How Accounting for Purchased Loans Changed With the Adoption of CECL

Changes Introduced by CECL

CECL represents a seismic shift in the way banks report credit losses, and it largely came about due to the Great Recession in 2007 and 2008, when subprime mortgages halted huge gains made in the housing market. What’s different now versus then is the technology and software used to assess potential credit losses. 

These are the major changes that CECL introduced for purchased loans:

1. Expected Credit Losses Recognition

Under the previous incurred loss model, banks recognized credit losses only when it was probable that a loss had been incurred.

With CECL, banks must now estimate and recognize expected credit losses at the time of loan purchase, reflecting all reasonable and supportable information, including historical experience, current conditions, and forecasts of future economic conditions.

2. Purchased With Credit Deterioration (PCD)

CECL introduces the concept of purchased credit deteriorated (PCD) loans. These are loans that, at the time of purchase, have experienced a significant deterioration in credit quality.

Banks must recognize the allowance for expected credit losses as part of the initial amortized cost basis of PFD loans. This means the purchase price plus the expected credit loss allowance is considered the initial amount of the loan on the balance sheet.

3. Day-One Loss Recognition

Under CECL, banks must establish an allowance for expected credit losses on the purchase date of a loan, which affects the day-one profit or loss. This contrasts with the previous model, where losses were recognized later as they became probable.

This immediate recognition of credit losses can impact the bank’s earnings at the time of purchase, making it crucial for banks to accurately estimate and manage these expectations.

4. Continuous Re-Evaluation

CECL requires continuous re-evaluation of the allowance for credit losses over the life of the loan. Banks must update their loss estimates regularly based on changes in economic conditions, borrower behavior, and other relevant factors.

Any adjustments to the allowance for expected credit losses are recognized in the income statement, ensuring that the financial statements reflect the current estimate of potential losses.

Initial Measurement & Recognition

Your community bank must begin measuring expected credit loss from PCDs from the moment you purchase this type of loan. Remember, these standards may change over time.

1. Identify the Loan Type

• PCD loans are loans that, at the time of purchase, have experienced a significant deterioration in credit quality since their origination.
• Non-PCD loans are loans that have not experienced significant credit deterioration.

Again, these standards may change in the coming years as FASB could change the rules to include all purchased financial assets (PFAs) and not just PCDs.

2. Determine Purchase Price and Fair Value

Account for the purchase price of the loan. When estimating the market value of the loan at the time of purchase, consider factors such as interest rates, credit risk, and market conditions.

3. Estimate Expected Credit Losses (ECL)

Use a reasonable and supportable forecast to estimate expected credit losses over the life of the loan. This involves analyzing historical data, current conditions, and future economic scenarios.

Various models can be used, such as discounted cash flow analysis, loss rate models, or probability-of-default models. With advanced computer software and the right controls, you can analyze the data on a regular basis.

4. Initial Recognition and Measurement for PCD Loans

PCD Loans With a Gross-Up Approach

The initial amortized cost basis of the PCD loan is the purchase price plus the allowance for expected credit losses (ECL). Establish an allowance for credit losses at the time of purchase, which reflects the expected credit losses over the life of the loan.

Journal Entries

• Debit: Loan (Amortized Cost Basis)
• Credit: Cash (Purchase Price)
• Credit: Allowance for Credit Losses (ECL)

Hypothetical Example

• Purchase Price: $90,000
• Fair Value: $90,000
• Expected Credit Losses: $10,000
• Amortized Cost Basis: $100,000 ($90,000 Purchase Price + $10,000 ECL)
• Journal Entry:

• Debit: Loan (Amortized Cost Basis) $100,000
• Credit: Cash $90,000
• Credit: Allowance for Credit Losses $10,000

Non-PCD Loans

Recognize the loan at its purchase price (fair value at the purchase date). Establish an allowance for expected credit losses based on the ECL estimate.

Journal Entries

• Debit: Loan (Purchase Price)
• Credit: Cash (Purchase Price)
• Debit: Provision for Credit Losses
• Credit: Allowance for Credit Losses

Hypothetical Example

• Purchase Price: $90,000
• Fair Value: $90,000
• Expected Credit Losses: $5,000
• Journal Entry:
  • Debit: Loan $90,000
  • Credit: Cash $90,000
  • Debit: Provision for Credit Losses $5,000
  • Credit: Allowance for Credit Losses $5,000

Estimation of Expected Credit Losses

Estimating expected credit losses (ECL) on a purchased loan involves a forward-looking approach that considers a variety of factors and data sources. The more data you gather, the more accurate your ECL numbers are.

1. Gather Relevant Historical & Current Data

Collect historical data on the performance of similar loans, including default rates, loss severity, and recovery rates. Historical economic indicators such as GDP growth, unemployment rates, and interest rates can also be used to determine any expected credit loss.

