Accounting Concepts and Practices

What Is the CECL Accounting Standard?

Understand the CECL accounting standard, a forward-looking framework that redefines how entities assess and provision for future credit risk.

The Current Expected Credit Losses (CECL) accounting standard, issued by the Financial Accounting Standards Board (FASB) in June 2016, represents a significant shift in how entities account for potential credit losses on financial assets. CECL introduces a forward-looking approach to recognizing these losses. The standard’s broad purpose is to enhance the timeliness of credit loss recognition on various financial instruments held by organizations, including financial institutions and other entities that extend credit or hold financial assets. CECL aims to provide a more accurate and comprehensive view of an entity’s financial health by requiring earlier recognition of anticipated credit losses. This involves estimating losses over the full contractual life of financial assets, rather than waiting for actual losses to be incurred. The FASB intended for this standard to improve financial reporting by ensuring that potential credit losses are reflected in financial statements sooner.

Understanding Expected Credit Losses

The core change introduced by CECL is the shift from an “incurred loss” model to an “expected credit loss” model. Under the previous incurred loss model, entities only recognized a loss when it was probable that a loss had occurred and the amount could be reasonably estimated. This often led to delayed recognition of credit losses, as companies waited for specific triggering events, such as a missed payment or a customer defaulting, before recording the loss.

CECL fundamentally alters this by requiring entities to estimate and recognize expected credit losses over the entire contractual life of a financial asset from its initial recognition. This means that an allowance for lifetime expected credit losses must be established as soon as a financial asset is recognized, even if there is no immediate indication of a loss. The standard mandates a proactive approach, requiring businesses to forecast potential credit risks based on a broader range of information, including future economic conditions.

The standard applies to a wide array of financial assets measured at amortized cost. This includes:
Loans held for investment
Held-to-maturity (HTM) debt securities
Net investments in leases
Trade receivables
Certain off-balance-sheet credit exposures like loan commitments and financial guarantees

While financial institutions such as banks and credit unions are significantly impacted, CECL also affects other entities holding financial assets, including manufacturing companies, healthcare entities, and any business with trade receivables or lease receivables. By anticipating losses earlier, entities can be better prepared for potential adverse economic events, and the shift aims to ensure consistency in how credit impairment is modeled across various debt instruments.

Key Inputs for CECL Measurement

To measure expected credit losses under CECL, entities must gather and consider specific types of information and data. The estimation process relies on three primary components:

Historical loss experience: Entities analyze their historical loss experience for financial assets with similar risk characteristics. For instance, a bank might examine the past default rates of similar loan portfolios, or a company might review its historical write-offs for trade receivables. This historical data serves as a starting point for estimating future losses.
Current conditions: Entities must adjust this historical data to account for present economic, industry, and asset-specific factors that may cause current loss expectations to differ from past experiences. Examples include changes in unemployment rates, interest rate fluctuations, commodity prices, or specific industry downturns. These adjustments ensure that the historical data is relevant to the current economic environment.
Reasonable and supportable forecasts: This involves projecting future economic outlooks and trends over the full contractual life of the financial asset. Entities use judgment to determine relevant information and estimation methods, which may include internal forecasts or external data from reputable sources. For periods beyond which reasonable and supportable forecasts can be made, entities are permitted to revert to historical credit loss experience or an appropriate proxy. This forward-looking aspect broadens the range of data considered in credit loss estimation.

How CECL Impacts Financial Reporting

CECL significantly affects the presentation and output of credit losses on an entity’s financial statements. The primary financial statement impact revolves around two key accounts: the “Allowance for Credit Losses” and the “Provision for Credit Losses.”

The Allowance for Credit Losses is a valuation account presented on the balance sheet as a contra-asset. This means it reduces the reported value of financial assets to reflect the net amount expected to be collected. For example, if a bank has $100 million in loans and estimates $2 million in expected credit losses, the loans would be presented net of the allowance, resulting in a net loan value of $98 million. This allowance is adjusted at each reporting period to reflect management’s updated estimate of expected losses.

The corresponding impact on the income statement is the Provision for Credit Losses. Increases to the Allowance for Credit Losses are recorded as a credit loss expense, which reduces net income. Conversely, decreases in the allowance are recognized as a reversal of credit loss expense, increasing net income. The timing of credit loss expenses can change under CECL compared to the prior incurred loss model, potentially leading to increased volatility in reported earnings.

CECL also requires expanded disclosures in the notes to the financial statements to provide a clear picture of an entity’s credit risk exposure. These disclosures provide users with information about the credit risk inherent in a portfolio, how management monitors credit quality, the methodology used for estimates, and significant assumptions and inputs. The overall effect of CECL is to provide a more transparent and timely reflection of credit risk, which can influence how investors and other stakeholders view an entity’s financial liquidity and performance.

Previous

Is Unearned Revenue the Same as Deferred Revenue?

Back to Accounting Concepts and Practices
Next

Is Inventory a Debit or a Credit in Accounting?