Sageworks Advisory Services PRACTICAL CECL TRANSITION GUIDANCE SUMMARY

Transcription

1 Sageworks Advisory Services PRACTICAL CECL TRANSITION GUIDANCE SUMMARY

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3 EXECUTIVE SUMMARY This chapter introduces the FASB s Accounting Standards Update , Topic 326 (CECL) standard and offers annotation to the guidance. We will be referring back to the guidance often over the course of this guide, and it is important for practitioners to have an understanding of the main provisions introduced by the standard: Scope: Assets measured at amortized cost to be presented at the net amount expected to be collected Expected Loss: Forward-looking measurement to incorporate current conditions and reasonable and supportable forecasts Contractual Life: Estimation of collectability of cashflows over the contract life of the asset, incorporating timing assumptions such as principal prepayments. Word-cloud from the ASU INTRODUCTION The guidance weighs in at a hefty two hundred and ninety-one pages, yet our principal concern is beyond the definitions and strikethroughs that comprise the majority of the document. We do not seek to replicate the guidance in its entirety within this section; rather, we seek to provide commentary on specific verbiage that will be germane in our transition methodology. Accounting guidance does not exist in a vacuum; it should be understood in the context of similar guidance and principles in GAAP. Simply reading a given update or topic cover-to-cover will not be fruitful without that context, and we further seek to provide it in this chapter. Users of this chapter should: Understand the main provisions. Understand what the guidance is requiring of the industry Understand what the guidance is not requiring of the industry Be able to justify elections, assumptions, and inputs in their modeling efforts using the accounting guidance 3

4 DEFINITIONS The ASU, as originally issued, clarifies certain definitions in pages Most notable are that of Amortized Cost Basis and Effective Interest Rate. Amortized Cost Basis The amount at which an investment is acquired, adjusted for accretion, amortization, collection of cash, previous other-than-temporary impairments recognized in earnings (less any cumulative-effect adjustments), foreign exchange, and fair value hedge accounting adjustments. FASB Accounting Standards Codification s Master Glossary The amortized cost basis is the amount at which a financing receivable or investment is originated or acquired, adjusted for applicable accrued interest, accretion or amortization of premium, discount, and net deferred fees or costs, collection of cash, writeoffs, foreign exchange, and fair value hedge accounting adjustments. FASB Accounting Standards Codification s Master Glossary, pending content ASU When considering the use of amortized cost basis for compliance with new accounting standards update, we should recall that the ALLL is a valuation account that should be used to adjust amortized cost basis to the net amount expected to be collected. Methodology elections will determine how adjustments to unpaid principal balances should be administered. Consider the following: If an entity estimates expected credit losses using a method other than a discounted cash flow method described in paragraph , the allowance for credit losses shall reflect the entity s expected credit losses of the amortized cost basis of the financial asset(s) as of the reporting date. For example, if an entity uses a loss-rate method, the numerator would include the expected credit losses of the amortized cost basis (that is, amounts that are not expected to be collected in cash or other consideration, or recognized in income). In addition, when an entity expects to accrete a discount into interest income, the discount should not offset the entity s expectation of credit losses p110, emphasis ours Note that unamortized balances should not offset credit loss expectations. Many institutions do not consider the impact of unamortized costs/(fees) within their current ALLL procedures citing immateriality. However, many institutions with acquired performing loan portfolios do offset allowance estimates with remaining fair value discount. Institutions with material acquired loan portfolios accounted for under ASC (non-pci) will likely experience the most significant impact due to the treatment of basis adjustments. Institutions handling of unamortized costs/(fees), etc. will often times determine the most appropriate treatment for consideration when estimating expected losses. If an entity, under current GAAP, recognizes unamortized costs/(fees), etc. through ALLL in the event of a chargeoff and has the ability to link such treatment to losses at the loan-level, then loss rates may be derived using amounts that are not expected to be collected or recognized in income. Alternatively, if an entity, under current GAAP, does not recognize unamortized costs/(fees), etc. through ALLL in the event of a chargeoff, then consideration of such adjustments would be asymmetrical and innapropriate. 4

