CECL: It doesn’t end with adoption

After years of anticipation and preparation, the Financial Accounting Standards Board’s (FASB’s) credit loss accounting standard (CECL) is now effective for all financial institutions. Larger institutions that file reports with the Securities and Exchange Commission (SEC) adopted the standard for fiscal years and interim periods beginning after Dec. 15, 2019. All other financial institutions adopted the standard for fiscal years beginning after Dec. 15, 2022. Although adoption is technically behind us, institutions can’t stop thinking about CECL now. Working through adoption of the standard with our clients, we’ve identified several common issues that will require many institutions to enhance and refine their models, supporting documentation, and controls to better align with the standard and support the largest estimate on their balance sheet. The requirement to support critical modeling decisions doesn’t go away after adoption. FASB’s post-implementation review of the standard has also resulted in some additional guidance that institutions are required to comply with.

CECL: Lessons from the field

1. Overreliance on third-party vendors

To assist with implementation and the ongoing calculation of the allowance for credit losses (ACL), many financial institutions are using third-party services and purchased applications. Although the methodology employed by most of these third-party models aligns with the standard and provides management with the necessary tools to mechanically perform otherwise complex calculations, the reliance on a third-party doesn’t alleviate management’s responsibilities.

Management is still required to maintain documentation that supports all significant modeling decisions, from the selection of an appropriate methodology to the ongoing support for all significant assumptions. It’s not sufficient to accept vendor model recommendations without assessing and documenting appropriateness for your specific institution.

2. Inconsistent qualitative factor framework

For many institutions, a large majority of the calculated reserve still comprises qualitative factors. Qualitative factors are intended to adjust the quantitative portion of the calculation to reflect the extent to which management expects current conditions and reasonable and supportable forecasts to differ from the conditions that existed for the period over which historical information was evaluated (the lookback period).

Institutions are still assessing qualitative factors under the logic commonly used with the incurred loss model by analyzing quarter-over-quarter portfolio and macroeconomic trends; however, this analysis should be identifying differences in the portfolio and economy when compared to the lookback period.

Many institutions have also opted to use peer data to drive the quantitative portion of their calculation. When peer data is the basis for the calculation, qualitative factors should acknowledge differences between the institution’s portfolio and the portfolios of the peer group.

Qualitative factors should also be supportable on a stand-alone basis. By assessing qualitative factors using this “directional consistency” concept quarter over quarter, it’s increasingly likely that the baseline hasn’t been supported to substantiate the total impact to the calculated reserve.

3. Inadequate internal controls

While review controls over your ACL calculation are likely similar to the controls that were in place under the incurred loss methodology, many CECL models are more complex and have additional considerations.

When developing your controls over the detail review of the calculation for mechanical accuracy, it’s important not only to consider manual inputs to the calculation each quarter but also to consider the consistent application of significant model settings and selections. Some models may have change management reports that can be reviewed, while other models may require that the detail reviewer manually review setting selections.

Review controls for overall adequacy and reasonableness of assumptions also likely require enhancement with most models. While qualitative factors were likely the only assumption that needed to be assessed under the incurred loss methodology, most CECL models rely on additional assumptions that need to be assessed periodically for appropriateness.

Some common additional assumptions to consider include:

• Segmentation
• Lookback period
• Forecast and reversion period
• Prepayment and curtailment speeds
• Peer group selection
• Economic variables used to apply forecast adjustments

Models that rely on specific loan-level inputs will also require management to consider appropriate design of the controls to ensure data integrity, such as loan boarding and maintenance review controls.

Accounting Standards Update (ASU) 2022-02

1. Troubled loan modifications

ASU 2022-02 became effective for financial institutions starting in 2023. This ASU eliminates the guidance for troubled loan restructurings (TDRs) and introduces new disclosure requirements to provide information about certain modifications to borrowers experiencing financial difficulty. Like the guidance for TDRs, identification of modifications for disclosure under this new ASU still starts with assessing whether the borrower is experiencing financial difficulty; however, there’s no longer a need to assess whether the modification constitutes a concession. Instead, there are four specific modification types that require disclosure:

• Principal forgiveness
• Interest rate reduction
• Other-than-insignificant payment delay
• Other-than-insignificant term extension

Under the new ASU, loan modifications that meet the criteria for disclosure aren’t required to be individually evaluated for purposes of your ACL calculation. These modifications are assessed the same as the rest of the loan portfolio and should only be individually evaluated if they don’t share risk characteristics with the collectively evaluated population. 

Institutions should define their criteria for individual evaluation in their ACL policy. If a modification is individually evaluated, there are no longer the same requirements on how to measure the specific reserve.

Like other individually evaluated loans, if foreclosure is probable or repayment is expected through operation or sale of collateral, the calculation is based on the fair value of the collateral. If a discounted cash flow method is used, projected cash flows should be discounted using the post-modification contractual interest rate to derive the effective interest rate, which is also a change from previous guidance for TDRs.

2. Updated disclosures

The disclosures for modifications made during the reporting period that meet the identification criteria are segmented by class of financing receivable and include:

• Amortized cost basis by modification type, as well as the percentage relative to the total period-end amortized cost basis of the total class.
• The financial effect of the modification-by-modification type.
• Receivable performance in the 12 months after modification.
• The amount and amortized cost basis of financing receivables that were granted the modification in the preceding 12 months and defaulted during the reporting period.

These disclosures are required regardless of whether the modification is considered a modification of an existing loan or a new loan when assessed under the guidance within ASC 310-20.

The ASU also enhances vintage disclosures for public business entities by requiring disclosure of gross write-offs by year of origination. This disclosure should cover each of the previous five annual periods starting with the date of the financial statements. However, upon adoption of the ASU, you wouldn’t have to provide the previous five annual periods of gross write-offs. This disclosure requirement is to be applied on a prospective-transition basis so that preparers can build the five-annual-period disclosure over time.

In Part 4 of the Plante Moran CECL Guidebook Series, we provide examples of all required CECL disclosures, including the updates from this ASU.

Although all financial institutions have adopted CECL, efforts to refine models, supporting documentation, and controls will continue for some time. As your institution works to comply, common pitfalls such as overreliance on third-party services, an inconsistent qualitative factor framework, and insufficient internal controls should be addressed. Institutions should also review the 2022-02 ASU for additional post-implementation guidance from FASB to ensure compliance.