Methods to Estimate Current Expected Credit Losses
Methods to Estimate Current Expected Credit Losses

Methods to Estimate Current Expected Credit Losses

The FASB introduced the current expected credit loss (CECL) model with the issuance of ASC 326, which requires financial instruments carried at amortized cost to reflect the net amount expected to be collected. This is achieved via an allowance for credit losses, a valuation account that is deduced from the amortized cost basis of the financial asset to present the net amount expected to be collected on the financial asset(s).

ASC 326 does not prescribe a method that must be used to estimate current expected credit losses. Rather, it provides guiding principles or core concepts on what should be considered when developing an estimate. For a comprehensive overview of the CECL model, check out our eLearning course, Credit Losses: Introduction to the CECL Model.

The FASB’s intention was to provide flexibility for calculating the estimate noting that the complexity and sophistication of the CECL analysis should be consistent with the complexity and sophistication of the entity and its portfolio of assets. While various methods are permitted, there were 5 loss estimate methodologies mentioned in ASC 326 – discounted cash flow method, loss-rate method, roll-rate method, probability of default method, or methods that utilize an aging schedule.

The remainder of this blog post will provide an overview of these methods.

CECL

Discounted Cash Flow Methodology

A discounted cash flow analysis is based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The allowance for credit losses is the difference between the amortized cost basis and the present value of the expected cash flows.

Loss-Rate Methodology

Under a loss rate approach, loss rate statistics are developed on the basis of the historical rate of loss of the financial assets. When computing its loss rates, an entity should segment its portfolio into appropriate groupings or sub-portfolios based on shared credit risk characteristics. These historical credit loss trends should then be adjusted for current conditions and expectations about the future. Credit losses are calculated using the estimated loss rate and multiplying it by the amortized cost of the asset at the balance sheet date.

Roll-Rate Methodology

The roll-rate method is often referred to as “migration analysis”. Roll rates are determined by predicting credit losses by segmentation (for example, by delinquency or risk rating) of a portfolio of financial assets. An assessment of the roll rate is made (the percentage of balances of the number of accounts which move from one delinquency stage to the next). Once a roll rate is determined for each segment, it is applied to the balance in each category to estimate the amount that will migrate to the next category. The total migrations across all categories are aggregated to determine the estimate of credit losses.

Probability of Default Methodology

Under the probability of default approach, expected credit losses are measured by multiplying the exposure at default by the probability of default by the loss given default. Exposure at default is the total value exposed to when a loan defaults. The probability of default is the likelihood that someone will default or not pay on time over a given time horizon. The loss given default is the loss that will be incurred if there is a default. A discount factor is applied to discount the future to today.

CECL

Aging Schedule Methodology

An aging schedule methodology is commonly used to estimate the allowance for bad debts on trade accounts receivable. Under this method, a historical credit loss rate is determined by age bucket or how long a receivable has been outstanding (e.g. 1-30 days past due, 31-60 days past due, etc.). The historical loss rates for each respective age bucket are then adjusted for current conditions using reasonable and supportable forecasts. Based on the aging categorization and the adjusted loss rate per category, an allowance for credit losses is calculated by multiplying the adjusted loss rate with the amortized cost in the respective age category.

Remember, ASC 326 is not prescriptive on a specific methodology and there are others to consider when determining the appropriate method that is relevant to the circumstances. It is important to know that the methodology chosen should be applied consistently and should faithfully represent the estimate of expected credit losses in accordance with the principles of ASC 326.

ASC 326 became effective for most SEC filers in fiscal years and interim periods beginning after December 15, 2019. The FASB delayed the effective date for all other non-SEC filer public business entities and for private entities to January 2023. While 2023 may seem far off into the future, there is no better time for education and preparation than now. A good place to start is our Impairment of Financial Instrument’s Topic Page where you will find a compilation of accounting issues, references, and links to various content on impairment, including our training courses. You will also find links to external thought leadership provided by the FASB, IASB, and Big 4 accounting firms.

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