5 Effective Interest Rate The rate of return implicit in the financial asset, that is, the contractual interest rate adjusted for any net deferred fees or costs, premium, or discount existing at the origination of acquisition of the financial asset. For purchased financial assets with credit deterioration, however, to decouple interest income from credit loss recognition, the premium or discount at acquisition excludes the discount embedded in the purchase price that is attributable to an acquirer s assessment of credit losses at the date of acquisition. FASB Accounting Standards Codification s Master Glossary The standard, as with many other valuation standards, requires institutions to perform discounting for future cash flows at the Effective Interest Rate (EIR). In most instances today, the EIR used for interest income recognition does not consider estimated prepayments. However, when there are inconsistencies in the loan term used to calculate EIR and the term used to project future cash flows, differences in the net amount expected to be collected will arise resulting in different allowance levels. Differences in allowance levels would remain present even where no expectations of credit loss exists. Institutions may choose, through an accounting policy election at the class of financing receivable level, whether it will use an EIR adjusted for prepayment. Prior to making this election, an impact analysis should be performed and support for the election documented. This practice was clarified in a December 2017 FASB board meeting: The Board decided to allow entities to determine the EIR and expected cash flows (including expected prepayments and defaults) using their own expectations (projections) of future interest rate environments when estimating credit losses on variable-rate financial assets using a DCF method provided those expectations are reasonable and supportable. However, the use of projections will not be required. To reflect this decision, an amendment to the FASB Codification will be drafted as a part of the ongoing Codification improvements project. FASB Memorandum, Minutes of December 13, 2017 Board Meeting, December 19, 2017, emphasis ours TRANSITION GUIDANCE These paragraphs specify the timing, required disclosures, and financial statement impacts of adoption of the standard. Readers should consult with their audit partners if unclear on which timeline impacts them. In summary: A cumulative-effect adjustment (one time) to retained earnings will be used at adoption for any increase (decrease) in reserve estimation Institutions should disclose this adjustment, the nature of the change, the nature of the adopted principle, the nature of their measurement(s), for interim and year-ending reports after the change becomes effective. Non-SEC-filing Public Business Entities (PBE) may phase-in vintage disclosures, beginning with three years and adding additional years until the disclosure requirement of five years is met. 5

6 Purchased Credit Impaired guidance (ASC ) is replaced with Topic 326. Adoption of the standard does not constitute an event for re-classification of Purchased Credit Impaired SCOPE AND EXCEPTIONS Topic 326 includes three subtopics; Overall, Financial Instruments-Credit Losses-Measured at Amortized Cost, and Financial Instruments-Credit Losses-Available-for-Sale Debt Securities. The guidance applies to all entities. Financial assets measured at amortized cost basis, including the following: o Financing receivables o Held-to-maturity debt securities o Receivables that result from revenue transactions within the scope of Topic 605 on revenue recognition, Topic 606 on revenue from contracts with customers, and Topic 610 on other income o Reinsurance receivables that result from insurance transactions within the scope of Topic 944 on insurance o Receivables that relate to repurchase agreements and securities lending agreements within the scope of Topic 860 Net investments in leases recognized by a lessor in accordance with Topic 842 on leases Off-balance-sheet credit exposures not accounted for as insurance. Off-balance-sheet credit exposure refers to credit exposures on off-balance-sheet loan commitments, standby letters of credit, financial guarantees not accounted for as insurance, and other similar instruments, except for instruments within the scope of Topic 815 on derivatives and hedging p102, emphasis ours Notably, the guidance specifically mentions its application to off-balance sheet items such as unfunded commitments. Note that unilaterally cancellable commitments do not constitute unfunded commitments for the purposes of this exercise INDIVIDUAL ANALYSIS An entity shall measure expected credit losses of financial assets on a collective (pool) basis when similar risk characteristic(s) exist (as described in paragraph ). If an entity determines that a financial asset does not share risk characteristics with its other financial assets, the entity shall evaluate the financial asset for expected credit losses on an individual basis. If a financial asset is evaluated on an individual basis, an entity also should not include it in a collective evaluation. That is, financial assets should not be included in both collective assessments and individual assessments. The new standard is much more broad than the Incurred Loss Model (ILM) in the evaluation of loans individually, broadening the concept of specific impairment as the sole criterion to the more permissive unshared risk characteristics standard. Certainly, loans that we would consider impaired under the ILM approach would meet that new standard, but institutions will need to formulate policy considerations for other criterion. Some examples might be: 6

