Current expected credit loss-(CECL) was introduced by the Financial Accounting Standard board in 2016. CECL model changes the allowance recognition from incurred mode to expected loss model.
Let me give you an idea of the change with receivable allowances. Currently, allowance for receivables is estimated based on past trends and past performance of the receivable balances. However, CECL changes the approach now, and companies need to look for the allowance for receivables, not the past performance.
Let’s discuss challenges and their solution for the implementation of CECL.
Increased documentation
Now you need to maintain massive documentation related to financial balances. The reason is that you need to forecast the probability of default based on your relation and external environmental analysis with the party/borrower. Developing an expectation always requires having an in-depth understanding which is best met by comprehensive documentation.
Solution:
Adopt documenting strategy as an embedded culture within the organization.
Understanding economic variables
You need to assess the probability of default as an input to expected loss based on external environmental factors. That’s really hard to understand and estimated the economic environment. 2020 has been a great example as no one thought about the severity of the economic repercussions in such a way.
Solution:
Keep closing monitoring of the external environment, especially, in an industry you’ve broader exposure with.
Number of assumptions
When you think about CECL, things that come to your mind are assumptions and assumptions, yes, because things need to be assumed when it comes to financial figures in the future. The problem is the subjectivity of the layers from expecting probability to using the discounted rate in the calculation of the expected loss within the process.
Solution:
Follow quarterly and annual SEC filings for the companies that have early adopted the CECL. Special consideration should be placed on the management, forecast, risk analysis, and their method of the assumptive forecast.
Conclusive remarks for current expected credit loss
CECL presents a greater implementation challenge and requires heavy brainstorming along with interdepartmental coordination. For instance, the credit and risk department of the financial institution must be on the same page to adopt the expected loss calculation methodology. Further, Not only internal but external metrics need to be analyzed and observed to make certain assumptions. That subjectivity of the process can be controlled with professionalism and understating of the internal and external environment.
