CECL Accounting Examples and Calculation Methods

The Current Expected Credit Loss (CECL) model, introduced by the Financial Accounting Standards Board (FASB), requires companies to estimate and recognize total expected credit losses over the life of a financial asset upon its origination or purchase. This forward-looking approach changes prior guidance, which used an “incurred loss” model that only recognized losses after they were probable. CECL mandates a day-one provision for expected future losses, providing a more timely reflection of credit risk in financial reporting.

Foundational Elements of CECL Estimation

Historical Loss Information

Historical loss information is the initial building block for the estimate. This data includes past events like loan charge-offs and recoveries, which are analyzed to establish a baseline loss rate. Companies must pool financial assets with similar risk characteristics to develop this historical experience, such as separating high-risk unsecured receivables from low-risk secured receivables.

Reasonable and Supportable Forecasts

The CECL framework requires incorporating reasonable and supportable forecasts to adjust the baseline loss rate for expected economic changes. Entities must consider relevant macroeconomic indicators, such as projected unemployment rates, GDP growth, or shifts in real estate values. The forecast period is the time over which a company can develop reliable projections and will vary by entity and asset type.

Qualitative Factors (Q-Factors)

Qualitative factors, or Q-Factors, adjust for risks and conditions not fully reflected in historical data or economic forecasts. These adjustments can be based on elements like changes in underwriting standards, shifts in portfolio concentration, or new external conditions like regulatory changes. Applying Q-Factors requires significant judgment.

Reversion to Historical Data

For periods beyond the reasonable and supportable forecast horizon, the CECL standard requires a reversion to historical loss information. After the forecast period ends, the loss estimate must return to the long-run average loss rate. The specific method of reversion, such as a straight-line or other systematic approach, is a matter of company judgment.

Example One Applying an Aging Schedule to Trade Receivables

A common application of CECL for non-financial companies uses an aging schedule for trade accounts receivable. This method begins by categorizing outstanding customer balances into time-based buckets, such as “Current” or “1-30 Days Past Due,” to provide a snapshot of the portfolio’s credit health.

Consider a manufacturing company, “Innovate Corp.,” with $2,500,000 in total accounts receivable. The company segments these receivables into an aging schedule, with the table below showing the outstanding balance in each category.

| Aging Bucket | Balance |
| — | — |
| Current | $1,800,000 |
| 1-30 Days Past Due | $400,000 |
| 31-60 Days Past Due | $150,000 |
| 61-90 Days Past Due | $100,000 |
| Over 90 Days Past Due | $50,000 |
| Total | $2,500,000 |

Next, historical loss rates are applied to the balances in each aging bucket. Based on its data, Innovate Corp. has established average loss percentages for each category. Multiplying the balance in each bucket by its historical rate gives an initial, unadjusted allowance for credit losses.

| Aging Bucket | Balance | Historical Loss Rate | Unadjusted Allowance |
| — | — | — | — |
| Current | $1,800,000 | 0.5% | $9,000 |
| 1-30 Days Past Due | $400,000 | 2.0% | $8,000 |
| 31-60 Days Past Due | $150,000 | 10.0% | $15,000 |
| 61-90 Days Past Due | $100,000 | 25.0% | $25,000 |
| Over 90 Days Past Due | $50,000 | 60.0% | $30,000 |
| Total | $2,500,000 | | $87,000 |

Innovate Corp. then incorporates a reasonable and supportable forecast. After analyzing economic projections, management determines a key customer industry is facing a downturn. They forecast this will lead to a 15% increase in expected losses across all aging buckets, applying this forward-looking adjustment to the unadjusted allowance: $87,000 (Unadjusted Allowance) \ 1.15 (Forecast Adjustment) = $100,050.

The company then considers qualitative factors. Innovate Corp. recently implemented a more stringent credit approval process and a new collections software system. Management concludes these actions, not yet reflected in historical data, will decrease credit losses by about 5%. This Q-Factor adjustment is applied to the forecast-adjusted allowance: $100,050 \ 0.95 (Qualitative Adjustment) = $95,047.50.

