The New CECL Approach

Tom Van Lenten, CPA, CFO Consulting Partners LLC

In mid-2016 the FASB issued its long-awaited standard on accounting for credit losses (ASU 2016-13). The new standard adds to US GAAP an impairment model known as the current expected credit loss model or CECL. In a shift from current practice the CECL model is based on expected losses rather than incurred losses. Under the new CECL model an entity recognizes its forward looking estimate of the expected credit losses in the Allowance for Loan and Lease Losses, or ALL when an asset is booked.

The FASB believes that the new standard will result in more timely recognition of credit losses. There is a long transition timeline and implementation is required at January 1, 2020 for calendar-year reporters that are SEC filers, and January 1. 2021 for other entities.

The CECL approach is to be applied to most debt instruments that are not measured at fair value. This includes loan commitments, financial guarantees, lease receivables, trade receivables and held-to-maturity securities. Available for sale debt securities are specifically excluded and will continue to be evaluated for impairment under the AFS securities impairment model.

The Standard does not require use of any one method to compute expected credit losses. Management is expected to maintain complete data sets, documentation, and analysis to support how the selected method fits with the standard and produces realistic estimates of future losses. Examples of some of the acceptable methodologies are:

• Loss rate: Historical loss rates can still be used as a starting point for determining expected credit losses. When using historical loss rates, the Bank would have to consider how conditions that existed during the historical charge-off period differ from current projections and adjust the future loss rates accordingly.
• Discounted cash flow: Projections of principal and interest flows over the life of the asset.
• Probability of default method estimates the probability loans in certain risk-stratified segments will default. This approach computes the percentage of loans that have defaulted in a pool over a look-back period.
• Roll-rate method. The roll-rate method is often referred to as “migration analysis”. It is based on determining a prediction of credit losses based on segmentation (by delinquency or risk rating, for example) of a portfolio of financial assets. No standard roll-rate model is used throughout the financial institutions industry, but most of the models used are based on similar underlying principles.
• Aging analysis: Banks use aging analysis in determining the effectiveness of their credit and collections functions and for estimating potential loan losses. The information from this analysis is used by Banks as a component of their estimate the allowance for loan & lease losses.
• Collateral-value: For loans that are collateral dependent, evaluation of collateral and costs of disposal can be used to estimate expected credit losses.

Institutions with multiple loan types will likely need several methodologies to properly analyze the loss content of each portfolio segment and then aggregate the results to understand the expected losses for entire loan portfolio.

Expected credit impairment will be recognized as an allowance, instead of as a direct write-down of the amortized cost of the financial asset. Changes to the ALLL are recorded immediately through credit loss expense. The carrying amount of a financial asset that is considered to be uncollectible will be written-off in a manner similar to current US GAAP.

While there is significant time until required implementation, it is imperative that management begin the implementation process as soon as possible. The most problematic aspects of CECL implementation will likely be: a) developing the support systems and processes, b) gathering and organizing the historical data to support new methodologies, and c) developing going forward data capture and analysis processes.

• With respect to a) above, existing modeling approaches currently used for Basel, and stress testing may be leveraged and adapted for CECL. However, new credit loss models will likely need to be implemented. It is anticipated that the development or purchase of credit models that estimate future credit losses may be the most time consuming phase of CECL implementation.
• For b) the historical data requirements for the new models will often not be resident in current financial and credit systems. This data will have to be developed from the bank’s core operating system and organized into databases which the models can access.
• For data capture and analysis c) the starting point for developing a future loss credit loss data base is current loan and credit loss data. Companies implementing CECL should undertake a robust review and analysis of its current loan and credit data so that the process of developing a future credit loss data base starts with historic data that has a high level of accuracy and integrity.

Many of the disclosures required under the new standard are similar to those required under current GAAP. For example disclosures on credit quality, ALLL roll-forward, policies tor determining credit losses, past due and non-accrual status, and collateral dependent assets are the same. There are, however, significant additional disclosures of credit quality indicators, disaggregated by year of origination for a five-year period.

Quality Assurance – Important?

What is the Problem?

Many firms, particularly smaller ones, have problems with controls or Quality Assurance (“QA”) over the “downstream” preparation of financial statements, footnotes and MD&A. Typically, “upstream” processes like AP, Cash, Journal Entries, etc. are strictly controlled, but limited staff and insufficient planning can lead to downstream QA issues. The complexities and ever-evolving accounting standards (e.g. Revenue Recognition., etc.) create challenges for any firm, while managements and boards have potential individual liability for errors and misleading reporting. The new administration’s focus on deregulation is unlikely to give relief from getting the reporting right, while senior SEC personnel have publicly stated their concerns about firms’ controls over implementing the new accounting standards.

A weak downstream QA process that results in errors in work papers, statements etc. being passed on to the firm’s independent auditors will cause more audit checking and testing, raising the cost and potentially leading to a material weakness being declared. Worse still, a weak QA process may result in the need for an embarrassing restatement.

Picking up wrong numbers as well as making calculation, factual and spreadsheet mistakes are common errors. “Version Confusion” also happens when nobody is sure which versions have been checked and updated. The risk of error increases with: more Excel spreadsheets; more manual hand-offs; limited available staff time; late changes; multiple, geographically dispersed operating subsidiaries, etc.

What is the Solution?

The goal of the QA process is to substantially reduce the probability of errors by ensuring that all numbers and narratives agree to back-up, all tables foot and, all calculations are correct and all disclosures are complete and make sense and the whole report is internally consistent. Best practices have the QA process built: (1) into the firm’s workflow with specific steps, defined responsibilities including a central point of control; and (2) into the firm’s timeline with sufficient time to ensure quality, with due consideration for last minute changes. All back-up support should be gathered into one location as on-line soft copy for easy access.

