Current Expected Credit Loss (CECL) final standard: Update

When last we blogged about the Financial Accounting Standards Board’s (FASB) new “current expected credit losses” (CECL) model for estimating an allowance for loan and lease losses (ALLL), we reviewed the process for developing reasonable and supportable forecasts for use in establishing the ALLL. Once you develop those forecasts, how does that information translate into amounts to set aside for loan losses?

A portion of the ALLL will continue to be based on specifically identified loans you’re concerned about. For those loans, you will continue to establish a specific component of the ALLL based on your estimate of the loss ultimately expected on the loans.

The tricky part, of course, is estimating an ALLL for the other 99% of the loan portfolio. This is where the forecasts come in. The new rules do not prescribe a particular methodology, and banking regulators have indicated community banks will likely be able to continue with their current approach, adjusted to use appropriate inputs in a manner that complies with the CECL model. One of the biggest challenges is the expectation in CECL that the ALLL will be estimated using the institution’s historical information, to the extent available and relevant.

Following is just one of many ways  you can approach it. I’ve also included a link at the end of this article to an example illustrating this approach.

Step One: Historical Loss Factors

1. First, for a given subset of the loan portfolio (e.g., the residential loan pool), you might first break down the portfolio by the number of years remaining until expected payoff (via maturity or refinancing). This is important because, on average, a loan with seven years remaining until expected payoff will have a higher level of remaining lifetime losses than a loan with one year remaining. It therefore generally wouldn’t be appropriate to use the same loss factor for both loans.
    
2. Next, decide on a set of drivers that tend to correlate with loan losses over time. FASB has indicated it doesn’t expect highly mathematical correlation models will be necessary, especially for community banks. Instead, select factors in your bank’s experience indicative of future losses. These may include:
   • External factors, such as GDP growth, unemployment rates, and housing prices
   • Internal factors such as delinquency rates, classified asset ratios, and the percentage of loans in the portfolio for which certain policy exceptions (e.g., loan-to-value ratio or minimum credit score) were granted
      
3. Once you select this set of drivers, find an historical loss period — a period of years corresponding to the estimated remaining life of the portfolio in question — where the historical drivers best approximate those you’re expecting in the future, based on your forecasts. For that historical loss period, determine the lifetime remaining loss rates of the loans outstanding at the beginning of that period, broken down by the number of years remaining until payoff. (This may require significant data mining, especially if that historical loss period was quite a few years ago.
    
4. Apply those loss rates to the breakdown derived in (a) above, by years remaining until maturity.

   Step Two: Adjustments to Historical Loss Rates

   The CECL model requires we adjust historical loss factors for conditions that may not be adequately captured by the historical loss period analysis we’ve just described. Let’s say a particular geographical subset of your market area is significantly affected by the economic fortunes of a large employer in that area.  Based on economic trends or recent developments, you might expect that employer to have a particularly bright – or dim – future over the forecast period; accordingly, you forecast loans to borrowers in that area will have losses that differ significantly from the rest of the portfolio.

   The approach for these loans is the same as in the previous step. However:

   These loans would be segregated from the remainder of the portfolio, which would be subject to the general approach in step one. As you think through this approach, there are myriad variations and many decisions to make, such as:

   Our intent in describing this methodology is to help your CECL implementation team start the dialogue in terms of converting theoretical concepts in the CECL model to actual loans and historical experience.

   To facilitate that discussion, we’ve included a very simple example here that illustrates the steps described above. Analyzing an entire loan portfolio under the CECL model is an exponentially more complex process, but the concepts are the same — forecasting future conditions, and establishing an ALLL based on the bank’s (or, when necessary, peers’) lifetime loan loss experience under similar historical conditions.

   Given the amount of number crunching and analysis necessary, and the potentially significant increase in the ALLL that may result from a lifetime-of-loan loss model, it’s safe to say the time to start is now! If you have any questions about CECL implementation, please contact Tracy Harding or Rob Smalley.

   Other resources
   For more information on CECL, check out our other blogs:

   CECL: Where to Start
   CECL: Bank and Branch Acquisitions
   CECL: Reasonable and Supportable

   To sign up to receive notification of our next CECL update, click here.

   • In substep (c), you would focus on forecasted conditions (such as unemployment rate and changes in real estate values) in the geographical area in which the significant employer is located.
   • You would then select an historical loss period that had actual conditions for that area that best correspond to those you’ve just forecasted.
   • In substep (d), you would determine the lifetime remaining loss rates of loans outstanding at the beginning of that period.
   • In substep (e), you would apply those rates to loans in that geographic area.
   • How to break down the portfolio
   • Which conditions to analyze
   • How to analyze the conditions for correlation with historical loss periods
   • Which resulting loss factors to apply to which loans

By now, pretty much everyone in the banking industry has heard plenty of talk about CECL – the forthcoming “Current Expected Credit Loss” model of accounting for an institution’s allowance for loan losses (ALL). While the previous “Incurred Loss” model has been problematic to implement conceptually, and most of us thought CECL would improve ALL accounting and make it more comparable to how banks account for other debt instruments, it’s beginning to feel a bit like the dog who caught the car – now that we have this model, how the heck do we implement it?

