Guidance: CECL Standard for CDFIs
The long-awaited Current Expected Credit Losses (CECL) Standard, Accounting Standards Update 2016-13 – Financial Instruments-Credit Losses (Topic 326) will be effective for nonpublic business entities and not-for-profit entities for fiscal years beginning after December 15, 2022. This means CECL will be effective for the calendar year 2023 reporting period and fiscal year 2024 for off-year end entities (e.g., June fiscal years).
The most significant change from current accounting guidance is the change from the incurred loss model to the expected loss model. Under the new CECL model, an organization will recognize the estimated expected loss over the lifetime of the loan at the origination date and subsequently adjusted at the end of each reporting period.
Criteria for Estimated Expected Losses
The evaluation of expected loan losses should be done on a collective (pool) basis where similar risk characteristics exist (e.g., loan product type). For assets that do not fall into a collective group with similar risk characteristics, the organization will evaluate the asset on an individual basis.
Below are the main criteria used to estimate the expected losses:
- Historical Credit Loss Experience *
- Current Conditions
- Reasonable and Supportable Forecasts
*An organization shall consider adjustments to historical loss information for differences in current asset specific characteristics and consider both qualitative and quantitative factors in the assessment.
Relevant Methods to Calculate Expected Losses
Under the CECL guidance, there is no specific method to measure losses, but rather what most closely aligns to management’s expectations of expected credit losses.
Below are some relevant and cited methods for consideration:
- Discounted Cash Flow Method
- Loss Rate Method
- Roll-Rate Method
- Probability – of – Default Method
- Aging Schedule
Out of Scope Assets and Receivables
The following common assets are scoped out of the new methodology:
- Available for sale debt securities
- Financial assets measured at fair value
- Held for sale loans
- Common control loans and receivables
- Promises to give (pledges receivable) for nonprofits
The implementation of CECL to the CDFI community may differ from other lending institutions in the way CDFIs historically have been more conservative with their allowances or had/have certain loan loss covenants equal to a certain percentage regardless of performance. Some CDFIs may be in a situation where the loan loss previously recognized is greater than the historical performance adjusted for current conditions and reasonable supportable forecasts. This could cause a recognition of income to “peel back” some of the existing allowances previously recorded as a contra-asset and expense.
Some benefits of the new CECL model to the CDFI community may be:
- Improvement of profit and loss based on actual performance
- Improvement of common ratio benchmarks such as net assets/assets.
- Set aside additional Board Designated Funds for Loan Losses allowing for more flexibility
- Relief of legacy covenants