7 Exposure size Time-to-maturity or administratively-past-due status Unique structures, industry, or geography Like under current GAAP, the standard explicitly forbids the practice of layering, that is to say, recording a specific and a general allocation on an individually evaluated asset. However, the assessment for an individual loan may result in that loan being reserved at the general rate. For example, consider a loan in the renewal process past its maturity date for which the borrower is making payments in good faith under the previous contract terms. An entity may evaluate this loan individually and apply the appropriate pool 1 reserve rate in their assessment until the renewal is complete. It may also be appropriate for an institution to evaluate a loan individually and elect to use the pool rate METHODOLOGIES FOR MEASUREMENT The allowance for credit losses may be determined using various methods. For example, an entity may use discounted cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilize an aging schedule. An entity is not required to utilize a discounted cash flow method to estimate expected credit losses. Similarly, an entity is not required to reconcile the estimation technique it uses with a discounted cash flow method. The guidance and many of its peripheral materials take pains to make clear that the use of a discounted cash flow as described in is not required by the standard. Further, different methods may be used for different pools. The language here indicates the methods enumerated in is not an exhaustive list PREPAYMENTS AND CONTRACT LIFE An entity shall estimate expected credit losses over the contractual term of the financial asset(s) when using the methods in accordance with the paragraph An entity shall consider prepayments as a separate input in the method or prepayments may be embedded in the credit loss information in accordance with paragraph An entity shall consider estimated prepayments in the future principal and interest cash flows when utilizing a method in accordance with paragraph An entity shall not extend the contractual term for expected extensions, renewals, and modifications unless it has a reasonable expectation at the reporting date that it will execute a troubled debt restructuring with the borrower p110, emphasis ours This paragraph introduces our second major change: estimation of losses over the contract life of the asset, adjusted for prepayments. Prepayment rate assumptions are material in any cashflow based modeling, and can dominate estimations of cashflows. In our modeling approach, we separately consider two pre-payment inputs: for loans with a contract principal schedule, we attempt to measure true pre-payments, often referred to as Conditional Prepayment Rate (CPR), which can come in the form of pay-off, re-financing, or periodic overpayment. For loan classes where principal payment is 1 We will use the term pool interchangeably with the standard s definition of Portfolio Segments 7

8 sporadic or voluntary, we separately measure a curtailment rate, better understood as a statistical tendency for an extended dollar of principal to be returned to the institution within a specific time period. This is the obverse of the funding rate. Both curtailment and prepayment assumptions fall under the concept of pre-payment as articulated in When using a methodology involving e.g. a cohort migration, pre-payment tendency can be modeled in an attrition analysis that would support the estimation for weighted average life, an example of an embedded consideration per FORECASTS AND AVAILABLE INFORMATION When developing an estimate of expected credit losses on financial asset(s), an entity shall consider available information relevant to assessing the collectibility of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts. An entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s). When financial assets are evaluated on a collective or individual basis, an entity is not required to search all possible information that is not reasonably available without undue cost and effort. Furthermore, an entity is not required to develop a hypothetical pool of financial assets. An entity may find that using its internal information is sufficient in determining collectibility p , emphasis ours The preceding paragraph introduces the third major change: the incorporation of reasonable and supportable forecasts also clarifies a few common misconceptions, and this clarification informs our Practical CECL approach in important ways. An institution should use judgment as to what comprises undue cost and effort. Practical CECL prefers institutions to spend their time using the data readily available. Institutions are permitted to rely on internal and external information in their estimations of collectability, though not required to use external information. As practitioners, we find that the use of external information is superior to the currently prevailing reliance on qualitative adjustment. This theme of considering all available sources is repeated in subsequent paragraphs. Qualitative considerations are still within the scope of the exercise as described in section HISTORICAL, CURRENT, FORECASTED, AND REVERTED CONDITIONS An entity shall not rely solely on past events to estimate expected credit losses. When an entity uses historical loss information, it shall consider the need to adjust historical information 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 adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, 8