The good news: We have a number of years before CECL’s effective date, and thus have some time to better understand the new rules and how to adapt an institution’s ALL model to reflect them. The bad news – the banking regulators recently announced they want banks to get cracking on this, and will expect to see some progress when they visit during upcoming exams – maybe not immediately, but likely at some point during the 2017 exam cycle.

This is the third in a series of articles addressing various aspects of this complex pronouncement. We hope that they provide you with practical advice that can help you get started on the nuts and bolts of CECL implementation.

Our previous article offered pointers on building the CECL team, brainstorming the process, and starting the data gathering conversation. In this article, we look at how to implement CECL when acquiring another bank, one or more branches of another bank, or simply a loan portfolio, such as a group of auto or credit card loans.

First, let’s remember the basics

The basic premise of CECL is that lifetime expected losses are to be booked at origination (or, in the case of an acquisition, at the acquisition date). You’ve likely heard some gnashing of teeth over the fact that this means losses are recorded “on Day One”, which many of us have some degree of conceptual difficulty with: For example, a higher risk loan will likely carry a higher yield at origination, so booking a higher level of expected losses on Day One (through the ALL) and the offsetting higher yield over the loan term (through interest income) feels like a mismatch between income and expense.

The Financial Accounting Standards Board (FASB) was sympathetic to this point, and spent a lot of time pondering it. Its international equivalent, the International Accounting Standards Board (IASB), which establishes – you guessed it – international accounting standards, actually tackled this issue by precluding Day One losses, unless they were expected to materialize within one year of origination (Day 365 losses?).

This approach, however, has led to a fairly convoluted – and challenging – model, which is already drawing a fair amount of criticism in the international community. In the end, although they had hoped to have a “converged” standard that would result in the same approach for U.S. and international institutions, FASB and the IASB decided to part company and use different models.

The short answer? We have to accept the notion of Day One losses as the price to pay for a less convoluted (but still complex to implement) model. This becomes important to remember as we look at accounting for acquisitions.

Accounting for acquisitions

Whether you’re acquiring a pool of loans, a branch, or an entire institution, the basic accounting under CECL is the same, and it’s the same (with a twist) as the accounting for originated loans: an ALL should be established for the purchase price allocated to the loans, and that ALL should reflect management’s estimate of the lifetime losses in the acquired portfolio.

Before we get into the details of how to do this, let’s take a moment to celebrate. Prior to CECL, it was not permissible to establish an initial ALL for acquired loans. Many bankers – and investors – complained that this made it difficult to compare one bank to another on metrics such as ALL coverage ratios. If one bank had a strategy that included acquisitions, and another didn’t, their ALLs would likely be quite different even if their loan portfolios and estimated incurred losses were similar. Now, with the CECL model, these two banks’ financial statements are much easier to compare.

As noted above, an ALL should be established for these loans under CECL, using the same methodology you would use for originated loans. The twist relates to what to do with the other side of the entry. The solution:

• For loans with a more-than-insignificant amount of credit deterioration since origination, the offset is to add this amount to the amount originally recorded for the purchase price allocated to the loans.

• For the rest of the acquired portfolio, the offset is to loan loss expense. That’s right, your provision is increased by the amount of ALL recorded in the transaction, except as noted in the previous bullet.

Why is this so? FASB is apparently assuming that:

• Buyers adjust the purchase price for the first item above. These loans, which we used to call “purchased – credit impaired (PCI)”, and now will call “purchased – credit deteriorated (PCD)” under CECL, are the loans with hair on them. They probably got some extra scrutiny during due diligence, thus theoretically depressing the purchase price a bit. Therefore, the amount of the purchase price allocated to loans is a lower number, and offsetting the establishment of the ALL by adding that amount to the purchase price assigned to the loans properly “grosses up” the recorded loan balance.

• Buyers don’t adjust the purchase price for other loans. This is probably true, as the lifetime losses on loans that aren’t PCD are just the cost of doing business for financial institutions. Therefore, as it is with originated loans, a big Day One provision is booked at closing.

It should be noted that the extent to which the definition of PCD loans differs from the previous definition of PCI loans depends on your interpretation of the old PCI definition. It appears clear that the new definition of PCD loans refers to loans that have specific indicators of significant credit deterioration since origination.

