Of the lessons learned from the 2008 financial crisis, one the FASB heard loud and clear was that recording loan loss allowances as incurred is too little, too late. Enter CECL. Under the current expected credit losses (CECL) model, companies are required to recognize a financial instruments’ lifetime expected credit losses at inception. The CECL guidance applies to all types of entities (not just banks) and all financial assets carried at amortized cost (not just loans). CECL is effective beginning January 2020 for most SEC filers, but continued misconceptions that it only impacts banks have caused some companies to get a late start on their implementation efforts.
If you need to catch up, here are five areas to focus on:
- The cast (scoping): Many are surprised to learn that CECL doesn’t just apply to loans and trade receivables. Loans and loan commitments to suppliers/joint ventures/employees, financial guarantees (including off-balance sheet guarantees), net investments in leases, and contract assets, among others, are all on the program. An important first step when implementing the CECL standard is to inventory which of the company’s assets will be within its scope.
- The plot (is your data fit for purpose): No matter the model a company uses to determine its credit allowance, the quality of the output will depend on the quality of the data. A company needs to determine what data is needed to run its CECL model, the source and quality of the data available, and the gaps between the two. The availability and quality of data is often the biggest challenge faced by our clients in their implementation efforts.
- Plot twists (parallel runs can identify implementation issues): Whether a company is using a relatively simple spreadsheet, outsourcing to a third-party service provider, or building a sophisticated in-house model, the new model should be run parallel with the current credit loss system more than once. The first parallel run can be based on current information and then using estimates of January 2020 balances. Parallel runs can shed light on the effect of CECL adoption and help a company determine whether the proper controls and processes have been put in place. Knowing whether a model is pulling the right data from the right source will be critical to a smooth transition. If your company is using a third-party service provider, management needs to have an understanding of where the service provider is getting its information and how the model is working, and needs to ensure sound end-user controls are in place.
- Next season (start thinking about day two): Like any accounting standard, an important part of CECL implementation is building controls and processes. These processes should be built to address every step of the process, from scoping and data collection to financial statement disclosure and other stakeholder communication. In addition, processes should be flexible enough to allow for changing economic and business conditions, the future availability of information, and other refinements management may plan for the future. Companies using a third-party service provider should develop a contingency plan in case the service provider isn’t able to perform as agreed.
- The red carpet (disclosure and stakeholder communication): While some preparers may be tempted to delay developing financial disclosure and other investor communications, waiting will put them behind a season. Given the judgments involved in developing expected credit losses, stakeholders will want to understand what the numbers mean. Companies will need to balance providing sufficient data and insights to allow for a deeper understanding without drowning stakeholders in too much data. Thinking through how your company will help stakeholders understand the new credit loss number, the key drivers, and the indicators of how the credit loss number will change in the future will be challenging and should be tackled sooner rather than later.
The FASB’s intent with the CECL standard was to provide a model that is scalable to the sophistication of the entity. Small companies with relatively simple financial asset types may have simple models to calculate expected credit losses while sophisticated companies with complex financial assets may require more complex models. Despite this scalable model, some companies (particularly non-financial services companies) are playing catch up. Fortunately for some, the FASB has delayed the CECL effective date for smaller reporting companies, private companies, and not-for-profit entities to 2023. But regardless of whether you have weeks or years, make sure CECL is at the top of your must-see list.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
By Heather Horn, PwC US Strategic Thought Leader, National Office