CECL Blog Series – Part #5

This blog was authored by my colleagues, Nick Meyer and Travis Whiting, managers in our financial institutions practice in Minneapolis, Minnesota

Welcome back to the CLA CECL Blog Series. As a reminder, over the next several weeks, CLA will take a deep dive into many of the hot topics surrounding the Current Expected Credit Loss (CECL) standard. In this blog, we’ll discuss impaired loans and troubled debt restructurings. Don’t forget – on October 28, 2021, CLA will host a webinar designed to answer any remaining questions you may have. You can sign up here. Make sure you receive our invitations by signing up for CLA communications here. We hope you find great value in this blog series and welcome the interaction with any of the authors.

Impaired Loans
Does the concept of impaired loans exist under CECL?

No. The technical term for an “impaired loan” is going away under CECL.

Similar Risk Characteristics

An important concept to understand within ASC 326 is that it requires expected losses to be evaluated for financial assets with similar risk characteristics. If a financial asset ceases to share risk characteristics (see CLA’s previous blog post regarding risk characteristics) with other assets in its pool, it should be moved to a different segment with assets sharing similar risk characteristics or evaluated individually if such a segment doesn’t exist. Therefore, a loan could technically still be evaluated individually under CECL (similar to how the previous “impaired” methodology was deployed).

However, under CECL, institutions could determine that there are groups of what were previously impaired loans which could now be evaluated together if they have similar risk characteristics (for example substandard credits with similar risk characteristics such as collateral, risk rating or geography).

An example of one change this will have to the allowance for credit loss (ACL) calculation is you should no longer have substandard rated loans grouped with pass rated loans as they do not share similar risk characteristics. Under prior GAAP, if a loan was risk-rated substandard but not deemed “impaired”, then it could still be grouped in the same bucket as pass rated loans for which the historical loss rate and qualitative adjustments were applied. 

Are loans still individually evaluated under CECL?

Yes. Although the term “impaired loans” no longer exists under CECL, if the institution determines a financial asset does not share similar risk characteristics with other assets, then that asset should be evaluated individually. Individually evaluated assets should not be included in the collective assessment of expected credit losses (like previous U.S. GAAP under ASC 450). This individual evaluation can be done using the appropriate methods identified in ASC 326-20, such as the present value of expected future cash flows or the collateral method.

Present Value of Expected Future Cash flows

One option for individually evaluating a loan’s ACL is to calculate the present value of expected future cashflows. This would include documenting:

• The amount and timing of cash flows;
• The effective interest rate (EIR) used to discount the cash flows; and
• The basis for determination of cash flows, including consideration of past events, current conditions, and reasonable and supportable future forecasts. 

Collateral-Dependent Loans

ASC-326-20-35-5 states that regardless of the initial measurement method, an institution should measure expected credit losses based on the fair value of the collateral at the reporting date when the institution determines foreclosure is probable. The institution should adjust the fair value of the collateral for the estimated costs to sell if it intends to sell rather than operate the collateral. When an institution determines foreclosure is probable, they should remeasure the financial asset at fair value at the reporting date (less costs to sell, if applicable) so the reporting of a credit loss is not delayed until actual foreclosure. 

The guidance also includes a practical expedient which allows you to determine the ACL as of the reporting date by determining the fair value of collateral if the borrower is experiencing financial difficulty based on management’s assessment. This can be utilized when repayment is expected to be provided substantially through either the operation or sale of the collateral. If an institution uses the practical expedient on a collateral-dependent financial asset and repayment depends on the sale of collateral, the fair value should be adjusted for estimated costs to sell. However, you should not determine the net carrying value of the financial asset by utilizing costs to sell if repayment depends only on the operation rather than sale of, the collateral.

For collateral-dependent loans, the following factors should be considered in the measurement of impairment:

• Volatility of the fair value of collateral;
• Timing and reliability of the appraisal or other valuations;
• Timing of the institution’s or third party’s inspection of collateral; and
• Confidence in the institution’s lien position on the collateral
  

Troubled Debt Restructurings (TDRs)

Will Accounting for TDRs change under CECL?

Yes. The FASB has determined that credit losses on TDRs should be calculated under the same expected credit loss methodology applied to other assets carried at amortized cost (i.e. forward looking under CECL). This will be a change from the current guidance (ASC 310-10-35) which requires any impairment on TDR loans is calculated using specific methods applied to individually impaired loans (ex: discounted cashflow or fair value of collateral).

Further, the new accounting standard requires:

• The value of concessions made by the creditor be incorporated into the ACL estimate, and
• The pre-modification effective interest rate be used to measure credit losses if applying the discounted cashflow method

However, the guidance for determining whether a modification of terms on a financial asset is a TDR remains unchanged from today’s U.S. GAAP. The two main criteria to consider with a TDR include:

• The borrower is experiencing financial difficulty, and
• The creditor grants a concession (that would otherwise not be considered)

Side Note – FASB Discussions on TDRs

Please note there is potential for future changes and possibly even the elimination of the concept of TDRs.  The FASB has been having conversations, which included a meeting with stakeholders on July 14, 2021, regarding the relevance of TDRs as a measurement of troubled loans. Given that CECL is a forward-looking model, there is debate over whether TDR measurements really provide useful information anymore or if it would better be conveyed through other disclosures.

How can we help?

Regardless of where your institution is at on your CECL journey, CLA is prepared to assist your institution in any way we can. Throughout this blog series or at any time, contact us with your questions. We look forward to being a resource for your institution as you navigate the implementation process!