Let’s look at an example:

A bank buys three branches from another bank, which have total loans with a principal balance of $20 million and a fair value of $20,100,000. The portfolio includes loans with a principal balance of $1 million, and a fair value of $910,000, that are PCD.

The buyer bank determines the ALL under CECL would be $100,000 for the PCD loans and $475,000 for the rest of the acquired portfolio. Thus, the buyer bank records an ALL of $575,000. What’s the offset? As noted above:

• For the PCD loans, the offsetting $100,000 will be added to the $910,000 of purchase price allocated to those loans. As a result, these loans will have a gross amount allocated of $910,000 plus $100,000, or $1,010,000, which will then be reduced by an ALL of $100,000 on the balance sheet, for a net reported amount of $910,000 (their fair value). The difference between the gross amount assigned ($1,010,000) and the principal balance ($1 million), or $10,000, represents an implied adjustment to reflect current market interest rates, and is therefore amortized over the expected loan term through interest income.

• For the rest, the offsetting $475,000 will be an increase to the provision for loan losses, and will thus reduce income.

The last number could be a big one for institutions that do large or frequent acquisitions; thus, their balance sheets may be more comparable to other banks, but their income statements in the year of acquisition won’t be! The good news – like other acquisition costs such as legal fees and conversion expenses, this amount will be separately disclosed, so a reader can adjust for it if they believe it’s appropriate to do so.

Next time, we’ll look at the nuts and bolts of CECL’s concept of “reasonable and supportable” by considering proper documentation and controls over the ALL.

The Ramifications of Fraud and How You Can Prevent it

Welcome to part two of our article on nonprofit fraud. If you missed our first installment, you can read it here.

You’ve just become aware of a fraud that has occurred at a nonprofit in your community. As someone who cares about the community and the nonprofit sector, you start to wonder, “What is going to happen to that organization”?

While the ramifications can differ in each case, they probably will include some, if not all, of the following:

• The board and management will want to understand how the fraud happened, and what management is doing to prevent it from ever happening again.
• The community is going to look to the board for answers, and wonder why the organization didn’t have controls in place to prevent the fraud.
• Management will be expected to explain to the board where the breakdown in controls occurred that allowed the employee to steal from the organization.
• The board knows it has a fiduciary duty to oversee the organization and its internal controls and assets. They aren’t sure what they should have done differently, given that they’re volunteers doing this community service in addition to their “day jobs.”
• The board and management will want to reach out to donors to assure them that their contributions to the organization are going to be recovered if possible, and that controls are being improved to help safeguard future gifts.

This organization could potentially lose major donors if they believe there are not enough controls in place to ensure their dollars are being spent according to their wishes. If enough donors are negatively affected by this event and choose not to support the organization, its very survival may be at stake, thus impacting those in the community the entity serves.

Management will now have to divert time and other resources not only to implement stronger internal controls to help ensure this does not happen again, but also to reassure the board and the public that the organization is well protected to prevent future fraud.

Fraud can be extremely costly to an organization, not only from a financial perspective, as often the organization will not recover the stolen funds, but also from the loss of an organization’s reputation as a trusted charity. This can be even more devastating. The organization may never recover in the public’s eye, risking their relationships with not only their long-time donors but also new and future donors.

What can you do?

So, what can you do to help prevent fraud from recurring, or to detect it quickly if it does? Here is a simple, yet effective three-step process:

1. Consider the risks of fraud and determine where it is more likely to occur.
2. Look closely at the internal controls the organization currently has in place and determine whether they address these risks sufficiently.
3. Identify gaps where controls are inadequate, and identify controls to be put in place where they are most needed.

Organizations can also consult their auditors to seek advice and guidance on how to implement these very important internal controls. It may be prudent to review previous audits to see if auditors have brought risks to management’s and the board’s attention, and if they provided recommendations on how to improve their current control structure.

The silver lining? The board and management now have a keener sense of the risks of fraud in the nonprofit environment, which should contribute to an engaged dialogue among the board, management and the auditors about how to develop and implement cost-effective controls that protect the organization’s assets.

As part of the audit, the auditors may point out one or more shortcomings in controls that they believe constitute a “material weakness.” While that may sound ominous, it merely means (in auditing jargon) a situation involving a reasonable possibility of a material misstatement of the financial statements. Auditors tend to set the bar low when it comes to classifying deficiencies that create fraud risks as material weaknesses, for the simple fact that users of the financial statements (donors, lenders, other funders) tend to have a lower materiality threshold with respect to misstatements caused by theft.