9 property values, commodity values, delinquency, or other factors that are associated with credit losses on the financial asset or in the group of financial assets). Some entities may be able to develop reasonable and supportable forecasts over the contractual term of the financial asset or a group of financial assets. However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information determined in accordance with paragraph that is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period. An entity may revert to historical loss information at the input level or based on the entire estimate. An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis p , emphasis ours This paragraph provides the key conceptual underpinning of the forward-looking requirement as well as the foundation of our Practical CECL approach. Unfortunately, it is also the source of many common myths regarding the standard. It is instructive to decompose the concepts in the above: Recognition that reasonable and supportable forecasts may be sourced from outside the institution. Explicit recognition that an entity s ability to forecast may not extend to the contract life, adjusted for prepayments, of an asset class. Prescriptive guidance that beyond the reasonable and supportable forecast period, an institution should not assume a certain economic scenario (adverse, performing, etc.) but should rather revert rates or inputs to long-run means/medians. In other words, entities should consider all possibilities equally likely beyond the reasonable and supportable forecast period. Broad latitude in reversion approaches permitted. Separate concepts of historical, current conditions, forecasted, and reverted. Equally important is what is lacking from : Requirement to use loan-level details to justify any of the four periods above. Requirement to use loan-level details for an entire economic cycle. Requirement to forecast correctly and/or back-test forecasting accuracy. 2 Put another way, the guidance provides and requires a mechanism to adjust loss expectations for likely future conditions; if an institution can reasonably and supportably forecast e.g. a proximate economic downturn, the entity should increase reserves or inputs appropriately. 2 Supervisory and audit stakeholders have separately and repeatedly signaled that entities will not be examined for their ability to make correct forecasts. 9

10 Considering how to address the requirements of can be daunting and complex when considered in light of current Allowance practices, namely, the measurement of some loss experience based on some number of trailing periods. Other chapters in this guide will demonstrate how we fulfill the requirements of in a defensible, intuitive manner requiring relatively little historical loan-level details. 10