Assess the current credit quality of the borrower, including credit scores, income levels, and debt-to-income ratios. Evaluate the terms of the loan, including interest rates, collateral, and maturity dates. Consider the current state of the economy and its impact on loan performance.

2. Develop Forecasts

Create forecasts of future economic conditions using reputable sources such as government economic reports and third-party economic models. Develop multiple economic scenarios (e.g., base case, adverse case, and optimistic case) to capture a range of potential future conditions.

3. Select an ECL Estimation Method

We recommend using one of three accepted ECL estimation methods to calculate an expected credit loss.

Discounted Cash Flow (DCF) Method

Estimate future cash flows from the loan, considering expected payments, prepayments, and default probabilities. Use the loan’s effective interest rate to discount future cash flows to their present value.

Loss Rate Method

Apply historical loss rates to the loan balance, adjusted for current conditions and forecasts. Segment the loan portfolio by risk characteristics (e.g., loan type, borrower credit quality) and apply loss rates specific to each segment.

Probability of Default (PD) and Loss Given Default (LGD) Method

The basic ECL formula is this:

ECL = PD × LGD × EAD

• Probability of default (PD) means you estimate the likelihood that the borrower will default on the loan over its lifetime.
• Loss given default (LGD) estimates the percentage of the loan balance that would be lost in the event of default.
• Exposure at default (EAD) allows you to estimate the expected loan balance at the time of default.

4. Calculate Expected Credit Losses

The most accurate ECL is the sum of the expected losses across all segments and scenarios, weighted by their respective probabilities.

Adjustments can be made based on qualitative factors, such as changes in lending practices, economic policy shifts, or industry-specific risks. Incorporate management’s judgment to adjust model outputs based on their experience and insights. For example, is the customer a long-standing one with a history of paying loans on time?

5. Validate and Back-Test Models

Conduct internal reviews and validations of the ECL models to ensure accuracy and reliability. If you need an objective assessment, engage third-party experts to validate the models your community bank uses.

Back-test the model by comparing the model’s predictions with actual loan performance to identify and address any discrepancies. This allows you to continuously refine and update models based on back-testing results and changing conditions, giving you more data points to rely on.

6. Document and Report

Document the methodology used for estimating ECL, including data sources, assumptions, and rationale for chosen models. Clearly document all assumptions and management judgments applied in the estimation process.

Provide detailed disclosures in financial statements about the ECL estimation process, including key assumptions, methodologies, and sensitivity analyses. Ensure that all reporting complies with relevant regulatory requirements and standards.

7. Continuous Monitoring and Adjustment

Continuously monitor economic conditions, borrower performance, and loan characteristics to identify changes that may impact ECL estimates. Regularly update models and assumptions to reflect new information and evolving risks.

Another thing to watch for is updated standards from FASB. As technology rapidly evolves to monitor credit losses, FASB may employ newer standards in the coming years.

Accounting for Different Types of Loans

Community banks must estimate and recognize expected credit losses for different types of loans throughout their entire life cycle. The CECL standard applies to all loans, whether they are originated, purchased, held for investment, or held for sale. Here’s how a community bank can account for different types of loans under the CECL standard. 

1. Originated Loans

At the time of origination, estimate and recognize the expected credit losses over the life of the loan.

Journal Entry Example

• Debit: Loan Receivable (Principal Amount)
• Credit: Cash (Principal Amount)
• Debit: Provision for Credit Losses (Expected Credit Losses)
• Credit: Allowance for Credit Losses (Expected Credit Losses)

2. Purchased Loans

Purchased Credit Deteriorated (PCD) Loans

Recognize the purchase price plus an allowance for expected credit losses. The allowance is added to the purchase price to determine the amortized cost basis of the loan.

Journal Entry Example

• Debit: Loan Receivable (Purchase Price + Expected Credit Losses)
• Credit: Cash (Purchase Price)
• Credit: Allowance for Credit Losses (Expected Credit Losses)

Non-PCD Loans

Recognize the loan at its purchase price. Establish an allowance for expected credit losses based on an estimate of credit losses over the life of the loan.

Journal Entry Example

• Debit: Loan Receivable (Purchase Price)
• Credit: Cash (Purchase Price)
• Debit: Provision for Credit Losses (Expected Credit Losses)
• Credit: Allowance for Credit Losses (Expected Credit Losses)

3. Held-for-Investment Loans

Recognize an allowance for expected credit losses at the time the loan is classified as held for investment.

Journal Entry Example

• Debit: Loan Receivable (Principal Amount)
• Credit: Cash (Principal Amount)
• Debit: Provision for Credit Losses (Expected Credit Losses)
• Credit: Allowance for Credit Losses (Expected Credit Losses)

4. Loan Commitments and Lines of Credit

Estimate expected credit losses for undrawn commitments and lines of credit. Recognize a liability for the expected credit losses.