It is also important to remember that control deficiencies noted in previous audits that may not have been considered material weaknesses in the past may be considered that way today, as expectations of management’s actions regarding fraud prevention and detection go up every time a nonprofit fraud incident hits the media.

Every organization that has more than one person (including board members) associated with it has the opportunity to segregate incompatible duties at some level to help protect assets. At times, organizations don’t have such segregation in place, but instead have implemented compensating controls, such as detailed review of monthly financial statements by the appropriate level of management and/or the board. If this is the case, the organization should ask itself the following questions in order to avoid over-relying on this compensating control:

• How does this compensating control work? Who reviews the financials, what is their experience level, and how do they document their review to confirm that it’s being done?
• How often do you question expenditures, and are these questions and their answers evaluated and documented? It is important to remember here that a fraudster would be working hard to escape detection by this compensating control.
• If the compensating control is a detailed review compared to budget:
  • Who is involved in building the budget?
  • What are the controls that would protect against a fraudster building their theft into budgeted expense line items?

Take a proactive fraud risk assessment and response like the one described here to give you reasonable comfort proper controls are in place to prevent and/or detect fraud. This isn’t about being paranoid – it’s simply a matter of prudently carrying out your fiduciary and management responsibilities to protect the organization you feel so strongly about.

Remember, the one characteristic that every financial theft in history shares—someone was trusted at some point.

It’s Monday morning. You grab a cup of coffee and flip on the local morning news before you get ready for work. The lead story catches your attention “Local Accounts Payable Manager Steals Thousands.” Based on your experience as a board member of a nonprofit organization and the prior fraud you’ve heard about in the community, three things come into your mind:

1. The fraud involves either a nonprofit organization or local government.
2. The Board will come out and say how shocked they are – Fred has been here forever, and we trusted him!
3. The Board will state they have now put in place proper controls to ensure this will never happen again.

And you may be close to the mark. Nonprofits and governmental organizations often have a higher risk of fraudulent behavior and theft due to their limited resources and ability to implement strict fraud prevention controls. What makes these organizations so susceptible?

• They frequently run on tight or breakeven budgets, which means they have difficulty hiring enough people to implement strict internal controls.
• They often have a salary structure that is lower than that of for-profit companies, creating incentive for employees to commit theft in order to make ends meet.
• They are sometimes targeted by unscrupulous individuals who know that they likely lack the resources available to stop them.

In addition, nonprofits often seek to hire people who believe in the mission. While this can lead to tireless, dedicated employees, certain side effects of this approach may come into play and increase the risk of theft. For example:

• The passion for, and shared commitment to, the mission at many nonprofits give rise to a culture of trust. This culture of trust may cause the organization to be less likely to implement checks and balances critical to sound internal controls.
• New employees are sometimes drawn to a specific nonprofit organization because they have experienced some of the challenges which the organization was formed to address. Working for the organization may help them in some ways, but it may also create more financial strain for them or family members, increasing the chances of them committing illegal acts.

There are three elements that must be present for fraud to occur. These are the three sides of what is collectively called the fraud triangle: opportunity, incentive, and rationalization.

• Opportunity: an employee working at a nonprofit may have opportunity if they are a trusted employee and resources are limited, causing the internal controls to be less robust than they should be.
• Incentive: the incentive is in place when an employee, as mentioned above, has unexpected events happen in their life that may pressure them into committing fraud.
• Rationalization: the employee rationalizes that they need the money for their family to survive. This often starts as “I’ll just borrow the money until payday”. Unfortunately, payday arrives and the funds aren’t available to be repaid; in fact, they need to “borrow” just a little more.

Let’s be clear, though – many nonprofits, regardless of size, have appropriately designed and implemented controls that properly protect the organization from the risks of fraud.

Soon we’ll look further at the ramifications frauds can have for nonprofits and how any organization—even small nonprofits, can put certain internal controls in place, to reduce the chances they’ll be the next organization in the headline story of the morning news.

I have to say, accountants have really been taking some uncalled-for heat for causing the 2008 financial crisis. I understand the need to identify scapegoats, but when people hire mortgage brokers to originate bad loans, sell interests in those bad loans to investors, and insure it all through AIG, is it really the accountants’ fault when those loans go bad? And if the federal bank examiners missed the fact that Fannie Mae and Freddie Mac were engaged in such shenanigans, what hope do we have of being able to adequately apprise investors of such details via financial statement disclosures?

Undaunted, FASB has taken a shot at developing new requirements for banks to report information in their financial statement footnotes about their exposure to liquidity and interest rate risk. I understand the pressure FASB is under, I really do. There’s something called the Group of Twenty, consisting of the top finance officials from the 20 largest industrialized countries, that’s been pressuring FASB to improve accounting rules in a manner that will somehow prevent future financial meltdowns. To me, the Group of Twenty sounds uncomfortably similar to the Gang of Four, which ran China with an iron fist back in the Sixties and Seventies, so, if I were FASB, this group would make me nervous, too.

