Credit Losses Standard, and Clearwater Updates

This article was updated on October 29, 2019.

The current model for recognizing credit losses for many financial assets is an “incurred loss” model. Basically, this model delays recognition of losses until it is probable a loss has been incurred. This made the valuation of certain financial instruments on the balance sheet less useful or reliable, which was exacerbated by the financial crisis in 2008.

On June 16, 2016, the FASB issued Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses (Topic 326). This update requires immediate recognition of management estimates of Current Expected Credit Losses (CECL) for assets held at amortized cost. Although the CECL model does not directly apply to securities held as Available-for-Sale (AFS), updates have been made to the AFS impairment standard such as requiring that credit losses be recognized as an allowance instead of a write-down.

For public SEC filers, the updates are effective for fiscal years beginning after December 15, 2019. For all other companies, the updates are effective for fiscal years beginning after December 15, 2022.

Assets Measured at Amortized Cost

The scope of the CECL model is intended for assets held at amortized cost, including: financing receivables, Held-to-Maturity (HTM) debt securities, reinsurance receivables from insurance contracts, certain other receivables, certain net investments in leases, and off-balance sheet credit exposures not accounted for as insurance. It is required that these assets are presented at the net amount expected to be collected. The measurement of an expected credit loss must be based on relevant information of past events including historical information, current conditions, and reasonable and supportable economic forecasts. The use of a discounted cash flow model is allowed but not required. Additionally, assets with similar risk characteristics must be pooled together when estimating credit losses.

AFS Securities

While many aspects of the impairment model remain the same, there are some key differences to be aware of. Securities will still be analyzed on an individual basis and will only be considered for impairment if the fair value is less than the amortized cost basis. However, the length of time a security has been in an unrealized loss position and the volatility of the fair value of the security should not be factors to conclude that a credit loss does not exist. If an entity decides to sell the security or, more likely than not will be required to sell the security before the recovery of its amortized cost basis, the amortized cost basis should still be written down to the fair value.

For the remaining securities where fair value is less than amortized cost, an entity will still need to determine whether a credit loss exists. If it is determined that a credit loss exists, it should be recorded as an allowance rather than a direct reduction in amortized cost. The book value is the net of amortized cost and the allowance amount. The allowance is limited by the amount by which the fair value is less than the amortized cost (fair value floor).

The amount of the credit loss or allowance is the difference between the current amortized cost and the present value of future expected cash flows. A discounted cash flow model must be used and be discounted based on the effective interest rate implicit at the date of acquisition. The estimates of expected future cash flows should be based on the entity’s best estimate based on past events, current conditions, and on reasonable and supportable forecasts.

Purchased Financial Assets with Credit Deterioration

For purchased financial assets with a more than insignificant amount of credit deterioration since origination (PCD assets), the allowance for credit losses will be determined using the same guidance above once classified as either HTM or AFS. However, the initial allowance should be added to the purchase price instead of recognized as an expense (balance sheet gross up). Subsequent changes to the allowance will be recognized in the income statement. Interest income should be recognized based on the effective interest rate, excluding the initial allowance at acquisition. This allows for a nuanced approach for the initial recognition of PCD assets, but unifies their subsequent measurement with other assets.

Transition Guidance

For most assets, a modified retrospective approach to adopting the new guidance will be correct. This would mean recognizing the allowance amount with an offset to retained earnings.

For securities that have previously recognized an Other-Than-Temporary Impairment, a prospective adjustment should be used, maintaining the same amortized cost before and after the effective date.

For PCD securities, a prospective approach should also be used, including adjusting the amortized cost to reflect the addition of the allowance for credit losses.

Additional Resources

Clearwater accounting experts and product owners have followed this guidance change closely to ensure that we are prepared. Clearwater has also assembled and published a variety of resources to help investment professionals understand the new guidance and how it will likely impact their processes.

To access all these resources in one place, please download our Preparing for CECL eGuide. This eGuide includes information on how Clearwater has prepared, key system updates to expect, and more.