CECL: A New Accounting Standard and a Challenging Credit Environment

Public companies across all industries have adopted or are adopting the current expected credit loss (CECL) impairment model, but that process has proved challenging within a pandemic-impacted economic environment. A recent ELFA Wednesday Webinar, “CECL: A New Accounting Standard and a Challenging Credit Environment,” offered a CECL refresher before discussing COVID-19 considerations and hot topics for lessors. The session was moderated by John Bober, Managing Member, IXL Lease Advisory Services, LLC and Chair of ELFA’s Financial Accounting Committee, and featured Drew Banach, Senior Manager, Strategy and Transactions, Ernst & Young LLP; Kyle Elken, Controller, DLL U.S.; and Joseph Soviero, Managing Director, Financial Accounting Advisory Services, Ernst & Young LLP.

The Ins and Outs of CECL

The new guidance under Accounting Standards Update (ASU) 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, makes significant changes to the accounting for credit losses on financial assets and disclosures about them. The Financial Accounting Standards Board (FASB) developed the guidance in response to concerns that credit losses had been identified and recorded “too little, too late” in the lead-up to the 2008 global financial crisis. 

The CECL impairment model under Accounting Standards Codification (ASC) 326-20 affects entities in many industries and applies to a wide variety of financial assets measured at amortized cost, including trade receivables, financing receivables (loans), held-to-maturity (HTM) debt securities, off-balance-sheet credit exposures not accounted for as insurance, and net investment in leases recognized by a lessor. The standard also modifies the existing impairment guidance for available-for-sale (AFS) debt securities and certain other types of financial assets. 

The standard introduces a new expected loss impairment model, which is a change from the current incurred loss model. The object of the new model is to recognize an allowance for credit losses that results in the financial statements reflecting the net amount expected to be collected from the financial asset. Under the expected loss model, management must also include an estimate of expected credit losses, measured over the contractual life of an instrument, that considers reasonable and supportable forecasts of future economic conditions in addition to information about past events and current conditions.

Under the expected loss model, many companies can expect the following changes:

• Credit loss estimates will incorporate forward-looking information. 
• Losses will likely be recognized sooner than under current guidance.
• Accounting policies, processes, controls and documentation will need to be updated and consideration given to whether changes are needed in financial reporting systems. 

ASC 326-20 provides entities with significant flexibility in how to pool financial assets with similar risk characteristics, determine the contractual term, and obtain and adjust the relevant historical loss information that serves as the starting point for developing the estimate of expected lifetime credit losses. As a result, applying the guidance will require significant judgment.

For lessors, the CECL model also applies to a lessor’s net investment in sales-type and direct financing leases (operating leases are not in scope). The net investment in a lease includes the lease receivable, the unguaranteed residual asset and deferred selling profit (for direct financing). The entire net investment in the lease is used to estimate the CECL, including the amount that the lessor expects to derive from the unguaranteed residual asset, which would be based on the expected value of the residual asset at the end of the lease term. In addition, the expected cash flows from the disposal of leased assets (including any gains and losses) should be included in the estimate of expected credit losses on net investments in leases in the scope of ASC 326.

COVID-19 Considerations

Companies are finding it challenging to estimate the economic effect of the COVID-19 pandemic because of its unprecedented nature. In addition, companies applying ASC 326 are required to consider reasonable and supportable forecasts of future economic conditions in their estimate of expected credit losses. 

Source: Ernst & Young LLP

In an Ernst & Young LLP survey of 100 entities that extend significant amounts of credit, most of the respondents stated in their disclosures that the COVID-19 pandemic was the most significant driver of their allowance for loan losses in the first quarter of 2020 
(Ernst & Young LLP, Review of the first wave of credit impairment disclosures under the new standard, June 25, 2020). In addition, 35% quantified their exposure to certain industries that were more heavily impacted, such as retail, hotels, travel, and oil and gas.

Affected companies that apply ASC 326 will need to consider the degree to which the market disruption may change their forecast under a number of possible scenarios, such as expected government support, and various sensitivity analyses. Business disruption and changes in demand will often increase the likelihood of lessees taking a longer time to repay amounts outstanding or being unable to repay their obligations when due. 

ASC 326 requires companies to pool financial assets but allows them to choose which risk characteristics to use.Companies should assess whether financial assets in pools continue to display similar risk characteristics or determine whether they need to revise their pools or perform an individual assessment of expected credit losses.

Lessors should consider the disclosures related to the basis of inputs and assumptions and estimation techniques used, and how forward-looking information has been incorporated. Many companies are disclosing inputs, assumptions or forward-looking adjustments associated with the impact of the COVID-19 pandemic.

Source: Ernst & Young LLP

Hot Topics for Lessors

How are companies approaching implementation? Many companies are taking a phased approach, similar to other accounting changes. They typically start with an assessment to determine the applicability of ASC 326 to their financial asset portfolio, identify gaps in accounting policy and financial reporting, and develop a workplan for design and implementation. A successful implementation will likely include ownership and sponsorship from affected business functions, such as finance/accounting and asset management, risk and credit. Going forward, these functions will likely require strong coordination, so training and education about ASC 326 and its impact on the business should be included in any effort.

What are some considerations around data, models and reasonable and supportable forecasts? There are several common credit loss calculation methods that are generally acceptable, such as the discounted cash flow (DCF) methods, loss-rate methods, and probability of default (PD) and loss-given default (LGD) methods.

Source: Ernst & Young LLP

When using these methods, the CECL impairment model requires an estimate of expected credit losses to consider in forecasts of future economic conditions, in addition to information about past events and current conditions. For historical data, companies may want to consider losses dating back several historical business cycles, including the financial crisis of 2008. 

Another area of focus is the incorporation of macroeconomic factors in the CECL estimate, such as unemployment, GDP or inflation-related indexes. However, lessors may not want to consider these factors simultaneously as they may be correlated. 

At the point that the reasonable and supportable forecast is no longer a better estimate of expected credit losses than historical loss information, companies should revert to historical loss information for the remaining contractual term of the financial asset. The reversion period timing and method is another area of management judgment. 

As previously mentioned, the CECL estimate includes the expected cash flows derived from the disposal of the residual asset at the end of the lease term (including any gains and losses). For example, if an asset at the end of its lease term is expected to be sold for a gain, then that additional cash flow should be considered in the CECL estimate. Collective pooling is required under CECL when assets share risk characteristics and lessors should consider residuals for contracts with similar risk characteristics for analysis. The nature of the leased asset is a key consideration as well as the value of the assets correlated among the leases. The end-of-lease-term residual asset cash flows, which may include a gain or loss on sale as well as an expectation of evergreen payments, are discounted back to the measurement date and offset against the estimate of expected credit losses.

With all these different complexities to consider, and depending on in-house capabilities, lessors should decide whether to gather the appropriate data and develop the estimate themselves or seek the assistance of a third-party vendor.

What about processes and controls? Lessors may need to consider updates to internal controls over financial reporting related to the adoption of ASC 326 — or even possibly new ones altogether. For instance, they may need to update controls around economic variables being relevant and accurate, and they will likely need processes and controls around the review and approval of the new estimate. Developing the estimate requires data to be appropriate, accurate and complete, with appropriate periods used to develop the expected credit loss calculation.

Source: Ernst & Young LLP

 Overall, models and calculations, including quantitative and qualitative adjustments made to outputs, should be appropriately factored into the estimate of expected credit losses in relation to GAAP requirements. This affects financial statement users as well, who will need to understand what caused changes to the allowance for credit losses and affected credit loss expense (or reversal) reported for the period. 

The views reflected in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.