On the surface, it seems reasonable to expect that more information about liquidity and interest rate risk experienced by banks would be a good thing, as these are probably the two risks you hear about most when banks fail. Dig deeper, though, and two points about these new proposed disclosures become apparent:

1. Most of this information is already available to users, through SEC and bank regulatory filings.
2. To the extent it isn’t, that’s because no one uses the information, not even management of the banks!

It would be interesting to look back at some of the banks that failed during the recent recession, identify which of the proposed disclosures weren’t already available to investors and regulators, and decide whether anyone would have reacted differently if they were. Or was it simply the case that bad business decisions were made, and, when that happens, companies go under? And when recessions hit, sometimes banks fail?

I remember a TV interview during the height of the 2008 crisis, in which the focus was on blaming stock analysts (they hadn’t gotten around to accountants yet). The interviewer asked, “How many stock analysts do we have to hang on Wall Street before they all get the message?” The expert he was interviewing said, “Probably just one.” I’m guessing that holds true for accountants, too. There are already rules in place to disclose significant risks, concentrations, obligations of the institution, and the like. If Lehman Brothers and AIG don’t follow them, appropriate sanctions (I’m not advocating hanging, mind you) should follow; we can pass more rules, but if they didn’t comply with the existing rules, what makes us think they’ll follow the new ones?

If you have questions, please reach out to Tyler Butler or Tracy Harding.

Read this if you are a CFO, CEO, COO, or CLO at a financial institution.

The preparation of financial statements by financial institutions involves a number of accounting estimates, some of which can be quite complex. As these estimates are often a significant focus of audits of those financial statements, financial institution personnel affected by the audit process might benefit from a discussion of the rules auditors need to follow when auditing estimates.

Accounting estimates

Across all industries, there are financial statement items that require a degree of estimation because they cannot be measured precisely. These amounts, called accounting estimates, are determined using a wide array of information available to management. In using such information to arrive at the estimates, a degree of estimation uncertainty exists, which has a direct effect on the risks of material misstatement of the resulting accounting estimates. For financial institutions, common examples of accounting estimates include the allowance for loan losses, valuation of investment securities, allocation of the purchase price in a bank or branch acquisition, and depreciation and amortization of premises and equipment, in addition to intangibles and goodwill. 

For entities other than public companies, the auditing rules are established by the American Institute of Certified Public Accountants’ Auditing Standards Board (ASB). Under these requirements a financial statement auditor has a responsibility to assess the risks of material misstatement for accounting estimates by obtaining an understanding of the following items: 

• The requirements of generally accepted accounting principles (GAAP) relevant to accounting estimates, including related disclosures. 
• How management identifies those transactions, events, and conditions that may give rise to the need for accounting estimates to be recognized or disclosed in the financial statements. In obtaining this understanding, the auditor should make inquiries of management about changes in circumstances that may give rise to new, or the need to revise existing, accounting estimates. 
• How management makes the accounting estimates and the data on which they are based. 

This final item—determining how management has calculated the accounting estimate in question—includes the following specific aspects for the auditor to address:

• the method(s), including, when applicable, the model, used in making the accounting estimate; 
• relevant controls; 
• whether management has used a specialist; 
• the assumptions underlying the accounting estimates; 
• whether there has been or ought to have been a change from the prior period in the method(s) or assumption(s) for making the accounting estimates, and if so, why; and 
• if so, how management has assessed the effects of estimation uncertainty. 

Professional skepticism

When analyzing management’s assessment of the effects of estimation uncertainty, the auditor needs to apply professional skepticism to the accounting estimate by considering whether management considered alternative assumptions, and, if a range of assumptions was reasonable, how they determined the amount chosen was the most appropriate. If estimation uncertainty is determined to be high, this is one indicator to the auditor that estimation uncertainty may pose a significant risk of material misstatement. An identified significant risk requires the auditor to perform a test of controls and/or details during the audit; in other words, analytical procedures and testing performed in previous audits will not suffice. 

CECL considerations

For audits of financial institutions, including those that have implemented the FASB CECL standard as well as those still using the incurred loss method, the allowance for loan losses will likely be deemed a significant risk due to its materiality, estimation uncertainty, complexity, and sensitivity from a user’s perspective.   

Additional factors the auditor needs to consider include whether management performed a sensitivity analysis as part of its consideration of estimation uncertainty as described above, and whether management performed a lookback analysis to evaluate the previous process used. Auditors of accounting estimates are required to do at least a high-level lookback analysis to gain an understanding of any differences between previous estimates and actual results, and to assess the reliability of management’s process. 

