Most companies have heard that the CECL model emphasizes the need to recognize “expected” credit losses over the contractual life of the loan versus the current “incurred” loss approach, which generally results in the recognition of losses over the next 12 months.
What Does it Mean to Estimate the Expected Credit Losses Over the Contractual Life of the Loan?
CECL’s concept of expected credit loss includes the use of forecast information over the contractual life of the asset, which is usually the most significant driver of the estimate and allowance balance. Generally, the longer the contractual life of the asset, the larger the CECL estimated expected credit loss. Under CECL, the contractual life of the instrument will be even more significant than it is today.
Does the FASB Expect Institutions to Estimate Credit Losses Over the Contractual or Expected Life of the Loan?
The Financial Accounting Standards Board (FASB) does not expect financial institutions to forecast credit losses over the entire contractual life of the loan. Institutions may consider the behavioral life of the loan (also referred to as the expected life), which includes the effects of future events, such as prepayments. Considering the behavioral life of the loan will be especially important for those that are longer dated, such as mortgages.
CECL also caps the period over which a credit loss is analyzed at the contractual duration of the instrument. Even if an expected credit loss could be economically incurred after the instrument’s contractual life, the CECL model will not include that expected credit loss unless a Troubled Debt Restructuring (TDR) is reasonably expected to occur. This would extend the contractual maturity of the instrument, or additionally if there is an extension option included in the contract that is at the discretion of the borrower.
For future periods beyond which an entity can make reasonable and supportable forecasts of expected credit losses, the entity should revert to historical loss information.
How Does This Work for Credit Card Receivables and Other Financial Instruments Without a Specified Contractual Life (Such as a Revolving Loan)?
For assets that are unconditionally cancellable by the lender or issuer, the current expected credit loss and allowance estimation are based on the outstanding receivable balance as of the reporting date. This means that future draws are not considered in the CECL estimate. For some entities, their CECL allowance might be lower than their incurred loss allowance for these types of asset portfolios.
However, unfunded commitments to extend additional credit that are not unconditionally cancellable by the lender or issuer should be included in the scope of the CECL expected credit loss estimate.
Some additional operational challenges exist in allocating borrower payments to the outstanding balances that permit flexibility in application, but require consideration by the lender in establishing the CECL model.
The Bottom Line
The period over which an expected credit loss is assessed is generally limited to the shorter of the full contractual life or its reduced “expected life” based on forecast prepayments. For periods beyond which the entity can make a reasonable and supportable forecast of expected credit losses, an entity should revert to historical credit loss information. Credit card and other revolving loans require a closer look to determine whether unfunded amounts should be included in the estimate of expected credit losses.
Because the expected life of the loan is a key driver of the magnitude of expected credit losses under CECL, it is important to consider the nature of the receivables, their contractual lives and prepayments, and, earlier rather later, estimate the impacts of CECL on your organization’s allowance and capital levels.
For more information, check out CECL for Credit Unions: In-House or Third-Party Modeling