The final allowance for credit losses is $95,047.50. Assuming the existing allowance from the prior period was $75,000, Innovate Corp. must record an additional provision. The journal entry is a debit to Bad Debt Expense for $20,047.50 and a credit to the Allowance for Credit Losses for the same amount, bringing the total allowance to the new estimate.

Example Two Applying Vintage Analysis to a Loan Portfolio

For institutions with loan portfolios like banks and credit unions, vintage analysis is a common CECL methodology. A “vintage” is a group of loans originated during the same period, such as all auto loans issued in a specific quarter. This method tracks the performance of each vintage throughout its life to observe how losses accumulate over time and to project lifetime loss behavior for new loans.

The process begins by compiling historical data on cumulative net charge-offs for several past vintages at various points after origination. For example, a credit union might create a table showing the cumulative loss rates for 60-month auto loan vintages from recent years, measured at different intervals.

| Vintage | 12 Months | 24 Months | 36 Months | 48 Months | 60 Months (Lifetime) |
| — | — | — | — | — | — |
| 2018 | 0.25% | 0.60% | 1.10% | 1.40% | 1.55% |
| 2019 | 0.22% | 0.55% | 1.05% | 1.35% | 1.50% |
| 2020 | 0.20% | 0.50% | 0.95% | 1.25% | 1.40% |

From this historical data, the institution develops an expected lifetime loss curve by averaging the performance of past vintages. This projects the likely trajectory of losses for loans currently on its books. For instance, the average lifetime loss rate from the table is approximately 1.48%, providing a baseline estimate of total expected loss over a loan’s life.

This projected loss curve is then applied to the current loan portfolio, which is also segmented by vintage. For a loan vintage originated 12 months ago, the model would estimate the remaining expected losses from month 13 through month 60. The total CECL allowance is the sum of the expected future losses for each vintage in the portfolio.

Finally, the model is adjusted for current conditions and reasonable and supportable forecasts. This can involve sophisticated modeling, such as correlating historical unemployment rates with historical loss rates. If an institution’s forecast includes a rising unemployment rate, it might adjust the entire lifetime loss curve upward to quantify the impact of the economic outlook on the final estimate.

Example Three Applying a Discounted Cash Flow Method

A discounted cash flow (DCF) method is another approach permitted under CECL, often used for individual financial assets like a portfolio of held-to-maturity corporate bonds. The allowance is calculated as the difference between the asset’s amortized cost and the present value of the cash flows the entity expects to collect. Any expected shortfall in cash flows is discounted to the measurement date to determine the required reserve.

Imagine a company holds a corporate bond with a face value and amortized cost of $100,000, a 5% annual coupon rate, and a remaining maturity of three years. The contractual cash flows are $5,000 in interest each year, plus the $100,000 principal repayment at the end of year three.

Due to a downturn in the issuer’s industry, the company revises its collection expectations. It now expects to receive the first year’s interest, but anticipates the issuer will default on the second year’s interest and only repay $90,000 of the principal at maturity. The table below compares the contractual cash flows with the new expected cash flows.

| Year | Contractual Cash Flow | Expected Cash Flow | Shortfall |
| — | — | — | — |
| 1 | $5,000 | $5,000 | $0 |
| 2 | $5,000 | $0 | $5,000 |
| 3 | $105,000 | $90,000 | $15,000 |
| Total | $115,000 | $95,000 | $20,000 |

The total expected cash shortfall is $20,000, but the CECL allowance is the present value of these shortfalls, not the total amount. The shortfalls must be discounted using the bond’s original 5% effective interest rate. The $5,000 shortfall in year two is discounted for two years, and the $15,000 shortfall in year three is discounted for three years. The sum of these discounted values is the required CECL allowance.