Auditing estimate procedures

Procedures for auditing estimates include an evaluation of subsequent events, tests of management’s methodology, tests of controls, and, in some instances, preparation of an independent estimate by the auditor. Tests of management’s method and tests of controls, including auditing the design and implementation of controls, are the most practical and likely procedures to apply to audits of the allowance for loan losses at financial institutions, both under the current guidance and following adoption of the current expected credit loss (CECL) method under Financial Accounting Standards Board (FASB) Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. As FASB has not prescribed a specific model, auditors must be prepared to tailor their procedures to address the facts and circumstances in place at each respective financial institution. 

In addition to auditing management’s estimate, auditors have the responsibility to audit related disclosures, including information about management’s methods and the model used, assumptions used in developing the estimate, and any other disclosures required by GAAP or necessary for a fair presentation of the financial statements. Throughout the audit process, auditors need to continue to exercise professional skepticism to consider what could have gone wrong during management’s process and to assess indicators of management bias, if any. 

For public companies, the Public Company Accounting Oversight Board (PCAOB) specifies auditors must evaluate both evidence that corroborates and evidence that contradicts management’s financial statement assertions in order to avoid confirmation bias. When considering the assessment of risks, as risk increases, the level of evidence obtained by the auditor should increase. As with audits of private companies, the auditor needs to consider whether the data is accurate, complete, and sufficiently precise and detailed to be used as audit evidence.

An added consideration under PCAOB rules is that the auditor is typically opining on the institution’s internal controls as well as its financial statements. This may restrict the results of control testing performed by parties independent of the function being tested from being used as audit evidence from a financial statement audit perspective. For financial institutions, this is often the case with independent loan review, since the loan review is considered part of the institution’s internal control upon which the auditor is opining. 

Supporting evidence

As with the incurred loss method, PCAOB auditing standards will require the auditor consider how much evidence is necessary to support the allowance for loan losses under CECL. All significant components of management’s allowance for loan losses estimate, including qualitative factors, will need to be supported by institution-specific data. If such data is unavailable (for example, because the institution introduces a new type of loan offering), the FASB standard indicates appropriate peer data may be acceptable. In such cases, management and the auditor may need to understand the controls in place at the vendor providing the peer data to determine its reliability. You may provide this information in the form of System and Organization Controls (commonly know as SOC1) reports of the vendor’s system.  

Recently, the International Auditing and Assurance Standards Board revised its auditing rules for estimates, with a goal of enhancing guidance regarding application of the basic audit risk model in the context of auditing estimates. The revised rules require that auditors must separately assess inherent and control risk when obtaining an understanding of controls, identifying and assessing risks, and designing and performing further audit procedures. The ASB seeks convergence of rules both internationally and domestically, and has therefore proposed changes to its requirements for auditing estimates to align with the IAASB revised rules. The ASB’s proposal on these changes indicated they would be effective beginning with audits of fiscal year ending December 31, 2022; the final effective date will be determined in conjunction with its issuance of the final rules.

The best CECL approach 

The best approach to take? Management should discuss planned changes to estimate the process with your auditors to get their perspective on best practices under CECL. Key areas to review in the discussion include documenting the decision-making process, key players involved, and the resulting review and approval process (especially for changes to methods or assumptions). Always retain copies of your final documentation for auditor review. If you would like more information, or have a specific question about your situation, please contact the team. We’re here to help. 

Recently, federal banking regulators released an interagency financial institution letter on CECL, in the form of a Q&A. Read it here. While there weren’t a lot of new insights into expectations examiners may have upon adoption, here is what we gleaned, and what you need to know, from the letter.

ALLL Documentation: More is better

Your management will be required to develop reasonable and supportable forecasts to determine an appropriate estimate for their allowance for loan and lease losses (ALLL). Institutions have always worked under the rule that accounting estimates need to be supported by evidence. Everyone knows both examiners and auditors LOVE documentation, but how much is necessary to prove whether the new CECL estimate is reasonable and supportable? The best answer I can give you is “more”.

And regardless of the exact model institutions develop, there will be significantly more decision points required with CECL than with the incurred loss model. At each point, both your management and your auditors will need to ask, “Why this path vs. another?” Defining those decision points and developing a process for documenting the path taken while also exploring alternatives is essential to build a model that estimates losses under both the letter and the spirit of the new rules. This is especially true when developing forecasts. We know you are not fortune tellers. Neither are we.

The challenge will be to document the sources used for forecasts, making the connections between that information and its effect on your loss data as clear as possible, so the model bases the loss estimate on your institution’s historical experience under conditions similar to those you’re forecasting, to the extent possible.

