CECL

Definition

CECL, or Current Expected Credit Loss, is an accounting standard that requires financial institutions to estimate and recognize expected credit losses over the life of a financial asset at the time of origination. This proactive approach shifts the focus from incurred losses to expected losses, enhancing the transparency and timeliness of credit loss recognition in financial reporting.

5 Must Know Facts For Your Next Test

1. CECL was introduced by the Financial Accounting Standards Board (FASB) in 2016 and is effective for public companies starting in 2020.
2. Under CECL, institutions must use historical data, current conditions, and reasonable forecasts to estimate future credit losses.
3. The standard aims to enhance the consistency of credit loss accounting across different financial institutions and improve comparability for investors.
4. CECL impacts various financial assets, including loans, trade receivables, and debt securities held at amortized cost.
5. The implementation of CECL may lead to increased volatility in financial statements due to more frequent recognition of expected losses.

Review Questions

• How does CECL differ from the incurred loss model in terms of credit loss recognition?
  • CECL differs from the incurred loss model by requiring financial institutions to recognize expected credit losses at the time of loan origination rather than waiting for a triggering event. This means that under CECL, banks must estimate future credit losses based on historical data, current conditions, and reasonable forecasts, leading to a more proactive approach in assessing credit risk. In contrast, the incurred loss model only recognized losses once they were considered probable, often resulting in delayed recognition of actual financial difficulties.
• Discuss the potential impact of CECL on a bank's financial reporting and capital requirements.
  • The implementation of CECL can significantly affect a bank's financial reporting by leading to earlier recognition of credit losses and potentially increasing the allowance for credit losses on balance sheets. This change can influence key financial ratios such as return on assets and equity, as well as capital adequacy ratios. Banks may need to hold more capital to cover these anticipated losses, which can impact their ability to lend and pursue growth opportunities, ultimately affecting their profitability and risk management strategies.
• Evaluate how CECL might influence lending practices and overall market behavior among financial institutions.
  • CECL has the potential to influence lending practices by prompting banks to adopt more conservative approaches to credit underwriting and risk assessment. Since lenders are required to account for expected losses upfront, they may become more cautious in extending credit, particularly to higher-risk borrowers. This shift could lead to tighter lending standards and a reduction in available credit in certain market segments. Additionally, the heightened focus on risk management may drive financial institutions to invest in advanced analytics and forecasting tools, shaping how they evaluate creditworthiness and manage their portfolios moving forward.

Related terms

Allowance for Credit Losses: A reserve set aside by financial institutions to cover potential losses from defaulted loans or credit exposures.

Incurred Loss Model: A method previously used to recognize credit losses, where losses were recorded only when they were deemed probable based on specific triggering events.

Financial Instruments: Contracts that represent an asset to one party and a liability to another, which include loans, securities, and derivatives.