Under existing Generally Accepted Accounting Principals (“GAAP”), allowance for loan and lease losses (“ALLL”) are recognized when it is “probable” a loss has been incurred. The financial crisis was exacerbated by the inability of market participants to understand banks’ exposures and expected credit losses. Money markets seized up, banks struggled to access credit and bank equity and debt sold off. A key premise of the stress tests then Treasury Secretary Geithner rolled out in February 2009 was to facilitate a “forward looking assessment” about the risk on bank balance sheets. The existing requirement a loan loss must be incurred before recognized in ALLL delayed the recognition of loan losses, the July 2009 report of FASB’s Financial Crisis Advisory Group concluded, citing the results of the first stress tests. Whereas the old incurred loss regime required an ALLL when an asset is deemed “impaired” because it is “probable that a loss has been incurred,”[i] the changes promulgated under CECL compel ALLL based on the “net amount expected to be collected” based upon “management’s current estimate of expected credit losses on an asset.”[ii]
The new CECL regime is not proscriptive. CECL can be calculated “on a collective or individual basis,” for example.[iii] At the highest level, a firm’s CECL must be grounded in: 1) current conditions and relevant quantitative and qualitative factors which relate to the environment in which the lender operates and which are specific to the borrower[iv] such as unemployment rates, property values, commodity prices or delinquency;[v] 2) internal or external data or a combination of both;[vi] and, 3) reasonable and supportable forecasts.[vii]
[i] FASB 310-10-35-4 (superseded by Accounting Standards Update No. 2016-3
[ii] FASB 326-20-30-1.
[iii] FSAB 326-20-30-7.
[iv] FASB 326-20-30-7 (in estimating expected credit losses on financial assets, “[a]n 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)”)
[v] FASB 326-20-30-9.
[vi] Id. (explaining “an entity is not required to search all possible information that is not reasonably available without undue cost and effort.)
[vii] FASB 326-20-30-9 (noting “[a]n 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.”)