Software may make this easier… or harder.               

The leading allowance software applications allow for virtually instantaneous switching between different models, permitting users to test various assumptions in a painless environment. These applications feature collection points that enable users to document the basis for their decisions that become part of the final ALLL package. Take care to try and ensure that the support collected matches the decisions made and assumptions used.

Whether you use software or not there is a common set of essential controls to help ensure your ALLL calculation is supported. They are:

• Documented review and recalculation of the ALLL estimate by a qualified individual(s) independent of the preparation of the calculation
• Control over reports and spreadsheets that include data that feed into the overall calculation
• Documentation supporting qualitative factors, including reasonableness of the resulting reserve amounts
• Controls over loan ratings if they are a factor in your model
• Controls over the timeliness of charge-offs

In the process of implementing the new CECL guidance it can be easy to focus all of your effort on the details of creating models, collecting data and getting to a reasonable number. Based on the regulators’ new Q&A document, you’ll also want to spend some time making sure the ALLL number is supportable.  

Next time, we’ll look at a lesser known section of the CECL guidance that could have a significantly negative impact on the size of the ALLL and capital as a result: off-balance-sheet credit exposures.

By now you have heard that the Financial Accounting Standards Board’s (FASB) answer to the criticism the incurred-loss model for accounting for the allowance for loan and lease losses faced during the financial crisis has been released in its final form. The Current Expected Credit Loss model (CECL), which was developed through an arduous (and sometimes contentious) process following the crisis, will bring substantial changes to the way community banks account for expected losses in their loan portfolios. 

Working closely with community banks in the years building up to final issuance, we recognized an uncomfortable level of uncertainty created by the ever-changing proposals and lack of concrete examples. Now that the guidance is final, we feel a strong sense of responsibility to provide our interpretations, thoughts and insights where we can. As the FASB has shown recently with its new revenue pronouncement, there is a good chance that updates to the guidance will occur as we move closer to the implementation dates. The banking regulators who have thus far been mostly silent on the guidance will also have their interpretations.

We find that with substantial new guidance breaking it down into bite size pieces can be the best approach to understanding and implementation. With that said, this is the first of a number of planned articles from BerryDunn to do just that.

Building your team

One of the first things your institution should do is create an implementation team. Building it now with staff from diverse backgrounds and experience including finance, lending and collections will bring significant rewards in the long run. This is also a good time to consider opportunities to include your auditor in the process. Ultimately, you will need them to perform audit procedures on your CECL allowance as part of your financial statement audit. That also means your model and the resulting estimate must be auditable. Including auditors in the early stages should also help your team think about implications the audit requirements may have for expectations related to retaining documentation and supporting assumptions. In addition, your auditor may be able to share observations based on how other institutions are implementing CECL that may be helpful for your team.  Auditors can do all this while maintaining independence if their services are structured properly.

When your team is assembled and is up-to-speed on the basics of what CECL is and isn’t, defining the team’s goals and creating a roadmap to get there will be your keys to success. And asking the right questions while creating the roadmap is a great place to start. 

Questions to consider:

What available method (under CECL) is the best fit for the institution?
We expect that largely most community institutions will start with a top-down approach using an adaption from their current loss-rate approach to reflect the change from the old incurred loss method to the “life of the loan” current expected credit loss method. We believe the following step-by-step model will be one practical approach that should fit most community banks and credit unions:

1. Determine which loans for specific reserves are appropriate, much in the same manner as you’re likely doing now. The notion of “impaired” loans goes away with CECL; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it’s been pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
2. Secondly, for the rest of the portfolio:
   1. Group loans by common characteristics – same as you are likely doing now. These groups can match your portfolio or class groupings used now in financial reporting, but can also be broken down further.
   2. For each group, create subgroups for each origination year. One of the disclosure requirements in the guidance suggests the current year and previous four years are the critical ones to focus on; anything older than five years could be combined together.
   3. For each subgroup:
      1. Establish economic and other relevant conditions for the average remaining term of loans in the subgroup. This will be a combination of forecasted conditions for the near future, probably based on the Fed’s three-year forecast, and long-term historical conditions for the remaining average loan term.
      2. Select an historical loss period that best approximates the conditions established in 2c(i).
      3. Determine average remaining lifetime losses for the historical loss period established in 2c(ii) for that loan type.
      4. Adjust the average determined in 2c(iii) for any current or expected conditions that you believe are different from this historical data. The regulators have indicated their expectation that these will likely be the types of items for which qualitative factors have been developed under the incurred loss model, or a subset thereof.