11 : OFF BALANCE SHEET (UNFUNDED COMMITMENTS) In estimating expected credit losses for off-balance-sheet credit exposures, an entity shall estimate expected credit losses on the basis of the guidance in this Subtopic over the contractual period in which the entity is exposed to credit risk via a present contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the issuer. At the reporting date, an entity shall record a liability for credit losses on off-balance-sheet credit exposures within the scope of this Subtopic. An entity shall report in net income (as a credit loss expense) the amount necessary to adjust the liability for credit losses for management s current estimate of expected credit losses on off-balance sheet credit exposures. For that period of exposure, the estimate of expected credit losses should consider both the likelihood that funding will occur (which may be affected by, for example, a material adverse change clause) and an estimate of expected credit losses on commitments expected to be funded over its estimated life. If an entity uses a discounted cash flow method to estimate expected credit losses on off-balance-sheet credit exposures, the discount rate used should be consistent with the guidance in Section p112, emphasis ours Put simply, entities will be expected to carry allocation for unfunded commitments that are not unilaterally cancelable. The exercise is conceptually simple: Estimate likely funding tendency over the weighted asset life (this would be the conceptual inverse of the curtailment tendency). Apply the appropriate reserve rate as measured for extended funds. It would be sensible to assume that funding was not extended for deteriorated credits and that the vast majority of expected funding would be into a pass-rated portfolio segment. Present estimated losses as a liability on the face of the balance sheet PURCHASED FINANCIAL ASSETS WITH CREDIT DETERIORATION (PCD) An entity shall record the allowance for credit losses for purchased financial assets with credit deterioration in accordance with paragraphs through and An entity shall add the allowance for credit losses at the date of acquisition to the purchase price to determine the initial amortized cost basis for purchased financial assets with credit deterioration. Any noncredit discount or premium resulting from acquiring a pool of purchased financial assets with credit deterioration shall be allocated to each individual asset. At the acquisition date, the initial allowance for credit losses determined on a collective basis shall be allocated to individual assets to appropriately allocate any noncredit discount or premium p112, emphasis ours This is relevant to any assets currently considered Purchased Credit Impaired (PCI) and/or accounted for under ASC (SOP 03-3) or any assets acquired after the transition date where it was determined that more than insignificant deterioration in credit quality since origination has occurred. Conversely, assets not meeting the definition of PCD will be treated in a manner consistent with any other financing receivable. This is to say that for reserve purposes, the fair value adjustments are simply treated as an adjustment to the amortized cost basis, which may not be used to offset expected credit losses. 11

12 An entity shall account for purchased financial assets that do not have a more-thaninsignificant deterioration in credit quality since origination in a manner consistent with originated financial assets in accordance with paragraphs through and An entity shall not apply the guidance in paragraphs through for purchased financial assets that do not have a more-than-insignificant deterioration in credit quality since origination p113, emphasis ours Specifically referring to PCD, the portion of the unamortized premium or discount relating to credit loss expectations would be recorded as an allowance. Any remaining portion would be recorded as unamortized premium or discount, which will be accounted for under general income recognition guidance. When recognizing interest income on purchased financial assets with credit deterioration within the scope of Topic 326, an entity shall not recognize as interest income the discount embedded in the purchase price that is attributable to the acquirer s assessment of expected credit losses at the date of acquisition. The entity shall accrete or amortize as interest income the non-credit-related discount or premium of a purchased financial asset with credit deterioration in accordance with existing applicable guidance in Section or B. p29, emphasis ours For a more detailed description of the accounting treatment for assets meeting the definition of PCD and transition from Purchased Credit Impaired (PCI) to PCD, refer to Practical Transition - Purchased Financial Assets with Credit Deterioration THROUGH 3 SUBSEQUENT MEASUREMENT Broadly speaking, these paragraphs indicate an institution should continue to estimate expected credit losses and report changes to that estimation between periods. Additional (decreased) funding for the Allowance for Credit Losses will flow through net income, as is the practice today. Institutions should generally use the same procedures for measurement in subsequent periods AND 5 COLLATERAL These paragraphs leave unchanged the collateral-test expedient for estimation currently employed under ASC analysis. The guidance clarifies the collateral value expedient should only be employed when the primary source of repayment is likely to be sale or operation of the collateral and not cash flow(s) from the borrower(s). Credit enhancements should be included in the analysis THROUGH 4 PRESENTATION Entities must separately present, on the face of the balance sheet, the allowance for credit loss as a valuation account which to be deducted from the amortized cost basis. Adjustments to the allowance will flow through the income statement similar to current GAAP. Uniquely, institutions using a discounted cash flow measurement may record the entire change in indicated allocation either as a 12

13 credit loss expense (or reversal), or elect to recognize changes due to timing as interest income, subject to additional disclosure requirements. Note that off balance sheet allocation should be recorded as a liability, to be reduced on the event of funding (realization of the asset) or expiration. Disclosures Disclosure topics are covered in Practical Transition - Disclosures 13