Pub 1 2021 Issue 4

August 2021 | 23 that one reserves for credit losses that are expected over the remaining life. Below are common myths related to CECL followed by reality-based responses. Quantitative & Qualitative Factors Within Your CECL Estimate Myth: Quantitative information is required to support qualitative assumptions, such as current condition adjustments and forecast estimates. Reality: Topic 326 does not require quantitative assessments to support current condition adjustments or forecast adjustments, which are qualitative assumptions, much like qualitative loss factors today. Topic 326 requires estimating expected credit losses over the contractual term of loans adjusted for prepayments. Historical credit loss experience of loans with similar risk characteristics, i.e., loan pools, generally provides a basis for an entity’s assessment of expected credit losses. An entity shall consider adjustments to historical loss information to reflect changes in current conditions and reasonable and supportable forecasts. These adjustments may be qualitative in nature. In plain English, the CECL gods are saying that one starts with historical loss information and adjusts for factors today and factors in the future. These factors are called the “current condition adjustment” and “forecasted loss adjustments.” Nowhere within Topic 326 does it state current condition and forecast adjustments need to be quantitatively derived from complex statistical models, such as regression, that predict future losses based on historic relationships of loss to changes in economic indicators such as unemployment, commodity prices, interest rate movement, etc. There is no prescriptive method outlined in Topic 326 related to current condition forecast adjustments. The development of these critical assumptions can be performed in a variety of ways, including top- level qualitative adjustments. With that being said, documentation of how qualitative assumptions were chosen, derived, and consistently applied is critical to a successful adoption. Peer Loss Information & the Historical LossWindow Myth: The use of peer losses is required when developing historical loss analyses. Reality: Topic 326 states historical loss information can be sourced from internal, external, or a combination of both when developing historical loss analyses. Nowhere in the topic does it state that external information, i.e., peer loss data, is required. Myth: An institution needs many years of historical loss information to adequately estimate future credit losses. Reality: Topic 326 does not state historical loss information is required for a full economic cycle, or many years. Instead, it only states that management may use a historical period that represents management’s expectations for future credit losses. If management believes losses from 2010 are not representative of losses in 2024, that information should not be used. However, there may be benefit in using a long-term historical loss average to supplement periods outside of a bank’s forecast period, which is typically one to two years. Having more loss information at your disposal helps support reserves without heavy reliance on qualitative loss factors. Software Applications Myth: Financial institutions should purchase software that will assist in estimating credit losses in order to comply with the standard. Reality: The CECL standard does not require the use of software when developing the estimate of credit losses. It does not require specific approaches when developing the estimate of expected credit losses. Instead, it explicitly states adopters should use judgment to develop estimation techniques that are applied consistently over time and should faithfully estimate the collectability of loans. Admittedly, a little direction would be nice. While many early adopters found software beneficial, specifically through process automation, the standard does not require its use. Myth: If my financial institution purchases software to assist in the CECL calculation, management can simply reply on its outputs. Reality: This myth has been a challenge to overcome. While software applications can be powerful, helpful tools, management must be able to document their understanding of conceptual design and assess the reasonableness and appropriateness of assumptions and the resulting allowance estimate. A software application in and of itself cannot tackle the CECL standard given its subjectivity. Continued on page 24 Initially, I read the CECL standard issued by FASB because I am a glutton for punishment. Recently, I re-read the standard because confusion abounds within the industry as to what is required versus what has been projected from software providers, accounting nerds, and the largest and most complex financial institutions throughout the country.