These adjustments should themselves be based on historical data, or peer historical data if institution-specific data isn’t available (for example, a new loan product); for example, a 25 basis point upward adjustment for actual and expected declines in real estate values beyond the average in the historical period in 2c(ii) should be supported by data that shows a 25 basis point increase in losses for this type of loan in previous periods in which real estate values had shown a similar decline.

What data do we need to start collecting?
The clock has started! The CECL model requires analysis of loss rates and environmental factors. Detailed loss-rate calculations for as far back as you can get is your goal. The next step after collecting the historical data on your losses is to document other factors that were in play during each period. You will also need to consider the factors that affected charge-off rates for different periods. Changes in overall economic conditions, underwriting (both risk and quality), the legal environment and other factors need to be documented and correlated to trends in charge-offs. Remember one of the first steps in preparing a CECL model is to decide which time period of losses best matches the current environment. Without considering the full picture, including the external forces in play, it will be impossible to select an appropriate time period.

How do we retain and access that data?
Many core providers restrict access to older loan level data, and in some cases historical information is readily available only for very short time periods. Knowing the restrictions on your older data will be key in planning for CECL. The model suggests that a starting point for considering historical data needs is to consider what time periods matter. This may vary for different types of loans.

Some core providers have started reaching out to their institutions to discuss CECL and options for collection of data through webinars and one-on-one meetings. Consider reaching out directly to your provider to see what options in terms of data collection, retention and reporting will be available to your team.

What is the next step?
Build a simple model so that your team can better grasp and discuss the fundamentals of CECL. This can serve to solidify the concept of “life of loan losses” vs. the incurred loss method, as well as get your task force focused on what is important in collecting data.

Now that you’ve got your team assembled and have begun to tackle these questions, it’s time to look at other factors to consider. In our next installment, we’ll take you through how to implement CECL for loans obtained in a merger or acquisition. In the meantime, please call us if you have any questions.

On June 16th the FASB issued the final standard for credit losses. We’ve analyzed the new standard and pulled together some key items you’ll need to know:

It looks like you should be able to implement CECL without purchasing expensive third-party models, if your institution is able to get adequate historical data from your core system and has the personnel available to crunch the numbers. Following is one approach that should pass muster with regulators (and, hopefully, the Public Company Accounting Oversight Board (PCAOB)):

1. Determine loans for which specific reserves are appropriate, much as you are currently doing. The notion of “impaired” loans goes away; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it would otherwise be pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
2. For the rest of the portfolio:
   Group loans by common characteristics – same as you’re doing now.
    

   a.	For each group, create subgroups for each origination year. It looks like current year and previous four years are the critical ones to focus on; anything older than five years could probably be lumped together.
   b.	For each subgroup, establish economic and other relevant conditions for the average term of loans in the subgroup. This includes actual conditions from year of origination to the present, forecasted conditions for the near future, and long-term historical conditions for the remaining average loan term.
   	•	Select an historical loss period that best approximates the conditions established in (b) above.
   	•	Determine average lifetime chargeoffs for that historical loss period for each loan type.
   	•	Adjust that average for any current or expected conditions that you believe are different from this historical data.  Such adjustments should be based on the institution’s chargeoff experience when similar conditions occurred in the past.  An example might be an actual or expected decline in real estate values that you believe is more pronounced than in the historical loss period chosen.

While not specifically mentioned in the guidance, we believe a modest unallocated allowance is still supportable, especially since imprecision is certainly higher when factoring in expected losses in addition to incurred losses.

Other points that caught our eye:

1. The guidance applies to purchased loans with credit deterioration, as well as originated loans. That will create more comparability in terms of the allowance as a % of loans for institutions that have done acquisitions vs. those who haven’t. An interesting twist, though – for acquired loans that have experienced a more-than-insignificant deterioration in credit quality since origination, the allowance established is simply an adjustment to (ultimately) the premium or discount, while for other loans acquired in the transaction, an allowance is established with an offset to loan loss expense at acquisition.
2. The guidance applies to held-to-maturity debt securities, and there’s specific guidance that affects the accounting for available-for-sale debt securities as well. These will likely only come into play for institutions with private-label mortgage-backed securities and/or corporate bonds. However, some of the CECL disclosure requirements apply to securities as well; in particular, the one that caught our eye was the requirement in ASC 326-20-50-5 to disclose credit quality indicators (e.g., S&P ratings) for securities as well as loans.
3. Surprisingly, you continue to assume no change in future interest rates for purposes of establishing expected credit losses for specific variable rate loans. We think FASB may have missed the boat on this one, as resetting ARMs were one of the factors that led to the 2008 crisis that CECL is intended to be responsive to.

There will obviously be much, much more dialogue about these new rules, and we’ll need to begin the process of helping you understand them and prepare for implementation sooner rather than later.

Please call us if you have any questions.