When it comes to applying the new current expected credit loss model (CECL) under U.S. GAAP, it can seem as if there are questions to answer at every turn. Off-balance sheet commitments, especially credit cards, can be a source of these conundrums. Credit cards have many unique aspects when compared to other, more traditional financing arrangements, like a mortgage or commercial term loan. Unfortunately, these unique qualities add to the already complex nature of the CECL model prescribed by ASC 326, Financial Instruments – Credit Losses. In this post we will provide you with some additional questions to consider when estimating the expected credit losses on off-balance sheet items, but first, let’s start with a quick overview of the basics!
CECL and Off-Balance Sheet Credit Exposures
The CECL model requires entities to estimate the net amount of the asset the entity expects to receive over the lifetime of the asset. Credit cards are an example of an off-balance sheet credit exposure. While the credit card has a limit (the maximum amount the institution will lend to the borrower), the card may not be fully drawn at the end of a period, for example at the end of the month. The amount drawn by the customer is the outstanding balance, which is a loan to the borrower (comprised of principal and interest portions). The difference between the credit limit and the outstanding balance is the off-balance sheet credit exposure. That difference is a commitment to lend the borrower money and is legally binding, therefore exposing the entity to credit loss. U.S. GAAP requires entities to estimate credit losses over the contractual period in which the entity is exposed to credit risk via a present contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the issuer. The entity records the liability for credit losses as an “other liability” on the balance sheet (i.e. NOT the “allowance for expected credit losses” as is the case for funded loans), with the offsetting entry to net income as a credit loss expense.
Although it may be complicated to say, the concept is pretty simple to understand. Regulatory capital rules define this concept as commitments that an organization, at any time, with or without cause, may cancel or prohibit additional extensions of credit. Many credit cards and home equity lines have these conditions written in the agreements signed between the lending organization and the borrower. For extensions of credit that are unconditionally cancellable, the entity is required to estimate the amount of credit losses on the outstanding balance only, not the full commitment amount.
Credit Card Specific Considerations
Take a few moments to reflect and answer the following questions about your credit card habits…
- Does your outstanding balance increase significantly some months during the year, or is the amount on your monthly statement consistent?
- Unlike your 15-year or 30-year mortgage, credit cards frequently don’t come with a term. How long have your credit card accounts been open? A few months, years, longer?
- How much did you pay on your credit card bill last month? Are you someone who pays the balance in full each period, or someone who makes minimum or partial payments with a balance that rolls-over to the next month’s bill?
While I’ve only listed a few questions, I’m sure you know someone whose answers would be opposite of yours for some or all of the questions above. Why do these questions matter when we are talking about estimating credit losses on credit cards? Well, they each add to the complexity of applying the CECL model. Let’s discuss in some additional detail.
Life of Loan and Payment Applications
ASC 326, Financial Instruments – Credit Losses, requires entities to estimate expected credit losses over the contractual term of the financial asset. Did you notice the problem in that statement? Credit cards usually don’t have a term. So how does an entity estimate the life?
When estimating the remaining life of a term loan, a historical analysis of prior amounts collected and the timing of prior payments is used to make an estimate. This evaluation becomes significantly more complex on a credit card with a revolving balance, as there is new borrowing activity added to the prior period’s balance that was not paid-in-full, combined with potential paydown activity also occurring at the same time. When determining the life of this revolving loan, should you estimate it based on the time it will take for the outstanding balance at the end of the period to be paid down (using historical payment activity in your estimate) or should you consider the anticipated additional borrowing activity coupled with the paydown activity? Now this is getting even more complicated!
The FASB has responded to these concerns with two options for entities to select from when determining payment amounts, for the purposes of estimating the life of a credit card receivable:
- Include either all of the expected future payments
- Include a portion of expected future payments
This decision effectively allows any combination of payment allocation methods to be applied; however, the methodology chosen will need to be consistently applied by entities. Entities will need to perform an analysis to determine which method works for their organization (including compliance with any applicable laws and regulations – e.g. The CARD Act) and apply the selected method consistently.
The guidance requires entities to measure expected credit losses of financial assets on a collective basis when similar risk characteristics are present. Similar risk characteristics could include loan type, underlying collateral, credit scores, or delinquency status. While credit cards may have some of the risk characteristics that an entity may also use when analyzing term loans, two new vocabulary words have been brought to the conversation when discussing the segmentation of a credit card portfolio: “transactor” and “revolver”. These words describe a borrower, based on the payments made by the borrower. A “transactor” is a borrower that pays the balance in full each period, while a “revolver,” makes either a minimum or partial payment and has a balance that rolls-over to the next period. Entities may be able to support a correlation between borrower type and historical credit losses experienced in their portfolios. Entities will want to consider these characteristics when segmenting their portfolio to form their estimate of expected credit losses.
The CECL model requires the consideration of past events, current conditions, and reasonable and supportable forecasts of the future when developing an estimate of expected credit losses. Entities consider qualitative factors that relate to the environment in which the entity operates to adjust their historical data. Examples of qualitative factors often used for term loans include credit score, delinquency status, and conditions of the entity’s external environment (e.g., regulatory, economic and legal). While the examples above could be applied to a credit card portfolio, these instruments have additional unique qualities.
- Transactors versus revolvers credit risk – Is an individual that makes the minimum payment or partial payments indicative of additional risk of loss to the entity?
- Payment timing changes due to seasonality – Do some categories of customers switch from being a transactor to a revolver around the holidays, then after a period of time, switch back to paying in full each month?
- Customer longevity – Are longstanding customers less risky than new customers?
Applying the CECL model is no easy feat, but hopefully we’ve highlighted some considerations when working to solve your CECL credit card conundrums! Trying to navigate the labyrinth of CECL? We can help! GAAP Dynamics offers courses on the CECL model as well as IFRS 9 across a variety of delivery methods.
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