Journal Entry Example

• Debit: Provision for Credit Losses (Expected Credit Losses)
• Credit: Liability for Credit Losses (Expected Credit Losses)

5. Loan Modifications, Formerly Troubled Debt Restructurings (TDRs)

The CECL standard eliminated the concept of a TDR and removes the requirement to individual evaluate TDRs for impairment as CECL is already calculating lifetime losses for all loans in the portfolio. However, the standard did not eliminate the requirement for institutions to disclose information about loan modifications where the borrower is experiencing financial difficulty. Institutions should establish appropriate internal controls to identify loan modifications to borrowers experiencing financial difficulty to ensure these loans are appropriately disclosed on their call reports and financial statements.

Subsequent Measurement & Reporting Under CECL

The CECL model requires community banks to regularly update their estimates of expected credit losses for all financial assets. This involves a continuous and systematic process to ensure accuracy and compliance.

Regular Updates

Conduct quarterly reviews of all loan portfolios to reassess and update ECL estimates. This includes analyzing historical data, current credit conditions, and reasonable forecasts of future economic conditions. It’s vital to integrate updated economic indicators, borrower financial health, and changes in the bank’s lending practices into the ECL models.

Monitoring and Adjustments

Continuously monitor loan performance and credit quality, adjusting ECL estimates as necessary to reflect changes in the risk profile of the portfolio. Regularly validate and, if necessary, recalibrate ECL models to ensure they remain accurate and reflective of current conditions. We recommend recalibrating once per quarter, as financial reporting happens every three months.

Reporting

Provide clear and comprehensive disclosures in financial statements detailing the methodologies, assumptions, and changes in ECL estimates. This includes a breakdown of ECL by loan type and a discussion of key drivers behind any significant changes. This is both for regulatory requirements and so the board can make decisions based on the reporting.

Common Challenges Faced by Community Banks

The Whitlock Co. sees three common challenges that community banks face when implementing CECL. 

Complexity

The complexity of CECL requires sophisticated modeling and significant data analysis from a historical and forecasting perspective. This generally requires an investment in robust analytics software to assess internal data points. Your community bank also needs to monitor external factors that could weigh on the loans you purchase.

Earlier Reporting of Losses

One of the benefits of CECL is that it encourages banks to make better decisions on the loans they purchase. However, it can introduce earnings volatility due to frequent updates in loss estimates. The paradox is that taking fewer risks could slow and hamper the growth of your community bank, which might make the board of directors shift priorities. Your institution must learn to balance risk and reward versus short-term and long-term gains with CECL.

Changing Standards

As we noted, FASB continues to update its standards regarding CECL. For now, CECL is focused on loans with an expected loss. In the future, it may incorporate CECL accounting for all purchased financial assets, whether they have deteriorated or not.

Best Practices for Effective CECL Implementation

Implementing these standards requires a structured and disciplined approach. Your community bank must satisfy bank examiners every 12 to 18 months, and your reporting must be accurate for your board of directors.

1. Establish a Cross-Functional Implementation Team

Form a team that includes members from credit risk, finance, IT, internal audit, and compliance to ensure all aspects of CECL implementation are covered. Define the roles and responsibilities of each team member to facilitate coordinated efforts and accountability.

2. Conduct a Comprehensive Gap Analysis

Assess current credit loss estimation practices against CECL requirements to identify gaps. Develop a detailed action plan to address identified gaps, including timelines and resource allocation for staff and technology.

3. Invest in Robust Data Infrastructure

All data points, including historical data, current credit information, and forward-looking data, should be accurate, complete, and readily accessible. Implement systems that integrate data from various sources for comprehensive analysis and modeling. This should include a customer data platform (CDP) that aggregates and collects data from multiple sources. The data infrastructure forms the foundation of your ECL models.

4. Implement Strong Governance and Controls

Establish a robust policy framework that outlines CECL methodologies, assumptions, and governance processes. Maintain thorough documentation of all processes, methodologies, and changes to ensure transparency and facilitate audits.

5. Comprehensive Training and Communication

Provide comprehensive training to all relevant staff on CECL standards, methodologies, and their roles in the implementation process. This includes how to use data analytics software.

Maintain clear and ongoing communication with all stakeholders, including senior management and the board, to keep them informed of progress and key findings.

6. Transparent Financial Reporting and Disclosures

Provide clear and detailed disclosures in financial statements about CECL methodologies, assumptions, and the impact on financial results. Ensure all reporting and disclosures comply with regulatory requirements and guidelines.

7. Strong Internal Audit and Review Processes

Regular internal audits should be conducted to assess the effectiveness of CECL implementation and identify areas for improvement. Engage external auditors or consultants for independent reviews to ensure compliance and enhance credibility.

Consult With The Whitlock Co. for Independent CECL Reviews

The community bank experts at The Whitlock Co. can help your organization with independent, objective, third-party reviews of your CECL calculation. As CECL standards may be updated in the coming years, it’s important to partner with a firm that can help you manage changes.

Contact The Whitlock Co. to request a consultation today.