CECL implementation: Four focus areas for affected companies
Executives who oversee this reporting need to understand that it will affect calculations on quarterly forms as early as the first quarter of 2023. While the change may not show up in financial statements until calendar year 2023 financials are prepared and issued in 2024, affected companies need to be up and running and able to make quarterly reports under the new standard in the next few months. With that in mind, here are four key areas of focus for those who are working to implement in the near term.
Executives who oversee this reporting need to understand that it will affect calculations on quarterly forms as early as the first quarter of 2023.
Calculations under the new CECL model
While the new CECL accounting standard still includes quantitative and qualitative factors, the overall goal of the change was to create a more principles-based high-level model that isn’t always explicit when it comes to the specific calculations that each company could perform. As a result, different CECL software packages can take different approaches to calculations that need to be verified against the company's loan documentation and other software programs. The key to supporting the calculation is to carefully document the methodology, inputs, and assumptions to ensure consistency and accuracy.
Companies that have relied on software to implement CECL models have at times encountered conflicts between their CECL programs and other related functions. For instance, companies that rely on asset liability management (ALM) software to source a prepayment rate have at times found conflicts in the way that ALM and CECL programs approach prepayments — a critical component of calculating the lifetime expected loss. If ALM software calculates prepayments at the beginning of the month and CECL calculates at the end of the month, a company can wind up with a conflict in logic between two programs that both contribute important information to financial statements.
CECL disclosure requirements & dry runs
The new CECL accounting standard modifies the financial statement disclosure requirements. While many of the disclosures are similar to the current disclosure requirements, there are key differences that must be understood. (For additional guidance, see our 2022 CECL guidebook, which provides illustrations of disclosures that companies will need for compliance with the new rules.)
Regardless of how a company prepares its CECL disclosures, it’s critical to practice preparing them before the required filing deadline. Some companies will rely on software that generates disclosures. Others will utilize software that performs calculations but doesn’t draft disclosures, and still others will use existing spreadsheet processes to meet the new requirements instead of licensing CECL-specific software. At the end of the process, the tables include key information such as outstanding loan amounts, loan vintages, and other critical data as described in the CECL guidebook.
Validation of a company's CECL model
Lastly, it’s important to take a step back and look at how the CECL model will fit into the overall risk mitigation structure of the company. A model risk management framework is part of the following three lines of defense against problems that can result in a material misstatement in the financials:
- First line: Management executes on processes and controls.
- Second line: Validation for software and models.
- Third line: Internal audit.
Because implementation of this new standard can rely heavily on the use of software, FDIC regulatory rules for companies would typically require a validation review every 12–18 months. Validation challenges a lot of the company's governance around the model itself. It compares the documentation to regulatory requirements to verify that management has an effective layer of governance to ensure the process is operating the way that it should.
CECL capital impacts can phase in
The move from the pre-CECL “incurred loss” model to the CECL accounting standard’s “lifetime expected loss” calculation is likely to require an increase in the overall expected reserve for companies. As companies come into compliance with the new standards, they will offset the increase to the allowance with an adjustment to beginning equity, net of tax. That increase can have an impact on FDIC regulatory capital requirements. Fortunately, the regulatory rules allow for a three-year phase-in period to soften the blow of that equity hit for affected companies.
Trends provide insights to changes at affected companies
It’s helpful to keep in mind the trends for allowances as a percentage of loans among those companies that have already adopted the CECL accounting standard. Among the companies that adopted as of Jan. 1, 2020, the average allowance coverage ratio went from 1.04 to 1.23%, which equates to an approximate 18% increase. In the intervening years since that first group adopted, the talk of recession has increased significantly, and many forecasts for credit losses are based on the occurrence of anything from a mild to a severe economic downturn. Those forecasts could be expected to result in even higher percentage increases in allowances at adoption as companies move to the CECL model for 2023.
At the same time, industry feedback from auditors and regulators seems to have had more focus on the documentation and support for the calculation rather than the number itself. While executives leading companies through this adoption will certainly need to be aware of changes to the actual numbers, the key elements to stress to those involved in the process are the documentation and support of the calculations.