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Five Pitfalls to Avoid as Your Financial Institution Transitions to CECL

By: Ron Mitchell, CPA

How comfortable are you with the updated CECL standards? Many financial institutions are struggling to comply with new GAAP standards relating to the current expected credit losses methodology (CECL) for estimating credit losses. That is not surprising, given the nature and scope of the changes. Being aware of common problem areas and missteps can help your financial institution remain in full compliance and make the change successfully.

First announced in June of 2016, ASU 2016-13 only became effective for some smaller banks and credit unions for fiscal years beginning after December 15, 2022. Making the transition has proven challenging for many institutions despite the long rollout period. To avoid negative outcomes, financial institutions should take care to avoid these common pitfalls.

1. Do not think of CECL as being the same as the current FAS 5 methodology. 

There is no question about it, CECL is one of the biggest changes ever made to accounting standards that affect financial institutions. Calculating allowances for credit losses under the new rules is very different than performing the same task under the older allowance for loan and lease losses (ALLL) guidance. Financial Institutions that equate the two processes—or expect the same results—can easily run into trouble. Factor in time and leeway for a significant learning curve in addition to potential financial ramifications stemming from CECL compliance.

2. Do not confuse current historical loss rate methodology with CECL methodology.

Compliance with ASU 2016-13 demands more complex calculations that mark a significant change from previous accounting standards. Chief among those differences is a reduced dependence on historical loss rates under CECL. While historical loss information is relevant and must be included in the calculation of credit loss allowances, CECL takes a much more forward-looking approach than the previous standard and relies on historical loss information as just one of many factors that influence expected loss allowance estimates. 

3. Do not over-segment your loan portfolio.

ASU 2016-13 requires financial institutions to segment loan portfolios into pools with similar risk characteristics and specifies that pools be “as granular as possible while maintaining statistical significance.” Many institutions interpret this statement as a requirement to increase portfolio segmentation, but, be careful, excessive segmentation can quickly create loan pools that are too small to offer meaningful or reliable risk insights. For optimal results, segment using broad criteria such as call code or risk grades that already incorporate more granular metrics.

4. Do not overanalyze one facet of the CECL methodology.

The goal of the new standard on credit losses is improved reporting that meets the needs of multiple users of the data, including investors and shareholders who rely on the financial institutions’ financial statements to make decisions. With that in mind, it is important not to get overly hung up on individual aspects of the CECL process—in other words, don’t focus on how the sausage is made. Rather, focus on the big picture. The real question is whether the number you are calculating under the new CECL methodology represents a reasonable and realistic assessment of risk for your loan portfolio given current economic conditions. If it does, then you can move on with a clear conscience.

5. Don’t be alarmed if your data tells you something that may not feel intuitive. 

The new methodology can lead to surprising results, spurring second-guessing that ultimately leads to mistakes. If your calculations yield unintuitive answers or figures that seem out of line, don’t assume they are wrong. Just go back and review all your inputs to ensure they make sense and that each one reflects the appropriate data set. Also, check that your expectations and assumptions are consistent throughout the calculations. If all of your inputs and expectations are correct and aligned, then your results are probably correct—just perhaps not what you’d expected to see.  

We cannot overemphasize the magnitude of change that CECL represents for financial institutions. If you’re not finding the transition to the new standard somewhere between intense and excruciating, then your financial institution is in the lucky minority. Be sure to work with an experienced advisor who can support you throughout the process and feel free to reach out to the professionals at Mauldin & Jenkins with any of your questions about CECL compliance.