In June 2016, the FASB released ASU 2016-13, Financial Instruments – Credit Losses (Topic 326). While 2016 seems like it was eons ago, the standard only just became effective for public companies in 2020. For private companies, the standard will become effective beginning in 2023. As more and more companies begin to implement the standard, I thought it would be prudent to give an overview of the standard and what to look out for.
What is ASU 2016-13?
ASU 2016-13 requires companies with financial assets measured at amortized cost to be presented at the net amount expected to be collected. Prior to the update, companies would only recognize credit losses when it was probable that they would occur. If a company was expecting a credit loss on an asset in the future, but the loss did not meet the FASB’s definition of “probable”, no loss was recorded. The new standard does a better job at recording credit losses on assets in the present when a company is expecting a loss in the future.
Does the new standard remind you of anything? If you thought of the allowance for doubtful accounts, you would be correct! The methodology here is the same. Companies utilize a valuation account, the Current Expected Credit Losses Reserve (the “CECL Reserve”) to present assets measured at amortized cost to be the net amount expected to be collected on the balance sheet. Similar to the allowance for doubtful accounts, companies are required to analyze the allowance every reporting period to determine whether an adjustment is needed.
Assets Measured at Amortized Cost
The standard applies only to assets measured at amortized cost. Per ASC 326-20-15-2, this includes the following:
- Financing Receivables
- Held-to-maturity debt securities
- Receivables that result from revenue transactions within the Scope of ASC 605, 606, and 610
- Reinsurance recoverables within the scope of ASC 944
- Receivables that relate to repurchase agreements and securities lending agreements within the scope of ASC 860
Assets that are measured at fair value with changes in fair value flowing through net income do NOT apply to this standard. Let’s focus on the first item, financing receivables, as this includes a majority of the types of assets measured at amortized cost that would need to follow the new standard. A financing receivable is essentially a contractual right to receive money either on demand or on fixed determinable dates. One example of a financing receivable is a loan receivable or a note receivable. Companies with a substantial loan receivable portfolio would have to record them net of a CECL Reserve each period.
How to Measure the CECL Reserve
Once a company has determined what types of financial assets need to be measured using the new standard, management must develop a model to estimate the loss recorded in the valuation allowance. There are numerous approaches to estimate the valuation allowance including the loss rate approach, aging schedule methodology, and discounted cash flow analysis approach. For purposes of this article, I will focus on the discounted cash flow approach. Companies with a loan receivable portfolio that use the discounted cash flow analysis method would make a forecast of the cash flows expected from each loan receivable in the portfolio. The total present value of the expected cash flow would then be compared with the amortized cost of each loan receivable in order to determine the expected credit loss. The valuation allowance would then be equal to the sum of the total expected credit loss for each loan within the portfolio.
Management must make assumptions to determine the expected cash flows within the discounted cash flow analysis. Macroeconomic data such as GDP, unemployment rates, and interest rates could be underlying assumptions that drive the determination of expected cash flows. Management could also focus on individual data related to each of the loans within the portfolio. One common data point utilized is the loan-to-value (“LTV”) ratio. For a secured loan, the LTV ratio is a calculation of the dollar amount of the loan over the fair value of the underlying collateral. The higher the LTV ratio, the greater risk that the borrower could default on the loan.
Calculating the CECL Reserve – Example
Let’s say that we are in the business of offering balloon payment 5-year mortgage loans to consumers. For this very simple example, we will assume the balloon payment occurs in year 5. As this is our first year in business, we only have one loan in the portfolio consisting of a $1M mortgage at a 4% interest rate. As we have no prior history to rely on in making our loss estimate, we will base the loss estimate on the LTV ratio and personal credit history of the customer. In our eagerness to make a deal with our first customer, we failed to conduct a proper credit history check and later found out that the customer has a credit score of 280. Furthermore, the LTV ratio of the loan is 99% (meaning that we loaned $1M for a house worth $999K). In general, LTV ratios higher than 80% are considered “higher risk”. Based on these facts, we estimate the probability of the customer paying back the $1M mortgage in year 5 at 70%. Here is how we would calculate the CECL reserve:
Our CECL reserve balance would be $246,598 ($1,000,000 – $753,402) and we would record a CECL reserve loss in the current year for $246,598
| Dr. Credit Loss | $246,598 |
| Cr. CECL Reserve | $246,598 |
The balance sheet would have the below presentation, note that the CECL reserve would be considered a contra asset in a similar form to the allowance for doubtful accounts.
Mortgage Loan Receivable, Net $753,402
Wrapping Up
Each subsequent period, the company would determine whether the CECL reserve needs to be adjusted either downward or upward. Let’s say in year 2, we determine that there is an 80% chance that we receive our final $1M balloon payment. The CECL balance would then be reduced accordingly (and there would be a resulting credit on the income statement to the loss account). One interesting tidbit with the CECL reserve balance is that the CECL reserve should always have a credit loss. Thinking about this from a practical standpoint, there is ALWAYS a risk of credit loss, no matter how remote. In rare situations, a company’s model might calculate that there are no expected credit losses on the portfolio. In these situations, the company would apply a loss override set at a defined percentage, as an example 1%, to the loan portfolio.