Preferably the QA responsibility is assigned to a person/team not involved in the day-to-day report preparation – smaller firm might consider outside support. The QA person then undertakes: checking the whole report; distributing a formal Issues Log; checking and logging changes being made; final checking of the main statements; and signing off with finance management. The QA person needs to be well skilled, not a junior, and should also be able to make a critical assessment of the back-up support.

Additional documentation should be maintained including the Issues log, work papers and a summary of the main QA steps undertaken signed off by the QA person and finance management.

All the same QA considerations apply if the firm is not a public company but is facing a major financial transaction (e.g. equity/ debt raises, PE investment, sale of firm, etc.) to avoid the loss of credibility from errors uncovered in due diligence.

There is real value in having a well-defined downstream QA process as part of robust Internal Control over Financial Reporting (“ICFR”) to ensure the firm’s financial reporting is accurate and transparent.

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Our firm is a team of senior financial executives. We provide a broad range of financial management services to public and private companies. We work for CEOs, CFOs, Controllers, as well as audit committees and boards.

Our mission is to apply our consultants’ considerable collective experience to resolve client issues in a professional and efficient manner.

Guest Article from iSiegel Consulting: Justifying the Spend on IT Security

Overview

Companies that underfund security intiatives wind up undermining a company’s ability to protect its information assets. The results can be catastrophic. IT leaders and CFOs need to understand the severity of the situation, specifically what the risks are and most importantly, how to present the business value of making the investment to upper management (CEO and board memebers). Here’s what’s to be done.

Justification

Upper management can easily come up with a hundred reasons not to properly fund security initiatives. And when they do fund they may not be investing wisely. Often the decision not to fund occurs when the executives lack adequate information to make an investment.

The best strategy is to consider Security as part of Risk Management. The strength of the argument on whether or not to fund rests on determining what the risk is to the organization, what losses can be incurred from the risk and how much it will cost to mitigate that risk. With this information upper management can decide whether it is worth the expenditure. What may shock the CFO is the degree of risk his company is facing. There is no need to exaggerate here. The risk most companies face is substantial enough to get the attention of the CFO.

Company executives will feel more comfortable investing in security when the business case and financial terms are solid and upper management is given choices of security strategies and investments to compare. Once funded, reporting strategies and regular statuses to upper management that are informative and clearly stated build credibility are necessary.

Identifying security problems

Fortunately the tools, such as intrusion detection systems and firewall logs, are readily available, and can determine where security problems already exist in your organization. These tools produce a mountain of data and can provide excellent supporting evidence for many security investment decisions.

The downside to using these tools to collect and assess network and system data is that they require a serious commitment in both time and effort. However, you will find the effort is well worth it as hard data makes the most compelling case for security investments.

Summary

Including in your deliverables a status report on how well things have gone is the last major step that upper management needs. Good communication is key. Measuring success or lack of it and making clear to management how success will be measured is important. A no nonsense semi-annual report is a great way to build credibility. Executives will then know which investments are paying off and which are not and should be cut back. This report is a great way to gain the respect of C level executives and their support for future projects.

Who we are

iSiegel Consulting is a technology firm made up of senior IT executives. We provide services to CFOs and upper management who have need for immediate solutions that improve performance, reduce spend and increase operational efficiency. We commonly work with CEOs, CFOs and Board of Directors of small to medium sized companies.

We principally focus on three technology challenges: Cyber Security; Budget/Project Management; and Compliance and Governance Design. Our teams of CIOS, CTOs and senior admins find solutions to the most demanding operational and organizational challenges facing organizations. More about us at http://isiegelconsult.com

Financial Transparency – A Case Study

The following is a composite case of several organizations, and any resemblance to an actual client is clearly coincidental.

Background:
A client suffered fraud, misappropriated funds, and confused financial concepts. This caused lots of frustration at the board level. The audit report took almost a year to complete, and the auditing firm pointed out a number of material weaknesses, which went years without being adequately addressed.

What was the problem? The accounting process was opaque, bookkeeping practices were cumbersome, information was not captured at a correct reportable level, internal controls were weak; executive management did not have appropriate skills, and most importantly, the board did not understand the way information was reported (too high-level with weak explanations). This resulted in serious cash flow problems.

Here is how the board/company addressed the problem:

Quality of staff – The board insisted that the accounting and executive staff be upgraded and reorganized, and that the new CEO be very close to the numbers.

Discipline – The board insisted on a standard financial reporting package. This consisted of a balance sheet, P&L, cash flow report, variance analyses of this year versus the prior year, accounts receivable and accounts payable aging reports, and other standard reports.

Restructuring the way information was reported – It is now reported in the way that the business is run. This meant a redo of the chart of accounts to re-organize the way information was reported and to capture certain information at a more detailed level.

Policies and procedures – They were developed in bullet point form; they were kept to a few pages and reviewed and approved by the board, and are now followed by senior management. For example, capital expenditures, which could be masked by leasing equipment in which the monthly payments are in relatively small amounts, could no longer fall under the radar.

Sense of openness:
The new CEO and the board encouraged openness in reporting and telling it like it is. Any spin was discouraged. Businesses were separately reported so one could see the contribution profit. A strategic plan preceded the budgeting process and the fist year of the plan became the budget.

Result:
The organization is on its way to meeting its goals with a renewed sense of excitement, and with a financial process that tells it like it is.
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Our firm is a team of senior financial executives. We provide a broad range of financial management services to public and private companies. We work for CEOs, CFOs, Controllers, as well as audit committees and boards.

Our mission is to apply our consultants’ considerable collective experience to resolve client issues in a professional and efficient manner.